06.14.19

With Compliance Deadline 12 Months Away, Industry Begins to Get Grip on New Advice Rules

by: Rich Blake

In at least one instance, the Securities and Exchange Commission’s just-finalized rules of retail customer engagement couldn't be clearer: No sales contests. Or, rather, at least none that involve bonuses or prizes for representatives hitting quotas for a specific product sold during a limited period of time.

In other cases, however, the new SEC professional conduct rules, a four-part, roughly 1,000-page volume collectively known as Regulation Best Interest, are much less explicit. And while sometimes the “Reg BI” rules read ambiguously, sizable policy chunks of the package still need to be fleshed out – by industry members themselves.

The compliance deadline for Reg BI is June 30, 2020. To help the industry start to digest the Reg BI ramifications beelining to the front-burner, a group of Eversheds Sutherland attorneys held a 30-minute briefing call on Friday, June 7, two days after the rules were passed. The call (listen to a reply HERE) was led by Clifford Kirsch, a partner at the firm, accompanied by Michael Koffler and Holly Smith, partners, as well as Issa Hanna and Ben Marzouk, counsels.

Taking apart the bundle of measures key piece by key piece, the Eversheds Sutherland team shared observations on the most critical portions of the rules relating to new conduct standards for broker-dealers, investment advisers and those professionals who carry both designations, or so-called "dual-hats."

Among the biggest takeaways:

 

• No Big Surprises: Reg BI in its final glory looks pretty much like it did during the proposal stage i.e. there were not many surprises or significant changes to the version that passed (3-1 as expected). This is particularly so when it came to the third and fourth components, the former being the Interpretation of the Standard of Conduct for Advisers – fiduciaries under the Investment Advisers Act and remaining so – and the latter being the SEC’s formally issued interpretation of the “solely incidental” language (in the Investment Advisers Act) that allows brokers to give some advice without registering as advisers and being subject to a fiduciary duty; likewise, the SEC let this be.

 

• Not Entirely Clear: Some ambiguity shrouds a few major aspects of the rules package, particularly with respect to the first and second components with which the industry now will have to wrestle. For example, within the rule set's namesake cornerstone, the actual BI package that impacts brokers and their associates, there happens to be no precise definition of "best interest." Instead, the rules pave the way for what essentially amounts to a self-imposed, disclosure-based regime, coupled with some other obligations rooted in past regulatory opinions and court decisions, containing trace elements drawn from the suitability standard and advisers' standards of care.

 

• Conflict Resolution Confusion: Among the most confusing issues, and one with the highest probability of creating problems down the line – and possibly even lawsuits – is this: what to do about conflicts beyond disclosing them. "There's not enough clarity on this," Kirsch said. It may be possible, given that broker-dealer firms will be left to write their own policies, that the door has been left slightly open to have the mere disclosure of a conflict constitute its mitigation in many instances; although there are, per the rules, going to be those thorny conflicts that are either so egregious or complicated to the point of inexplicability that disclosure is not enough, bearing in mind that there's no express SEC guidance regarding which types of conflicts would be considered of an ilk that they can’t be disclosed away. The SEC did, however, provide a specific definition of “conflict of interest,” defined as: "an interest that might incline a broker-dealer or associated person, consciously or unconsciously, to make a recommendation that is not disinterested.” Compliance people get out your dictionaries, because that key word, incline, as verb, has two meanings: “favorably disposed;” and “having a tendency."

 

• Brand New Beast: The Form CRS Relationship Summary is an upfront deliverable from advisory professionals to their retail clients. It’ll give clients a brief description of a firm's services, investment offerings, fees, and conflicts of interest. If written out in narrative format, Form CRS can't be more than two pages (although dual hats can go up to four pages); importantly, the final rule left the industry latitude to explore alternative formats, i.e. short videos conveying the summary. Still, and it can’t be stressed enough, this requirement looms among the largest new realities for industry professionals who will be tasked with creating, delivering, recording and updating the form.

The rules pertaining to exactly what Form CRS needs to say reflect a mix of SEC-prescribed and firm-authored wording. It's important to note that the disclosure aspect of Form CRS is distinct from the disclosure obligation contained in Reg BI. "There's less prescribed language in the final version of the Form CRS compared to the proposed version," Ben Marzouk, counsel, Eversheds Sutherland, explained.

Eversheds Sutherland partner Holly Smith spelled out the separate Reg BI disclosure obligation, one of four obligations found in Reg BI, which, to reiterate, is the banner nickname of the rules set and also a specific batch of conduct rules written specifically for brokers.

Firms will have leeway to provide Reg BI disclosures in a way that suits their individual circumstances, but firms need to keep in mind that there is a “materiality” legal standard (based on Supreme Court-decided shareholder-disclosure law) governing what is to be considered full and fair disclosure.

Three other obligations are ushered into the industry under Reg BI:

• Client care: File this one under self-regulation based on a "reasonable basis" test for coming to the belief that a professional’s care serves the client's best interest.
• Conflicts of interest: This is an obligation to create a reasonably designed process to disclose and mitigate conflicts.
• Compliance: Firms need to develop overarching Reg BI policies and procedures, reasonably designed to achieve compliance.

On the issue of mitigating conflicts, the SEC appears to have erred on the side of vagueness.

According to Michael Koffler, partner, Eversheds Sutherland, the longstanding debate – whether merely disclosing a conflict is always going to be a sufficient means of mitigation – has been settled by the new rules. The answer is no, disclosure is not always enough. However, Koffler said, when it comes to SEC interpretive guidance on conflicts that require elimination or modification, the verbiage is "about as clear as mud."