August 9, 2020

Volume X, Number 222

August 07, 2020

Subscribe to Latest Legal News and Analysis

August 06, 2020

Subscribe to Latest Legal News and Analysis

The Best Laid Plans SEC Announces Examination Priorities for Regulation Best Interest and Form CRS

On June 5, 2019, the Securities and Exchange Commission (“SEC”) adopted Regulation Best Interest (“Regulation Best Interest” or “Reg BI”), which establishes a new standard of conduct under the Securities Exchange Act of 1934 (“Exchange Act”) for broker-dealers and persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer.[1]  As part of the adoption of Regulation Best Interest, the SEC also adopted Form CRS which requires SEC registered broker-dealers and investment advisers, including dual-registrants,[2] to provide a brief relationship summary to retail investors. The SEC also adopted new rules and forms to require broker-dealers and investment advisers to provide a brief relationship summary (“Form CRS”) to retail investors.[3] In addition, the SEC adopted formal interpretations summarizing existing jurisprudence regarding an investment advisers’ standard of conduct under the Investment Advisers Act of 1940 (the “Advisers Act”)[4] and the “solely incidental” prong of the broker-dealer exclusion from the Advisers Act.[5]  These are part of a long-standing SEC initiative to protect retail investors.[6]

For investment advisers, Form CRS will be a new Form ADV Part 3 that will be in addition to the currently required Form ADV Part 1 and Part 2 Brochures. Further, the Part 3 Form CRS is subject to different delivery obligations than the Part 2 Brochure. The Form CRS relationship summary does not replace or substitute for any other reporting or disclosure obligations of an SEC-registered investment adviser firm. Regulation Best Interest imposes a new standard of care on broker-dealers that are similar, but not identical, to the fiduciary duties that are deemed to be imposed on investment advisers under the antifraud provisions of the Advisers Act. That said, it is a significantly greater obligation of care than had been in place under the prior regulatory regime for broker-dealers.

On April 7, 2019, the SEC Office of Compliance Inspection and Examinations (“OCIE”) announced its areas of focus in 2020 for examining compliance by broker-dealers with Regulation Best Interest and Form CRS and by investment advisers with Form CRS.[7]  The following is a summary of Regulation Best Interest, the Form CRS and the OCIE Alerts.

Regulation Best Interest

While investment advisers long have been deemed to have fiduciary duties to their clients which are summarized by the SEC in the Interpretation Regarding Standard of Conduct for Investment Advisers that was adopted at the same time as Regulation Best Interest. Historically broker-dealers have not been deemed to have similar fiduciary duties to their clients under the federal securities laws. While stopping short of explicitly stating that broker-dealers are subject to fiduciary duties, Regulation Best Interest creates four new obligations of broker-dealers: (1) a disclosure obligation, (2) a care obligation, (3) a conflict of interest obligation and (4) a compliance obligation. Given the similarities to fiduciary duties under the Advisers Act, it is reasonable to expect that OCIE will look at these obligations similarly when performing examinations.

OCIE Areas of Examination for Regulation Best Interest

Items OCIE has stated it will review include when examining broker-dealers and registered investment advisers include the following.

1.  Disclosure Obligation. Regulation Best Interest requires full and fair disclosure of all material facts relating to the scope and terms of the relationship with the retail investor, as well as material facts relating to conflicts of interest. This should include limitations on strategies, in-depth discussion of fees and costs and the capacity in which recommendations are made.

2.  Care Obligation. Firms must exercise reasonable diligence, care and skill when making recommendations, understand the risks, rewards and costs in connection with the recommendations made, and consider these factors in light of the retail customer’s investment profile. Documentation should be maintained showing the broker-dealer’s decision-making process, particularly when recommendations relate to complex, risky or expensive products.

3.  Conflict of Interest Obligation. Broker-dealers must establish, maintain and enforce written policies that are reasonably designed to address conflicts of interest. Anything that might create an incentive for the firm or an associated person to put its interest ahead of that of the client should be mitigated. Also this may create a need to eliminate certain types of compensation, such as volume quotas and sales contests, and there should be documentation as to what actual conflicts there were and how the conflicts were mitigated (and if not addressed by the policies, how the policies were adjusted so they could be mitigated in the future).

4.  Compliance Obligation. Broker-dealers must establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest. In particular, this should include maintaining records that evidence the broker-dealer’s compliance.

Form CRS

The SEC’s stated goal of Form CRS is to provide summary information in a standard way that allows retail investors to more easily compare investment advisers and broker-dealers. A retail investor is as “a natural person, or the legal representative of such a natural person, who seeks to receive or receives services primarily for personal, family or household purposes.” Form CRS is “intended to inform retail investors” about:

  • The types of client and customer relationships and services the firm offers;

  • The fees, costs, conflicts of interest and required standard of conduct associated with those relationships and services;

  • Whether the firm and its financial professionals currently have reportable legal or disciplinary history; and

  • How to obtain additional information about the firm.

