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On April 18, the SEC approved the publication of three releases (the “Releases”) proposing new regulatory requirements that are intended to expand and clarify the duties that broker-dealers and investment advisers owe to their clients under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”), respectively. The Releases were adopted by a 4-1 vote (Commissioner Stein voting no), with even the Commissioners who voted to publish the Releases expressing concerns about their substance, albeit for opposing reasons.
The first section of this memorandum provides an overview of the Releases, their significance and background to their issuance. The next three sections of the memorandum describe each of the Releases in turn. The final section of this memorandum discusses the differing viewpoints of the Commissioners and the underlying policy debates informing those viewpoints.
Although the requirements applicable to broker-dealers and investment advisers are distinct, substantive similarities and even greater philosophical similarities link the Releases. Given that many broker-dealers and investment advisers are either dual registrants or affiliated with a registrant in the other regulatory category, it is important that each type of registrant fully understand all three Releases.
The SEC Commissioners voted 4‑1 in favor of publishing the Releases.4 Commissioner Kara Stein dissented and issued a public statement vigorously opposing the SEC’s approach. In addition, Commissioners Michael Piwowar, Hester Peirce and Robert Jackson each indicated they likely would have voted “no,” albeit for very different reasons, if the vote had been to adopt the rules set out in the Releases as proposed.
All of the Commissioners (other than Chairman Clayton) agreed that the standards imposed by the Releases were unclear in fundamental respects. However, there were significant disagreements beyond that. Commissioners Peirce and Piwowar took the view that the material difference between the services provided by broker-dealers and investment advisers should be preserved, and that the imposition of a “best-interest” standard on broker-dealers is not appropriate and would limit the services available to retail investors and drive up costs for those investors. By contrast, Commissioners Stein and Jackson advocated for a more stringent rule that would impose strict “fiduciary” and “best-interest” obligations on broker-dealers making recommendations to retail investors.
Collectively, the adoption of the proposals in the Releases would have a significant impact on the manner in which financial services are provided to retail investors. The Best Interest Requirement would likely discourage the offering of “full-service” brokerage and encourage alternatives such as “discount” brokerage and fee-based advisory accounts.
Beyond these issues of practical concern, the Releases (and the debate over their adoption) raise very significant questions of regulatory policy and philosophy. Of these questions, which are discussed in the last section of this memorandum, the most significant is (i) whether retail investors can be protected adequately through a disclosure-based regime in which the primary obligation that financial intermediaries have is to tell the truth and investors make self-determined investment decisions; or (ii) whether that disclosure-based regime should be replaced by a system in which broker-dealers making a recommendation must also oversee their customers’ financial circumstances and are discouraged, even if not expressly prohibited, from offering more complicated or risky products.5
An important driver to the background to the publication of the Releases (or the “elephant in the room,” in the words of Commissioner Piwowar) is the so-called “Fiduciary Rule.” In April of 2016, the DOL issued a final regulation revising the definition of the term “fiduciary” as it relates to investment advice fiduciaries (the “Fiduciary Rule”).6 The Fiduciary Rule significantly expanded the circumstances in which a person could become an investment advice fiduciary under the Employee Retirement Income Security Act of 1974 (“ERISA”). In such event, the person becomes subject to, among other things, the fiduciary responsibility provisions of ERISA and the conflict of interest prohibited transaction provisions of ERISA and Section 4975 of the Internal Revenue Code. The Fiduciary Rule has a significant impact on broker-dealers interacting with plans and individual retirement accounts, as their sales and marketing activities to such plans accounts are now more likely to result in fiduciary status under ERISA and, as a result, such broker-dealers could be precluded from receiving transaction-based compensation with respect to, or transacting on a principal basis with, such plans or accounts.
It suffices at this point to say that Fiduciary Rule was extremely controversial, attracting both significant praise and criticism. Critics of the Fiduciary Rule, including Chair Clayton of the SEC, focused on its burdens, the fact that those burdens would discourage the provision of full-service brokerage and be confusing, as broker-dealers would become subject to two sets of customer protection rules, (i) those of the SEC and FINRA and (ii) those of the DOL.
