[Federal Register Volume 84, Number 134 (Friday, July 12, 2019)]
[Rules and Regulations]
[Pages 33318-33492]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-12164]
[[Page 33317]]
Vol. 84
Friday,
No. 134
July 12, 2019
Part II
Securities and Exchange Commission
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17 CFR Part 240
Regulation Best Interest: The Broker-Dealer Standard of Conduct; Form
CRS Relationship Summary; Amendments to Form ADV; Commission
Interpretation Regarding Standard of Conduct for Investment Advisers;
Commission Interpretation Regarding the Solely Incidental Prong of the
Broker-Dealer Exclusion From the Definition of Investment Adviser;
Final Rule
Federal Register / Vol. 84, No. 134 / Friday, July 12, 2019 / Rules
and Regulations
[[Page 33318]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-86031; File No. S7-07-18]
RIN 3235-AM35
Regulation Best Interest: The Broker-Dealer Standard of Conduct
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (the ``Commission'')
is adopting a new rule under the Securities Exchange Act of 1934
(``Exchange Act''), establishing a standard of conduct for broker-
dealers and natural persons who are associated persons of a broker-
dealer (unless otherwise indicated, together referred to as ``broker-
dealer'') when they make a recommendation to a retail customer of any
securities transaction or investment strategy involving securities
(``Regulation Best Interest''). Regulation Best Interest enhances the
broker-dealer standard of conduct beyond existing suitability
obligations, and aligns the standard of conduct with retail customers'
reasonable expectations by requiring broker-dealers, among other
things, to: Act in the best interest of the retail customer at the time
the recommendation is made, without placing the financial or other
interest of the broker-dealer ahead of the interests of the retail
customer; and 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 instances where we have determined that
disclosure is insufficient to reasonably address the conflict, to
mitigate or, in certain instances, eliminate the conflict. The standard
of conduct established by Regulation Best Interest cannot be satisfied
through disclosure alone. The standard of conduct draws from key
principles underlying fiduciary obligations, including those that apply
to investment advisers under the Investment Advisers Act of 1940
(``Advisers Act''). Importantly, regardless of whether a retail
investor chooses a broker-dealer or an investment adviser (or both),
the retail investor will be entitled to a recommendation (from a
broker-dealer) or advice (from an investment adviser) that is in the
best interest of the retail investor and that does not place the
interests of the firm or the financial professional ahead of the
interests of the retail investor.
DATES:
Effective date: This rule is effective September 10, 2019.
Compliance date: The compliance date is discussed in Section II.E
of this final release.
FOR FURTHER INFORMATION CONTACT: Lourdes Gonzalez, Assistant Chief
Counsel--Office of Sales Practices; Emily Westerberg Russell, Senior
Special Counsel; Alicia Goldin, Senior Special Counsel; John J. Fahey,
Branch Chief; Daniel Fisher, Branch Chief; Bradford Bartels, Special
Counsel; and Geeta Dhingra, Special Counsel, Office of Chief Counsel,
Division of Trading and Markets, at (202) 551-5550, Securities and
Exchange Commission, 100 F Street NE, Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is adopting new rule 17 CFR
240.15l-1 under the Exchange Act to establish a standard of conduct for
broker-dealers and natural persons who are associated persons of a
broker-dealer when they make a recommendation to a retail customer of
any securities transaction or investment strategy involving securities.
The Commission is also adopting amendments to rules 17 CFR 240.17a-3
and 17 CFR 240.17a-4 to establish new record-making and recordkeeping
requirements for broker-dealers with respect to certain information
collected from or provided to retail customers.
Table of Contents
I. Introduction
A. Background
B. Overview of Regulation Best Interest
C. Overview of Modifications to the Proposed Rule Text and
Guidance Provided
D. Overview of Key Enhancements
II. Discussion of Regulation Best Interest
A. General Obligation
1. Commission's Approach
2. General Obligation To ``Act in Best Interest''
B. Key Terms and Scope of Best Interest Obligation
1. Natural Person Who Is an Associated Person
2. Recommendation of Any Securities Transaction or Investment
Strategy Involving Securities
3. Retail Customer
C. Component Obligations
1. Disclosure Obligation
2. Care Obligation
3. Conflict of Interest Obligation
4. Compliance Obligation
D. Record-Making and Recordkeeping
E. Compliance Date
III. Economic Analysis
A. Introduction and Primary Goals of the Regulation, Comments on
Market Failure and Quantification, and Broad Economic Considerations
1. Introduction and Primary Goals of the Regulation
2. Broad Economic Considerations
3. Comments on Market Failure of the Principal-Agent
Relationship and Quantification; Comments That the Broker-Dealer,
Commission-Based Model Should Be Severely Restricted or Eliminated
B. Economic Baseline
1. Providers of Financial Services
2. Regulatory Baseline and Current Market Practices
3. Investment Advice and Evidence of Potential Investor Harm
4. Trust, Financial Literacy, and the Effectiveness of
Disclosure
C. Benefits and Costs
1. General
2. Disclosure Obligation
3. Care Obligation
4. Conflict of Interest Obligation
5. Compliance Obligation
6. Record-Making and Recordkeeping
7. Approaches To Quantifying the Potential Benefits
D. Efficiency, Competition, and Capital Formation
1. Competition
2. Capital Formation and Efficiency
E. Reasonable Alternatives
1. Fiduciary Standard for Broker-Dealers
2. Prescribed Format for Disclosure
3. Disclosure-Only
IV. Paperwork Reduction Act
A. Respondents Subject to Regulation Best Interest and
Amendments to Rule 17a-3(a)(35) and Rule 17a-4(e)(5)
1. Broker-Dealers
2. Natural Persons Who Are Associated Persons of Broker-Dealers
B. Summary of Collections of Information
1. Disclosure Obligation
2. Care Obligation
3. Conflict of Interest Obligation
4. Compliance Obligation
5. Record-Making and Recordkeeping Obligations
V. Final Regulatory Flexibility Act Analysis
A. Need for and Objectives of the Rule
