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SEC Imposes New Requirements for Brokers and Advisers in Adoption of Regulation Best Interest

On June 5, 2019, the Securities and Exchange Commission (SEC) approved a higher standard of care for broker-dealers, and their financial professionals, when making a recommendation to a retail investor regarding a securities transaction, such as the purchase or sale of a stock, bond, option or other security. This new higher standard, referred to as Regulation Best Interest or Reg BI, is intended to narrow the gap between the different standards of care that a broker-dealer and an investment adviser owe to a retail investor. 

For more than two decades, broker-dealers have been held to a suitability standard of care because their recommendations tend to be isolated to a single securities transaction or trade. Investment advisers, on the other hand, have been held to a fiduciary standard because their investment advice is considered ongoing in nature and can cover a broad array of services and, therefore, investment advisers have been deemed by the Supreme Court to be in a relationship with a retail investor that requires loyalty and trust, hence the need for a higher standard of care than the suitability standard (SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963)). Over the last two decades, the lines have blurred between the services offered by broker-dealers and investment advisers, prompting the SEC to re-evaluate the applicable regulatory regimes.       

Regulation Best Interest has four components:

  1. Duty of Care
    Before making a recommendation to a retail client - as opposed to a corporate/institutional client - a broker is now required to understand the risks and costs associated with a recommendation and consider these factors in view of the client’s age, investment objectives, and risk tolerance. 
  2. Conflicts of Interest
    A broker-dealer must have written policies and procedures to identify conflicts of interest and, at a minimum, disclose them, and where possible, eliminate them.  Specifically, firms are now required to identify and address incentives that can lead brokers to put their interest ahead of their client’s interest.  Examples of such conflicts include a broker favoring the firm’s proprietary products over other products that may be more appropriate for a client because the broker receives a bonus for selling a certain quota of proprietary products, and a firm promoting a sales contest to its brokers that incentivizes brokers to sell a specific security or type of security. 
  3. Disclosure
    Broker-dealers must now disclose the fees they charge, the type and scope of the services they offer as well as any limitations on those services, any conflicts that exist, and whether they provide ongoing monitoring of an investor’s account. 
  4. Compliance
    Broker-dealers are required to develop, maintain and enforce policies and procedures to comply with Regulation Best Interest.    

In conjunction with approving Regulation Best Interest, the SEC also approved and now requires that both broker-dealers and investment advisers at the beginning of a client relationship provide the retail investor with a Customer Relationship Summary (Form CRS) to allow the retail investor to compare one financial professional’s services to another. Form CRS must contain a summary of the services offered, fees charged, costs, conflicts of interest, standard of conduct, and disciplinary history, if any, of the firm and its financial professionals.

On June 5, the SEC also clarified the federal fiduciary duty that an investment adviser owes to a client under the Investment Advisers Act of 1940. The SEC also clarified the long-standing exemption that applies to a broker-dealer that provides advice to a retail investor considered “solely incidental” to a brokerage transaction where the broker-dealer does not receive special compensation for such advice. According to the SEC’s new interpretation of “solely incidental,” the advice provided by a broker-dealer must now be “reasonably related to the broker-dealer’s primary business of effecting securities.” 

Regulation Best Interest and Form CRS will be effective 60 days after publication in the Federal Register. To give broker-dealers time to modify their compliance programs, the enforcement date of this new rule and form is extended until June 30, 2020. 

The SEC’s new interpretations of the federal fiduciary duty and “solely incidental” will be effective upon publication in the Federal Register. 

For questions regarding Regulation Best Interest, Form CRS, or the SEC’s new interpretations of the federal fiduciary standard and the “solely incidental” exemption for broker-dealers, please contact Michael P. Shaw, Esq. at mpshaw@nilesbarton.com or 410-783-6382. 

Michael Shaw is a corporate and regulatory attorney at Niles, Barton & Wilmer, LLP, focusing on serving the legal, compliance and enforcement defense needs of registered investment advisers, broker-dealers, hedge funds, private equity firms and insurance agencies.

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