FINRA Reminds Broker-Dealers and Investment Advisers to Comply with the SEC’s “Best Interest” Requirements

FINRA Reminds Broker-Dealers and Investment Advisers to Comply with the SEC’s “Best Interest” Requirements

On June 5, 2019, the United States Securities and Exchange Commission issued Release No. 34-86031, titled Regulation Best Interest: The Broker-Dealer Standard of Conduct (“Regulation BI”), which provides for a best interest standard applicable to broker-dealers. The same day, the SEC issued Release No. IA-5248, titled Commission Interpretation Regarding Standard of Conduct for Investment Advisers (herein, “SEC Interpretation”). Both documents take effect on June 30, 2020, to allow sufficient time for financial professionals to implement the new requirements.

Differences between Broker-Dealers and Investment Advisers

There are important distinctions between brokerage firms and investment advisers. They are subject to different laws, regulated separately by different entities, and the duties they owe to their customers are distinct. Unfortunately, most investors are confused about the differences between broker-dealers and registered investment advisers.

Brokerage firms, known formally as broker-dealers, must register with the SEC but their primary regulator is the Financial Industry Regulatory Authority, known as “FINRA,” which acts under authority delegated by the SEC. All broker-dealers are regulated by FINRA regardless of the size of the firm, although the states have concurrent jurisdiction in certain areas.

Registered Investment Advisers (“RIAs”)are subject to the Investment Advisers Act of 1940. The SEC regulates investment advisers who manage $110 million or more in client assets. Advisers with less than $100 million in assets under management must register with the state in which they have their principal place of business. Those advisory firms that have greater than $100 million but less than $110 million in assets under management may elect to register with SEC. Those that do not will continue to be regulated by the states.

Historically, broker-dealers and investment advisers performed different functions in the marketplace. A broker-dealer is a company that is in the business of buying and selling securities on behalf of its customers or for its own account. The sales personnel who work for broker-dealers are known as brokers or, more formally, “registered representatives.” Traditionally, broker-dealers and registered representatives were compensated by commissions charged on each transaction and had no duty to the customer (for example, to monitor the performance of a security) after the sale was completed.

RIAs, on the other hand, are paid for providing securities advice to their customers. The services offered often include advice concerning a customer’s investment holdings, recommendations concerning securities purchases and sales, and follow-up monitoring of customer holdings. Financial professionals who are employed by investment advisers are often called investment advisers, but the formal designation is “investment adviser representatives” or “IARs.” RIAs and IARs are typically compensated based on a fixed fee that is equal to a percentage of the customers’ holdings.

The legal standards applicable to broker-dealers and RIAs are distinctly different. In keeping with the broker-dealer’s traditional sales function, the primary duty owed to the customers of a broker-dealer is transaction-based – a recommended transaction must be “suitable” for the customer. On the other hand, the RIA is held to a fiduciary standard in keeping with its duties to provide ongoing advice and monitoring.

Market forces have blurred the distinction between broker-dealers and RIAs. Most broker-dealers are dual-registered and offer a fixed fee arrangement as an option to commissions. Most brokerage firms offer financial planning services that are indistinguishable from the core service offered by RIAs. Although broker-dealers are not legally obligated to monitor customers’ holdings, most tell their customers that will do so. It is no wonder then that investors are confused about the differences between the two.

Following the financial crisis that began in September 2008, Congress sought to reform the standards applicable to broker-dealers to reflect the expanded nature of their business model. In July 2010, President Obama signed the Dodd-Frank financial reform law, which gave the SEC the authority to develop a uniform fiduciary standard for retail investment advice that was no less stringent than the standard applicable to investment advisers under the Investment Advisors Act of 1940. In January 2011, the SEC staff issued a report that recommended the SEC propose a uniform fiduciary rule. and on April 14, 2016, the Department of Labor issued its final version of the fiduciary rule. Full compliance with the new fiduciary standard was to occur by January 1, 2018. However, in August 2017, the Labor Department proposed that compliance with the fiduciary rule be delayed for 18 months, until July 1, 2019. By that time, President Trump had been elected. The new administration stated its opposition to imposing a fiduciary standard on broker-dealers, and Department of Labor’s rule was shelved.

Instead of adopting extending the fiduciary standard to broker-dealers, the SEC adopted Regulation Best Interest on June 5, 2018.

Regulation Best Interest is Applicable to Broker-Dealers

The stated purpose of Regulation BI is to establish a standard of conduct for broker-dealers and their associated persons when they make recommendations to retail customers for any securities transaction or investment strategy involving securities. According to the SEC’s 771-page release, the Regulation BI enhances the broker-dealer standard of conduct by requiring broker-dealers “to act in the best interest of the retail customer at the time the recommendation is made,” to refrain from “placing the financial interest of the broker-dealer ahead of the interests of the retail customer,” to “address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest,” and, in certain instances, to mitigate or eliminate conflicts.

The SEC’s Interpretation of Investment Advisers’ Fiduciary Duties to Customers

The SEC Interpretation is not a rule, like Regulation Best Interest. Rather, the SEC Interpretation provides the SEC’s views on the nature and extent of fiduciary duty owed by Investment Advisers under the Investment Advisers Act of 1940 (“Advisers Act” or “Act”). The Advisers Act itself does state that investment advisers are fiduciaries to their customers. Rather, courts have found that section 206 of the Act (29 U.S.C. § 80b-6) establishes federal fiduciary standards to govern the conduct of investment advisers. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (“Courts have imposed on a fiduciary an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ his clients.”).

FINRA’s Regulatory Notice 19-26

Regulatory Notice 19-26 sets forth the requirements for broker-dealers and investment advisers to comply with the new laws by June 30, 2020.

© Andrew Whiteman 2019
The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Click here for more information about our securities litigation and arbitration practice. Please contact us for more information.

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