While Chair Clayton criticized the Fiduciary Rule, its concepts are to a good extent embedded in the Best Interest Release. Chair Clayton appears to be seeking a middle ground: (i) to adopt an SEC Rule that would be close enough to the Fiduciary Rule that the DOL would be willing to drop the Fiduciary Rule on the basis that the SEC’s new requirements are good enough, (ii) but not so onerous as to kill the full-service brokerage model. The reaction of his fellow Commissioners to this approach is discussed in more detail in the latter sections of the memorandum.
As described in the Best Interest Release, a broker-dealer would be required to “act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or salesperson ahead of the interest of the retail customer.” As the Commissioners generally agreed, these words are so open-ended that they are essentially meaningless as practical guides for behavior. However, SEA Rule 15l-1 stating that this obligation would be satisfied as follows:7
Certain of the terms used above are further explained or defined in the Best Interest Release or in the proposed rule. The key terms are as follows:
The Best Interest Release identifies the activities listed below as questionable. Specifically, proposed Regulation Best Interest would not per se prohibit “a broker-dealer from transactions involving conflicts of interest, such as the following,” but neither would they be per se permitted.
The Best Interest Release provides that broker-dealers would be required to institute the following procedures in their Best Interest compliance programs:
The Best Interest Release also explains that certain procedures that broker-dealers would be required to follow with respect to their compensation arrangements should:
Even without waiting for further action on the Releases, firms should consider whether to adopt some of these compliance measures now, most importantly: (i) formalized procedures to identify conflicts of interest;21 (ii) the careful calibration of compensation schedules and the elimination of any compensation methods that appear unseemly, such as sales contests;22 and (iii) the formalized product-specific training of salespersons.
The Best Interest Release is sending a very strong message to broker-dealers that they need to look at compensation practices. To the extent that firms have any compensation practices that appear at all inappropriate, such as sales contests, consideration should be given to discontinuing them; they are a regulatory red flag.23 Firms should review the amounts that they charge customers, and the amounts they pay salespeople, for different types of products, and for proprietary products vs. third-party products, and be able to explain why the differences exist.
According to the Best Interest Release, the SEC does “not believe proposed Regulation Best Interest would create any new private right of action or right of rescission, nor do we intend such a result.” The SEC’s assertion is predicated upon the basis that the regulation is being proposed, “in part” in reliance on authority in Section 15(l) of the Exchange Act, which does not create a private right of action.24
While Regulation Best Interest may be based “in part” on Section 15(l), the Regulation is also, according to the Best Interest Release, based “in part” on at least 48 other sections of the securities laws, including the main antifraud provision of the Exchange Act, Section 10(b).25 To the extent that Regulation Best Interest is based on Section 10(b) or any other provision of the securities laws that has an explicit or implied private right of action, it seems inevitable that plaintiffs will assert—and it seems at least possible that a court may ultimately agree—that Regulation Best Interest has expanded the grounds for lawsuits in federal court by investors for violations of the securities laws.
Similarly, it seems quite possible that retail investors will have increased grounds to bring claims under the FINRA Suitability Rule if a broker-dealer has not complied with Regulation Best Interest. Further, as noted above, FINRA has stated that it could examine its own Suitability Rule if Regulation Best Interest is adopted, and indeed, on the heels of the Releases, has proposed amendments to its Suitability Rule that would eliminate the requirement that a broker-dealer have control over a customer account as a predicate to any finding that the broker-dealer had violated quantitative suitability obligations. In short, we certainly expect that Regulation Best Interest could generate increased litigation and arbitration claims, as plaintiffs test the effect of the requirements in courts and arbitration.
The Fiduciary Guidance Release purports to reaffirm, and in some case clarify, the fiduciary duty that investment advisers owe to their clients:26
An investment adviser is a fiduciary, and as such is held to the highest standard of conduct and must act in the best interest of its client. Its fiduciary obligation, which includes an affirmative duty of utmost good faith and full and fair disclosures of all materials facts, is established under federal law and is important to the Commission’s investor protection efforts.27
In addition, the Fiduciary Guidance Release requests comments on whether certain aspects of SEC investment adviser regulation should be expanded so that they would mirror broker-dealer regulation. Note that the Fiduciary Guidance Release generally applies to an investment adviser’s relationship with all categories of clients, including institutional as well as retail clients.
