On April 18, 2018, the Securities and Exchange Commission (“SEC”) proposed a new rule (the “Proposed Rule” or “Regulation Best Interest”)[1] under the Securities Exchange Act of 1934 (“Exchange Act”) establishing a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer (together referred to as a “broker-dealer”)[2] when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.[3] The core principle of Regulation Best Interest is the requirement of a broker-dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, to act in the best interest of the retail customer at the time the recommendation is made without placing the financial or other interest of the broker-dealer ahead of the interest of the retail customer.
Obligations Under Regulation Best Interest
The Proposed Rule provides that the required best interest obligation is satisfied if:
- The broker-dealer, prior to or at the time of the recommendation, reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer and all material conflicts of interest that are associated with the recommendation (the “Disclosure Obligation”).
- The broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence to: (A) understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (B) have a reasonable basis to believe that the recommendation is in the best interest of the particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and (C) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile (the “Care Obligation”).
- The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed (A) to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations; and (B) to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations (together, the “Conflict of Interest Obligations”). [4]
Regulatory Reference Points of Regulation Best Interest.
In a 2011 study mandated by the Dodd-Frank Act, the SEC staff recommended the adoption of a uniform fiduciary standard for broker-dealers and investment advisers. In 2013, the SEC’s Investor Advisory Committee similarly adopted a recommendation on implementation of a uniform fiduciary standard. Further, in 2016, the Department of Labor adopted a new and expanded definition of “fiduciary” that treats persons who provide investment advice or recommendations for compensation with respect to assets of an ERISA plan or IRA as fiduciaries in a wider array of advice relationships than under the previous regulation (“DOL Fiduciary Rule”).[5]
While the SEC took account of these recommendations and rule proposals, Regulation Best Interest as proposed does not impose a fiduciary standard on broker-dealers across the range of a broker-dealer’s activities and relationship with clients. Rather, Regulation Best Interest builds on the established broker-dealer regulatory requirements imposed by the Exchange Act and FINRA rules.[6] Further, and significantly, although Regulation Best Interest does not impose a fiduciary duty on broker-dealers across the range of their activities and relationships with clients, the Proposed Rule does impose a fiduciary duty in the circumstance of a broker-dealer making a securities or investment strategy recommendation to its client.
“Under Regulation Best Interest, as proposed, a broker-dealer’s duty to exercise reasonable diligence, care, skill and prudence is designed to be similar to the standard of conduct that has been imposed on broker-dealers found to be acting in a fiduciary capacity. See, e.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1215 (8th Cir. 1990) (the district court did not abuse its discretion in instructing the jury that licensed securities brokers were fiduciaries that owed their customers a duty of utmost good faith, integrity and loyalty); see also Paine, Webber, Jackson & Curtis, Inc. v. Adams, 718 P.2d 508, 515-16 (Colo. 1986) (evidence “that a customer has placed trust and confidence in the broker” by giving practical control of account can be ‘indicative of the existence of a fiduciary relationship’); SEC v. Ridenour, 913 F.2d. 515 (8th Cir. 1990) (bond dealer owed fiduciary duty to customers with whom he had established a relationship of trust and confidence).” (Proposing Release, footnote 222, page 134.)[7]
The SEC expressed concern in the Proposing Release that the imposition on broker-dealers of a fiduciary standard on par with that applicable to investor advisers could have the untoward effect of reducing options for financial advice available to retail customers in the market place.
“At the same time, we are sensitive to the potential risk that any additional regulatory burdens may cause investors to lose choice and access to products, services, service providers, and payment options. In particular, we sought to preserve the ability of investors to pay for advice in the form of brokerage commissions. Various commenters asserted that the commission-based model may be more appropriate for many investors, and we believe that such investors may prefer a commission-based brokerage relationship over a fee-based account. We also share concerns raised by commenters about retail customers losing access to advice they receive through recommendations from broker-dealers, or if advice from broker-dealers is effectively eliminated, particularly as not all such customers have the option to move to fee-based accounts.” (Proposing Release at pages 38-39).
An important objective of Regulation Best Interest is to preserve retail customer choice as to the levels and types of advice and products provided by investment advisers and broker-dealers, including the traditional “pay as you go” model for advice from broker-dealers.[8]
Essential Attributes of Regulation Best Interest:
Disclosure and Conflicts of Interest Obligations
- Focus on Conflicts Arising from Financial Incentives. Regulation Best Interest specifically addresses conflicts arising from financial incentives—including conflicts associated with broker-dealer compensation incentives, the sale of proprietary products, and effecting transactions in a principal capacity. The Proposed Rule is clear that disclosure alone is insufficient to deal with these types of conflicts. Regulation Best Interest requires the broker-dealer entity to establish, maintain, and enforce written policies and procedures reasonably designed to identify, and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.