B. Significant Issues Raised by Public Comments
C. Small Entities Subject to the Rule
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Disclosure Obligation
2. Care Obligation
3. Conflict of Interest Obligation
4. Compliance Obligation
5. Record-Making and Recordkeeping Obligations
E. Agency Action To Minimize Effect on Small Entities
VI. Statutory Authority and Text of the Rule
I. Introduction
We are adopting a new rule 15l-1 under the Exchange Act
(``Regulation Best Interest'') that will improve investor protection
by: (1) Enhancing the obligations that apply when a broker-dealer makes
a recommendation to a retail customer and natural persons
[[Page 33319]]
who are associated persons of a broker-dealer (``associated persons'')
(unless otherwise indicated, together referred to as ``broker-dealer'')
and (2) reducing the potential harm to retail customers from conflicts
of interest that may affect the recommendation. Regulation Best
Interest enhances the broker-dealer standard of conduct beyond existing
suitability obligations, and aligns the standard of conduct with retail
customers' reasonable expectations by requiring broker-dealers, among
other things, to: (1) Act in the best interest of the retail customer
at the time the recommendation is made, without placing the financial
or other interest of the broker-dealer ahead of the interests of the
retail customer; and (2) 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 instances where we have determined that
disclosure is insufficient to reasonably address the conflict, to
mitigate or, in certain instances, eliminate the conflict. Regulation
Best Interest establishes a standard of conduct under the Exchange Act
that cannot be satisfied through disclosure alone.
A. Background
Broker-dealers play an important role in helping Americans organize
their finances, accumulate and manage retirement savings, and invest
toward other important long-term goals, such as buying a house or
funding a child's college education. Broker-dealers offer a wide
variety of brokerage (i.e., agency) services and dealer (i.e.,
principal) services and products to both retail and institutional
customers.\1\ Specifically, the brokerage services provided to retail
customers range from execution-only services to providing personalized
investment advice in the form of recommendations of securities
transactions or investment strategies involving securities to
customers.\2\
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\1\ See Regulation Best Interest, Release No. 34-83062 (Apr. 18,
2018) [83 FR 21574] (May 9, 2018) (``Proposing Release'') at 21574-
75; see also Staff of the U.S. Securities and Exchange Commission,
Study on Investment Advisers and Broker-Dealers As Required by
Section 913 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Jan. 2011) (``913 Study'') at 8-12, available at
www.sec.gov/news/studies/2011/913studyfinal.pdf (discussing the
range of brokerage and dealer services provided by broker-dealers).
\2\ See Proposing Release at 21574-21575; see also 913 Study.
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Investment advisers play a similarly important, though distinct,
role. As described in the Fiduciary Interpretation, investment advisers
provide a wide range of services to a large variety of clients, from
retail clients with limited assets and investment knowledge and
experience to institutional clients with very large portfolios and
substantial knowledge, experience, and analytical resources.\3\
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\3\ See Commission Interpretation Regarding Standard of Conduct
for Investment Advisers, Advisers Act Release No. 5248 (June 5,
2019) (``Fiduciary Interpretation'').
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As a general matter, broker-dealers and investment advisers have
different types of relationships with investors, offer different
services, and have different compensation models when providing
investment recommendations or investment advisory services to
customers. Broker-dealers typically provide transaction-specific
recommendations and receive compensation on a transaction-by-
transaction basis (such as commissions) (``transaction-based''
compensation or model). A broker-dealer's recommendations may include
recommending transactions where the broker-dealer is buying securities
from or selling securities to retail customers on a principal basis or
recommending proprietary products.\4\ Investment advisers, on the other
hand, typically provide ongoing, regular advice and services in the
context of broad investment portfolio management, and are compensated
based on the value of assets under management (``AUM''), a fixed fee or
other arrangement (``fee-based'' compensation or model).\5\ This
variety is important because it presents investors with choices
regarding the types of relationships they can have, the services they
can receive, and how they can pay for those services. It is also common
for a firm to provide both broker-dealer and investment adviser
services.
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\4\ See Proposing Release at 21574-21575; see also 913 Study.
\5\ See 913 Study.
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Like many principal-agent relationships--including the investment
adviser-client relationship--the relationship between a broker-dealer
and a customer has inherent conflicts of interest, including those
resulting from a transaction-based (e.g., commission) compensation
structure and other broker-dealer compensation.\6\ These and other
conflicts of interest may provide an incentive to a broker-dealer to
seek to increase its own compensation or other financial interests at
the expense of the customer to whom it is making investment
recommendations.
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\6\ The investment adviser-client relationship also has inherent
conflicts of interest, including those resulting from an asset-based
compensation structure that may provide an incentive for an
investment adviser to encourage its client to invest more money
through an adviser in order increase its AUM at the expense of the
client. See Fiduciary Interpretation at footnotes 53-72 and
accompanying text for a discussion of how investment advisers
satisfy their fiduciary duty when conflicts of interest are present.
