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Overview of the Standards of Conduct for Investment Professionals Rulemaking Package

April 18, 2018

1. What are our objectives?

First, enhance retail investor protection and decision making by:

  • Raising the standard of conduct for broker-dealers when they provide recommendations to retail investors, and
  • Reaffirming and in some instances clarifying the terms of the relationships that retail investors have with their investment professionals.

Second, preserve retail investor access (in terms of choice and cost) to a variety of types of investment services and investment products.

Third, raise retail investor awareness of whether they are transacting with registered financial professionals.

2. What prompted us to act?

Investor Confusion Regarding the Differences Between Broker-Dealers and Investment Advisers. Broker-dealers (“BDs”) and investment advisers (“IAs”) both provide investment advice to retail investors, but have different relationships and are subject to various different regulatory regimes. However, it has long been recognized that many investors do not have a firm grasp of the important differences between BDs and IAs — from differences in the variety of services that they offer and how investors pay for those services, to the regulatory frameworks that govern their relationship. This investor confusion could cause investor harm if investors fail to select the type of service that is appropriate for their needs, or if conflicts of interest are not adequately understood and addressed.

The Need for Standards of Conduct That Meet Reasonable Investor Expectations and Adequately Address Conflicts of Interest. A wide array of market participants agree that, whether a retail investor engages with a BD or an IA, investment professionals should be held to a standard that meets reasonable investor expectations, including addressing conflicts of interest. Misalignment between reasonable investor expectations and actual legal standards can cause investor harm. For example, retail investors may be harmed if they do not understand when BDs and IAs may have conflicting financial interests. In addition, without sufficient clarity, retail investors may be more deferential to, or place greater reliance on, their BD or IA than they otherwise would. I believe that clarifying the legal standards of conduct that apply and reducing investor confusion through disclosure can significantly mitigate these potential harms as well as increase investor protection.

I also recognize that, in many cases, self-imposed standards and general professionalism have helped to fill any gap between reasonable investor expectations and legal standards. I applaud these long-standing efforts, but believe that proposing additional regulatory steps is necessary and appropriate. For BDs, this includes proposing to prohibit putting their interests ahead of the interests of their retail customers when making a recommendation of a securities transaction or investment strategy. For IAs, this includes clarifying that we do not believe IAs can simply “disclose away” the effect of their key duties with disclosures.

Regulatory Complexity Resulting from DOL Rule, Reduction in BD Service Offerings. In 2016, the Department of Labor (“DOL”) sought to address some of these issues by deeming all investment professionals who provide investment advice to retirement accounts to be “fiduciaries” with respect to those accounts. While the status of the DOL’s rule is currently in doubt following the Fifth Circuit’s ruling, during the time the rule was in effect it imposed an additional standard of conduct for broker-dealers, amplifying significant regulatory complexity and uncertainty in this area, including through the introduction of multiple regulatory standards to the same investor relationship.

This action and other developments drove significant change in the market for investment advice. A number of BDs limited the products or services they provide to customers, particularly those customers with fewer assets. More specifically with respect to those services, some BDs shifted customers from full-service brokerage, which includes investment advice, to discount brokerage, which does not. Other firms that are dually registered as both BDs and IAs, as well as BDs that have an affiliated IA, shifted customers into advisory accounts, where, depending on the customer’s investment strategy, they may pay more in fees for advice and services. This reduction in transaction-based service offerings has, and will continue to have, negative impacts on certain types of retail investors — for example, for buy-and-hold investors that transact infrequently, a brokerage account may be a more appropriate, and potentially less expensive account option. I believe it is important to preserve retail investors’ ability to choose to receive transaction-based investment advice from BDs or portfolio-based advice from IAs and that our efforts should not increase the costs borne by retail investors.

Regulatory Complexity More Generally. Our concerns regarding regulatory complexity go well beyond the impact of the DOL rule. I am concerned that there are an increasing number of inconsistencies in the standards of conduct applicable to the provision of financial advice— in regulatory text, inspection, and enforcement— and therefore, regardless of the impact of the DOL rule, the potential for increased investor confusion and harm and decreased investor choice.

An investment professional that provides advice to an investor that has a 401(k), an annuity, and a brokerage account is subject to regulation by no less than five regulators (the SEC, FINRA, DOL, state securities regulators, and state insurance regulators). That relationship may also be subject to regulation, inspection, and enforcement by banking regulators, state attorneys general, and other state and federal regulators. This level of complexity and uncertainty undoubtedly has the potential to increase the fees paid by retail investors and reduce the availability of retail investor-oriented products and services — particularly for those investors who have fewer assets.

I believe the SEC has broad jurisdiction and decades of relevant expertise with respect to these issues, and is well-placed to bring forward an approach that can be a focal point for regulatory clarity and cooperation across the market. I also value greatly the perspective and experience of our fellow regulators, including state securities and insurance regulators. We frequently work with our state colleagues, particularly on investigations and enforcement matters, and look forward to engaging much more closely with them and our other fellow regulators as we move forward with this rulemaking process.