The Fiduciary Guidance Release states that Section 206 of the Advisers Act establishes a federal fiduciary standard for investment advisers comprising a duty of care and a duty of loyalty. The Release states that the federal fiduciary duty cannot be negotiated or disclosed away.28 While the existence of the duty cannot be negotiated away, the scope of the relationship between an investment adviser and its client can be modified by disclosure and “informed consent.”
According to the SEC, an investment adviser’s fiduciary duty is “made enforceable by the antifraud provisions of the Advisers Act,”29 which prohibits an investment adviser from engaging in conduct that operates as a “fraud or deceit upon any client.”30 Historically, such enforcement has been “regulatory,” rather than by private right of action. In Transamerica Mortgage Advisors, Inc. v. Lewis, the Supreme Court held that there is no general private right of action under Section 206 of the Advisers Act, and instead recognized only a limited private remedy under Section 215 of the Advisers Act to void contracts made in violation of the statute.31 Nonetheless, the Fiduciary Guidance Release raises the specter of an increase in the amount of litigation against investment advisers, as any actual or perceived enlargement of an adviser’s fiduciary obligations could result in an increase in actions that proceed under state law rather than the Advisers Act.
Investment advisers owe their clients a duty of care. The Fiduciary Guidance Release specifies that the duty of care includes, but is not limited to, (i) the duty to provide advice in the client’s best interest, (ii) a duty to seek best execution, and (iii) a duty to provide advice and monitoring over the course of the relationship. These duties, as described in the proposed Fiduciary Guidance Release, are explained in greater detail below.
The Fiduciary Guidance Release would require investment advisers, before providing investment advice, to make a reasonable inquiry into a client’s “financial profile” (i.e., a client’s financial situation, level of financial sophistication, investment experience and investment objectives). The nature of this inquiry hinges on what is reasonable under the circumstances. Advisers would have an ongoing obligation to update a client’s investment profile and adjust advice accordingly.
Investment advisers also would be required to have a reasonable belief that investment advice is suitable for and in the best interest of the client based on a client’s investment profile. Therefore, investment advice must take into account a client’s entire circumstances, beyond the particular investments that are recommended or purchased. The Fiduciary Guidance Release states that investment advisers are not necessarily required to recommend the lowest cost product or strategy.32 Advisers must take into account factors such as a product’s, or strategy’s investment objectives, liquidity, risk, volatility and expected performance in a variety of market conditions. The Fiduciary Guidance Release also indicates that establishing a reasonable belief that investment advice is in the best interest of a client requires a reasonable investigation into an investment, and it is not sufficient to base advice on information known or suspected to be materially incomplete or inaccurate.
When an adviser has the responsibility to select broker-dealers to execute client trades, an adviser has a duty to seek best execution of the client’s transactions. The Fiduciary Guidance Release states that an adviser fulfills this duty by seeking to maximize value for the client under the particular circumstances occurring at the time of a transaction. The proposed guidance provides that lowest execution cost is not necessarily a determinative factor. Rather, advisers should consider “the full range and quality of a broker’s services in placing brokerage including . . . the value of research provided as well as execution capability, commission rate, financial reasonability, and responsiveness.”
The Fiduciary Guidance Release would require investment advisers to provide advice and services “at a frequency that is both in the best interest of the client and consistent with the scope of advisory services agreed.” The duty to provide advice and monitoring would be commensurate with the scope of the relationship. This duty is particularly important where an adviser has an ongoing relationship with a client. In contrast, less would be required where the relationship is one of limited duration.
The Fiduciary Guidance Release explains that an investment adviser’s fiduciary duty also encompasses a duty of loyalty. As such, an adviser must not favor its own interests or unfairly favor one client over another. In addition, an adviser must make “full and fair disclosure” of all material facts relating to the advisory relationship.
According the Fiduciary Guidance Release, the duty of loyalty requires advisers to seek to avoid conflicts of interest, and, at a minimum, make full and fair disclosure of all material conflicts. Any disclosure must be clear and detailed enough for a client to provide informed consent with respect to a conflict. Nevertheless, the proposed guidance states that disclosure of a conflict alone is not always sufficient to satisfy an adviser’s duty of loyalty. The Fiduciary Guidance Release indicates that disclosure is insufficient where (i) the facts and circumstances indicate that the client did not understand the nature and import of the conflict or (ii) the material facts concerning a conflict cannot be fully or fairly disclosed. Thus, the SEC appears to be taking the position that certain conflicts are of a nature and extent such that they cannot be disclosed away. Where disclosure is insufficient, the SEC would expect advisers to eliminate or adequately mitigate the conflict so that it can be fairly disclosed.