- Types of Financial Incentive Conflicts. The SEC provides guidance on the types of material conflicts of interest which can arise from “financial incentives” associated with a recommendation: (1) compensation practices established by the broker-dealer, including fees and other charges for the services provided and products sold; (2) employee compensation or employment incentives (e.g., quotas, bonuses, sales contests, special awards, differential or variable compensation, incentives tied to appraisals or performance reviews); (3) compensation practices involving third-parties, including both sales compensation and compensation that does not result from sales activity, such as compensation for services provided to third-parties (e.g., sub-accounting or administrative services provided to a mutual fund); (4) receipt of commissions or sales charges, or other fees or financial incentives, or differential or variable compensation, whether paid by the retail customer or a third-party; (5) sales of proprietary products or services, or products of affiliates; and (6) transactions that would be effected by the broker-dealer (or an affiliate thereof) in a principal capacity.
- SEC Guidance of Financial Incentive Mitigation Policies. Regulation Best Interest does not mandate specific measures designed to mitigate conflicts arising from financial incentives, although the SEC furnishes recommendations on appropriate mitigation policies (Proposing Release, pages 181-183):
“For example, broker-dealers generally should consider incorporating the following non-exhaustive list of potential practices as relevant into their policies and procedures to promote compliance with [the financial incentive mitigation aspect] of proposed Regulation Best Interest:
* avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;
* minimizing compensation incentives for employees to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis – for example, establishing differential compensation criteria based on neutral factors (e.g., the time and complexity of the work involved);
* eliminating compensation incentives within comparable product lines (e.g., one mutual fund over a comparable fund) by, for example, capping the credit that a registered representative may receive across comparable mutual funds or other comparable products across providers;
* implementing supervisory procedures to monitor recommendations that are: near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products or transactions in a principal capacity; or, involve the rollover or transfer of assets from one type of account to another (such as recommendations to rollover or transfer assets in an ERISA account to an IRA, when the recommendation involves a securities transaction) or from one product class to another;
* adjusting compensation for registered representatives who fail to adequately manage conflicts of interest; and
* limiting the types of retail customers to whom a product, transaction or strategy may be recommended (e.g., certain products with conflicts of interest associated with complex compensation structures).”
- Better Disclosure of Roles of Broker-Dealers and Investment Advisers. While intending to preserve the range investment services and products currently made available by investment advisers and broker-dealers, a key objective of Regulation Best Interest is to mandate adequate disclosure regarding the capacity in which an investment professional is acting in service of her client. Chairman Clayton underscored the need for this disclosure in practical terms in his Speech –
“’Financial advisor,’ ‘financial consultant,’ ‘wealth manager.’ Your financial professional may have any of a number of different titles that firms use to advertise their services. But from the SEC’s perspective, the federal securities laws recognize, and we regulate, two different types of legal entity: investment advisers, or IAs, and broker-dealers, or BDs.
“Why does this matter? Because a lot turns on this distinction. For example, the fees you will pay to your investment professional — fees that impact the value of your investment over time — differ between BDs and IAs.
“BDs generally charge their customers per transaction — that is, they charge for their advice, execution, and related services in the form of a commission that is associated with each transaction.
“Investment advisers typically charge an ongoing management fee that is a percentage of your assets that they manage. You may have to pay an additional brokerage fee for trades that the IA places on your behalf, or you may choose a so-called ‘wrap fee’ — a single fee covering advice and most or all of the transactions in your account.
“Similarly, the type of service you receive differs. Broker-dealers, as I just mentioned, interact with their customers in connection with each transaction that they recommend or that their customer directs. While you may have a long-term relationship with a single broker-dealer, and they may or may not monitor your account to determine whether they should recommend additional transactions to you, the relationship is fundamentally a transaction-by-transaction relationship.
“Investment advisers commonly have a broader and deeper approach, which typically includes services over time, such as understanding your investment objectives, building a portfolio for you that matches those objectives, then monitoring progress of that portfolio.
“We have found that most investors are not aware whether they are dealing with an investment adviser or a broker-dealer. That confusion may be most acute when they are dealing with a firm that is dually-licensed or an individual that is dual-hatted — that is, someone who offers both investment adviser and broker-dealer services.
“As a result, people may be signing up for a relationship or account type that does not match their expectations and can be more costly.”
- Layered Disclosure. In order to deal with the issue of client confusion regarding the capacity in which the financial professional is acting and to impose a heightened disclosure duty on broker-dealers, the SEC intends for Regulation Best Interest to be part of a “layered” disclosure approach. In a separate, concurrent rulemaking,[9] the SEC has proposed a rule to: (1) require broker-dealers and investment advisers to deliver to retail investors a short (i.e., four page or equivalent limit if in electronic format) relationship summary (“Relationship Summary”); (2) restrict broker-dealers and associated natural persons of broker-dealers, when communicating with a retail investor, from using as part of a name or title the term “adviser” or “advisor” in certain circumstances; and (3) require broker-dealers and investment advisers, and their associated natural persons and supervised persons, respectively, to disclose in retail investor communications the firm’s registration status with the SEC and an associated natural person’s and supervised person’s relationship with the firm (“Regulatory Status Disclosure”).[10]
- Enhanced Disclosure Requirements for Dual Registrants. The SEC’s view is that retail customers of dual-registrants are more susceptible to confusion regarding the capacity in which their financial professionals are acting with respect to any particular recommendation. Therefore, delivery of the Relationship Summary and compliance with the Regulatory Status Disclosure is not considered reasonable disclosure of the capacity in which a dually-registered broker-dealer or dually-registered individual is acting at the time of the recommendation. The SEC does not mandate the form, specific timing, or method for delivering appropriate capacity disclosure; however, the SEC provides guidance in the Proposing Release:
“For example, dual-registrants could disclose capacity through a variety of means, including, among others, written disclosure at the beginning of a relationship (e.g., in an account opening agreement or account disclosure) that clearly sets forth when the broker-dealer would act in a broker-dealer capacity and how it will provide notification of any changes in capacity (e.g., ‘All recommendations will be made in a broker-dealer capacity unless otherwise expressly stated at the time of the recommendation.’ or ‘All recommendations regarding your brokerage account will be made in a broker-dealer capacity, and all recommendations regarding your advisory account will be in an advisory capacity. When we make a recommendation to you, we will expressly tell you which account we are discussing and the capacity in which we are acting.’). So long as the broker-dealer provides this type of disclosure in writing prior to the recommendation, we preliminarily believe that the broker-dealer would not need to provide written disclosure each time it changes capacity or each time it makes a recommendation, provided it makes clear the capacity in which the broker-dealer is acting in accordance with its initial disclosure.” Proposing Release, pages 106-107.
- Oral Disclosure Regarding Capacity. Regulation Best Interest provides flexibility in regard to disclosure of the capacity in which the financial professional is operating (as an investment adviser or as a broker-dealer) by allowing the professional to make that disclosure to the client orally at the time of the recommendation, as long as the prior written disclosure establishes this form of capacity communication protocol.
“As noted above, we preliminarily believe that a broker-dealer would satisfy the Disclosure Obligation expressly by providing written disclosure setting forth when the broker-dealer is acting in a broker-dealer capacity versus an advisory capacity and how the broker-dealer will clarify when it is making a recommendation whether it is doing so in a broker-dealer capacity versus an advisory capacity. However, one important distinction is that the written disclosure requirement would apply to the initial disclosure (i.e., setting forth when the broker-dealer is acting in a broker-dealer capacity and the method it will use to clarify the capacity in which it is acting at the time of the recommendation), but we would not consider the subsequent disclosure of capacity at the time of recommendation to also be subject to the ‘in writing’ requirement (i.e., a broker-dealer could clarify it orally).” (Proposing Release, footnote 216, page 120).
- Disclosure of Conflicts; Definition of a Material Conflict. The Disclosure Obligation explicitly requires the broker-dealer, prior to or at the time of a recommendation, to reasonably disclose all material conflicts of interest associated with the recommendation. In this regard, the SEC defines a “material conflict of interest” as a conflict of interest that a reasonable person would expect might incline a broker-dealer—consciously or unconsciously—to make a recommendation that is not disinterested. In determining how to interpret what constitutes a “material conflict of interest,” the SEC states in the Proposing Release that it considered but rejected the definition of material conflict of interest under the DOL Fiduciary Rule,[11] and instead drew upon the Advisers Act: “ … we believe it is appropriate to interpret the term [material conflict of interest] in accordance with existing and well-established Commission precedent regarding identification of conflicts of interest for which advisers may face antifraud liability under the Advisers Act in the absence of full and fair disclosure.” (Proposing Release, page 111.)[12]
- Disclosure Limited to Material Conflicts of Interest. The Disclosure Obligation in respect of conflicts of interest only applies to “material conflicts of interest,” versus “any conflicts of interest” that a broker-dealer may have with the retail customer. The SEC explains in the Proposing Release that an expansion of the disclosure obligation to cover any conflicts a broker-dealer may have would inappropriately require broker-dealers to provide information regarding conflicts that would not ultimately affect a retail customer’s decision about a recommended transaction or strategy and might obscure more important disclosures.
