SEC clarifies varying roles of financial professionals

By Patricia Foster
BridgeTower Media Newswires
Last year the U.S. Securities and Exchange Commission adopted a package of rules, forms and interpretations designed to enhance the experience of the retail investor. Collectively, these developments are intended to provide greater clarity with respect to the distinct roles of broker-dealers and investment advisers, and the standards of conduct applicable to their activities. In this column we take a look at the new Regulation “Best Interest” (Reg BI) standard of conduct to which broker-dealers and their representatives will be subject beginning June 30, 2020, and contrast that standard of conduct to the fiduciary standard of conduct applicable to investment advisers.


The new standard of conduct for broker-dealers

Reg BI establishes a new standard of conduct for broker-dealers and their “associated persons.” It is designed to improve investor protection by enhancing the quality of broker-dealer recommendations to retail customers and reducing the potential harm to retail customers that may be caused by conflicts of interest. The new standard will soon replace the existing “suitability” standard which requires that the associated person have a “reasonable basis” for believing that a recommended transaction or investment strategy is suitable for a customer, based on information about the customer obtained through reasonable diligence.

Reg BI requires much more than the “suitability” standard in connection with recommendations made to retail customers. It imposes a General Obligation on broker-dealers and their “associated persons” which, requires that they act in the customer’s best interest, and prohibits them from placing their own interests ahead of their customer’s best interest. This General Obligation consists of four components, each of which must be satisfied: (1) Disclosure Obligation, (2) Care Obligation, (3) Conflict of Interest Obligation and (4) Compliance Obligation.

Disclosure Obligation. The Disclosure Obligation requires that, before or at the time a broker-dealer makes a recommendation to a retail customer, it must disclose in writing all material facts about the scope and terms of its relationship with the customer, including (1) the fact that it is acting in the capacity of a broker-dealer or an “associated person” of a broker-dealer; (2) the material fees and costs that apply to the customer’s transactions, holdings and accounts; (3) 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; and (4) “material facts” relating to conflicts of interest associated with a recommendation, e.g. compensation. For example, it would be reasonable to expect that an individual who is licensed to sell only mutual funds and variable annuities (i.e. rather than a full range of securities) would disclose that fact to a retail customer.

Care Obligation. The Care Obligation includes, among other things, a “reasonable-basis” component and a “customer-specific” component. The first component requires that a broker-dealer have an understanding of the risks, rewards and costs of a recommendation and also have a reasonable basis for its belief that the recommendation could be in the best interests of at least some retail customers. The customer-specific component requires that the broker-dealer then apply that understanding to reasonably determine that the particular product or strategy recommended is in the best interest of the particular customer at the time that the recommendation is made.

Conflict of Interest Obligation. Under the Conflict of Interest Obligation, broker-dealers are required to disclose all conflicts of interest associated with a recommendation. Conflicts of interest can occur when a broker-dealer has placed material limitations on recommendations that may be made to a retail customer, e.g. offering only proprietary products or a limited range of products. Retail investors are entitled to know about those conflicts of interest which might include, among other things, a financial incentive to sell one product rather than another.

Compliance Obligation. The Compliance Obligation requires broker-dealers to establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with each of the elements of Reg BI. Additional compliance obligations are imposed on broker-dealers by the Financial Industry Regulatory Authority (FINRA). Some are product-specific. For example, brokers-dealers that sell variable annuities are required to adopt and implement sales practices in accordance with the comprehensive regime established by FINRA.


Fiduciary status of investment advisers

Contemporaneously with the adoption of Reg BI, the Commission issued an interpretive release that reaffirms the status of investment advisers as fiduciaries under the federal securities laws. An adviser’s fiduciary duty is based on equitable common law principles, and consists of a duty of loyalty and a duty of care that apply throughout the entire relationship between an investment adviser and its client. The Commission explained these twin duties by stating that the duty of care requires an investment adviser to provide investment advice in the “best interest” of its client, based on the client’s objectives, and the duty of loyalty requires an investment adviser to eliminate, or make full and fair disclosure of, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which is not disinterested so that a client can provide informed consent to the conflict.


Understanding the industry models

The actions taken by the Commission last year, which preserve both the brokerage model and the advisory model, reflect an effort to clarify the differences between these models. The differences are substantial.

Brokerage Model. The brokerage model is transactional. The broker-dealer earns transaction-based compensation in the form of commissions when securities are purchased or sold. The investment advice that a broker-dealer may provide is limited to advice that is “solely incidental” and “reasonably related” to its primary business of effecting securities transactions. The Reg BI standard of conduct will require broker-dealers and their “associated persons” to act in a retail customer’s best interest when they make a recommendation of any securities transaction or investment strategy involving securities. Reg BI imposes no duty on the broker-dealer to monitor a customer’s account following a recommendation.

Advisory Model. The contours of the advisory model are shaped by an agreed upon scope of services that are provided in return for a fee. Unlike broker-dealers, investment advisers are subject to a “fiduciary” standard that includes both a duty of loyalty and a duty of care, and requires investment advisers to act in the best interest of their clients. This fiduciary duty applies throughout the entire relationship between an investment adviser and its client. Clients of investment advisers are entitled to expect that their adviser will provide advice that is in their best interest, seek best execution of portfolio transactions (when the adviser is responsible for selecting broker-dealers to execute trades), and provide advice and monitoring over the entire course of the relationship, taking into account the agreed-upon scope of the relationship.

Dual Registrant Model. Because of the statutory limitations on the scope of investment advice that broker-dealers can provide, many brokerage firms have registered as investment advisers, thereby becoming Dual Registrants, in recent decades. The Dual Registrant Model has been a source of confusion for the retail investor. It is not uncommon for an investor working with a financial professional employed by a Dual Registrant to have both brokerage accounts and advisory accounts, and not even realize that. Moreover, that investor does not realize that the standard of conduct is different and depends on account type. The term “stock broker” virtually disappeared from the industry lexicon as these firms began to assign more generic titles, such as “financial advisor” and “financial consultant” to their financial professionals, thereby increasing the confusion.


Form CRS

Despite considerable pressure to adopt a uniform fiduciary standard that would apply to both investment advisers and broker-dealers, the Commission declined to do so, stating that it sought to preserve retail investor access (in terms of choice and cost) to differing types of investment services and products. The hope is that a new disclosure mandate will enable investors to understand the contours of their relationship with financial services professionals.

After June 30, 2020, both broker-dealers and investment advisers will be required to deliver a new customer or client relationship summary (Form CRS) to retail investors. Intended to reduce investor confusion, Form CRS will provide a two-page summary of information about the services offered to retail investors as well as information about fees and costs, the requisite standard of conduct, and information about any reportable legal or disciplinary history of the firm or its financial professionals. The Commission has also provided guidance relating to the use of “adviser” and “advisor.” We can expect to see title changes on some business cards.

We encourage investors to read Form CRS carefully and ask questions. Caveat emptor!


Patricia Foster is a securities law attorney whose experience includes representation of clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Foster and David Peartree. Peartree is a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice.