Regulation BI, as adopted by the SEC, establishes a new standard of conduct for broker-dealers. The adopting release imposes requirements on broker-dealers that elevate their standard of conduct beyond the suitability standard, requiring them to act in the best interest of their clients and address conflicts of interest. It states that the standard of conduct, established by Reg BI, draws from “key principles underlying fiduciary obligations, including those that apply to investment advisers under the Investment Advisers Act of 1940.”
The release that interprets the Standard of Conduct for Investment Advisers, the Final Interpretation (Interpretation), is only 42 pages, quite a bit shorter than the 770-page Reg BI. While the intent of Reg BI is to make significant changes to broker-dealer duties, advisers also may need to change their policies and procedures to comply with these new requirements. Reg BI, however, does not apply to internal pension fiduciaries. It does, however, apply to investment advisers whether they are providing investment advice on retirement or non-retirement assets, handling 401(k) rollovers, or giving investment advice, specifically related to rolling over 401(k)s into other types of accounts, such as IRAs.
Clarification or More Uncertainty?
The SEC states that the intent of the Interpretation is to affirm investment advisers’ understanding of fiduciary duty, reduce uncertainty and facilitate compliance. However, the Interpretation’s lengthy discussion likely will raise many questions for advisers as they assess their compliance with the new Regulation BI.
According to the Interpretation, an investment adviser’s fiduciary duty is principles-based and applies to the entire relationship between the adviser and its client. It dictates that fiduciary duty follows the contours of the relationship, which is shaped by the agreement, provided that there is full and fair disclosure and informed consent. Although the SEC provides guidance and numerous footnotes and references, the Interpretation gives advisers the leeway to judge their own fiduciary duty based on their specific facts and circumstances. It will be interesting to see how the SEC examines and/or enforces advisers’ compliance with this new regulation, as much of the guidance seems to be subjectively qualified by the statement, “within the scope of the relationship.”
For examples of “following the contours,” the Interpretation uses varied types of adviser-client relationships – from one-time financial planning to ongoing discretionary management – and notes the differing levels of duty are defined by the relationship and the client’s sophistication, noting that an adviser’s duties would be different for institutional vs individual investors. According to the Interpretation, fiduciary duty is comprised of two overriding components – Duty of Care and Duty of Loyalty.
Duty of Care
The Duty of Care breaks down further into:
The duty to provide advice that is in the best interest of the client
This section includes a suitability requirement but goes further to incorporate requirements for a “reasonable inquiry into client’s objectives” and a “reasonable belief that advice is in the best interest of the client.” Considerations for each are highlighted within and encompass a client’s: 1) investment experience, 2) financial goals, 3) current income, 4) assets and liabilities, and 4) marital status. Also mandated is an adviser’s obligation to update its clients’ investment profiles so their financial advice accurately reflects their clients’ current situation. However, the frequency of this update is not dictated in the Interpretation other than saying it “would…turn on the facts and circumstances…”
The duty to seek best execution
This section does not provide any new information about the SEC’s expectations and/or definition of “best execution.” It only states that the duty of best execution is part of the Duty of Care.
The duty to provide advice and monitoring over the course of the relationship o This section provides little explanation other than duty would be defined by the scope of the relationship, leaving it up to each adviser to determine what advice and how much monitoring is appropriate. Guidelines, such as the recommended frequency for monitoring with a discretionary relationship involving continuous management and supervision, are not provided.
Duty of Loyalty
The Duty of Loyalty breaks down into:
Full and fair disclosure of conflict
In the case of disclosure of conflicts, the SEC provides the example of a dual registrant who must disclose: 1) in what capacity it is providing services, 2) how the client should be charged for such services, and 3) the limitation on investment choices imposed by the broker-dealer affiliate. The other example given relates to allocating investments with self-interest, such as favoring accounts that pay higher or performance-based fees.
An adviser must put clients’ interests first
An adviser should not subordinate clients’ interests to its own, which applies to all advice, not just security selection.
Full and fair disclosures need to be specific and clear and provide the ability for the client to make an informed decision
Disclosure alone does not fulfill an adviser’s duty to act in its clients’ best interests. In a situation where full and fair disclosure is not possible, an adviser must eliminate or mitigate the conflict by modifying its practices. Examples or further explanation are not provided in the Interpretation.
To illustrate what is full and fair disclosure, the Interpretation provides guidance on specificity and reiterates prior guidance with the use of the word “may.” Finally, the Interpretation states that whether disclosure is “full and fair” depends on the nature of client, the scope of services and the material fact or conflict.
Not only are full and fair disclosure part of an investment adviser’s duty of loyalty, it is required on the company’s Form ADV, Part 2 A, and it soon will be required on the relationship summary (Form CRS), which would include a “plain English” summary (limited to 2 pages) of the firm’s conflicts of interest.
Conclusion
Despite the SEC’s assertion that the Interpretation clarifies investment advisers’ fiduciary duty, and affirms what investment advisers already know, the Interpretation should encourage advisers to review their policies and procedures related to client relationships, from the first meeting and throughout the life of the client-adviser relationship. While the language in the Interpretation enables each adviser to use their own judgment, it does provide guidelines. It also dictates that investment advisers create their own guidelines, which will require thorough review of client onboarding documents, suitability determinations, investment management agreements, and policies and procedures pertaining to account monitoring, communications with clients and books and records.