SEC Proposes Enhanced Investment Adviser and Broker-Dealer Standards of Conduct

On April 18, the Securities and Exchange Commission (SEC) proposed a trio of rules and interpretations designed to enhance the quality and transparency of investors’ relationships with investment advisers (IAs) and broker-dealers (BDs) while preserving access to a variety of types of advice relationships and investment products.

The three proposals included Proposed Regulation Best Interest, Proposed Investment Adviser Interpretation and Proposed Form CRS Relationship Summary. Overall, the SEC indicated that the proposed rules and interpretations “would enhance investor protections by applying consistent principles to investment advisers and broker-dealers,” including providing clear disclosures, exercising due care and addressing conflicts of interest. The SEC also clarified that IAs’ and BDs’ specific obligations would be “tailored to the differences in the types of advice relationships that they offer.”

Proposed Regulation Best Interest

The first proposed rule would create a standard of conduct for any BD or person associated with a BD who recommends securities transactions or investment strategies involving securities to a retail customer. That standard of conduct includes a duty “to 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 retail customer” and is similar to the Department of Labor’s fiduciary rule, which the 5th Circuit Court of Appeals vacated in March.

Essentially, the SEC’s Regulation Best Interest codifies the principle that a BD may not put its financial interests ahead of those of a retail customer while making recommendations. The proposed rule outlines specific obligations that must be satisfied for compliance:

• Disclosure: The covered entity must disclose in writing to the customer all material facts about the relationship, including associated conflicts of interest.
  
  
• Diligence and Care: The BD must “exercise reasonable diligence, care, skill, and prudence” to (i) understand the recommended product, (ii) have a reasonable basis to believe that the product is in the customer’s best interest and (iii) have a reasonable basis to believe that a series of recommended transactions is in the retail customer’s best interest in the context of their overall investment profile.
  
  
• Conflict of Interest: The covered entity is required to establish, maintain and enforce written policies and procedures reasonably designed to identify and to disclose or eliminate all material conflicts associated with the recommendations.

Proposed Form CRS Relationship Summary

Under the second proposed rule, IAs, BDs and their respective associated persons would be required to provide retail investors a summary outlining information about the relationships and services the firm offers, the fees and costs associated with those services, specified conflicts of interest, and whether the firm and its financial professionals have any reportable legal or disciplinary events. The SEC intends the Form CRS (Customer/Client Relationship Summary) to provide clarity for investors so they understand both “who they are dealing with” (i.e., an IA, a BD or a “dual-hatted” entity) and “what that means and why it matters.” This includes a two-pronged approach:

• Clear Labeling: Requires BDs and IAs to be direct and clear about their legal form in communications with investors and prospective investors. In addition, stand-alone BDs and their financial professionals would be restricted from using the terms “adviser” and “advisor” as part of their names or title, as the SEC states they are so similar to “investment adviser” that their use by a stand-alone BD may mislead prospective customers.
  
  
• Fee, Conflict and Other Material Disclosure: Requires IAs, BDs and dual-hatted entities to provide investors with a standardized, short-form disclosure. At a maximum length of four pages, the disclosure must highlight important differences in the types of services offered, the legal standards of conduct that apply to each, any customer fees and conflicts of interest that may exist. It will also inform customers how to get more information, including on the firm’s or investment professional’s disciplinary history.

The SEC also released three Form CRS mock-ups to help IAs, BDs and retail customers visualize how they would look, providing examples of potential disclosures for stand-alone BDs, stand-alone IAs and dually registered firms.

Proposed Investment Adviser Interpretation

Finally, the SEC proposed interpretation of the standard of conduct for IAs under the Investment Advisers Act of 1940, with the intent of reaffirming and clarifying certain aspects of their fiduciary duties in light of the “comprehensive nature” of the two accompanying proposed rules. Overall, the interpretation states that “[a]s fiduciaries, investment advisers owe their clients a duty of care,” including (i) the duty to act and to provide advice in the best interest of the client, (ii) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select BDs to execute client trades, and (iii) the duty to provide advice and monitoring over the course of the relationship. The interpretation also outlines an IA’s duty of loyalty requiring it “to put its client’s interests first,” which includes providing “full and fair disclosure … of all material facts relating to the advisory relationship,” such as any potential conflicts of interest.

The SEC is accepting public comment on all three proposals, and the comment period will remain open for 90 days following publication of the documents in the Federal Register.