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Comparing the Standard of Conduct: Broker-Dealers vs. Investment Advisers

The SEC’s standard of conduct for broker-dealers under Regulation Best Interest (Reg BI) became effective on June 30, 2020. While registered investment advisers (RIAs) always have been subject to a best interest standard of conduct (i.e., the overarching standard that encompasses both the duty of care and the duty of loyalty), the SEC’s clarification of that standard in its Interpretation Regarding Standard of Conduct for Investment Advisers (the RIA Interpretation) has  been in effect since July 12, 2019. There are similarities in these two standards, but there are significant differences as well. Here is how the two standards compare:

 

Reg BI

RIA Interpretation

When Does the Standard Apply?

Transaction-based.

It applies when a broker-dealer makes a covered recommendation. A covered recommendation occurs when a broker-dealer recommends to a retail customer any securities transaction or investment strategy involving securities. Recommending an account type is considered to be recommending an investment strategy for this purpose.

Investment advisers always have a best interest duty defined by the scope of the agreed-upon adviser/client relationship.

 

It applies to the full range of investment advisory services provided to the client under the agreed-upon adviser/client relationship (e.g., advice about investment strategy, advice about account type, ongoing portfolio management, etc.).

Does the Standard Apply to All Clients?

No.

It only applies to retail customers. A retail customer for this purpose is defined as any natural person who receives a recommendation from the broker-dealer and uses it primarily for personal, family or household purposes. It includes individual plan participants. It does not apply to an employee seeking services for an employer or an individual who is seeking services for a small business. However, it does apply to a sole proprietor who decides service arrangements for a workplace retirement plan and participates in the plan to the extent such individual receives recommendations primarily for personal, family or household purposes.

Yes.

It applies to all clients, regardless of whether the client is an individual or institution.

Scope of the Standard

Applies to the recommended transaction.

A broker-dealer must act in the best interest of the retail customer at the time the covered recommendation is made, without placing the financial or other interests of the broker-dealer ahead of the interests of the retail customer.

Applies to all investment advice provided within the scope of the agreed-upon adviser/client relationship.

An investment adviser must have a reasonable belief that the investment advice it provides in carrying out the agreed-upon services is in the best interest of the client and must not subordinate the client’s interest to its own.

Process Requirement

The broker-dealer needs to consider the potential risks, rewards and costs associated with the covered recommendation and determine whether those factors align with the services requested by the customer and the customer’s investment profile.

When recommending an account type, the broker-dealer needs to consider the services and products provided in the account (e.g., account monitoring services, access to products with break-points, etc.), the projected cost to the customer and the alternative account types available.

Note: Dual registrants need to consider the full spectrum of accounts offered – both brokerage and advisory – and recommend the one that is in the customer’s best interest. If the advisor is only registered as an associated person of a broker-dealer and can only offer brokerage accounts, the advisor needs to have a reasonable basis to believe that the recommended brokerage account is in the customer’s best interest.

In carrying out the agreed-upon services, the investment adviser must assess whether the advice is in the client’s best interest by considering the client’s investment objectives and profile. This includes consideration of the client’s financial situation, level of financial sophistication, investment experience, and financial goals and other relevant factors, such as the client’s risk tolerance and the costs of the recommended investment or investment strategy.

The best interest process for investment advisers in advising about an account type is likely similar to the process specified by the SEC for broker-dealers, and investment advisers should consider those same factors.

Is There a Monitoring Obligation?

No, unless the broker-dealer agrees to provide monitoring services.

Yes. An investment adviser’s duty of care includes the duty to monitor at a frequency that is in the best interest of the client, taking into account the scope of the agreed-upon relationship.

For an ongoing relationship, an investment adviser’s duty to monitor extends to all personalized advice provided to the client, including an evaluation of whether a client’s account or program type (for example, a wrap account) continues to be in the client’s best interest.

On the other hand, the adviser and the client can agree to a relationship with limited duration that does not include a monitoring obligation such as a one-time financial plan for a one-time fee. In that instance, the adviser is unlikely to have a duty to monitor.

Mitigation of Conflicts of Interest

Broker-dealers must establish, maintain and enforce written policies and procedures reasonably designed to mitigate conflicts of interests that create an incentive for the firm’s financial professional to place its interests or the firm’s interest ahead of the customer’s interest.

Investment advisers do not need to mitigate a conflict of interest (i.e., modify practices to reduce the conflict) unless, absent mitigation, the conflict cannot be fully and fairly disclosed to a client in order for the client to provide informed consent.

Elimination of Conflicts of Interest

Broker-dealers must eliminate sales contests, sales quotas, bonuses and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

Investment advisers do not need to eliminate a conflict of interest unless even with mitigation, the conflict cannot be fully and fairly disclosed to a client in order for the client to provide informed consent.

