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The Vault

May 7, 2018

SEC Addresses Standards of Care for Investment Advisers and Broker-Dealers in Proposed Rules

By Kay A. Gordon, James S. Rollins, Mollie K. Davis

The Securities and Exchange Commission (“SEC”) has released a set of proposed rules governing relationships between investment professionals and their clients. The proposed rules—a hefty 1,000 pages with 1,800 footnotes— seek to close the gaps between investor expectations and the current patchwork of rules that control the relationship between investment advisers (“IAs”) and broker-dealers (“BDs”) and their clients. The SEC also aimed to “enhance investor protection by applying consistent principles to investment advisers and broker-dealers: provide clear disclosures, exercise due care, and address conflicts of interest.”[1]  

By a vote of 4 to 1, with Democratic Commissioner Kara Stein opposing, the SEC published the following proposals addressing three main concepts:

  1. A new “best interest” standard for BDs,
  2. Interpretation on the current fiduciary standard for IAs, and
  3. Mandatory Disclosures to retail investors (Form CRS).

Some of the proposals (the “best interest standard,” imposing a standard of care on BDs and the Form CRS, requiring SEC-registered IAs and BDs to provide a “client relationship summary” to retail clients) only target BDs and IAs with retail clients.  However, the proposal interpreting the current fiduciary standards aims at enhancing IA regulation generally and, therefore, applies to IAs more broadly, including those IAs that only provide investment advice to institutional clients.

Regulation Best Interest

Under the proposed rule, BDs are required to act in the best interest of their retail investors when making investment recommendations. This Regulation Best Interest attempts to heighten the current duty of care for BDs, which only requires BDs to offer investors “suitable” investments. To comply under the new rule, a BD must demonstrate a holistic consideration of the best interests of the investor when making a recommendation. This includes disclosure of any conflicts of interest that might sway the broker in presenting one investment over another. Specifically, the BD must:

  1. Disclose material facts. The BD must disclose in writing all material facts about the relationship with the investor, particularly identifying any material conflict of interest which influences the recommendation made. This disclosure may be included in the proposed form Customer Relationship Summary (discussed below).
  2. Exercise reasonable care. The BD must exercise appropriate skill, attention, and care in recommending investment products. In particular, a BD must (a) understand the nature of the investment product he or she is recommending and reasonably believe that the particular investment product could be in the best interest of at least some retail customers, (b) have a reasonable basis to believe the product is in the best interest of that particular retail customer based on that customer’s investment profile, and (c) have a reasonable basis to believe that the whole series of recommended investments is not excessive and is together in the customer’s best interests. 
  3. Mitigate conflicts of interest. The BD must identify and mitigate the impact of any material conflict of interest influencing the recommendation. Material conflicts, such as financial incentives for sales of certain products and prizes like vacations for top brokers, must be disclosed to the retail customer, at a minimum, or mitigated and eliminated from the investment recommendation process completely.

According to Chairman Jay Clayton, this charge to mitigate and eliminate conflicts of interest is the “most critical enhancement over existing standards applicable to BDs.”[2] Despite the Chairman’s support, Regulation Best Interest has thus far been met with criticism, especially as it fails to define “best interest” and “recommendation,” possibly leaving more questions than answers.

Interpreting the Standard for IAs

Next up, the SEC proposed an interpretation clarifying the current fiduciary standard for IAs found in the Advisers Act. This interpretation generally spells out the SEC’s understanding of the fiduciary standard, which is based on equitable common law principles: IAs are required to act in the client’s best interests to accomplish the client’s objectives and goals in accordance with their duties of care and loyalty. The interpretation proposed seeks comment on a few discrete areas of regulation where previously little guidance has been offered, such as licensing requirements or continuing education procedures; whether the IA should be subject to net capital rules or other financial responsibility requirements, such as a fidelity bond, to ensure they can meet their financial obligations; and whether registered IAs should be required to obtain annual audits of their own financials and provide such information on Form ADV.