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Notwithstanding these inherent conflicts of interest in the broker-
dealer-customer relationship, there is broad acknowledgment of the
benefits of, and support for, the continuing existence of the broker-
dealer business model, including a commission or other transaction-
based compensation structure, as an option for retail customers seeking
investment recommendations.\7\ For example, retail customers that
intend to buy and hold a long-term investment may find that paying a
one-time commission to a broker-dealer recommending such an investment
is more cost effective than paying an ongoing advisory fee to an
investment adviser merely to hold the same investment. Retail customers
with limited investment assets may benefit from broker-dealer
recommendations when they do not qualify for advisory accounts because
they do not meet the account minimums often imposed by investment
advisers. Other retail customers who hold a variety of investments, or
prefer differing levels of services (e.g., both episodic
recommendations from a broker-dealer and continuous advisory services
including discretionary asset management from an investment adviser),
may benefit from having access to both brokerage and advisory accounts.
Nevertheless, concerns exist regarding (1) the potential harm to retail
customers resulting from broker-dealer recommendations provided where
conflicts of interest exist and (2) the insufficiency of existing
broker-dealer regulatory requirements to address these conflicts when
broker-dealers make recommendations to retail customers.\8\ More
specifically, there are concerns that existing requirements do not
require a broker-dealer's recommendations to be in the retail
customer's best interest.\9\
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\7\ See Proposing Release at 21579.
\8\ Id. at 21577-21579.
\9\ Id. See also Section I.C, Overview of Modifications to the
Proposed Rule Text and Guidance Provided.
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B. Overview of Regulation Best Interest
On April 18, 2018, we proposed enhancements to the standard of
conduct that applies when broker-dealers make recommendations to retail
customers.\10\ Specifically, the proposal would have established an
express best interest obligation that would require all broker-dealers
and associated persons,
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when making a recommendation of any securities transaction or
investment strategy involving securities to a retail customer, to act
in the best interest of the retail customer at the time the
recommendation is made without placing the financial or other interest
of the broker-dealer or associated person making the recommendation
ahead of the interest of the retail customer.
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\10\ Proposing Release at 21575.
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The Commission received substantial comment on proposed Regulation
Best Interest. We received over 6,000 comment letters in connection
with the Proposing Release, of which approximately 3,000 are unique
comment letters, from a variety of commenters including individual
investors, consumer advocacy groups, financial services firms
(including broker-dealers, investment advisers, and insurance
companies), investment professionals, industry and trade associations,
state securities regulators, bar associations, and others.\11\
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\11\ Comments received in response to the Proposing Release are
available at: https://www.sec.gov/comments/s7-07-18/s70718.htm.
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The Commission also solicited individual investors' input through a
number of forums in addition to the traditional requests for comment in
the Proposing Release. Among other things, seven investor roundtables
were held in different locations across the country to solicit further
comment on the proposed relationship summary,\12\ and the Commission
and its staff received in-person feedback from almost 200 attendees in
total.\13\ The Commission also received input and recommendations from
a majority of its Investor Advisory Committee (``IAC'') on proposed
Regulation Best Interest.\14\
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\12\ In a separate, concurrent rulemaking, the Commission
proposed to, among other things, require broker-dealers and
investment advisers to deliver to retail investors a short
relationship summary (``Relationship Summary''). See Form CRS
Relationship Summary; Amendments to Form ADV; Required Disclosures
in Retail Communications and Restrictions on the use of Certain
Names or Titles, Release No. 34-83063, IA-4888, File No. S7-08-18
(Apr. 18, 2018), 83 FR 23848 (May 23, 2018) (``Relationship Summary
Proposal'').
Along with adopting Regulation Best Interest, the Commission is
adopting Exchange Act Rule 17a-14 (CFR 240.17a-14) and Form CRS (17
CFR 249.640) under the Exchange Act (``Form CRS''). See Form CRS
Relationship Summary; Amendments to Form ADV Exchange Act Release
No. 86032, Advisers Act Release No. 5247, File No. S7-08-18 (June 5,
2019) (``Relationship Summary Adopting Release''). The Commission is
also providing interpretations: (1) Clarifying standards of conduct
for investment advisers, and (2) regarding when a broker-dealer's
advisory services are solely incidental to the conduct of the
business of a broker or dealer. See Fiduciary Interpretation;
Commission Interpretation Regarding the Solely Incidental Prong of
the Broker-Dealer Exclusion to the Definition of Investment Adviser,
Advisers Act Release No. 5249 (June 5, 2019) (``Solely Incidental
Interpretation'').
\13\ The transcripts from the seven investor roundtables, which
took place in Atlanta, Baltimore, Denver, Houston, Miami,
Philadelphia, and Washington DC, are available in the comment file
at https://www.sec.gov/comments/s7-08-18/s70818.htm#transcripts.
The Commission also used a ``feedback form'' designed
specifically to solicit input from retail investors with a set of
questions requesting both structured and narrative responses, and
received more than 90 responses from individuals who reviewed and
commented on the sample proposed relationship summaries published in
the proposal. The feedback forms are available in the comment file
at https://www.sec.gov/comments/s7-08-18/s70818.htm.