The Fiduciary Guidance Release includes a request for comments regarding three proposals for enhanced investment adviser regulation:
If adopted, these proposals would move the regulatory framework for investment advisers closer to that of broker-dealers. The costs associated with such requirements could prove to be substantial, and risk putting smaller and start-up investment advisers out of business. Small investment advisers, in particular, would likely find the financial reporting requirements to be quite expensive relative to their revenues. Further, we would point to the potential costs not only to investment advisers, but to the SEC itself, of establishing capital requirements on investment advisers.33 Promulgating any such set of requirements, along with related financial record keeping rules, and attempting to enforce them, would be an enormous drain on the resources of the SEC, particularly as it could not rely upon FINRA to supplement the SEC’s own compliance efforts. Unless the SEC is planning a very substantial expansion of its staff, we would caution the SEC against taking on a rulemaking that seems so large in expense for so many without any obvious commensurate benefit.
The SEC proposed a rule that would require broker-dealers and investment advisers to provide retail investors with a short-form “relationship summary” referred to as Form CRS, which would be in addition to existing disclosure and reporting obligations.34 Additionally, broker-dealers and investment advisers would be required to deliver information as to their registration status and the obligations that attend to such status.35 The SEC stated that it is proposing Form CRS as a means to address financial illiteracy among retail investors. In particular, the proposed CRS Release cites studies showing that retail investors do not understand the differences between broker-dealers, investment advisers, and dually registered firms.
The relationship summary would be limited to four pages and would be subject to restrictions on page size, font, and margins. Form CRS would require information on the following items:
The proposed rule broadly defines “retail investor” as “a prospective or existing client or customer who is a natural person (an individual).”37 Broker-dealers and investment advisers, therefore, would be required to deliver Form CRS to all individual investors regardless of net worth or financial sophistication.
Delivery must occur, in the case of investment advisers, before or at the time an advisory agreement is entered into, or in the case of broker-dealers, before or at the time the retail investor engages the firm’s services. Firms also would be required to deliver the relationship summary when a new account is opened or if changes are made to a retail investor’s account that would materially change the nature and scope of the relationship. The CRS Release includes various requirements regarding the method of delivery. In addition, firms must file Form CRS with the SEC and the document would be publicly available.
The CRS Release also seeks to mitigate investor confusion by restricting broker-dealers and any natural associated persons, when communicating with retail investors, from using as part of its name or title the words “adviser” or “advisor,”38 unless the broker-dealer is registered as an investment adviser with the SEC or any state, or the natural associated person is a supervised person of a registered investment adviser and such person provides investment advice on behalf of such investment adviser. In addition, the proposed rule would require firms to disclose their registration status as a broker-dealer or investment adviser with the SEC in retail investor communications. Natural associated persons of broker-dealers and supervised persons of investment advisers would also need to disclose their status.
As stated earlier, the DOL Fiduciary Release informs the Releases. At the most general level, the DOL Fiduciary Rule raises the following policy questions: (i) in the interest of protecting retail investors, did the DOL Fiduciary Rule impose such heavy burdens on financial service providers, that broker-dealers simply stopped offering a large range of services and products to retails investors; (ii) if so, were retail investors better off or worse off; and (iii) is it good regulatory policy for the Department of Labor to issue a rule governing the customer obligations of SEC-registered broker-dealers. It is against that background that the statements of the various Commissioners must be understood.
Fundamentally, Commissioner Stein seems to object to the broker-dealer model in which (i) brokers are paid based on receiving commissions for transactional business and (ii) dealers make a profit by entering into transactions as counterparties to their clients. While this may seem to trivialize Commissioner Stein’s position, it is, in fact, a realistic position. In short, Commissioner Stein seems essentially to advocate for investors to interact only with investment advisers that were neither broker-dealers nor affiliated with broker-dealers. Investors could then pay fees to advisers who would be required to act purely as agents in the best interest of clients. Broker-dealers would then be simply execution agents.39
The problem, or the weakness, in the model that Commissioner Stein suggests is that many investors, particularly buy and hold investors, would find it not economical to pay investment advisory fees, and thus would have only the option of discount (execution-only) brokerage. But Commissioner Stein might argue that this would not be a bad result, if one believes that the services that investors otherwise receive from broker-dealers are so materially flawed as to be worth less than nothing.