Clarification as to Client Understanding of Investment Professionals

Finally, the rulemaking package proposes two additional rules to close the gap between perception and reality of retail customers’ understanding of the investment professional’s role. Under the proposed rules, both BDs and IAs would be required to provide clients with a form Client Relationship Summary (“CRS”) which identifies the role of the BD or IA, types of fees and fee structures potentially paid, any material conflicts of interest, and the legal standards of conduct that govern. With its proposal, the SEC provided mock-ups of the CRS forms, which can be found below:

  • Broker-Dealer Mock-up CRS (here)
  • Investment Adviser Mock-up CRS (here)
  • Dual-Registrant Mock-up CRS (here)

In addition, the SEC imposed new restrictions on the use of the term “advisor” or “adviser” in a title to avoid the confusion of retail investors. The role of a BD, which is generally paid on commission for the sale of certain investment products, and the role of an IA, which is generally paid a percentage of the client’s total investment account, must be kept clearly delineated in the mind of the investor. This title restriction and the form CRS disclosures are designed to bolster existing protections for retail investors and avoid misleading consumers as to the services they are provided.


Initial comments on the proposed rules and the general response from the industry appear to fall into one of two camps—either concerned by the rules’ vagueness (especially regarding its failure to define BDs’ obligations to act in clients’ “best interests” when making a “recommendation”) or noting that because of these ambiguities, the rules may have limited impact on the day-to-day operations of investment firms. The proposal may also be  signal the end to the Department of Labor’s Fiduciary Rule, which imposed a heightened fiduciary standard of care on certain classes of BDs in an attempt to protect retail investors. While the SEC would require BDs to also ‘act in the best interest of the retail customer,’ the SEC’s proposal is less prescriptive as it places a greater emphasis on the disclosure of information to investors. Though this possible demise of the DOL Fiduciary Rule will limit the scope of investment activities that are fiduciary in nature, there are still investment services that will be fiduciary and thus subject to the prohibited transaction requirements. As a result, if they have not already done so, firms should take steps now to identify those activities and take appropriate steps for compliance.

While this proposed rulemaking package by the SEC aims to protect retail investors by heightening standards for BDs, it, for some, may have missed its mark. Commissioner Kara Stein expressed her frustration that “despite the hype, today’s proposals fail to provide comprehensive reform or adequately enhance existing rules”[3] for standards of care.

Expect more comments and reactions over the next ninety (90) days as the Commissioners receive public feedback. Commissioner Michael S. Piwowar stated his own serious misgivings about the rules package, but that did not keep him from voting to present it for public comment. Though the rules may not have either harmonized or fully clarified IA and BD standards of conduct, Piwowar pointed out that at least critics can no longer say, “the SEC really needs to do something about this.”[4]

Nelson Mullins attorneys will be working closely with our clients affected by the proposed package to offer solutions to minimize any unfavorable impact of the regulation on current investment business models. Please contact your Nelson Mullins attorney, or any of the authors, to discuss.

[1] Press Release, SEC Proposes to Enhance Protections and Reserve Choice for Retail Investors in their Relationships with Investment Professionals https://www.sec.gov/news/press-release/2018-68

[2] Jay Clayton, Overview of the Standards of Conduct for Investment Professionals Rulemaking Packagehttps://www.sec.gov/news/public-statement/clayton-overview-standards-conduct-investment-professionals-rulemaking

[3] Kara Stein, Statement on Proposals Relating to Regulation Best Interest, Form CRS, Restrictions on the Use of Certain Names or Titles, and Commission Interpretation Regarding the Standard of Conduct for Investment Advisers, https://www.sec.gov/news/public-statement/stein-statement-open-meeting-041818

[4] Michael S. Piwowar, Statement at Open Meeting on Form CRS, Proposed Regulation Best Interest and Notice of Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers (Proposed Rule) https://www.sec.gov/news/public-statement/statement-piwowar-041818

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