Finally, the Commission's Office of the Investor Advocate
engaged the RAND Corporation to conduct investor testing of the
proposed relationship summary. Angela A. Hung, et al., RAND
Corporation, Investor Testing of Form CRS Relationship Summary
(2018), available at https://www.sec.gov/about/offices/investorad/investor-testing-form-crs-relationship-summary.pdf (``RAND 2018'').
See also Investor Testing of the Proposed Relationship Summary for
Investment Advisers and Broker-Dealers, Commission Press Release
2018-257 (Nov. 7, 2018), available at https://www.sec.gov/news/press-release/2018-257. As noted in the Relationship Summary
Adopting Release, the amount of information available from the
various investor surveys and investor testing described in this
release is extensive. We considered all of this information
thoroughly, using our decades of experience with investor
disclosures, when evaluating changes to the disclosure required by
Regulation Best Interest, as well as to the Relationship Summary.
See Relationship Summary Adopting Release.
\14\ Recommendation of the Investor as Purchaser Subcommittee
Regarding Proposed Regulation Best Interest, Form CRS, and
Investment Advisers Act Fiduciary Guidance, Nov. 7, 2018, available
at https://www.sec.gov/spotlight/investor-advisory-committee-2012/iac110718-investor-as-purchaser-subcommittee-recommendation.pdf
(``IAC 2018 Recommendation''). Generally, a majority of the IAC made
the following recommendations related to Regulation Best Interest:
(1) That the meaning of the best interest obligation should be
clarified to require both broker-dealers, investment advisers, and
their associated persons to recommend the investments, investment
strategies, accounts, or services, from among those they have
reasonably available to recommend, that they reasonably believe
represent the best available options for the investor; (2) that the
best interest obligation be expanded to apply to the implicit ``no
recommendation'' recommendation that a broker makes when reviewing
an account and recommending no change, to rollover recommendations
and recommendations by dual registrant firms regarding account
types; and (3) that the best interest obligation should be
explicitly characterized as the fiduciary duty that it is, while
making clear that the specific obligations that flow from that duty
will vary based on differences in business models. The Commission is
statutorily obligated to respond to the recommendations of the IAC,
which we are doing in this section and throughout the adopting
release in the relevant sections, for example, in the discussion of
the General Obligation in Section II.A.1, the discussion of
recommendations in Section II.B.1, Recommendation of Any Securities
Transaction or Investment Strategy Involving Securities, and the
Care Obligation in Section II.C.2.
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After careful review and consideration of comments received and
upon further consideration, the Commission is adopting Regulation Best
Interest, with certain modifications as compared to the Proposing
Release. As discussed below, while the Commission is generally
retaining the overall structure and scope set forth in the Proposing
Release, we are making modifications to the text of the rule and also
providing interpretations and guidance to address points raised during
the comment process.
The Commission has crafted Regulation Best Interest to draw on key
principles underlying fiduciary obligations, including those that apply
to investment advisers under the Advisers Act, while providing specific
requirements to address certain aspects of the relationships between
broker-dealers and their retail customers. Regulation Best Interest
enhances the existing standard of conduct applicable to broker-dealers
and their associated persons at the time they recommend to a retail
customer a securities transaction or investment strategy involving
securities. This includes recommendations of account types and
rollovers or transfers of assets and also covers implicit hold
recommendations resulting from agreed-upon account monitoring. When
making a recommendation, a broker-dealer must act in the retail
customer's best interest and cannot place its own interests ahead of
the customer's interests (hereinafter, ``General Obligation'').\15\ The
General Obligation is satisfied only if the broker-dealer complies with
four specified component obligations. The obligations are: (1)
Providing certain prescribed disclosure before or at the time of the
recommendation, about the recommendation and the relationship between
the retail customer and the broker-dealer (``Disclosure Obligation'');
(2) exercising reasonable diligence, care, and skill in making the
recommendation (``Care Obligation''); (3) establishing, maintaining,
and enforcing policies and procedures reasonably designed to address
conflicts of interest (``Conflict of Interest Obligation''), and (4)
establishing, maintaining, and enforcing policies and procedures
reasonably designed to achieve compliance with Regulation Best Interest
(``Compliance Obligation'').\16\
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\15\ See generally Section II.A, General Obligation.
\16\ As discussed in further detail below, although Regulation
Best Interest identifies specified obligations with which a broker-
dealer must comply in order to meet its General Obligation,
compliance with each of the component obligations of Regulation Best
Interest will be principles-based. In other words, whether a broker-
dealer has acted in the retail customer's best interest will turn on
an objective assessment of the facts and circumstances of whether
the specific components of Regulation Best Interest are satisfied at
the time that the recommendation is made.
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First, under the Disclosure Obligation,\17\ before or at the time
of the recommendation, a broker-dealer must disclose, in writing, all
material facts about the scope and terms of its relationship with the
customer. This includes a disclosure that the firm or representative is
acting in a broker-dealer capacity; the material fees and costs the
customer will incur; and the type and scope of the services to be
provided, including any material limitations on the recommendations
that could be made to the retail customer. Moreover, the broker-dealer
must disclose all material facts relating to conflicts of interest
associated with the recommendation that might incline a broker-dealer
to make a recommendation that is not disinterested, including, for
example, conflicts associated with proprietary products, payments from
third parties, and compensation arrangements.
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\17\ See generally Section II.C.1, Disclosure Obligation.
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Second, under the Care Obligation,\18\ a broker-dealer must
exercise reasonable diligence, care, and skill when making a
recommendation to a retail customer. The broker-dealer must understand
potential risks, rewards, and costs associated with the recommendation.
