SEC proposes rules and interpretations to protect retail investors

Image of female hand touching modern tablet

Financial Services Alert

Investment Management Alert


As we reported in last week's Investment Management Alert, the Securities and Exchange Commission has voted to propose a package of rulemaking and interpretations that is intended to enhance the quality and transparency of retail investors' relationships with registered investment advisers and broker-dealers. While our Investment Management Alert provided a high-level summary of the proposed rules and interpretations, this Alert contains a more detailed look at each component of the SEC's proposals.

Under proposed "Regulation Best Interest," broker-dealers will be required to act in the best interest of each retail customer when making a recommendation of any securities transaction, or any investment strategy involving securities, to a retail customer. The proposed regulation is designed to make it clear that a broker-dealer may not put its financial interests ahead of the interests of its retail customers when making recommendations.

The SEC also proposed an interpretation that will reaffirm and clarify its views with respect to the fiduciary duty that investment advisers owe to their clients, and to require broker-dealers and investment advisers to distribute a new, short-form customer or client "relationship summary" that is intended to help clarify for retail investors the nature of their relationships with different types of investment professionals. The SEC is also proposing to restrict certain broker-dealers and their financial professionals from using the terms "adviser" or "advisor" in their names or titles when dealing with retail investors. Finally, broker-dealer and investment advisers would be required to disclose their registration status in certain communications with retail investors.

The SEC's goal is to enhance investor protection by applying consistent principles to investment advisers and broker-dealers while acknowledging the inherent differences in the customer relationship for each. These principles include clear disclosure, exercising due care, and properly addressing conflicts of interest. Specific obligations will be tailored to the particular types of advice relationships that each firm offers. Viewing the proposed rules and interpretations as a "significant step" to achieving the SEC's objectives "on behalf of our Main Street investors" SEC Chairman Jay Clayton explained that the SEC "can increase investor protection and the quality of investment services by enhancing investor understanding and strengthening required standards of conduct," and "achieve these objectives while simultaneously preserving investors' access to a range of products and services at a reasonable cost."


I. Regulation Best Interest

Broker-dealers offer a wide range of services to retail customers – from execution-only, discount brokerage services to full-service brokerage. The latter generally includes investment advice while the former does not. Whether acting as the customer's agent (ie, as a broker) or as principal (ie, as a dealer), a broker-dealer is considered to be providing advice when it recommends particular securities transactions or investment strategies that involve securities. According to the SEC, the relationship between a broker-dealer and an investor comes with inherent conflicts of interest including the possibility that the broker-dealer will have an incentive to maximize its compensation rather than provide the customer with the most appropriate advice. The potential harm to retail customers from such conflicts of interest has long been a concern of the SEC.

In proposing Regulation Best Interest, the SEC noted that while broker-dealers are subject to extensive SEC and self-regulatory organization rules when making recommendations, as well as conflict of interest rules, which reflect the unique characteristics of the relationship between a broker-dealer and its retail customers, there is no specific obligation under the Securities Exchange Act of 1934 (Exchange Act) for broker-dealers to make recommendations that are in their customers' best interest.1

Under proposed "Regulation Best Interest," a broker-dealer making a recommendation to a retail customer will have a duty to act in the best interest of the customer at the time the recommendation is made, and may not put its own financial or other interests ahead of the interests of its retail customer. The broker-dealer can discharge this duty by complying with three specific obligations.

  • The broker-dealer or natural person who is an associated person of a broker-dealer (natural associated person), prior to or at the time of making a recommendation, must reasonably disclose to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer and all material conflicts of interest that are associated with the recommendation;
  • The broker-dealer or natural associated person, in making such recommendation, must exercise reasonable diligence, care, skill and prudence to:
    • understand the potential risks and rewards associated with the recommendation and have a reasonable basis to believe that it could be in the best interest of at least some retail customers
    • have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer's investment profile and the potential risks and rewards associated with the recommendation and
    • have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer's best interest when viewed in isolation, is not excessive and is in the retail customer's best interest when taken together in light of the retail customer's investment profile
  • The broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to identify and disclose or eliminate all material conflicts of interest associated with such recommendations, and identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations. Other material conflicts of interest also must be disclosed.

