• SEC Proposing Releases: Enhancing Investment Adviser Regulation and Regulation Best Interest
  • June 1, 2018 | Author: Frederick C. Leech
  • Law Firm: Leech Tishman - Pasadena Office
  • On April 18, 2018, the Securities and Exchange Commission (the “SEC”) issued concurrent releases impacting broker-dealers and investment advisers. In the broker-dealer release (“Regulation Best Interest Release”), the SEC proposes a new rule under the Securities Exchange Act of 1934 called “Regulation Best Interest.” Regulation Best Interest would impose a standard of conduct for broker-dealers and natural persons who are associated persons of broker-dealers when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. In the investment adviser release (the “Investment Adviser Release”), the SEC explains its interpretation of the standard of conduct for investment advisers under the Investment Advisers Act of 1940 – notably the fiduciary duties of loyalty and care. The Investment Adviser Release also requests comment on enhanced regulatory requirements for investment advisers in the areas of licensing and continuing education, delivery of account statements to clients, and financial responsibility standards, including fidelity bonds.[1] Read together, the Regulation Best Interest Release and the Investment Adviser Release (collectively, the “Releases”), underscore the SEC’s regulatory goals of harmonizing duties owed to retail customers from broker-dealers and investment advisers within the existing business models offered by these financial professionals.


    SEC Chair Jay Clayton emphasized these dual goals as follows:
    “Taking a step back, I believe retail investors rightfully expect that investment advice, whether through the relationship-based IA, or the transaction-based BD, be provided in their best interest. And we have proposed a rule for broker-dealers that would do just that.
    “The proposed rule heightens broker-dealer current standards of conduct by requiring that recommendations to retail investors be in the best interest of those retail investors, without putting the financial interest of the broker-dealer ahead of the retail customer. That duty would then be satisfied through a broker-dealer (1) disclosing material facts about the relationship, including conflicts, services provided, and fees; (2) exercising reasonable diligence, care, skill, and prudence to make recommendations that are in the best interest of the retail customer; and (3) eliminating, or disclosing and mitigating, conflicts of interests related to financial incentives. Here, our disclosure tools and our conduct tools are complementary.
    “With regard to the obligations of investment advisers, we are also proposing an interpretation to address in one release and reaffirm and, in some cases clarify, certain aspects of the fiduciary duty an investment adviser owes to its clients, including application of the duties of care and loyalty in practice. Again, here, making our disclosure tools and conduct tools more complementary and effective.
    “By raising the conduct standard applicable to broker-dealers, we are applying consistent, fiduciary principles across the spectrum of investment advice. In a word: harmonization.
    “Broker-dealers will be, and investment advisers already are, required to act in the investor’s best interests. They have to make disclosures. They have to exercise due care. And they have to address conflicts of interest. Some of the specific obligations underlying these principles will differ, because the relationship types of the investment professionals differ. This is a practical necessity. But the principles are the same, and I believe the outcomes in both cases should be the same: investors expect high-quality advice that is in their best interest — and I believe our proposals are designed to make sure they get precisely that.”[2]
    The Releases address areas of intended harmonization between the broker-dealer and investment adviser regulatory regimes. The Releases also address areas of intended continued divergence in regulatory approach, resulting from the different business models employed by broker-dealers and investment advisers. These key areas of intended harmonization and regulatory divergence are as follows.
    Areas of Harmonization
    • Imposition of duties of loyalty and care on broker-dealers (fiduciary duties). The core principle of Regulation Best Interest is the requirement of a broker-dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, 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 interest of the retail customer. The Regulation Best Interest Release makes clear, if not expressly defining them as such, that these requirements involve both the duty of loyalty and the duty of care. Unlike, however, the obligation of an investment adviser to adhere to the duties of loyalty and care across the full range of the client-adviser relationship, these fiduciary duties imposed on broker-dealers are limited in two respects. First, the fiduciary duties are imposed on the broker-dealer in his or her dealings with retail customers. Second, the fiduciary duties obtain only in the circumstance of the broker-dealer making a recommendation of a securities transaction or investment strategy involving securities.[3]
    • Tenor of fiduciary duties, when applicable, are similar as between broker-dealers and investment advisers. Although the circumstances in which fiduciary duties apply to a broker-dealer are more limited, the tenor of such duties, when applicable to a broker-dealer, are the same as those imposed on investment advisers. SEC Chair Clayton underscored this point on May 22, 2018, at the annual FINRA conference. Chair Clayton’s comments were reported on May 23, 2018 in Wealth Management.com:

    “Speaking at the annual conference of the Financial Industry Regulatory Authority on Tuesday afternoon [May 22, 2018], Clayton said the SEC’s proposed rulemaking package, including the introduction of new, shorter and more concise disclosures for broker/dealers and advisors, as well as what the SEC is calling a ‘Regulation Best Interest’ requirement for broker/dealers to ensure they put their client’s interests ahead of their own, were all drawn from a singular lens: What is the expectation of the client?

    ‘They can’t expect guaranteed returns. But they can expect that the professional does not put their own interest ahead of the investors’ interest,’ he said.

    “What that looks like in practice between advisors and broker/dealers ‘is going to be different,’ he said, emphasizing the rule is meant to make obvious the difference between the one-time-transaction brokerage model, and an ongoing, time-based investment advisory model.

    ‘But the core duty is the same,’ Clayton said. ‘There are people who try to say there is daylight between the two. But [that is] not the way we think about it.’ …

    “For broker/dealers, that requires not just “best interest” recommendations that put client interests’ before those of the broker/dealer, but transparent disclosures around the relationship. ‘Not the investments,’ he said. ‘But I would hope we could have a conversation that in less than two or three minutes I could explain the relationship: Here is how I get paid. Here is how I make money. Our disclosure form is essentially that conversation.’

    “Clayton noted the SEC deliberately avoided using the word ‘fiduciary’ when articulating their ruling.

    ‘Fiduciary is a buzzword that can mean a lot of things in a lot of contexts,’ he said. ‘It is definitely a fiduciary principle,’ he said.

    • Importation of broker-dealer regulation elements to investment advisers. The SEC is also seeking harmonization of broker-dealer and investment adviser regulation through the proposed importation of broker-dealer regulatory requirements to the investment adviser regulatory regime: (1) licensing and continuing education requirements for investment adviser personnel; (2) delivery of account statements to clients with investment advisory accounts; and (3) financial responsibility requirements for investment advisers, including fidelity bonds.
    Areas of Continued Divergence
    • Client Differential. As indicated above, an investment adviser’s duties apply to all clients of the adviser, whereas the heightened duties of the broker-dealer under Regulation Best Interest apply only to retail clients.[4] Further, the duty of loyalty imposed on the investment adviser applies to relationships among clients – so that, for example, an investment adviser cannot treat one client unfairly to the benefit of another client – whereas the breadth of this duty of loyalty is not imposed on broker-dealers by Regulation Best Interest.


    • Circumstances under which fiduciary duties are applicable. Also, as indicated above, the duties of an investment adviser apply across the full range of the professional relationship between the client and the investment adviser,[5] whereas the duties of the broker-dealer under Regulation Best Interest apply at the time the broker-dealer makes a recommendation of a securities transaction or investment strategy.[6]Disclosure of Conflicts. The obligation of a broker-dealer to disclose material conflicts of interest are those associated or arise with the recommendation made by the broker-dealer. By contrast, an investment adviser’s conflict disclosure requirement is more extensive. An investment adviser is required to make full and fair disclosure of all material conflicts of interest that could affect the advisory relationship.