The broker-dealer must then consider those risks, rewards, and costs in
light of the customer's investment profile and have a reasonable basis
to believe that the recommendation is in the customer's best interest
and does not place the broker-dealer's interest ahead of the retail
customer's interest. A broker-dealer should consider reasonable
alternatives, if any, offered by the broker-dealer in determining
whether it has a reasonable basis for making the recommendation.
Whether a broker-dealer has complied with the Care Obligation will be
evaluated as of the time of the recommendation (and not in hindsight).
When recommending a series of transactions, the broker-dealer must have
a reasonable basis to believe that the transactions taken together are
not excessive, even if each is in the customer's best interest when
viewed in isolation.
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\18\ See generally Section II.C.2, Care Obligation.
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Third, under the Conflict of Interest Obligation,\19\ a broker-
dealer must establish, maintain, and enforce reasonably designed
written policies and procedures addressing conflicts of interest
associated with its recommendations to retail customers. These policies
and procedures must be reasonably designed to identify all such
conflicts and at a minimum disclose or eliminate them. Importantly, the
policies and procedures must be reasonably designed to mitigate
conflicts of interests that create an incentive for an associated
person of the broker-dealer to place its interests or the interest of
the firm ahead of the retail customer's interest. Moreover, when a
broker-dealer places material limitations on recommendations that may
be made to a retail customer (e.g., offering only proprietary or other
limited range of products), the policies and procedures must be
reasonably designed to disclose the limitations and associated
conflicts and to prevent the limitations from causing the associated
person or broker-dealer from placing the associated person's or broker-
dealer's interests ahead of the customer's interest. Finally, the
policies and procedures must be reasonably designed to identify and
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.
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\19\ See generally Section II.C.3, Conflict of Interest
Obligation.
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Fourth, under the Compliance Obligation,\20\ a broker-dealer must
also establish, maintain, and enforce written policies and procedures
reasonably designed to achieve compliance with Regulation Best Interest
as a whole. Thus, a broker-dealer's policies and procedures must
address not only conflicts of interest but also compliance with its
Disclosure and Care Obligations under Regulation Best Interest.
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\20\ See generally Section II.C.4, Compliance Obligation.
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The enhancements contained in Regulation Best Interest are designed
to improve investor protection by enhancing the quality of broker-
dealer recommendations to retail customers and reducing the potential
harm to retail customers that may be caused by conflicts of interest.
Regulation Best Interest will complement the related rules,
interpretations, and guidance that the Commission is concurrently
issuing.\21\ Individually and collectively, these actions are designed
to help retail customers better understand and compare the services
offered by broker-dealers and investment advisers and make an informed
choice of the relationship best suited to their needs and
circumstances, provide clarity with respect to the standards of conduct
applicable to investment advisers and broker-dealers, and foster
greater consistency in the level of protections provided by each
regime, particularly at the point in time that a recommendation is
made.\22\
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\21\ See Relationship Summary Adopting Release; Fiduciary
Interpretation; Solely Incidental Interpretation.
\22\ We believe each rule and interpretation stands on its own
and enhances the effectiveness of existing rules, and is reinforced
by the other rules and interpretations being adopted
contemporaneously.
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At the time a recommendation is made, key elements of the
Regulation Best Interest standard of conduct that applies to broker-
dealers will be similar to key elements of the fiduciary standard for
investment advisers.\23\ Importantly, regardless of whether a retail
investor chooses a broker-dealer or an investment adviser (or both),
the retail investor will be entitled to a recommendation (from a
broker-dealer) or advice (from an investment adviser) that is in the
best interest of the retail investor and that does not place the
interests of the firm or the financial professional ahead of the
interests of the retail investor.
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\23\ Specifically, an investment adviser's fiduciary duty under
the Advisers Act comprises a duty of care and a duty of loyalty.
This combination of care and loyalty obligations has been
characterized as requiring the investment adviser to act in the
``best interest'' of its client at all times. See Fiduciary
Interpretation.
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There are also key differences between Regulation Best Interest and
the Advisers Act fiduciary standard that reflect the distinction
between the services and relationships typically offered under the two
business models. For example, an investment adviser's fiduciary duty
generally includes a duty to provide ongoing advice and monitoring,\24\
while Regulation Best Interest imposes no such duty and instead
requires that a broker-dealer act in the retail customer's best
interest at the time a recommendation is made. In addition, the new
obligations applicable to broker-dealers under Regulation Best Interest
are more prescriptive than the obligations applicable to investment
advisers under the Advisers Act fiduciary duty and reflect the
characteristics of the generally applicable broker-dealer business
model.\25\
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\24\ See Fiduciary Interpretation, Section II.B.3 (Duty to
Provide Advice and Monitoring over the Course of the Relationship).
\25\ See, e.g., Sections II.A and III.E.
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The Commission has been studying and carefully considering the
issues related to the standard of conduct for broker-dealers for many
years, which led to the development of Regulation Best Interest.\26\ In
designing Regulation Best Interest, we considered a number of options
to enhance investor protection, while preserving, to the extent
possible, retail investor access (in terms of choice and cost) to
differing types of investment services and products. There
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were several options, including, among others: (1) Applying the
fiduciary standard under the Advisers Act to broker-dealers; (2)
adopting a ``new'' uniform fiduciary standard of conduct that would
apply equally to both broker-dealers and investment advisers, such as
that recommended by the staff in the 913 Study; \27\ and (3) the path
we ultimately chose, adopting a new standard of conduct specifically
for broker-dealers, which draws from key principles underlying
fiduciary obligations, including those that apply to investment
advisers under the Advisers Act.\28\ The standard also provides
specific requirements to address certain aspects of the relationships
between broker-dealers and their retail customers, including certain
conflicts related to compensation of associated persons.\29\
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\26\ Proposing Release at 21579-21583.
