SEC finally prevails with investment advice ‘best interest’ rule

The Securities and Exchange Commission, on Wednesday, voted to adopt a package of rulemakings intended to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations while preserving access (in terms of choice and cost) to a variety of investment services and products.

The rulemaking package is designed to enhance investor protections while preserving retail investor access and choice in the type of professional with whom they work; the services they receive; and how they pay for these services.

“With the adoption of this package, regardless of whether a retail investor chooses a broker-dealer or an investment adviser (or both), the retail investor will be entitled to a recommendation (from a broker-dealer) or advice (from an investment adviser) that is in the best interest of the retail investor and that does not place the interests of the firm or the financial professional ahead of the interests of the retail investor,” the SEC wrote.

Specifically, these actions include Regulation Best Interest, a new Form CRS Relationship Summary, and interpretations under the Investment Advisers Act of 1940.

“These actions are designed to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made,” the Commission said in a statement.

“The rules and interpretations we are adopting today address issues that the Commission has been actively considering for nearly two decades,” SEC Chairman Jay Clayton said in a statement. “This rulemaking package will bring the legal requirements and mandated disclosures for broker-dealers and investment advisers in line with reasonable investor expectations, while simultaneously preserving retail investors’ access to a range of products and services at a reasonable cost.”

Under Regulation Best Interest, broker-dealers will be required “to act in the best interest of a retail customer” when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. It will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations.

The Form CRS Relationship Summary will require registered investment advisers and broker-dealers to provide retail investors with “simple, easy-to-understand” information about the nature of their relationship with their financial professional. While facilitating layered disclosure, the format of the relationship summary allows for comparability among the two different types of firms in a way that is distinct from other required disclosures.

“This rulemaking package will bring the legal requirements and mandated disclosures for broker-dealers and investment advisers in line with reasonable investor expectations, while simultaneously preserving retail investors’ access to a range of products and services at a reasonable cost.”

Jay Clayton, Chairman, SEC

Form CRS will also include a link to a dedicated page on the Commission’s investor education Website, Investor.gov, which offers educational information about broker-dealers and investment advisers and other materials.

The SEC also issued an interpretation to reaffirm and clarify the Commission’s views of the fiduciary duty that investment advisers owe to their clients under the Advisers Act. “The interpretation reflects how [we] have applied and enforced the law in this area, and inspected for compliance, for decades,” it wrote. “By highlighting principles relevant to the fiduciary duty, investment advisers and their clients will have greater clarity about advisers’ legal obligations.”

Finally, the Commission issued an interpretation of the “solely incidental” prong of the broker-dealer exclusion under the Advisers Act, which is intended “to more clearly delineate when a broker-dealer’s performance of advisory activities causes it to become an investment adviser.”

Regulation Best Interest and Form CRS will become effective 60 days after they are published in the Federal Register and will include a transition period until June 30, 2020, to give firms sufficient time to come into compliance. Interpretations under the Advisers Act will become effective upon publication in the Federal Register.

“The Commission recognizes that these new rules will require various market participants to make changes to their operations, including to mandatory disclosures, marketing materials and compliance systems,” the rulemaking announcement says. To assist firms with planning for compliance with these new rules, the Commission is establishing an inter-Divisional Standards of Conduct Implementation Committee. It is encouraging firms to actively engage with this committee as questions arise in planning for implementation. Questions and concerns may be sent by e-mail to by IABDQuestions@sec.gov.

As detailed in an SEC fact sheet, Regulation Best Interest includes the following components:

Disclosure obligations

Broker-dealers must disclose material facts about the relationship and recommendations, including specific disclosures about the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services. 

Care obligation

A broker-dealer must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation. The broker-dealer must then consider these factors in light of the retail customer’s investment profile and make a recommendation that is in the retail customer’s best interest. The final regulation, which is an enhancement from the proposal, explicitly requires the broker-dealer to consider the costs of the recommendation.

Conflict of interest obligations

The broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify and at a minimum disclose or eliminate conflicts of interest.

This obligation, an enhancement from the proposal, specifically requires policies and procedures:

• to mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest;
• prevent material limitations on offerings, such as a limited product menu or offering only proprietary products, from causing the firm or its financial professional to place his or her interest or the interests of the firm ahead of the retail customer’s interest; and
• eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

Compliance obligations

In an enhancement from the initial proposal, broker-dealers must establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.

Form CRS

Investment advisers and broker-dealers will be required to deliver a relationship summary to retail investors at the beginning of their relationship. Firms will summarize information about services, fees and costs, conflicts of interest, legal standard of conduct, and whether or not the firm and its financial professionals have disciplinary history.

The relationship summary will have a standardized question-and-answer format to promote comparison by retail investors in a way that is distinct from existing disclosures. The relationship summary will permit the use of layered disclosure so that investors can more easily access additional information from the firm about these topics.

In rather lengthy remarks prior to the vote, Clayton defended what has been a controversial rulemaking process.

“Just two days ago, on Monday evening, we celebrated the 85th anniversary of the Commission. The overriding issue we address today—the obligations of financial professionals when they provide investment advice and services to retail customers—has been at the heart of our mission for those 85 years,” he said. “This is a vast, multifaceted, complex, and critically important facet of our economy and our society. It directly affects 43 million American households.”

The current effort, he said, is long overdue.

“The fact that it is overdue does not make it easier,” Clayton said. “I believe the delay has made it more difficult as many interested parties have developed strident and divergent views on the state of the market, as well as current law and regulation, and what should be done to better serve the interests of our Main Street investors. Another complicating factor is that we regulate two types of financial professionals that play important roles in this vast market—broker-dealers and investment advisers—but do so in significantly different ways and under different regulatory regimes.”

“You may hear that Regulation Best Interest does not truly enhance the broker-dealer standard of conduct beyond existing suitability obligations, that it can be satisfied by disclosure alone, or that we are doing a disservice to investors by calling it a ‘best interest’ standard,” Clayton shot back at critics of the rulemaking. “This is simply not true—you will hear from the Division of Trading & Markets specifically how the rule goes significantly beyond existing broker-dealer obligations. To be clear, Regulation Best Interest cannot be satisfied through disclosure alone.”

“You may hear that our Relationship Summary will confuse retail investors, will not accomplish its goals, or should have been subject to further testing,” he added. “This criticism misses the point of how much an improvement the Relationship Summary will be for retail investors over existing disclosures. No existing disclosures provide the level of transparency and comparability that the Relationship Summary will provide. The criticism also ignores the extensive amount of investor testing and other information our staff considered in developing the final recommendation, leveraging their considerable expertise with investor disclosures.

“Finally, you may hear that our Fiduciary Interpretation weakens the existing fiduciary duty that applies to investment advisers—also not true. The interpretation reflects how the Commission and its staff have applied and enforced the law in this area, and inspected for compliance, for decades.”

There are roughly 2,700 SEC-registered broker-dealers that provide services to retail investors, with nearly $4 trillion in total assets and almost 139 million customer accounts. There are also more than 8,000 SEC-registered investment advisers that provide services to retail investors, with over $41 trillion in assets under management and over 40 million client accounts.

In the last five years, the SEC’s Office of Compliance Inspections and Examination has conducted more than 8,200 examinations of SEC-registered investment advisers. During fiscal year 2018, it examined 17 percent of all SEC-registered investment advisers (more than 2,300 examinations).