Commissioner Stein indicated that the Fiduciary Guidance Release and the CRS Release were less concerning than the Best Interest Release, but nonetheless criticized them for not proposing meaningful change. She argued that the proposed client relationship summary is inadequate to cure investor confusion, and instead advocated for disclosures that provide retail investors with an understanding of the application of a firm’s obligations to the investor. She was also skeptical that retail investors would read and take seriously the client relationship summary unless it used “visual, design-oriented techniques,” such as tables, color-coding and pictograms, to get investors to pay attention.
With respect to the Fiduciary Guidance Release, Commissioner Stein questioned why the SEC “might be in the best position to issue interpretive guidance on an area that is heavily informed by decades of common law.” She also expressed concern that by limiting the interpretation of fiduciary duties to those duties required by Section 206 of the Advisers Act, the SEC might be suggesting a narrowing of an investment adviser’s broader fiduciary duties.
In contrast to Commissioner Stein, Commissioner Peirce advocates for the continuance of the broker-dealer business model, saying that it had “served many investors so well for so many decades.” Indeed, she compared the broker-dealer regulatory regime favorably to the investment adviser regime “with [the adviser regime’s] lack of a self-regulatory organization, its flexible standards that can be tailored through disclosure, its relative lack of rules, and its potentially lucrative asset-based fees.” In this regard, she noted that firms were generally switching from acting as broker-dealers to acting as investment advisers, implicitly emphasizing the point that broker-dealers are actually more heavily regulated than are investment advisers.
On the Form CRS proposal, Commissioner Peirce questioned its usefulness for retail investors. Additionally, Commissioner Peirce, although broadly supportive of the SEC providing guidance with respect to investment advisers’ fiduciaries duties, expressed concern that the Fiduciary Guidance Release makes new law. By way of example she cited the imposition of an informed consent requirement on the ability to shape advisory relationships. She also criticized the proposed additional regulatory obligations for investment advisers, such as licensing and net capital requirements, arguing that they represent a paradigm shift away from the current principles-based model of adviser regulation.
Similar to Commissioners Stein, Jackson and Peirce, Commissioner Piwowar questioned the usefulness of the proposed client relationship summary in its current form. He also expressed concerns as to whether the SEC has legal authority to issue the Fiduciary Guidance due to the lack of case law underpinning much of the interpretation.
The Releases and the differing views expressed by the Commissioners raise a number of very fundamental policy questions that in many ways go to the heart of the way in which our markets operate and the services and products that financial intermediaries may offer. We list a few of these issues below and then somewhat focus on two of the major issues:
To put it in the bluntest possible terms, the underlying premises of the Best Interest Release is that (i) all household investors should be treated as “financially illiterate” and structurally vulnerable (and to the extent that there are exceptions, they are too unusual to be worried about), (ii) investors’ financial illiteracy and vulnerability is so great that information asymmetries cannot be cured with disclosure,41 and (iii) the threat of litigation risk combined with the express rules against conflicts of interest should be used to push investors into conservative investments.42
As a starting matter, these premises, while they sound harsh, are not so unreasonable. Studies have shown that the financial literacy of many Americans is remarkably low, that many do not understand the difference between a debt security and an equity security. In effect, for purposes of making investment decisions, these investors should be treated as a protected class.
Of course, one can say that financial illiteracy is a problem that should be confronted, but that is not a problem that the SEC is charged with solving, nor is it one that can be fixed in the short term. If one accepts that the SEC must take financial illiteracy as the norm, then a question that follows is whether any exceptions from that norm should be recognized. The answer that the Releases seems to give is “no,” that exceptions are too slight, too small and too fleeting to be acknowledged.
The premise of acting as a full-service broker-dealer is that there is an inherent, but acceptable, conflict between the broker-dealer and the customer in that the broker or dealer only makes money if the investor trades and pays the broker-dealer for trading.43 Notwithstanding this conflict of interest, this model may work sufficiently well (which is to say better than alternatives) for the same reason that many commercial sales models work sufficiently well: because the broker-dealer provides enough value that customers believe it works.44 However, the Best Interest Release says that it is the SEC goal “to enhance investor protection, while preserving, to the extent possible access and choice for investors who prefer the “pay as you go” model for advice from broker-dealers.”