- SEC Guidance on Required Disclosure. The SEC provides specific guidance in the Proposing Release on types of conflicts that should be disclosed:
“We preliminarily believe that a material conflict of interest that generally should be disclosed would include material conflicts associated with recommending: proprietary products, products of affiliates, or limited range of products; one share class versus another share class of a mutual fund; securities underwritten by the firm or a broker-dealer affiliate; the rollover or transfer of assets from one type of account to another (such as recommendations to rollover or transfer assets in an ERISA account to an IRA, when the recommendation involves a securities transaction); and allocation of investment opportunities among retail customers (e.g., IPO allocation).” (Proposing Release, pages 112-113).
- Nature of Reasonable Disclosure. The Disclosure Obligation of Regulation Best Interest is that of reasonable disclosure. The SEC describes this standard as follows in the Proposing Release: “In order to ‘reasonably disclose’ in accordance with this Disclosure Obligation, a broker-dealer would need to give sufficient information to enable a retail customer to make an informed decision with regard to the recommendation. Disclosures made pursuant to the Disclosure Obligation must be true and may not omit any material facts necessary to make the required disclosures not misleading. (Proposing Release, pages 114-115). Further, compliance with the Disclosure Obligation will be measured against a negligence standard, not against a standard of strict liability. In this regard, the SEC stated that it was sensitive to the risk of “over disclosure” into areas unrelated to the key area targeted by the Proposed Rule – the recommendation to a retail customer of a securities transaction or investment strategy involving securities:
“… if we instead proposed an express obligation that broker-dealers ‘disclose material facts relating to the scope and terms of the relationship with the retail customer and material conflict of interest,’ broker-dealers, in an effort to avoid any inadvertent failure to disclose this information as required, could opt to disclose all facts and conflicts (including those that do not meet the materiality threshold). This could result in lengthy disclosures that do not meaningfully convey the material facts and material conflicts of interest and may undermine the Commission’s goal of facilitating disclosure to assist retail customers in making informed investment decisions.” (Proposing Release at page 116).
- Elements of Effective Disclosure. Although Regulation Best Interest does not establish explicit requirements for effective disclosure, the SEC views the necessary disclosure as being concise, clear and understandable to promote effective communication between a broker-dealer and the retail customer. Specifically, broker-dealers should use plain English and avoid legal jargon and highly technical business terms. The SEC suggests (but does not mandate) that broker-dealers make use of graphics to help investors better understand and evaluate the written disclosures. Regulation Best Interest does not mandate a prescribed form of disclosure such as the brochure requirement under the Advisers Act.
“Given the variety of ways retail customers may communicate with their broker-dealer, as well as the type of compensation and other conflicts presented and the variety in the frequency and level of advice services provided (i.e., one-time, episodic or on a more frequent basis), we believe that some disclosures may be effectively provided in a standardized document at the beginning of the relationship, whereas others may need to be tailored to a particular recommendation. Accordingly, we preliminarily believe that broker-dealers should have the flexibility to make disclosures by various means (e.g., different types of disclosure documents), as opposed to requiring a single standard written document. As noted, however, whether there is sufficient disclosure will depend on the facts and circumstances.” (Proposing Release, page 118).
- Telephonic Communications. While adhering to the Regulation Best Interest requirement that disclosure must be in writing, the SEC offers flexibility in recognition of the fact that communications between a broker-dealer and her client are often undertaken over the telephone.
“We recognize that broker-dealers may provide recommendations by telephone. In such instances, we believe that a broker-dealer could meet its obligation to reasonably disclose ‘in writing,’ ‘prior to or at the time of such recommendation’ through a variety of approaches … For example, the broker-dealer may have already provided relevant disclosures prior to the telephone conversation (e.g., in a relationship guide, an account opening agreement or account disclosure). The broker-dealer may also be able to meet the delivery obligation by sending the relevant disclosure electronically (e.g., by email) to the retail customer during the telephone conversation.” (Proposing Release, footnote 213, page 117).