\27\ One of the staff's primary recommendations was that the
Commission engage in rulemaking to adopt and implement a uniform
fiduciary standard of conduct for broker-dealers and investment
advisers when providing personalized investment advice about
securities to retail customers. The staff's recommended standard
would require firms ``to act in the best interest of the customer
without regard to the financial or other interest of the broker,
dealer or investment adviser providing the advice.'' The staff made
a number of specific recommendations for implementing the uniform
fiduciary standard of conduct, including that the Commission should:
(1) Require firms to eliminate or disclose conflicts of interest;
(2) consider whether rulemaking would be appropriate to prohibit
certain conflicts, to require firms to mitigate conflicts through
specific action, or to impose specific disclosure and consent
requirements; and (3) consider specifying uniform standards for the
duty of care owed to retail customers, such as specifying what basis
a broker-dealer or investment adviser should have in making a
recommendation to a retail customer by referring to and expanding
upon broker-dealers' existing suitability requirements. See
generally 913 Study.
\28\ See supra footnote 23.
\29\ In addition to these alternatives, we also considered
several other reasonable alternatives. See Section III.E.
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We have declined to subject broker-dealers to a wholesale and
complete application of the existing fiduciary standard under the
Advisers Act because it is not appropriately tailored to the structure
and characteristics of the broker-dealer business model (i.e.,
transaction-specific recommendations and compensation), and would not
properly take into account, and build upon, existing obligations that
apply to broker-dealers, including under FINRA rules.\30\ Moreover, we
believe (and our experience indicates), that this approach would
significantly reduce retail investor access to differing types of
investment services and products, reduce retail investor choice in how
to pay for those products and services, and increase costs for retail
investors of obtaining investment recommendations.\31\
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\30\ See also 913 Study at 139-143.
\31\ See, e.g., Section 913 Study. at 143-159 for the study's
consideration of the potential costs, expenses, and impacts of
various regulatory changes related to the provision of personalized
investment advice to retail investors. See also Section II.A.1,
Commission's Approach.
---------------------------------------------------------------------------
We have also declined to craft a new uniform standard that would
apply equally and without differentiation to both broker-dealers and
investment advisers. Adopting a ``one size fits all'' approach would
risk reducing investor choice and access to existing products,
services, service providers, and payment options, and would increase
costs for firms and for retail investors in both broker-dealer and
investment adviser relationships. Moreover, applying a new uniform
standard to advisers would mean jettisoning to some extent the
fiduciary standard under the Advisers Act that has worked well for
retail clients and our markets and is backed by decades of regulatory
and judicial precedent.
Our concerns about the ramifications for investor access, choice,
and cost from adopting either of these approaches are not theoretical.
With the adoption of the now vacated Department of Labor (``DOL'')
Fiduciary Rule,\32\ there was a significant reduction in retail
investor access to brokerage services,\33\ and we believe that the
available alternative services were higher priced in many
circumstances.\34\ Moreover, because key elements of the standard of
conduct that Regulation Best Interest applies to broker-dealers at the
time that a recommendation is made to a retail customer will be
substantially similar to key elements of the standard of conduct that
applies to investment advisers pursuant to their fiduciary duty under
the Advisers Act, we do not believe that applying the existing
fiduciary standard under the Advisers Act to broker-dealers or adopting
a new uniform fiduciary standard of conduct applicable to both broker-
dealers and investment advisers would provide any greater investor
protection (or, in any case, that any benefits would justify the costs
imposed on retail investors in terms of reduced access to services,
products, and payment options, and increased costs for such services
and products).
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\32\ As discussed in more detail in the Proposing Release, on
April 8, 2016, the DOL adopted a new, expanded definition of
``fiduciary'' that treats persons who provide investment advice or
recommendations for a fee or other compensation with respect to
assets of a plan subject to the Employee Retirement Income Security
Act of 1974 (``ERISA'') (an ``ERISA plan'') or individual retirement
account (``IRA'') as fiduciaries in a wider array of advice
relationships than under the previous regulation and issued certain
related prohibited transaction exemptions (``PTEs'') (together, the
``DOL Fiduciary Rule''). The rule was subsequently vacated in toto
by the United States Court of Appeals for the Fifth Circuit. See
Chamber of Commerce v. U.S. Dep't of Labor, 885 F.3d 360 (5th Cir.
2018).