At the same time, determining whether the provision of advice is “solely incidental” to the conduct of a broker-dealer45 is not easy. And as Commissioner Jackson noted, nowhere in the Releases does the SEC appear to directly answer the policy question raised by Section 211(g) of the Advisers Act of whether a broker-dealer providing personalized investment advice and an investment adviser providing personalized investment advice should be subject to the same standards for the provision of that advice. Instead, the SEC simply implies its answer to the question is “no,” that provision of advice that is “incidental” to other (paid) services should be regulated differently from advice that is paid for directly. This has merit as a policy, but is heavily reliant on the view that investors – whom the SEC elsewhere requires broker-dealers to treat as though they know little about investing – will understand, via a brief disclosure document, the complicated regulatory differences that result in financial advice given by broker-dealers, investment advisers, and others (e.g., financial planners) to be subject to wholly different standards.
And this comes back to one of the core questions posed by the Releases: should the full-service, advice-providing broker-dealer model be preserved or should the market be pushed to move entirely to a combination of discount (no-advice) brokerage and investment advisers without any transaction-based fees? The SEC does not take a firm stand on this question, notwithstanding four of the five Commissioners are prepared to take one (albeit opposite stands). Instead, the SEC is proposing to adopt a regulatory scheme that suggests it believes a place for a middle ground of advice-providing broker exists (i.e., by not simply adopting the Advisers Act standard for advice from a broker), but one that also imposes obligations on broker-dealers in that middle ground that are significant enough to raise the question of what exactly is different, and will the liability and compliance risk from that standard be too costly for a broker continue to provide advice without receiving “special compensation” for that advice.
* * *
The Releases raise very significant business and compliance questions for broker-dealers and investment advisers, and will likely create material litigation risks to the extent that firms continue with their current business models. Even if the Releases do not proceed, or are significantly modified, the Releases serve as a warning to firms that they should now review a number or their existing compliance procedures and potentially to restrict their product or service offerings.
The heated debate over the substance of the Releases reflects very substantial philosophical divides as to our appropriate regulatory model. On the one hand, there is the view that investors are generally not able to fend for themselves, even given disclosures, and, thus, that any recommendations provided to investors must be given in a fiduciary capacity. Coupled with the view that broker-dealers must act entirely in the best interest of their clients, this position raises questions as to whether the full-service broker-dealer model, where broker-dealers provide advice and receive transaction fees, is viable.
On the other hand, there is the view that we should accept that broker-dealers may be less than fiduciaries and that many investors will be much better served if broker-dealers are able to present them with recommendations that do not bear all of the regulatory risk and litigation risk of being deemed a fiduciary. This model has the advantage that investors will have the opportunity to obtain a wider range of products and services, and at a lower cost; but the disadvantage that their purchases may bear more risk or they may receive advice that is conflicted in one way or another.
1 SEC Release No. 34-83062.
2 SEC Release No. IA-4889.
3 SEC Release No. 34-83063; SEC Release No. IA-4888.
4 See “Clayton Statement,” the “Peirce Statement,” the “Piwowar Statement,” the “Jackson Statement” and the “Stein Statement.”
5 This debate is ongoing on multiple levels at the SEC. See, e.g., Michael S. Piwowar, Remarks at the “SEC Speaks” Conference 2017: Remembering the Forgotten Investor (Feb. 24, 2017) (noting, among other things, that limiting certain products to “accredited investors” provides a “blanket prohibition” on higher returns to non-accredited investors).
6 81 Fed. Reg. 20945 (Apr. 8, 2016). The DOL Fiduciary Rule requirements generally became applicable on June 9, 2017, but the DOL postponed the application of many conditions of the two new exemptions discussed in this section until July of 2019 while it re-examines the DOL Fiduciary Rule and exemptions as directed by the President. In March of 2018, the Fifth Circuit issued a ruling vacating the DOL Fiduciary Rule. As of this date, the DOL has yet to indicate whether it is going to seek a rehearing or appeal the decision.
7 Certain key terms are bolded and discussed below.
8 Note that this requirement is separate from the obligation to provide a relationship summary, as would be mandated by the CRS Release.