- Flexibility; Retain Proven and Effective Forms of Communication. Regulation Best Interest provides that the Disclosure Obligation applies “prior to or at the time of” the recommendation, and the SEC emphasizes that the timing of the disclosure is critically important to whether it may achieve the effect contemplated by the Proposed Rule.[13] The SEC is also aware that the manner in which a broker-dealer and his client communicate takes many forms, and that the timing requirement of the Proposed Rule should not unnecessarily impair proven and effective forms of communication.[14] Importantly, the SEC refers to its concept of “layered disclosure” and states that more specific information regarding a recommendation can come after completion of a transaction if the prior written disclosure made clear that such protocol would apply:
“For example, a broker-dealer may determine that certain disclosures may be most effective if they are made at multiple points in the relationship, or, if pursuant to a layered approach to disclosure, certain material facts are conveyed in a more general manner in an initial written disclosure and followed by more specific information in a subsequent disclosure, which may be at the time of the recommendation or even after the recommendation (i.e., in the trade confirmation). Disclosure after the recommendation, such as in a trade confirmation for a particular recommended transaction would not, by itself, satisfy the Disclosure Obligation, because the disclosure would not be ‘prior to, or at the time of the recommendation.’ However, a broker-dealer could satisfy the Disclosure Obligation, depending on the facts and circumstances, if the initial disclosure, in addition to conveying material facts relating to the scope and terms of the relationship with the retail customer, explains when and how a broker-dealer would provide additional more specific information regarding the material fact or conflict in a subsequent disclosure (e.g., disclosures in a trade confirmation concerning when the broker-dealer effects recommended transactions in a principal capacity). We believe that including in the general disclosure this additional information of when and how more specific information will be provided would help the retail customer understand the general nature of the information provided and alert the retail customer that more detailed information about the fact or conflict would be provided and the timing of such disclosure.” (Proposing Release, pages 119-120).
- Repetitive Disclosure Unnecessary. The SEC recognizes the limited utility of repetitive disclosures in circumstances where there have been no material changes to previously disclosed information:
“Because the Disclosure Obligation would apply ‘prior to or at the time of’ the recommendation, if a broker-dealer has previously made the relevant disclosure to the retail customer (and there have been no material changes to the previously disclosed information), it would not be expected to repeat such disclosure at each subsequent recommendation, depending on the facts and circumstances of the prior disclosure. As noted above, we would like to emphasize the importance of determining the appropriate timing and frequency of disclosure. For example, where a significant amount of time passes between the disclosure and a recommendation, the broker-dealer generally should determine whether the retail customer should reasonably be expected to be on notice of the prior disclosure; if not, the broker-dealer generally should not rely on such disclosure. The Commission preliminarily believes this flexible approach to disclosure is consistent with the broker-dealers’ liabilities or obligations under the antifraud provisions of the federal securities laws.” (Proposing Release, pages 121-122).
Care Obligation
- Two-Pronged Nature of the Care Obligation; Fiduciary Duty. The Care Obligation require a broker-dealer making a recommendation of a securities transaction or investment strategy involving securities to a retail customer to have a reasonable basis for believing that the recommended transaction or investment strategy is in the best interest of the retail customer and does not put the financial or other interest of the broker-dealer before that of the retail customer. Thus, in the circumstances of making a securities or investment strategy recommendation, the SEC views the Care Obligation as constituting a fiduciary duty.
- First Element of Care Obligation: Reasonable Basis Suitability. A fundamental aspect of the Care Obligation is adherence to the requirement of “reasonable-basis suitability”. In order to meet this requirement, a broker-dealer must: (1) undertake reasonable diligence (i.e., reasonable investigation and inquiry) to understand the potential risks and rewards of the recommended security or strategy (i.e., to understand the security or strategy), and (2) have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers based on that understanding. A broker-dealer must adhere to both components to meet this obligation. This obligation relates to the particular security or strategy recommended, rather than to any particular retail customer.
- Due Diligence. While stating that the broker-dealer must make its owns assessment of appropriate due diligence steps, the SEC prescribes a method of analysis that a broker-dealer should undertake to satisfy this aspect of the Care Obligation. (Proposing Release, pages 139-140).
“In general, what would constitute reasonable diligence … will vary depending on, among other things, the complexity of and risks associated with the recommended security or investment strategy and the broker-dealer’s familiarity with the recommended security or investment strategy. For example, the cost associated with a recommendation is ordinarily only one of many factors to consider when evaluating the risks and rewards of a subject security or investment strategy involving securities. Other factors may include, but are not limited to, the investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility, and likely performance of market and economic conditions, the expected return of the security or investment strategy, as well as any financial incentives to recommend the security or investment strategy.