We understand that in the absence of a PTE, broker-dealers that
would be considered to be a ``fiduciary'' for purposes of ERISA and
the Internal Revenue Code (the ``Code'') would be prohibited from
engaging in purchases and sales of certain investments for their own
account (i.e., engaging in principal transactions) and would be
prohibited from receiving common forms of broker-dealer compensation
(notably, transaction-based compensation). See DOL, Best Interest
Contract Exemption, 81 FR 21002 (Apr. 8, 2016) (``BIC Exemption
Release''). To avoid this result, the DOL published, among other
PTEs, the Best Interest Contract Exemption (``BIC Exemption''),
which would have provided conditional relief for an ``adviser,'' as
that term is used in the context of the BIC Exemption, and the
adviser's firm, to receive common forms of ``conflicted''
compensation, such as commissions and third-party payments (such as
revenue sharing), provided that the adviser's firm met certain
conditions. See id. Generally, the BIC Exemption and other PTEs
required that, among other things, the advice be provided pursuant
to a written contract that commits the firm and the adviser to
adhere to standards of impartial conduct, including providing advice
in the investor's best interest; charging only reasonable
compensation; and avoiding misleading statements about fees and
conflicts of interest) (``Impartial Conduct Standards''). See
generally id. See also Proposing Release at 21580-21582.
\33\ While the full effects of the DOL Fiduciary Rule were not
realized as it was vacated during the transition period, a number of
industry studies indicated that, as a result of the DOL Fiduciary
Rule, industry participants had already or were planning to alter
services and products available to retail customers. For example, of
the 21 members of the Securities Industry and Financial Markets
Association (``SIFMA'') that participated in the SIFMA Study, 53%
eliminated or reduced access to brokerage advice services and 67%
migrated away from open choice to fee-based or limited brokerage
services. See SIFMA & Deloitte, The DOL Fiduciary Rule: A Study on
How Financial Institutions Have Responded and the Resulting Impacts
on Retirement Investors (Aug. 9, 2017), available at https://www.sifma.org/wp-content/uploads/2017/08/Deloitte-White-Paper-on-the-DOL-Fiduciary-Rule-August-2017.pdf (``SIFMA Study''). Other
studies also saw shifts from commission-based accounts to fee-based
accounts. See infra footnote 1009. In addition, an industry study
found that some customers were shifted from commission-based
brokerage accounts to self-directed accounts, while the same study
observed that 29% of their survey participants expected to move
clients, particularly those with low account balances, to robo-
advisors. See infra footnote 1010.
\34\ It was widely reported that a number of firms responded to
the DOL Fiduciary Rule by either requiring customers to enter into
more expensive advice relationships or by passing through higher
compliance costs to customers, which altered many retail customer
relationships with their financial professionals. See infra footnote
1007. From the SIFMA Study, for those firms whose retail customers
faced eliminated or reduced brokerage advice services, 63% of firms
had customers that chose to move to self-directed accounts rather
than fee-based accounts and cited the customers' reasons as ``not
wanting to move to a fee-based model, not in the best interest to
move to a fee-based model, did not meet account minimums, or wanted
to maintain positions in certain asset classes prohibited by the
fee-based models.''
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We acknowledge certain commenters urged the Commission to take
additional
[[Page 33323]]
or different regulatory actions than the approach we have adopted,
including the alternatives discussed above. We do not believe that any
rulemaking governing retail investor-advice relationships can solve for
every issue presented. After careful consideration of the comments and
additional information we have received,\35\ we believe that Regulation
Best Interest, as modified, appropriately balances the concerns of the
various commenters in a way that will best achieve the Commission's
important goals of enhancing retail investor protection and decision
making, while preserving, to the extent possible, retail investor
access (in terms of choice and cost) to differing types of investment
services and products.\36\
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\35\ See supra footnotes 11-13 and accompanying text.
\36\ If any of the provisions of these rules, or the application
thereof to any person or circumstance, is held to be invalid, such
invalidity shall not affect other provisions or application of such
provisions to other persons or circumstances that can be given
effect without the invalid provision or application.
---------------------------------------------------------------------------
The Commission's staff will offer firms significant assistance and
support during the transition period and thereafter with the aim of
helping to ensure that the investor protections and other benefits of
the final rule are implemented in an efficient and effective manner.
Further, we will continue to monitor the effectiveness of Regulation
Best Interest in achieving the Commission's goals.
C. Overview of Modifications to the Proposed Rule Text and Guidance
Provided
The vast majority of commenters supported the Commission's
rulemaking efforts to address the standards of conduct that apply to
broker-dealers when making recommendations, but nearly all commenters
suggested modifications to proposed Regulation Best Interest.\37\ These
suggestions touch on almost every aspect of the proposal, as discussed
in more detail below. A variety of commenters offered suggestions on
the overall structure and scope of the proposed rule, including:
whether the standard should be a fiduciary standard; \38\ whether the
standard should apply to both investment advisers and broker-dealers;
\39\ whether the standard should be principles-based or more
prescriptive; \40\ whether the standard should define ``best
interest;'' \41\ whether the standard is or should be a safe harbor;
\42\ what should be considered a recommendation, including whether
Regulation Best Interest should apply to recommendations to roll over
or transfer assets or take plan distributions, and to recommendations
of particular account types (i.e., brokerage or advisory); \43\ whether
Regulation Best Interest should apply to account monitoring services
provided by a broker-dealer, or impose a continuing duty; \44\ and
whether Regulation Best Interest's protections should apply to a
broader or narrower set of ``retail customers.'' \45\
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\37\ See, e.g., Letter from David Certner, Legislative Counsel
and Legislative Policy Director, AARP (Aug. 7, 2018) (``AARP August
2018 Letter''); Letter from Christopher Gilkerson, Senior Vice
President and General Counsel, and Tara Tune, Director and Corporate
Counsel, Charles Schwab & Co., Inc. (Aug. 6, 2018) (``Schwab
Letter''); Letter from Barbara Roper, Director of Investor
Protection, and Micah Hauptman, Financial Services Counsel, Consumer
Federation of America (``CFA'') (Aug. 7, 2018) (``CFA August 2018
Letter''); Letter from Joseph Borg, President, North American
Securities Administrators Association, Inc. (``NASAA'') (Aug. 23,
2018) (``NASAA August 2018 Letter''); Letter from Kenneth E.