9 See, e.g., FINRA Notice 11-02 (the “determination of the existence of a recommendation has always been based on the facts and circumstances of the particular case) ; see also fn. 10 (“FINRA has stated that defining the term “recommendation” is unnecessary and would raise many complex issues . . .”)
10 See, e.g., FINRA Notice 96-60. (“In particular, a transaction will be considered recommended when the member or its associated person brings a specific security to the attention of the customer through any means . . . “)
11 Note that this use of the term “person” is not restricted to a natural person, and would thus include family trusts and offices.
12 This language is lifted from the CFTC and SEC swap guidance, which provides an exemption for consumer contracts relating to personal, family or household purposes. Similarly, SEC Regulation S-P, which sets forth privacy requirements for broker-dealers and investment advisers, defines a “consumer” as an individual who obtains a financial product or service that is to be used “primarily for personal, family, or household purposes.” See SEC Regulation S-P Rule 248.3(g)(1).
13 By contrast, an individual investor with at least $50 million in total assets would be considered an “institutional account” for purposes of FINRA Rule 2111 (the “Suitability Rule”). See FINRA Rule 2111(b) incorporating the definition of “institutional account” in FINRA Rule 4512(c)(3).
14 ERISA Section 404(a)(1)(B) establishes that a fiduciary must act with care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. Lack of knowledge is not an excuse for a bad decision; a fiduciary under ERISA is judged according to the standards of others with the necessary expertise in a particular area. A fiduciary may satisfy ERISA’s prudence requirements by giving appropriate consideration to the facts and circumstances that, given the scope of the fiduciary’s investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action, including the role it plays in the portfolio, and act accordingly. “Appropriate consideration” would include determining that the investment is reasonably designed, as part of the investor’s portfolio, to further the purposes of the investor, taking into consideration risk of loss and opportunity for gain, the investor’s portfolio’s diversification, liquidity and projected returns. DOL Reg. § 2550.404a-1(b)(1).
15 See FINRA Notice 11-02 (describing the various types of suitability obligations: reasonable basis, customer specific, and quantitative).
16 Notably, immediately after the SEC issued the Best Interest Release, FINRA issued Regulatory Notice 18-13, which would make it easier to impose liability on a broker-dealer where there had been excessive trading in a customer’s account. In that Notice, FINRA also stated that that if Regulation Best Interest were adopted, it would consider the impact of the Regulation on the FINRA Suitability Rule more generally, presumably meaning that it might conform Rule 2111 to Regulation Best Interest.
17 Currently, FINRA’s equivalent “quantitative suitability” requirement applies to a broker-dealer that has control over a customer’s account. See FINRA Rule 2111.05(c). However, following the Best Interest Release, FINRA sought comment on a proposal to eliminate the control requirement. See FINRA Reg. Notice 18-13.
18 Best Interest Release notes at FN. 15
19 Cabinet News: SEC Division Director Vows Support for ICOs
20 In its 2017 Exam Report, FINRA observed a variety of effective practices in recommending the purchase and sale of certain products, including tailoring supervisory systems to products’ features, and sources of risk to customers.
21 This is a suggestion that has been made several times by the regulators, most recently in a 2013 FINRA report on conflict management (see Best Interest Release at p. 18), but likely has not been institutionalized at most firms because it is a difficult and amorphous concept to embody in a conflict manual and, for most firms, Dodd-Frank and other rulemakings have been entirely overwhelming.
22 Firms should also be mindful of the extent to which third parties provide benefits to a firm that may influence recommendations and that may not be disclosed to investors.
23 See, e.g., FINRA Notice 16-29.
24 See footnote 88 of the Best Interest Release.
25 See footnote 87 of the Best Interest Release.
26 The Fiduciary Guidance Release applies to advisory relationships with all clients, not only retail investors.
27 Fiduciary Guidance Release, pages 3-4.
28 Fiduciary Guidance Release, pages 7-8 & n.21.
29 Fiduciary Guidance Release, pages 6-7.
30 15 U.S.C. § 80b-6.
31 Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 19-26 (1979) (“when Congress declared in § 215 that certain contracts are void, it intended that the customary legal incidents of voidness would follow, including the availability of a suit for rescission or for an injunction against continued operation of the contract, and for restitution”).