Initial Delivery Requirement for the Customer/Client Relationship Summary (Form CRS)

Comment: The Form CRS is intended to provide a succinct high-level overview of a firm’s services, fees, costs, standards of conduct, conflicts of interest and disciplinary history.

A broker-dealer must deliver the Form CRS to each retail investor, before or at the earliest of (1) a recommendation of an account type, a securities transaction or an investment strategy involving securities; (2) placing an order for the retail investor; or (3) the opening of a brokerage account for the retail investor.

At or before entering into an investment advisory agreement, the adviser must deliver the Form CRS to retail investors.

Note: Dual registrants must deliver the Form CRS before or at the earliest of the timing requirements described in (1) through (3).

GENERAL DISCLOSURE OBLIGATION UNDER REG BI AND RIA INTERPRETEATION

 

Reg BI

RIA Interpretation

A. Scope of Disclosure Obligation

Disclosure specific to recommendation.

Broad-based disclosure of investment adviser’s business with ongoing disclosure obligation if there are material changes.

B. Timing of Initial Disclosure

Before or at the time of the recommendation, a broker-dealer or natural person who is an associated person of a broker or dealer must provide to the retail customer a written disclosure of material facts about the scope and terms of its relationship with the retail customer and conflicts of interest associated with the recommendation.

At or before entering into an advisory agreement with the prospective client, an investment adviser must deliver to the client a brochure, under Part 2A of Form ADV, that sets out disclosure requirements regarding the firm’s business practices, firm background and conflicts of interest. The purpose of the brochure is to enable the client to use the information to decide whether to enter into the advisory relationship.

C. Changes in Disclosure

Generally not required since the disclosure obligation tends to be a point-in-time requirement.

Note that for both broker-dealers and investment advisers, if any information in the Form CRS becomes materially inaccurate, then the Form CRS must be updated and filed with the SEC within 30 days, and retail investors must be notified within 60 days after the updates are required to be made.

Each year that there are material changes to the brochure, an investment adviser must deliver within 120 days of the end of its fiscal year to each client either (1) an updated brochure that includes or is accompanied by a summary of material changes or (2) a summary of material changes that includes an offer to provide a copy of the updated brochure and information on how to obtain it.

Note that for both broker-dealers and investment advisers, if any information in the Form CRS becomes materially inaccurate, then the Form CRS must be updated and filed with the SEC within 30 days, and retail investors must be notified within 60 days after the updates are required to be made.

D. Contents of the Disclosure

The broker-dealer’s disclosure should include:

  • A description of the type and scope of services to be provided

  • The fees and costs

  • Limitations on the services and products

  • Whether the broker-dealer agrees to provide monitoring services

  • A description of conflicts of interests (e.g., conflicts associated with proprietary products, payments from third parties and compensation arrangements).

An investment adviser must disclose all material facts relating to the advisory relationship and all conflicts of interest that might incline the adviser to render advice that is not disinterested. The disclosure must include, among other things:

  • A description of its advisory business

  • Fees and compensation

  • Methods of analysis

  • Investment strategies

  • Risk of loss explanation

  • Disciplinary information

  • Code of ethics

  • Brokerage practices

  • Ownership and affiliations.

E. Dual Registrant Requirements

Dually registered associated persons and associated persons who are not dually registered but only offer broker-dealer services through a firm that is dually registered as an investment adviser must disclose whether they are acting (or only acting) as an associated person of a broker-dealer. Also, an associated person of a dual-registrant who does not offer investment advisory services must disclose that fact as a material limitation.

For firms that are dually registered as investment advisers and broker-dealers and who serve the same client, the disclosure must describe the circumstances in which they intend to act in their brokerage capacity and their advisory capacity, and any circumstances under which advice will be limited to certain product offerings through the affiliated broker-dealer or affiliated investment adviser.

Final Takeaway

While both broker-dealers and investment advisers may be subject to a best interest standard of conduct, there are significant differences in the customer/client relationship covered, the disclosure obligation, the duty to monitor and the duty to mitigate and/or eliminate conflicts. Firms, and particularly those that are dually registered, should review policies and procedures to reflect these distinctions and ensure compliance.

© 2020 Faegre Drinker Biddle & Reath LLP. All Rights Reserved.National Law Review, Volume X, Number 223

TRENDING LEGAL ANALYSIS


About this Author

Joan M. Neri, Counsel, Drinker Biddle, Employee Benefits, Executive Compensation
Counsel

Her practice focuses on all aspects of employee benefits counseling.  Joan represents plan service providers (including registered investment advisers, third party administrators, and recordkeepers) in fulfilling their obligations under ERISA.  Joan also represents plan sponsor clients on the design of qualified retirement plans (including ESOPs), nonqualified executive compensation plans and welfare benefit plans, day-to-day plan administrative issues and transactional planning involving benefit plan acquisitions, plan mergers and plan terminations.  Joan has represented major publicly-...

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