“While every inquiry will be specific to the broker-dealer and the investment or investment strategy, broker-dealers may wish to consider questions such as:
* Can less costly, complex, or risky products available at the broker-dealer achieve the objectives of the product?
* What assumptions underlie the product, and how sound are they? What market or performance factors determine the investor’s return?
* What are the risks specific to retail customers? If the product was designed mainly to generate yield, does the yield justify the risk to principal?
* What costs and fees for the retail customer are associated with this product? Why are they appropriate? Are all of the costs and fees transparent? How do they compare with comparable products offered by the firm?
* What financial incentives are associated with the product, and how will costs, fees, and compensation relating to the product impact an investor’s return?
* Does the product present any novel legal, tax, market, investment, or credit risks?
* How liquid is the product? Is there a secondary market for the product?”
- Second Element of Care Obligation: Customer-Specific Suitability (Enhanced). The second-level requirement of the Care Obligation – beyond establishing an understanding of the recommended securities transaction or investment strategy – is the requirement for the broker-dealer to have a reasonable basis to believe that a specific recommendation is in the best interest of the particular retail customer based on its understanding of the investment or investment strategy and in light of the retail customer’s investment objectives, financial situation, and needs. The SEC intends for this aspect of the Care Obligation to be an enhancement to existing suitability obligations imposed on broker-dealers: “For the reasons set forth below, this proposed obligation is intended to incorporate a broker-dealer’s existing well-established obligations under “customer-specific suitability,” but enhances these obligations by requiring that the broker-dealer have a reasonable basis to believe that the recommendation is in the “best interest” of (rather than “suitable for”) the retail customer.” (Proposed Release, pages 141-142). Importantly, in the view of the SEC, under this standard, a broker-dealer could not have a reasonable basis to believe that the recommendation is in the “best interest” of the retail customer if the broker-dealer puts its interest ahead of the retail customer’s interest.
- Considerations of Cost of the Security to the Client and Remuneration to the Broker-Dealer. In the context of the Care Obligation, the SEC specifically addresses the cost of an investment product or strategy and the remuneration to the broker-dealer of the product or strategy.
“In addition, … we emphasize that the costs and financial incentives associated with a recommendation would generally be one of many important factors – including other factors such as the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions – to consider when determining whether a recommended security or investment strategy involving a security or securities is in the best interest of the retail customer. Thus, where, for example, a broker-dealer is choosing among identical securities available to the broker-dealer, it would be inconsistent with the Care Obligation to recommend the more expensive alternative for the customer. Similarly, we believe it would be inconsistent with the Care Obligation if the broker-dealer made the recommendation to a retail customer in order to: maximize the broker-dealer’s compensation (e.g., commissions or other fees); further the broker-dealer’s business relationships; satisfy firm sales quotas or other targets; or win a firm-sponsored sales contest. (emphasis added).
“We preliminarily believe that, under this prong of the Care Obligation, when a broker-dealer recommends a more expensive [emphasis in original text] security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost is justified (and thus nevertheless is in the retail customer’s best interest) based on other factors (e.g., the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), in light of the retail customer’s investment profile. When a broker-dealer recommends a more remunerative [emphasis in original text] security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that—putting aside the broker-dealer’s financial incentives—the recommendation was in the best interest of the retail customer based on the factors noted above, in light of the retail customer’s investment profile. Nevertheless, this does not mean that a broker-dealer could not recommend the more remunerative of two reasonably available alternatives, if the broker-dealer determines the products are otherwise both in the best interest of—and there is no material difference between them from the perspective of—retail customer, in light of the retail customer’s investment profile. [emphasis added].” (Proposing Release, pages 147-149.)
- Disclosure Alone is Insufficient to Meet Care Obligation. The SEC takes the position that a broker-dealer is unable to meet its Care Obligation through disclosure alone.
“Thus, for example, where a broker-dealer is choosing among identical securities with different cost structures, we believe it would be inconsistent with the best interest obligation for the broker-dealer to recommend the more expensive alternative for the customer, even if the broker-dealer had disclosed that the product was higher cost and had policies and procedures reasonably designed to mitigate the conflict under the Conflict of Interest Obligations, as the broker-dealer would not have complied with its Care Obligation. Such a recommendation, disclosure aside, would still need to be in the best interest of a retail customer, and we do not believe it would be in the best interest of a retail customer to recommend a higher cost product if all other factors are equal.” Proposing Release, page 149; emphasis added.
