SEC headquarters in Washington. (Photo: AP)

On June 5, 2019, the Securities and Exchange Commission (SEC) adopted a rulemaking package that is applicable to investment advisers and broker-dealers. The package includes two final rules and two interpretations: Regulation Best Interest, Investment Adviser Standard of Conduct Interpretation, Form CRS — Relationship Summary, and the Solely Incidental Broker-Dealer Exclusion Interpretation. This is the first in a series of articles describing the SEC’s rulemaking package.

The Regulation Best Interest final rule (Reg BI) under the Securities Exchange Act of 1934 established a standard of conduct for broker-dealers and their registered representatives. Reg BI requires that broker-dealers act in their retail customers’ best interest when making investment or investment strategy recommendations.

Compliance with the new Reg BI will require the creation and updating of broker-dealer disclosures, as well as the development (or revision) of policies, procedures and systems. The SEC set an effective date for Reg BI that is 60 days after the rule is published in the Federal Register and a compliance transition period that ends June 30, 2020.

This transition period provides allows time for broker-dealers to make the required changes for Reg BI compliance.

The SEC clarified Reg BI’s scope by defining “retail customer” to mean “a natural person, or the legal representative of such natural person, who: 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 who uses the recommendation primarily for personal, family, or household purposes.”

Determining whether a broker-dealer makes a “recommendation” will be based on how that term is currently interpreted under broker-dealer regulations. The SEC explains, “the more individually tailored a communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a recommendation.”

While the SEC declined to define “recommendation” under the rule, it identified various types of communication that it does not generally consider to constitute a recommendation:

  • General financial and investment information, such as basic investment concepts, historic asset class returns, estimates of future income needs, and investment profile assessments;.
  • Descriptive information about an employer-sponsored retirement plan, such as the benefits of participating in the plan and the investment options available under the plan;.
  • Asset allocation models, subject to certain requirements and disclosures; and
  • Interactive investment materials, subject to certain conditions.

The SEC rule also clarified that the definition of a securities transaction or investment strategy should apply broadly and added “account recommendations” to the text of Reg BI. Further, the SEC described several types of recommendations that it considers to be covered by the rule and subject to regulations, including:

  • Rolling over or transferring assets from one type of account to another (e.g., from an employer-sponsored retirement plan to an IRA);
  • Taking distributions from proceeds of specific securities or taking in-service loans from an employer-sponsored plan;
  • Opening an IRA or other brokerage account; or
  • Implicitly holding a security, if the broker-dealer agreed to provide account monitoring services.

Reg BI also sets forth specific obligations that, if fulfilled, satisfy the rule. Specifically, broker-dealers are required to comply with the Disclosure Obligation, the Care Obligation, the Conflict of Interest Obligation, and the Compliance Obligation.

  • Disclosure Obligation: Prior to (or at the time of) a recommendation, broker-dealers must provide retail customers with all material facts relating to the scope and term of the relationship and any conflicts of interest associated with a recommendation. The SEC identified certain “material facts” that broker-dealers must provide. For example, Reg BI requires broker-dealers to disclose that the broker, dealer or natural person is acting as a broker, dealer, or an associated person of a broker-dealer with respect to a recommendation; the material fees and costs that apply to the retail customer’s transactions, holdings and accounts; and the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies that may be recommended to the retail customer. However, the SEC emphasized that broker-dealers will need to determine whether other material facts relating to the scope and terms of the relationship with the retail customer need to be disclosed.

The SEC also deemed restricting broker-dealers from using the term “adviser” or “advisor” as part of a name or title unnecessary, believing that the Disclosure Obligation creates a presumption that the use of these terms in a name or title by a broker-dealer that is not also registered as an investment adviser or an associated person that is not also supervised by an investment adviser is a violation of the Disclosure Obligation. Thus, broker-dealers should review their names, titles and marketing practices to ensure that these terms are removed, if necessary.

Reg BI defines a “conflict of interest” as “an interest that might incline a broker, dealer or a natural person who is associated … to make a recommendation that is not disinterested.” Compensation practices associated with recommendations to retail customers and related conflicts of interest must be disclosed. The SEC further explains that the disclosure should summarize how the broker-dealer and its financial professionals are compensated for their recommendations and the conflicts of interest that such compensation creates.

  • Care Obligation: The Care Obligation requires broker-dealers to act in the retail customers’ best interest. The SEC illustrated its meaning of “best interest” when describing this obligation. Specifically, a broker-dealer’s financial or other interests cannot be placed ahead of the retail customer’s interests when making a recommendation. For example, a broker-dealer must have a reasonable basis to believe that a recommendation to open an IRA is in the best interest of the retail customer and does not place the broker-dealer’s financial or other interests first.

The SEC added “cost” as a factor that broker-dealers must consider in connection with this obligation, but only to emphasize that it is one of many factors to consider when making a recommendation.

  • Conflicts of Interest Obligation: Broker-dealers have an obligation to establish written policies and procedures to identify and disclose all conflicts of interest associated with a recommendation. In addition, they must establish policies and procedures that are reasonably designed to mitigate or eliminate certain conflicts of interest. For example, Reg BI requires that broker-dealers identify and eliminate “any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.”
  • Compliance Obligation: Because the SEC views the Conflicts of Interest Obligation as focusing primarily on conflicts, Reg BI also contains a separate Compliance Obligation. The Compliance Obligation creates an affirmative duty under the Exchange Act to establish ongoing compliance policies and procedures. Broker-dealers are required to establish, maintain, and enforce written policies and procedures to achieve compliance with Reg BI. The SEC recognizes that broker-dealers provide services under various business models, and the rule allows broker-dealers the flexibility to design their compliance policies and procedures to prevent violations of Reg BI, and promptly detect and correct violations based on the firm’s scope, size, and the risks associated with the firm’s business and operations.

Beth Miller is an attorney with Spencer Fane LLP in the firm’s Overland Park, Kansas, office. Her practice focuses on helping clients by identifying practical solutions to a wide variety of legal matters in the areas of employer-sponsored retirement plans, executive compensation, fiduciary obligations, and advisory services. She can be reached at bmiller@spencerfane.com.