3. What are we doing?

I believe that we can increase investor protection and the quality of investment services by enhancing investor understanding and increasing required standards of conduct, while simultaneously preserving investor choice, through a comprehensive package of rules and guidance that includes the following:

a. Raising and Clarifying Standards of Conduct for BDs and IAs

We have a proposed rule, and a proposed interpretation, that would enhance the standard of conduct for BDs and reaffirm and, in some instances, clarify the standard for IAs, respectively. The proposed rule for BDs draws from the principles applicable to IAs to enhance existing BD standards of conduct and codify them in the SEC’s regulations. As a result, our proposed rule and interpretation would impose common principles across the spectrum of relationships, while applying specific regulatory obligations that reflect the differing relationship types. In other words, while the type of advice provided, whether episodic or ongoing, may be different, the obligations to the investor should embody common best interest principles.

Proposed Rule: Regulation Best Interest.[1] Under this proposed rule, a BD, when making a recommendation of a securities transaction or investment strategy to a retail customer, will be required to act in the best interest of that customer at the time the recommendation is made, without placing the financial or other interest of the BD ahead of the interest of the retail customer. This best interest duty is discharged if the BD complies with a disclosure obligation, a care obligation, and two conflict of interest obligations. Specifically:

  • Disclosure. The BD must reasonably disclose to the retail customer the material facts relating to the scope and terms of the relationship, including material conflicts of interest associated with the recommendation;
  • Care. The BD must exercise reasonable diligence, care, skill and prudence to (A)understand the potential risks and rewards associated with the recommendation and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (B)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 (C) have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest;
  • Conflicts of Interest. The BD must establish, maintain, and enforce written policies and procedures reasonably designed to identify and then to (A) at a minimum disclose, or eliminate, material conflicts of interest associated with the recommendation; and (B) disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with the recommendation.

This regulation prohibits BDs from putting their interests ahead of their customers’ interests. While each of the component obligations of the BD’s duty contributes to this outcome, the establishment of policies and procedures to mitigate or eliminate material conflicts arising from financial incentives is perhaps the most critical enhancement over existing standards applicable to BDs; it means that BDs must do more than simply disclose their conflicts of interest. We have drawn on our considerable experiences in examinations and enforcement in formulating our approach in this area. Certain inherently risky sales practices such as contests, trips, and prizes will merit scrutiny in this analysis.

Notice of Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation. As this proposed interpretation reaffirms, IAs owe a fiduciary duty to their clients. To the extent that current market conduct falls below what the Commission believes the IA fiduciary duty means, this interpretation would put the market on notice of the Commission’s views.

b. Providing Clarity Regarding Fees, Conflicts and other Material Matters

Second, we have a proposed rule that contains a two-pronged approach to increasing clarity for investors. Put bluntly, we want investors to understand who they are dealing with, i.e., what category — IA, BD, or dual-hatted— their investment professional falls into and, then, what that means and why it matters. This proposed rule will also help highlight for investors that they are dealing with a registered entity, and that dealing with persons who are not registered raises significant risks.

Proposed Rule: Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles. This proposed rule has two major component obligations to address the “who” and “why” questions, respectively.

  • Clear Labeling. The first prong, labeling, will help investors properly categorize their existing or prospective investment professional by (A) requiring BDs and IAs to be direct and clear about their legal form in communications with investors and prospective investors; and (B) restricting standalone BDs and their financial professionals from using the terms “adviser” and “advisor” as part of their names or title, which are so similar to “investment adviser” that their use by a standalone BD may mislead the BD’s prospective customers.
  • Fee, Conflict, and Other Material Disclosure. The second prong, disclosure, will help investors understand why the legal categories matter by requiring IAs and BDs, and dual-hatted entities, to provide investors with a standardized, short-form (4 page maximum) disclosure. The disclosure will highlight key differences in: the principal types of services offered, the legal standards of conduct that apply to each, the fees the customer will pay, and certain conflicts of interest that may exist. The disclosure will also provide customers direction as to where and how they might get more information, including on the firm’s or investment professional’s disciplinary history.

    The disclosure — on Form CRS, or “Customer/Client Relationship Summary” — is intended to advance a layered approach to disclosure. More detailed information about an IA can be found in the IA’s ADV Part 2A brochure, and more detailed information about a BD will be required through Regulation Best Interest’s Disclosure Obligation.

    To help IAs and BDs, as well as retail customers, begin to visualize what Form CRS would look like, we have provided mock-up forms that would be used by standalone BDs, standalone IAs, and dually-registered firms.[2]

    These paper mock-ups reflect a traditional approach to how firms could choose to communicate with retail investors. Advances in communications technology provide various channels for effective communication, including, for example, interactive summaries. We also recognize that the inclusion of graphic presentations can be more effective than text only presentations. We are proposing to allow BDs and IAs to use electronic communications and graphics to meet their Form CRS obligations, provided that such presentations are true to the content requirements and page limits of Form CRS.

Annex A

Rule Text for Regulation Best Interest

Annex B

Form CRS Mock-up – Dual Registrant

Form CRS Mock-up – Standalone Broker-Dealer

Form CRS Mock-up – Standalone Investment Adviser

[1] The text of Proposed Regulation Best Interest is attached hereto as Annex A.

[2] The mock-up Client Relationship Summaries are attached here to as Annex B.

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