- Third Element of Care Obligation: Quantitative Suitability (Enhanced). The existing quantitative suitability rule requires the broker-dealer to have a reasonable basis for believing that a series of recommended transactions is not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. This element of the Proposed Rule, instead, would require a broker-dealer to have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. Notably, in this circumstance the Proposed Rule imposes on the broker-dealer an obligation to have formed a reasonable basis to believe that the series of recommended transactions is in the best interest of the retail customer in light of the retail customer’s investment profile and based on factors other than the broker-dealer’s financial incentive to recommend such series of transactions.
- Obligation Applies Regardless of Whether Broker-Dealer Has Control Over a Client’s Account. This third element of the Care Obligation requires a broker-dealer to have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest, regardless of whether the broker-dealer has actual or de facto control over a retail customer account.[15] In the view of the SEC, the elimination of “control” element will provide consistency in retail investor protection by requiring a broker-dealer always to form a reasonable basis as to the recommended frequency of trading in a retail customer’s account – irrespective of whether the broker-dealer “controls” or exercises “de facto control” over the retail customer’s account.
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[1] Regulation Best Interest was proposed in Release No. 34-83062; 83 Federal Register 21574 (the “Proposing Release”). Comments to the SEC on the Proposed Rule are due on or before August 7, 2018.
[2] See, however, footnote 4 and accompanying text.
[3] A “Retail Customer” under Regulation Best Interest is “a person, or the legal representative of such person, who: (A) Receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) Uses the recommendation primarily for personal, family, or household purposes.” Section 240.15l-1 (b)(1).
[4] Unlike the Disclosure and Care Obligations, which apply to a broker or dealer and to natural persons who are associated persons of a broker or dealer, the proposed Conflict of Interest Obligations apply solely to the broker or dealer entity, and not to the natural persons who are associated persons of a broker or dealer. While the Conflict of Interest Obligations apply only to the broker-dealer entity, the conflicts of interest that the broker-dealer entity must analyze are between: (1) the broker-dealer entity and the retail customer; (2) the natural persons who are associated persons and the retail customer; and (3) the broker-dealer entity and the natural persons who are associated persons (if the retail customer is indirectly impacted).
[5] On March 15, 2018, the DOL Fiduciary Rule was vacated by the United States Court of Appeals for the Fifth Circuit. Chamber of Commerce of the U.S.A., et al. v. U.S. Dep’t of Labor, et. al., No. 17-10238 (5th Cir.) (Mar. 15, 2018). The Department of Justice, acting on behalf of the DOL, allowed the appeal deadline (April 30, 2018) to pass without filing an appeal of the Fifth Circuit decision. Three states (New York, California and Oregon), as well as the AARP, filed motions to intervene in the proceeding and those motions were denied on May 9, 2018. AARP and the three states have until May 16, 2018 to seek reconsideration of the denial of their motions. The DOL has until June 13, 2018 to appeal the Fifth Circuit’s decision to the Supreme Court.
[6] “We wish to reemphasize that we recognize that components of these obligations draw from obligations that have been interpreted under the antifraud provisions of the federal securities laws, or may be specifically addressed by the Exchange Act or the rules thereunder or SRO rules. In proposing these obligations, we are not proposing to amend or eliminate existing broker-dealer obligations, and compliance with Regulation Best Interest is not determinative of a broker-dealer’s compliance with obligations under the general antifraud provisions of the federal securities laws.” (Proposing Release at pages 96-97).
[7] SEC Chair Jay Clayton emphasized that, in the circumstance of a broker-dealer making a securities or investment recommendation to a client, the Duty of Care included within Regulation Best Interest is a fiduciary duty: “By raising the conduct standard applicable to broker-dealers, we are applying consistent, fiduciary principles across the spectrum of investment advice.” Speech, Chairman Jay Clayton, May 2, 2018: The Evolving Market for Retail Investment Services and Forward-Looking Regulation – Adding Clarity and Investor Protection while Ensuring Access and Choice” (“Chairman Clayton’s Speech” or “Speech”). See also, footnote 12 below and accompanying text.
[8] “Finally, we believe that our model — a rigorous standard that, in practice, can cover a range of relationship types — will produce high-quality advice while maintaining a range of options for retail investors. (Chairman Clayton’s Speech).
[9] Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles, Release No. 34-83063, IA-4888, File No. S7-08-18 (“Relationship Summary Proposal”).