While this applies to all registered broker-dealers and registered investment advisers that have retail investors, the adopting release was clear to note that this is not applicable to exempt reporting advisers such as private fund advisers and venture capital fund advisers. Financial advisors who do not have retail clients – such as investment advisers who solely advise funds and broker-dealers that only provide institutional research reports and execution services – are not required to prepare or file a Form CRS. Financial advisors that do not have retail clients are required to do so before accepting any retail clients. While the states may require state-registered advisers to also comply with Form CRS and its related rules, to date none have adopted this requirement.

As noted in the OCIE Alerts, the SEC staff will focus on the following in its inspections of broker-dealer and SEC registered investment advisers with respect to the Form CRS.

1.         Delivery and Filing. The Form CRS should be properly filed with the SEC, posted to the firm’s website and delivered to existing retail investors in a timely manner (July 30, 2020) and in a manner that works for the type of investor and type of account. Policies and procedures will be vetted to ensure that Form CRS gets amended when required and will be delivered when there are new investors or new accounts for existing investors.

2.         Content. The Form CRS contains all of the information that is required by the form and all statements in the form must be true, accurate and not misleading, and stated in a way that retail investors will be able to easily understand. As historically has been the case with OCIE examinations, there is promised to be a strong focus on disclosures regarding fees, expenses, conflicts of interest and compensation.

3.         Formatting. Firms should ensure that precise language is included where required, text features (such as tables, graphics and QR codes) are used, that the form does not exceed two pages and that the disclosure is written in plain English and speaks directly to the investor.

4.         Updates. Policies and procedures should be in place, monitored and enforced so that the firm updates Form CRS at the required times, is able to assess when there might be material inaccuracies and can deliver updates in a timely manner and in a way that highlights the changes.

5.         Recordkeeping. Firms must comply with recordkeeping obligations, with OCIE particularly focusing on records regarding proof of delivery and timing of delivery.

Investment advisers that are federally registered, or that have an application for registration pending with the SEC before June 30, 2020, must electronically file the Form CRS beginning on May 1, 2020 and by no later than June 30, 2020, either as: (1) an other than-annual amendment or (2) part of the initial application or annual updating amendment. After June 30, 2020, the SEC will not accept any initial application that does not include a Form CRS.

In contrast to the extensions and other concessions that the SEC has granted in response to the novel coronavirus epidemic and social distancing requirements, the SEC explicitly stated that it will not extend the compliance deadlines for Regulation Best Interest and Form CRS. Broker-dealer and investment advisers and broker-dealers to which these requirements apply will need to be compliant no later than the June 30 compliance date.

Key Takeaways

Broker-dealers and investment advisers required to file Form CRS should immediately work on doing so. Before a broker-dealer or investment adviser files Form CRS, it should be reviewed by counsel and compliance professionals to ensure that it is complete, clear, and written in plain English. A secondary goal of an external review process is to create a good record of the firm’s commitment to a culture of compliance.

While OCIE stated that it likely will not start performing examinations relating to Regulation Best Interest until a year after the compliance date, examinations relating to Form CRS could start immediately after the June 30 compliance date or July 30 delivery date. Firms should also consider how they will satisfy their delivery requirements in the age of social distancing, particularly in circumstances where some existing clients may have become used to receiving required disclosures in person.

The Regulation Best Interest alert contains sample lists of questions that OCIE may ask and documents the SEC staff may request during an examination. Broker-dealers and investment advisers should be familiar with these questions and the documents that will be requested and should be prepared to address these questions. Firms should also use OCIE alerts to anticipate issues that could arise and to design policies and procedures that are compliant and suitable for their business.

Contrary to common criticism, the SEC and its staff historically have been transparent on what constitutes a conflict of interest. Years of enforcement actions, settlements, speeches and releases have made it clear what the SEC believes to be a conflict of interest and what constitutes a suitable disclosure of a conflict of interest.

Broker-dealers currently have a duty under FINRA Rule 2010 to observe “high standards of commercial honor and just and equitable principles of trade,” Regulation Best Interest represents a meaningful addition to that duty. Broker-dealers also have a duty under SEC and FINRA rules to maintain proper policies and procedures tailored to their unique business that are designed to ensure compliance with the securities laws, SEC and FINRA rules. Broker-dealers also have a duty to maintain such policies and procedures as part of the firm’s books and records. These duties now include the development of policies and procedures that are designed to ensure the firm’s compliance with Regulation Best Interest.

Investment advisory firms that are not an SEC-registered should confirm whether compliance might be necessary at the state level. While to our knowledge no state has implemented a Form CRS analog for state-registered investment advisers, it will be required for dual registrants. Further, certain states have instituted laws similar to Regulation Best Interest and, in the case of Massachusetts, it goes even further than Regulation Best Interest in establishing an actual fiduciary duty. Last, consider whether to attempt compliance as a matter of best practices.