Regulation Best Interest was designed to make clear that broker-dealers may not put their own financial interests ahead of those of their retail customers when making recommendations. The SEC's goal is "to enhance investor protection, while preserving, to the extent possible, access and choice for investors who prefer the 'pay as you go' model for advice from broker-dealers, as well as preserve retail customer choice of the level and types of advice provided and the products available." The SEC believes that Regulation Best Interest will do that by enhancing the standards of conduct that apply to broker-dealers making recommendations to retail customers.

The SEC is requesting comments on proposed Regulation Best Interest within 90 days after its publication in the Federal Register.

II. Investment Adviser Interpretation

An investment adviser owes a fiduciary duty to its clients. The SEC has issued a proposed interpretation that reaffirms and, in some cases, clarifies certain aspects of that fiduciary duty.

According to the proposed interpretation, the fiduciary standard for investment advisers is based on common law principles of equity and is fundamental to the relationship advisers have with their clients under the Investment Advisers Act of 1940 (Advisers Act). That duty, while not specifically defined in the Advisers Act or the SEC rules thereunder, reflects Congress' recognition of the "delicate fiduciary nature of an investment advisory relationship," and its intention to eliminate, or at least expose, all conflicts of interest that might incentivize an investment adviser to render advice that is not disinterested. The fiduciary duty recognizes the nature of the relationship between an investment adviser and its client and the need to eliminate the kinds of the abuses that led Congress to enact the Advisers Act.

An investment adviser's fiduciary duty has two components – a duty of care and a duty of loyalty. It requires an adviser to adopt the client's goals, objectives, or ends and at all times serve the client's best interest. It must never subordinate the clients' interest to its own. And while the adviser and client may shape that relationship by contract, provided the client receives full and fair disclosure and provides informed consent, the relationship in all cases remains that of fiduciary and client; the adviser cannot disclose or negotiate away and the investor cannot waive this fiduciary duty.

The proposed interpretation elaborates on these concepts in detail, explaining that, with respect to the duty of care, the adviser has, among other things, a duty to act and to provide advice that is in the client's best interest, to seek best execution of the client's transactions when the adviser selects the broker-dealers that will execute trades, and to provide advice and monitoring over the course of the relationship. With respect to the duty of loyalty, an investment adviser must put the client's interests first and must not favor its own interests over those of the client. The adviser also may not unfairly favor one client over another. To meet this obligation, the adviser must make full and fair disclosure of all material facts relating to the relationship with the client. The adviser also must seek to avoid conflicts of interest with its clients. At minimum, the adviser must fully and fairly disclose all material conflicts of interest that could affect the relationship, in a manner sufficiently specific to allow the client to make an informed decision whether to consent to the conflict.

In the proposed interpretation, the SEC discusses aspects of each duty in detail. It also discusses the economic effects of the proposed interpretation, including the ways in which the proposed interpretation may benefit investors and reduce problems by reaffirming and clarifying the fiduciary duty an investment adviser owes to its clients. The SEC also discusses potentially broader economic effects on the market for investment advice; for example, how improved compliance may reduce agency costs in current investment advisory relationships and increase the value of those relationships to current clients, as well as potentially increasing trust in the market for investment advice among investors generally, thus leading to an increase in advisory business.

The SEC is requesting comments on the proposed interpretation, as well as on related issues including whether individual investment adviser representatives should be subject to federal continuing education and registration or licensing requirements and, if so, which advisory personnel should be included. Comments should be submitted within 90 days after the proposal's publication in the Federal Register.

III. Form CRS – Relationship Summary

Finally, the SEC is proposing that investment advisers and broker-dealers, and their respective associated persons, be required to provide retail investors with a "relationship summary" (Form CRS) – a standardized, short-form (four page maximum) disclosure document that will highlight key differences in the principal types of services offered, the legal standards of conduct that apply to each, the fees a customer might pay, and certain conflicts of interest that may exist. Investment advisers and broker-dealers, and their financial professionals, would be required to be direct and clear about their registration status in communications with investors and prospective investors and certain broker-dealers and their natural associated persons would be restricted from using, as part of their name or title, the terms "adviser" and "advisor," which may mislead retail customers into believing they are dealing with a registered investment adviser.

