SEC Proposes New Broker-Dealer "Best Interest" Standard

AlertNew rules include disclosures for both broker-dealers and investment advisers, title restrictions and clarifications for Investment Adviser Fiduciary Standard
By Eric Mikkelson

Last Wednesday, the Securities and Exchange Commission (SEC) proposed a new set of rules under the Securities and Exchange Act of 1934 (Proposed Rules) that would establish a new "best interest" standard by which broker-dealers would conduct their interactions with retail customers. The Proposed Rules would require new disclosures to retail customers by both broker-dealers and investment advisers. Related to those new Proposed Rules, the SEC also proposed an interpretation clarifying the existing fiduciary standards applicable to investment advisers' dealings with their customers.


Since taking the helm last year, SEC Chair Jay Clayton has spoken about his focus on protection of the retail investor. The Proposed Rules are a thoughtful effort to provide additional such protection in an area that has generated long-standing concern.

For years, there has been study and discussion at the SEC and throughout the industry of a "unified" standard that would protect retail customers and reduce confusion. The Dodd-Frank Act authorized the study and implementation of related rules. Currently, the "suitability" standard applicable to broker-dealers is deemed by many to be insufficient to protect investors from conflicts of interest, particularly given the transaction-based nature of most broker-dealer compensation and the resulting incentives such commissions create.

Suitability is a lesser standard than the fiduciary duty to put a client's interest ahead of one's own. Currently, that higher fiduciary duty generally applies to investment advisers but not broker-dealers. Further compounding the perceived problem is the fact that retail customers often don't know the difference, particularly when dealing with firms and representatives that may hold dual-registrations.

The Proposed Rules may disappoint those who expected a uniform, highest fiduciary standard to be applied to broker-dealers, identical to the one that currently governs investment advisers. The SEC declined to do so for a number of reasons including the different business and compensation models between the two types of financial services, and the desire not to unduly limit choices available to customers. The Proposed Rules neither raise the standard for broker-dealers that high, nor offer a unified standard for broker-dealers and investment advisers. But Regulation Best Interest does have much in common with the fiduciary rule, and it enhances the existing standard for broker-dealers in a way that should provide greater protection for the retail investor from abusive practices.

In April of 2016 the Department of Labor (DOL) adopted its own rule to address these problems with advice on securities trades in retirement accounts. The DOL's "fiduciary rule" generally required those providing certain retirement investment services to benefit plans and retirement accounts to abide by a higher fiduciary standard. The breadth of the rules picked up many broker-dealers that had been handling and advising plans and retirement accounts that had not previously been subject to such a standard.
Implementation of those contentious DOL rules has been substantially delayed, however, and in March 2018 the U.S. Court of Appeals for the Fifth Circuit vacated that DOL rule in its entirety. While that decision may yet be appealed, these new Proposed Rules could substantially supplant them if finalized.

New Proposed Regulation Best Interest

In proposing a new "Regulation Best Interest", the Proposed Rules would require that a broker-dealer "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."

A precise definition of "best interest" is not provided in the Proposed Rules due to the SEC's view that such determination varies based on facts and circumstances. To satisfy the new standard the Proposed Rules require that the broker comply with several new obligations, including a "Disclosure Obligation," a "Care Obligation," and "Conflict of Interest Obligations."

The Disclosure Obligation would require written disclosure to the customer of material facts, including conflicts of interest. The Care Obligation would require the broker-dealer to exercise reasonable diligence to develop a reasonable basis and belief that the investment is in the customer's best interest. The Conflict of Interest Obligations would require the broker-dealer to implement written policies and procedures to identify, disclose, eliminate or mitigate material conflicts of interest, including those arising from financial incentives associated with specific recommendations.

Regulation Best Interest is not designed to eliminate conflicts of interest entirely. But material conflicts, including certain financial incentives for more trading caused by the industry's transaction-based commission structure in broker relationships, should be disclosed and mitigated to some extent, reducing risk of adverse impact to the retail customer.

Although guidance and suggestions are provided with respect to all the new obligations, the Proposed Rules generally allow broker-dealers flexibility to tailor the compliance specifics to their respective particular circumstances.

New Form CRS

Related to the new Disclosure Obligation, the Proposed Rules also require both broker-dealers and investment advisers to provide retail investors a new short (4-page maximum) client "Relationship Summary" (called Form CRS), and a "Regulatory Status Disclosure". The Proposed Rules include a sample Form CRS for each of broker-dealers, investment advisers, and dual-registrants to use respectively in tailoring their own compliant disclosure documents. In addition, the Proposed Rules prohibit a broker-dealer from using the term "advisor" or "adviser" (such as describing oneself as a financial advisor) to avoid misleading investors.

New Proposed Interpretation of Fiduciary Standard for Investment Advisers

In addition to, and in conjunction with, the Proposed Rules, the SEC also released a proposed interpretation of the existing fiduciary standard that applies to investment advisers. In doing so, the SEC took the opportunity to compare that fiduciary duty standard with the Regulation Best Interest it has now proposed for broker-dealers. Although as clarified in this release, the SEC is intentionally not unifying the standards applicable to investment advisers and broker-dealers as some had hoped, it does identify some areas where harmonization should be considered including for example whether 1) investment adviser representatives should be subject to Federal licensing and qualification standards similar to those required of broker-dealer representatives (individual investment adviser representatives are currently generally only subject to state licensing); 2) periodic account statement requirements should be harmonized for broker-dealers and investment advisers; and 3) financial responsibility rules such as minimum net capital requirements currently imposed on broker-dealers should be harmonized to include investment advisers.

What Comes Next

Since the Proposed Rules rely heavily (but not exclusively) on disclosure, and do not precisely define "best interest" of the customer, one dissenting SEC Commissioner derided them as "regulation status quo". A few of the four SEC Commissioners who voted to advance the Proposed Rules also expressed serious reservations. One aptly said the Proposed Rules were best described as "suitability-plus" rather than a true fiduciary standard. The Proposed Rules could undergo substantial revisions before any final adoption.

For now, however, the Proposed Rules check a long-open box for the SEC to propose something to address the perception of confusion, and risks of conflicts, related to certain financial services to retail investors. During the 90-day comment period, the Proposed Rules are sure to spark a renewed, robust discussion before any finalization. Extensions and delays are possible, and adoption is uncertain given the headwinds such proposals are facing. For firms preparing to comply with any new rule that gets adopted, it will require monitoring and adjustment along the way before any clear finalized rule materializes.

If the Proposed Rules are implemented in a form similar to the proposal, they could further undermine and even supplant the embattled DOL fiduciary rule, notwithstanding the fact that industry firms have spent heavily to prepare for compliance with that DOL rule. It will be interesting to see whether the Fifth Circuit's decision to vacate that rule is appealed by the DOL (it has until early May to decide to request rehearing). The timing of the Proposed Rules may make that less likely but we'll see.

In the meantime, the Proposed Rules offer a middle-ground approach, moving the needle to protect retail investors from abusive and confusing practices, but also allowing broker-dealers the flexibility to tailor compliance without fundamentally disrupting business models.

Visit the SEC's website for the text of the Proposed Rules.

For any questions or if we can otherwise assist with your broker-dealer or investment adviser compliance and transactions, please contact Eric Mikkelson or any other member of the Investment Management Group of Stinson Leonard Street.

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