Coast to coast
compliance
Samantha Bonamassa • Jun 24, 2019
On April 18, 2018, the Securities and Exchange Commission (the “SEC”) proposed a set of rules and an interpretation to address confusion among retail investors and clarify the standards of conduct applicable to investment advisers and broker-dealers. After certain modifications to the SEC’s proposal based on feedback from investors and commenters, on June 5, 2019, the SEC voted in favor to adopt a final package of rules, amendments, and interpretations. This included: (i) a new rule requiring registered investment advisers and broker-dealers to provide retail investors a client relationship summary (Form CRS); (ii) a new rule creating a best interest standard of conduct for broker-dealers when recommending securities to retail investors (Regulation Best Interest); and (iii) two separate interpretative releases pertaining to an investment advisers' fiduciary duties to clients, as well as the “solely incidental” prong of the broker-dealer exclusion from registration as an investment adviser. Collectively, these rules and interpretive releases enhance the quality and transparency of investor’s relationships with registered investment advisers and broker-dealers.
Client Relationship Summary
The new Client Relationship Summary rule (“Form CRS”) requires that registered investment advisers and broker-dealers provide a disclosure document to retail investors, which includes summarized information about the nature of their relationship. This disclosure document is designed to provide better transparency and help retail investors effectively compare different firms and the services that they offer. For the purposes of Form CRS, a “retail investor” is defined as “a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes.” It is important to note, that if a registrant does not have any retail investors, then the firm is not required to prepare or file a Form CRS with the SEC. Additionally, the Form CRS requirement is not applicable to exempt reporting advisers.
The finalized Form CRS is a rather prescriptive document with five required sections: (i) introduction; (ii) relationship and services; (iii) fees, costs, conflicts, and standard of conduct; (iv) disciplinary information; and (v) additional information. While investment advisers and broker-dealers have a strict two-page limit for the Form CRS, dual registrants can utilize up to four pages, if the Form CRS includes the dual registrant’s brokerage and advisory services. In all instances, the Form CRS must be drafted in plain English and use reasonable margin size, font size, etc. The instructions require that the Form CRS be concise, direct, easy to read, and specifically instruct to: “(i) use short sentences and paragraphs; (ii) use definite, concrete, everyday words; (iii) use active voice; (iv) avoid legal jargon or highly technical business terms unless you clearly explain them; and (v) avoid multiple negatives. You must write your response to each item as if you are speaking to the retail investor, using “you,” “us,” “our firm...”.
For investment advisers, the Form CRS becomes the new Form ADV, Part 3 and must be filed electronically with the Investment Adviser Registration Depository (“IARD”). Broker-dealers will file the Form CRS electronically through the Central Registration Depository (“Web CRD”). For dual registrants, the Form CRS will be filed using both IARD and Web CRD.
For investment advisers who are registered or have an application for registration pending with the SEC, as well as broker-dealers who are already registered with the SEC, the Form CRS must be filed electronically between May 1, 2020 and June 30, 2020. For investment advisers, the Form CRS must be submitted either as: (i) an other than-annual amendment; or (ii) part of the initial registration application or annual updating amendment. For broker-dealers who have filed an application for registration or have an application pending with the SEC on or after June 30, 2020, it is required that the Form CRS be filed by no later than the date that registration becomes effective.
Registered investment advisers must initially deliver the Form CRS to each retail investor before or at the time the investment adviser and the retail investor enter into an investment advisory agreement. Registered broker-dealers must initially deliver the Form CRS to each retail investor, before or at the earliest of: (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor. Moving forward, for new and prospective retail investors, investment advisers and broker-dealers must begin delivery as soon as the Form CRS has been filed online. However, for existing clients, investment advisers and broker-dealers must deliver a Form CRS within thirty days from the date the Form CRS was filed online. Similar to the Form ADV Part 2, the Form CRS has certain updating and re-delivery requirements. Generally, it is required that an update to the Form CRS be filed within thirty days of information becoming materially inaccurate and such updates must be communicated to retail investors within sixty days.
In addition to electronically filing the Form CRS, investment advisers and broker-dealers will be required to post the most current version of their Form CRS on their website (if they have one) in a public, prominent, and easily accessible manner for their retail investors.
For more information on the Form CRS, please refer to the final rule: https://www.sec.gov/rules/final/2019/34-86032.pdf
Regulation Best Interest
Under Regulation Best Interest (“Regulation BI”), broker-dealers will be held to a “best interest” standard of conduct, beyond the existing suitability obligations, when making recommendations of any securities transactions or investment strategies involving securities to a retail client. Therefore, a broker-dealer must not place its own interests ahead of the interests of a retail client. For the purposes of Regulation BI, a “retail client” includes “any natural person who receives a recommendation from the broker-dealer for the natural person’s own account (but not an account for a business that he or she works for), including individual plan participants”. Contrary to the Financial Industry Regulatory Authority’s (“FINRA”) institutional suitability obligations, Regulation BI does not allow for high net worth individuals to opt out of coverage. Additionally, broker-dealers are now required to implement policies and procedures that would reasonably enforce Regulation BI as a whole, and specifically eliminate product-specific sales contests and sales quotas. Further, broker-dealers cannot reference themselves as an “adviser” or “advisor” without being dually registered as an investment adviser.
For more information on Regulation BI, please refer to the final rule: https://www.sec.gov/rules/final/2019/34-86031.pdf
Interpretive Release on the Standard of Conduct for Investment Advisers
This interpretation clarifies an investment adviser’s fiduciary duty to its clients (retail and otherwise) and specifically addresses an investment adviser’s duty of care and duty of loyalty. Under the duty of care, an investment adviser must provide advice and account monitoring that is in the best interest of the client and seek best execution of a client’s transactions where the investment adviser has the responsibility to select broker-dealers to execute client trades. Under the duty of loyalty, an investment adviser must disclose all material facts and conflicts of interest related to the advisory relationship. The level of detail can differ based on the type of client (i.e. retail vs. institutional), but in all cases, the disclosure must be sufficiently specific so that a client is able to make an informed decision. In instances where a conflict of interest actually exists, as opposed to having the potential to exist in the future, the SEC has stated that the use of qualifiers such as “may” is not adequate. If an investment adviser cannot provide full and fair disclosure as to a conflict of interest, then the adviser must either eliminate or mitigate such conflict so that adequate disclosure can be provided, and informed consent by the client would be possible.
For more information on this interpretation, please refer to: https://www.sec.gov/rules/interp/2019/ia-5248.pdf
Interpretive Release on the “Solely Incidental” Prong of the Broker-Dealer Exclusion from Registration as an Investment Adviser
This interpretation resulted based on comments to the Regulation Best Interest proposal and addresses the portion of the definition of “investment adviser” that excludes any broker-dealer that provides advisory services, so long as: (i) such services are “solely incidental” to the conduct of the broker-dealer’s business; and (ii) such incidental advisory services are provided without special compensation. The interpretation provides illustrations as to this exclusion related to the limited scope of exercising investment discretion over client accounts, as well as the monitoring of client accounts reasonably in connection with the broker-dealer’s primary business of effecting securities transactions.
For more information on this interpretation, please refer to: https://www.sec.gov/rules/interp/2019/ia-5249.pdf
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