The Supreme Court also has strictly limited the ability of federal courts to imply private rights of action in federal statutes:
“Like substantive federal law itself, private rights of action to enforce federal law must be created by Congress. . . . Language in a regulation may invoke a private right of action that Congress through statutory text created, but it may not create a right that Congress has not . . . [I]t is most certainly incorrect to say that language in a regulation can conjure up a private cause of action that has not been authorized by Congress.” Alexander v. Sandoval, 532 U.S. 275, 286 & 291 (2001).
32 The Fiduciary Guidance Release states that an adviser could not reasonably believe that a recommended security is in the best interest of a client if it is a higher cost than an otherwise identical security.
33 We note that in 2014, the National Futures Association (the “NFA”) requested comments on, and subsequently abandoned, a similar proposal to impose capital requirements on CPOs. See NFA NTM I-14-3 (Jan. 23, 2014).
34 The CRS Release includes as appendices mock relationship summaries for an investment advisory firm, a brokerage firm, and a dual-registrant. See: Proposed SEA Rule 17a-14: Form CRS, for preparation, filing and delivery of Form CRS; Proposed IAA Rule 204-5: Delivery of Form CRS; Proposed SEC Rule 249.640: Form CRS, Relationship Summary for Broker-Dealers Providing Services to Retail Investors pursuant to §240.17a-14 of this chapter
35 Proposed SEA Rule 15l-3: Disclosure of Registration Status; Proposed IAA Rule 211h-1: Disclosure of Registration Status;
36 The regulators have long been very focused on whether investors understand the differences between dealing with an investment adviser and dealing with a broker-dealer. This concern largely dates to a 2008 RAND Study (discussed at Best Interest Release footnote 28), which found that investors generally did not understand the difference between investment advisers and broker-dealers. Interestingly, the study also found that investors were equally pleased with both types of service providers, so the confusion over types seems of less significance than the regulators often make it out to be.
37 Note that the CRS Release proposes a different definition of “retail investor” than in the Best Interest Release.
38 SEC Commissioner Kara Stein observed that the limited scope of this ban creates a “whack-a-mole” problem, and advocated a more robust bar on broker-dealers holding themselves out as advisors.
39 Commissioner Stein does not expressly advocate for the position described above, but her remarks seem strongly to point in that direction. For example, one of the questions that she would pose to the public is “Should the Commission’s proposal require financial professionals to provide their retail customers with unconflicted investment advice.” This is a reasonable question to ask; but if the answer is yes, it follows that the financial professional cannot have any interest in the investor’s execution of the transaction; i.e., it cannot be a broker or a dealer. Commissioner Stein also asks “Should a broker-dealer [be required to] consider other products in the marketplace, such as those that are offered by other firms.” As a practical matter, it is not the job of a broker-dealer to market the products that it does not sell. That said, Commissioner Stein is, of course, correct that investment advisers might be directed to research the market for products offered by a variety of firms.
In short, the problem with Commissioner Stein’s questions is not that they lack any basis; it’s that if answered “yes,” they would effectively abolish the full-service brokerage model. This is an intellectually defensible position if Commissioner Stein believes, as she seems to, that the model is inherently flawed and unworkable. But then she should make the argument straight-out, and debate the consequences of the loss of that model, rather than advocating for rules that would end the model without following through to the consequences.
40 Commissioner Peirce stated bluntly that the “term Best Interest sets an impossible standard.” She went on to describe the term itself as being an “incantation, ”that is having a meaning that no one can define. . “
41 See pages 10-11 of the Best Interest Release as to disclosure alone being inherently insufficient.
42 This is not intended as a sarcastic comment on the Releases. The belief that retail investors require protection is a central theme. Further, the concern that retail investors are not capable of making investment decisions for themselves is not a trivial or unrealistic concern. Therefore, even if society acknowledges that some investors are capable, it may be prudent for society not to attempt distinctions between investors, but simply to assume their general incapacity.
43 The Best Interest Release acknowledges this in a number of places, including at page 22 and at footnote 33.
44 To be sure, the SEC of 2018 is not the first person to suggest that the commission-based compensation system has its flaws. See, e.g., Report of the Committee on Compensation Practices (Apr. 10, 1995) at 3 (committee would not, if starting from scratch, design a commission-based compensation system, noting “inevitable” conflicts of interest, but concluding that it would be too “radical” to seek changes in the near term, while noting a shift toward alternative arrangements).
45 See Advisers Act § 202(a)(11).