Raising The Bar? SEC Proposes Broker-Dealer Standard Of Care And Guidance On Investment Advisers' Fiduciary Standard

Author:Shearman & Sterling LLP
Profession:Shearman & Sterling LLP


On April 18, 2018, the U.S. Securities and Exchange Commission (“SEC”) took the long-awaited step of proposing rules, interpretations and guidance (the “Proposed Rules”) that would seek to enhance and clarify the standards of care applicable to broker-dealers and to investment advisers when dealing with retail clients through standardized and additional disclosure, and through newly promulgated or clarified standards of care for broker-dealers and investment advisers.1 Three proposals have been published for comment, designed to be interlocked and complementary. The comment period for each proposal will be 90 days from each respective proposal's publication in the Federal Register.

The Proposed Rules, which are further described below, follow recent developments in respect of the Department of Labor's “Fiduciary Rule,” which expanded the applicability of “fiduciary” status (and corresponding duties) to various financial service providers under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and effectively imposed similar “fiduciary” status to comparable financial service providers to retail customers, including with respect to Individual Retirement Accounts (IRAs).2

In the open meeting introducing the proposals, SEC Chairman Jay Clayton highlighted that the goals of the Proposed Rules include better aligning regulations and obligations of broker-dealers and investment advisers with the expectations of retail investors, and preserving retail investor choice.3 With respect to the latter, Chairman Clayton suggested that confusion and compliance costs associated with certain federal and state standard of care requirements4 have created unintended consequences, such as disrupting or limiting the availability of transaction-based or pay-as-you-go retail investment models.5

In addition, the web of regulation relating to professional standards of care extends beyond the U.S. border, as discussed below.

The Proposed Rules, generally, take the following steps, as described in greater detail below:

Form CRS relationship summary. Require broker-dealers and investment advisers to provide a relationship summary (limited to a maximum of four pages) to investors that captures certain information, as discussed in greater detail below, through the use of newly proposed Form CRS, and place restrictions on the use of certain names and titles, such as “adviser” and “advisor,” for firms and financial professionals6; Regulation Best Interest. Implement “Regulation Best Interest,” under the Securities Exchange Act of 1934 (the “Exchange Act”), which would establish a standard of conduct applicable to broker-dealers when making a recommendation of a securities transaction to a retail customer7; and Interpretation of investment adviser standard of conduct. Clarify the standard of conduct for investment advisers, and request comments with respect to enhancing investment adviser regulation under the Investment Advisers Act of 1940 (the “Advisers Act”), including requesting comment regarding the licensing of investment adviser personnel and capital requirements for investment advisers.8 A Recent History of Retail Standard of Care

2011 SEC Staff Study on Investment Advisers and Broker-Dealers and 2013 SEC Release

As a result of the requirement under Section 913 of the Dodd-Frank Act to evaluate regulatory standards of care, the SEC staff released a study on January 22, 2011 (the “2011 Study”) and made several recommendations addressing retail customer confusion about the differing standards of care applicable to broker-dealers and investment advisers.

In the 2011 Study, the staff of the SEC addressed the need for the establishment of uniform fiduciary standards applicable to broker-dealers and investment advisers. The language for this uniform fiduciary standard was based on SEC staff's review of the broker-dealer and investment adviser industries, the regulatory landscape, issues raised by commenters and other considerations required by the Dodd-Frank Act.9 Additionally, the 2011 Study concluded that the SEC should engage in rulemaking and/or provide interpretive guidance on the following aspects of a uniform fiduciary standard:

How to prohibit certain conflicts; How to facilitate effective disclosures to retail investors about the terms of their relationships with broker-dealers and investment advisers (including any material conflicts of interest); Specifying uniform standards for the duty of care owed to retail investors; Providing guidance on how to conduct principal trading; and Defining “personalized investment advice about securities.” In determining the practicality of a uniform fiduciary rule, the staff of the SEC also considered the potential alternatives of: (i) eliminating the broker-dealer exclusion from the definition of “investment adviser” in the Advisers Act; and (ii) applying the duty of care and other requirements of the Advisers Act to broker-dealers. The SEC staff determined, however, that these alternatives “would not provide the Commission with a flexible, practical approach to addressing what standard should apply to broker-dealers and investment advisers when they are performing the same functions for retail investors.”

In addition to a uniform fiduciary standard, the 2011 Study suggested harmonizing the laws and regulations applicable to investment advisers and broker-dealers in order to provide retail investors similar protections when receiving like services from these two groups. These suggestions included:

Rules about the content of advertising and similar communications about services; Disclosure requirements related to finders and solicitors; The harmonization of oversight of these entities; Maintaining consistency between similar disclosures required for registration and licensing; and The modification of the books and records requirements of the Advisers Act to be consistent with the rule applied to records requirements applied to broker-dealers. Addressing certain concerns regarding the impact of a proposed rule, the staff of the SEC noted that

Section 913 explicitly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities does not, in and of itself, violate the uniform fiduciary standard of conduct applied to a broker-dealer. Section 913 also provides that the uniform fiduciary standard does not necessarily require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice.

After review of the 2011 Study, the SEC followed up with a release on March 1, 2013 (the “2013 Release”) requesting data concerning standards of conduct and the potential harmonization of certain other aspects of broker-dealer and investment adviser regulation. Assumptions in the 2013 Release intended to guide commentators provided the public with insight into the alternative proposals being considered by the SEC. Of most importance, commentators were instructed to assume that:

A broker-dealer or investment adviser would not have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice; Any action would apply to all broker-dealers and investment advisers; and The uniform fiduciary standard would be designed to accommodate various business models and fee structures.10 In addition, the 2013 Release provided that a uniform fiduciary standard would not necessarily require all firms to:

Provide the lowest-cost alternative; Stop offering proprietary products; Charge only asset-based fees (as opposed to charging commissions); and Continuously monitor all accounts. Department of Labor Fiduciary Rule

Subsequently, in April of 2016, the Department of Labor (theDOL) issued new regulations and a series of prohibited transaction exemptions and amendments referred to collectively as theFiduciary Rule. The Fiduciary Rule expanded the definition offiduciary for purposes of ERISA and Section 4975 of the Internal Revenue Code of 1986, as amended (theCode), so as to include a broader array of financial service providers, including broker-dealers and other service providers not previously subject to ERISA or Section 4975 of the Code. Because both ERISA and Section 4975 of the Code prohibitfiduciaries from providing certain kinds of conflicted investment advice or receiving certain kinds of compensation, the Fiduciary Rule effectively prohibited several standard compensation arrangements for broker-dealers providing recommendations to investors subject to ERISA or Section 4975 of the Code, absent an applicable exemption. Anticipating this, the DOL included in the Fiduciary Rule several new exemptions and safe harbors for these kinds of arrangements. As applied to retail customers like owners of IRAs and participants in 401(k) plans, these exemptions typically requiredfiduciaries to conform to a heightenedprudent person standard of care when making recommendations, to actwithout regard to conflicts of interest and otherwise comply with several technical...

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