[10] “The Relationship Summary highlights certain features of an investment advisory or brokerage relationship, which is designed to alert retail investors to information for them to consider when choosing a firm and a financial professional. This would be achieved by requiring that the Relationship Summary be initially delivered to a retail investor before or at the time a retail investor enters into an investment advisory agreement or first engages a brokerage firm’s services.”
“By virtue of the high level nature of the disclosures in the Relationship Summary, constituting a mix of prescribed language and more firm-specific disclosures, and the space constraints (no more than four pages or equivalent limit if in electronic format), the Relationship Summary would form just one part of a broker-dealer’s broader set of disclosures. Firms would include information retail investors need to understand the services, fees, conflicts, and disciplinary history of firms and financial professionals they are considering, along with references and links to other disclosure where interested investors can find more detailed information. In this way, the Relationship Summary is intended to foster a layered approach to disclosure, as described above. It is also designed to facilitate comparisons across firms that offer the same or substantially similar services.
“The Disclosure Obligation under Regulation Best Interest further builds on and complements these obligations as it would require a broker-dealer or natural person who is an associated person of a broker-dealer to, prior to or at the time of the recommendation, reasonably disclose, in writing, the material facts relating to the scope and terms of the relationship with the retail customer and all material conflicts of interest associated with the recommendation. The Disclosure Obligation under Regulation Best Interest would apply specifically to the broker-dealer or natural person who is an associated person of the broker-dealer and the specific recommendation triggering Regulation Best Interest.
“For example, whereas the Relationship Summary would require a brief and general description of the types of fees and expenses that retail investors will pay, under the Disclosure Obligation we would generally expect broker-dealers to build upon the Relationship Summary to provide more specific fee disclosures relevant to the recommendation to the retail customer and the particular brokerage account for which recommendations are made. In addition, while the Relationship Summary would require a high-level description of specified conflicts of interest, the Disclosure Obligation would require more comprehensive disclosure of all material conflicts of interest related to the recommendation to the retail customer.
“Thus, as a general matter, the Regulatory Status Disclosure and the Relationship Summary reflect initial layers of disclosure, with the Disclosure Obligation reflecting more specific and additional, detailed layers of disclosure.” Proposing Release, pages 102-103 (footnotes omitted)
[11] “In the BIC Exemption [under the DOL Fiduciary Rule], a Material Conflict of Interest exists when an Adviser or Financial Institution has a ‘financial interest that a reasonable person would conclude could affect the exercise of its best judgment as a fiduciary in rendering advice to a Retirement Investor.’” (Proposing Release, footnote 197, page 110).
[12] In this regard, in the Proposing Release, the SEC makes clear that the broker-dealer’s duty to disclose material conflicts of interest at the time of making a securities recommendation is a fiduciary duty, citing to the Capital Gains case: “See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92, 194 (1963), (stating that as part of its fiduciary duty, an adviser must ‘fully and fairly’ disclose to its clients all material information in accordance with Congress’s intent ‘to eliminate, or at least expose, all conflicts of interest which might incline an investment adviser— consciously or unconsciously—to render advice which was not disinterested’).” (Proposing Release, footnote 198, page 111).
[13] “Investors should receive information early enough in the process to give them adequate time to consider the information and promote the investor’s understanding in order to make informed investment decisions, but not so early that the disclosure fails to provide meaningful information (e.g., does not sufficiently identify material conflicts presented by a particular recommendation, or overwhelms the retail customer with disclosures related to a number of potential options that the retail customer may not be qualified to pursue).” (Proposing Release, page 119).
[14] “In light of these goals, we would like to emphasize the importance of determining the appropriate timing and frequency of disclosure that may be effectively provided ‘prior to or at the time of’ the recommendation, but which may be achieved through a variety of approaches: (1) at the beginning of a relationship (e.g., in a relationship guide, such as or in addition to the Relationship Summary, or in written communications with the retail customer, such as the account opening agreement); (2) on a regular or periodic basis (e.g., on a quarterly or annual basis, when any previously disclosed information becomes materially inaccurate, or when there is new relevant material information); (3) at other points, such as before making a particular recommendation or at the point of sale; and/or (4) at multiple points in the relationship or through a layered approach to disclosure.” (Proposing Release, page 119).
[15] Currently, to prove a churning claim under the antifraud provisions of the Exchange Act, the broker-dealer must be shown to have exercised actual or de facto control over a customer’s account. Similarly, FINRA’s quantitative suitability rule only applies to a member or associated person who has actual or de facto control over a customer account.