According to the SEC, studies have shown that retail investors can be confused about the differences between broker-dealers and investment advisers, including the scope and nature of the services that each provides, the fees and costs associated with those services, conflicts of interest, and the applicable legal standards and duties to investors. While the SEC recognizes the benefits to retail investors of having access to different types of relationships, and of preserving investor choice with respect to the services they may wish to choose, the SEC is concerned that retail investors need "clear and sufficient information" so that they can understand the differences between available services and the key characteristics of each. Armed with such information, investors can make an informed choice when choosing an investment professional to advise them and the type of account that will best meet their needs.

The SEC is thus proposing that both registered investment advisers and registered broker-dealers be required to deliver a relationship summary to each retail investor. Investment advisers would deliver the relationship summary to new clients before or at the time the adviser enters into an advisory agreement with the retail investor. Broker-dealers would initially deliver the relationship summary before or at the time the retail investor first engages the firm. Dually registered investment adviser/broker-dealer firms would deliver the relationship summary at the earlier of entering into an investment advisory agreement with the retail investor or the retail investor engaging the firm.

The relationship summary would have a mix of tabular and narrative information. Required sections would include an introduction; a description of the relationships and services offered to retail investors; the standard of conduct that applies to those services; the fees and costs to be charged to retail investors; comparisons of brokerage and investment advisory services; conflicts of interest; how to find additional information (including reportable legal or disciplinary events by the firm and its financial professionals) and who to contact about complaints; and key questions for retail investors to ask. As noted above, it will be short – no more than four pages (or the electronic format equivalent of four pages).

The relationship summary will be in addition to, and not in lieu of, current disclosure and reporting requirements for broker-dealers and investment advisers. It will alert retail investors to important information to consider when choosing a firm and a financial professional, and it is intended to encourage retail investors to ask informed questions. The content should facilitate comparisons across firms offering the same or substantially similar services. Firms would be required to electronically file the relationship summary, and any updates, with the SEC. Investment advisers would file through the Investment Adviser Registration Depository (IARD) while broker-dealers would file through the SEC's EDGAR system. Dually registered investment adviser/broker-dealer firms would file through both.

Finally, in connection with proposed Form CRS, the SEC is proposing restrictions on the use of certain names and titles and required disclosures. Recognizing that Form CRS will not be a complete remedy for investor confusion and that the educational and informational value of the form could be overwhelmed by the way in which financial professionals present themselves to potential or current retail investors, certain names or titles used by broker-dealers, including "financial advisor," can contribute to confusion about the distinction among types of firms and investment professionals, misleading retail investors into believing that they are engaging an investment adviser in a fiduciary relationship when they are not. Similarly, unclear communications with prospective or existing retail investors can further confuse retail investors as to whether they are dealing with an investment adviser or a broker-dealer.

Consequently, the SEC is proposing restrictions to mitigate the risk that the names or titles used will result in retail investors being misled, resulting in uninformed decisions regarding which firm or financial professional to engage, which can lead to investors being harmed. By restricting the use of the terms "adviser" and "advisor" while requiring firms to disclose their regulatory status in retail investor communications, the SEC hopes to prevent or deter potentially misleading sales practices and reduce the chances that retail investors will select the wrong firm.

Comments on proposed Form CRS and the SEC's related restrictions should be submitted within 90 days after their publication in the Federal Register.

We will continue to monitor this important rulemaking process. If you would like to learn more about the SEC's proposals and what they may mean for your business, or if you would like assistance in analyzing the proposals and preparing comments for submission to the SEC, please contact the authors or any member of the Financial Services or Investment Management team.

1 Of course, FINRA Rule 2111 imposes a duty on broker-dealers to make suitable recommendations.  The SEC's initiative goes beyond what FINRA has done to date to define and enforce this obligation.