Additional Information

The SEC has created a webpage focused on Regulation Best Interest and Form CRS that provides useful information for broker-dealers and investment advisers.[8]  FINRA has also created a webpage focused on Regulation Best Interest and Form CRS that provides useful information for broker-dealers.[9]

[1] Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 34-86031 (June 5, 2019), 84 Fed. Reg. 33318 (July 12, 2019), available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12164.pdf. The SEC has also prepared a Regulation Best Interest Small Entity Compliance Guide, available at: https://www.sec.gov/info/smallbus/secg/regulation-best-interest and FINRA has prepared guidance on Regulation Best Interest, available at: https://www.finra.org/rules-guidance/key-topics/regulation-best-interest.

[2] A dual registrant is an investment adviser solely with respect to those accounts for which a dual registrant provides investment advice or receives compensation that subjects it to the Investment Advisers Act of 1940. Although this discussion focuses on the treatment of broker-dealers that are dually registered with the Commission as investment advisers, a broker-dealer should perform the same analysis when it is engaged in other financial services (such as a bank, a commodity trading advisor, or a future commission merchant).

[3] Exchange Act Release No. 86032, Form CRS Relationship Summary, Amendment to Form ADV (final rule) (June 5, 2019), 84 Fed. Reg. 33492 (July 12, 2019), available at: https://www.sec.gov/rules/final/2019/34-86032.pdf, Form ADV Instructions, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-a.pdf, and Form CRS Instructions, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf.

[4] Investment Advisers Act Release No. 5248 (June 5, 2019), 84 Fed. Reg. 33669 (July 12, 2019), available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12208.pdf

[5] Investment Advisers Act Release No. 5249 (June 5, 2019), 84 Fed. Reg. 33681 (July 12, 2019), available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12209.pdf.

[6]  See, e.g., 2010 Examination Priorities, Office of Compliance Examinations and Inspections, available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf; 2019 Examination Priorities, Office of Compliance Examinations and Inspections, available at https://www.sec.gov/files/OCIE%202019%20Priorities.pdf.

[7] Risk Alert: Examinations that Focus on Compliance with Regulation Best Interest (April 7, 2019), available at: https://www.sec.gov/files/Risk%20Alert-%20Regulation%20Best%20Interest%20Exams.pdf, and Risk Alert: Examinations that Focus on Compliance with Form CRS (April 7, 2019, available at: https://www.sec.gov/files/Risk%20Alert%20-%20Form%20CRS%20Exams.pdf (collectively, the “OCIE Alerts”).

[7] SEC Plain English Guide: How to create clear SEC disclosure documents, available at: https://www.sec.gov/pdf/handbook.pdf.

[8] https://www.sec.gov/regulation-best-interest, Frequently Asked Questions on Regulation Best Interest, https://www.sec.gov/tm/faq-regulation-best-interest and frequently Asked Questions on Form CRS, https://www.sec.gov/investment/form-crs-faq.

[9] FINRA SEC Regulation Best Interest Resource Webpage, https://www.finra.org/rules-guidance/key-topics/regulation-best-interest#notices.

© Polsinelli PC, Polsinelli LLP in CaliforniaNational Law Review, Volume X, Number 108

TRENDING LEGAL ANALYSIS


About this Author

Daniel L. McAvoy Shareholder Investment Funds Securities & Corporate Finance Mergers, Acquisitions and Divestitures Corporate and Transactional Joint Ventures and Strategic Alliances
Shareholder

Dan McAvoy focuses his practice on private closed-end investment funds, corporate finance and M&A with a focus on private investment fund transactions, including complex GP-led restructurings and secondary transactions. Dan is a trusted adviser to numerous investment advisers, fund sponsors and investors, and has represented a range of companies, from startups to Fortune 500 companies. Dan has also represented portfolio companies and sponsors through all parts of the corporate life cycle, including formation, venture financings, add-ons, stock sales, asset sales, private and...

212-413-2844
Shareholder

Richard Levin brings his experience as a senior legal and compliance officer on Wall Street and in London to bear in advising clients on corporate, securities and regulatory issues. A problem-solver by nature, his practice focuses on helping financial services and technology (FinTech) clients identify and address regulatory issues as they build their businesses.  

The FinTech sector is experiencing rapid changes that are producing innovative new technologies: digital currencies, blockchain technology, peer to peer lending, robo advisors, crowdfunding portals, and electronic trading platforms. These changes are challenging early stage companies and established financial services firms to understand the legal and regulatory issues associated with the development of these innovative technologies. Polsinelli is at the vanguard of these changes.

303.583.8261
Peter Waltz, Polsinelli Law Firm, Denver, Corporate and Finance Law Attorney
Counsel

Peter Waltz is dedicated to helping clients achieve their objectives by employing a comprehensive, interdisciplinary approach to their legal and business challenges. He advises companies in all phases of the business cycle and provides ongoing advice and counsel on day-to-day operational, business, and legal issues. This focus includes the preparation and negotiation of documents related to entity selection and formation, corporate structure, corporate governance, and commercial contract matters. Peter advises a variety of clients with their business transactions,...

303-583-8254