On June 5, 2019, the SEC voted to adopt the Form CRS Relationship Summary and Regulation Best Interest, also known as Reg BI. On the same day, the Commission issued two interpretations of the Investment Advisers Act of 1940. In its press release, the SEC stated that its actions were designed to enhance the quality and transparency of retail investors’ relationships with and to increase protection for retail investors in their relationships with Registered Investment Advisers (RIAs) and broker-dealers (BDs).
The Commission’s package of rules and interpretations can be separated into four categories:
- Form CRS, which is the client relationship summary (required under Part 3 of Form ADV for RIAs)
- SEC’s interpretation of the standard of conduct for RIAs
- Regulation Best Interest, which is a standard of conduct for BDs
- SEC’s interpretation of the “solely incidental” language in the BD exclusion from registration as an RIA
Information regarding these rules and interpretations can be found in the SEC’s press release HERE.
Form CRS/Form ADV Part 3 (Client Relationship Summary)
Form CRS, referred to as the client relationship summary, will be required to be filed for existing RIAs between May 1, 2020 and June 30, 2020. For RIA filing purposes, the Form CRS is identified as the Form ADV, Part 3. The SEC expressed the belief that existing disclosures “do not provide this level of transparency and comparability across investment advisers, broker-dealers, and dual registrants. The relationship summary also encourages retail investors to ask questions and highlights additional sources of information.”
Form CRS utilizes a simple question-and-answer format and summarizes the firm’s services, conflicts of interest, fees, costs and its legal standard of conduct. Form CRS provides information regarding the disciplinary history of the firm and its financial professionals. It must not exceed four 8½” x 11″ pages if converted to PDF format, using at least an 11 point font size and a minimum 0.75″ margins on all sides. The Form will be posted at a link on the SEC’s investor information site at www.investor.gov.
Both RIAs and BDs must be compliant with their Form CRS requirements by no later than June 30, 2020. RIA firms must post the current version of the Form CRS on their public website, in a location and format that is easily accessible for retail investors.
RIA Compliance Group will be reaching out to its RIA clients early next year to assist with drafting any required disclosures pursuant to the instructions for Form ADV Part 3 (“Form CRS”). As always, please contact your consultant with any questions you may have.
SEC’s Interpretation Regarding the Standard of Conduct for Investment Advisers
The SEC also set forth its views on fiduciary duty, so RIAs and their clients will fully understand their legal obligations. According to the SEC, the specific obligations that flow from an RIA’s fiduciary duty depend upon what tasks the adviser has agreed to assume for the client. As an example, the obligations of an adviser providing comprehensive, discretionary advice in an ongoing relationship with a retail client will be significantly different from the duties owed by an adviser to a registered investment company or private fund where the contract specifically addresses the scope of the adviser’s services and the limitations on its authority.
Although an investment adviser’s fiduciary duty will vary according to the scope of the relationship, there will always be a fiduciary obligation, which cannot be waived. The SEC’s lengthy discussion of fiduciary duty focuses on an adviser’s duty of care, which includes, among others, the:
- Duty to provide advice that is in the best interest of the client;
- Duty to seek best execution of a client’s transactions where the RIA is responsible for selecting broker-dealers to execute client trades; and
- Duty to provide advice and monitoring throughout the course of the relationship.
Regulation Best Interest – Standard of Conduct for BDs
Regulation Best Interest implements a higher standard of conduct for BDs and any natural persons associated with a BD when they recommend a securities transaction or investment strategy relating to securities. Regulation Best Interest raises the standard of conduct for a BD above the suitability requirement that has historically applied.
BDs must act in the investor’s best interest. As an example, a BD must have a reasonable basis to believe that an IRA rollover is in the best interest of the retail customer. The BD must consider a number of factors including the:
- Retail customer’s investment profile; and
- Potential risks, rewards, and costs of the rollover compared to the investor’s existing retirement plan and other financial circumstances.
A BD must also act in investors’ best interest if the firm agrees to monitor their accounts. The term “best interest” is not specifically defined in the new regulation. FINRA will be responsible for enforcing Regulation Best Interest for member firms.
Pursuant to Regulation Best Interest, BDs are obligated to:
- Disclose the capacity in which the broker is acting, the fees charged, the scope and type of services provided, limitations on services and products, and conflicts of interest, as well as disclosing if the firm provides monitoring services.
- Exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The BD must take note of the potential risks, rewards, and costs related to the recommendation. The BD must consider these factors in view of the retail customer’s investment profile in order to make a recommendation in the retail customer’s best interest. The BD must also consider the costs that would be incurred with the recommendation.
- Implement reasonable policies and procedures to foster compliance with Regulation Best Interest.
- Establish, maintain, and enforce written policies and procedures that are reasonably designed to ensure that conflicts of interest are identified and disclosed or eliminated.
The conflict of interest disclosure requirement obligates the BD to establish written policies and procedures that are reasonably designed to identify and disclose all conflicts of interest associated with a recommendation. For example, a BD must disclose any material limitations on the securities or investment strategies involving securities that may be recommended to retail customers.
In addition, the conflict of interest disclosure obligation stipulates that policies and procedures should be drafted to:
- Mitigate conflicts of interest that give an incentive for the firm’s financial professionals to place their own or the firm’s interest ahead of the retail customer’s interest;
- Prevent material limitations on offerings, such as only making proprietary products available; and
- Eliminate sales contests, bonuses, quotas, and non-cash compensation that is derived from the sale of specific securities or certain types of securities.
Although Regulation Best Interest contains some fiduciary principles, BDs will not become fiduciaries.
BDs must be compliant with Regulation Best Interest by June 30, 2020.
SEC’s Interpretation of the “Solely Incidental” Language in the BD Exclusion from Registration as an RIA
Section 202(a)(11)(C) of the Investment Advisers Act states that the law does not apply to a broker or dealer “whose performance of such advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation” for those services. This language is referred to as the BD exclusion.
The SEC stated that it would be inconsistent with the solely incidental language for BDs to exercise investment discretion with respect to any of their accounts, unless discretion is granted by a customer on a temporary or limited basis. This temporary or limited discretion is not indicative of a relationship that is primarily advisory in nature. Generally, these are situations where the discretion is limited in time and scope, or they lack the comprehensive and continuous character of investment discretion.
When a BD has unlimited discretion to effect securities transactions and possesses ongoing authority over a customer’s account, the relationship is primarily advisory in nature. When that occurs, the BD’s services are no longer solely incidental to effecting securities transactions.
Takeaway
It remains to be seen if the SEC’s actions will withstand court challenges and whether they help investors better understand the financial services available to them. Hopefully, the rules and interpretations will bring more clarity and transparency to retail investors’ relationships with RIAs and BDs. The SEC’s goal is to make certain that retail investors have the opportunity to hire and select the type of professional with whom they want to work and can decide how much they want to pay for those services.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com.
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