Bentsen, Jr., President and Chief Executive Officer, SIFMA (Aug. 7,
2018) (``SIFMA August 2018 Letter'').
\38\ See, e.g., Letter from Jon Stein, Founder and CEO, Benjamin
T. Alden, General Counsel, and Seth Rosenbloom, Associate General
Counsel, Betterment (Aug. 7, 2018) (``Betterment Letter''); Letter
from Kurt N. Schacht, Managing Director, James Allen, Head, Capital
Markets Policy, and Linda L. Rittenhouse, Director, Capital Markets,
CFA Institute (Aug. 7, 2018) (``CFA Institute Letter''); Letter from
Jill I. Gross, Associate Dean for Academic Affairs, Professor of
Law, Elisabeth Haub School of Law, Pace University (Mar. 11, 2019)
(``Pace March 2019 Letter''); Letter from Sharon Cheever, Senior
Vice President and General Counsel, Pacific Life Insurance Company
(Aug. 3, 2018) (``Pacific Life August 2018 Letter''); Letter from
Melanie Fein, Fein Law Offices (Jun. 6, 2018) (``Fein Letter'');
Letter from Elizabeth Warren, U.S. Senator (Aug. 3, 2018) (``Warren
Letter''); Letter from Dean P. McDermott, McDermott Investment
Advisors (Jul. 7, 2018) (``McDermott Letter''); Letter from Brian
Hamburger, President and CEO, MarketCounsel (Aug. 7, 2018)
(``MarketCounsel Letter'').
\39\ See, e.g., AARP August 2018 Letter; Letter from Americans
for Financial Reform et al. (Aug. 7, 2018) (``Americans for
Financial Reform Letter''); Letter from Robert J. Moore, Chief
Executive Officer, Cetera Financial Group (``Cetera'') (Aug. 7,
2018) (``Cetera August 2018 Letter''); Letter from L.A. Schnase,
Individual Investor and Attorney at Law (Jul. 30, 2018) (``Schnase
Letter''); Pacific Life August 2018 Letter; Pace March 2019 Letter;
MarketCounsel Letter; Letter from Dennis M. Kelleher, President and
CEO, Stephen Hall, Legal Director and Securities Specialist, Lev
Bagramian, Senior Securities Policy Advisor, Better Markets (Aug. 7,
2018) (``Better Markets August 2018 Letter''); Letter from Attorneys
General of New York, California, Connecticut, Delaware, Hawaii,
Illinois, Maine, Maryland, Massachusetts, Minnesota, New Mexico,
Oregon, Pennsylvania, Rhode Island, Vermont, Washington, and the
District of Columbia (Aug. 7, 2018) (``State Attorneys General
Letter'').
\40\ See, e.g., SIFMA August 2018 Letter; Letter from Mortimer
J. Buckley, President and Chief Executive Officer, Vanguard (Aug. 7,
2018) (``Vanguard Letter''); Letter from Chris Lewis, General
Counsel, Edward Jones (Aug. 7, 2018) (``Edward Jones Letter'');
Letter from Joseph E. Sweeney, President, Advice & Wealth Management
Products and Service Delivery, Ameriprise Financial (Aug. 6, 2018)
(``Ameriprise Letter''); Letter from Sheila Kearney Davidson,
Executive Vice President, Chief Legal Officer & General Counsel, New
York Life Insurance Company (``NY Life'') (Aug. 7, 2018) (``NY Life
Letter''); Letter from Keith Gillies, NAIFA President, National
Association of Insurance and Financial Advisors (``NAIFA'') (Aug. 2,
2018) (``NAIFA Letter''); Letters from Tom Quaadman, Executive Vice
President, Center for Capital Markets Competitiveness, U.S. Chamber
of Commerce (``CCMC'') (Aug. 7, 2018) (supplemented by letter dated
Sep. 5, 2018) (``CCMC Letters''); Letter from Dave Paulsen,
Executive Vice President, Chief Distribution Officer, Transamerica
(Aug. 7, 2018) (``Transamerica August 2018 Letter'').
\41\ See, e.g., Letter from Seth A. Miller, General Counsel,
Senior Vice President, Chief Risk Officer, Cambridge (Aug. 7, 2018)
(``Cambridge Letter''); SIFMA August 2018 Letter; Vanguard Letter;
Edward Jones Letter; Ameriprise Letter; NY Life Letter; NAIFA
Letter; CCMC Letters; Letter from Aron Szapiro, Director of Policy
Research, Morningstar (Aug. 7, 2018) (``Morningstar Letter'');
Letter from David Kowach, Head of Wells Fargo Advisors, Wells Fargo
(Aug. 7, 2018) (``Wells Fargo Letter'').
\42\ See, e.g., CFA August 2018 Letter; Letter from Anthony
Chereso, President & CEO, Institute for Portfolio Alternatives
(``IPA'') (Aug. 7, 2018) (``IPA Letter''); Letter from Heather
Slavkin Corzo, AFL-CIO et al. (Apr. 26, 2019) (``AFL-CIO April 2019
Letter'').
\43\ See, e.g., Letter from Jason Bortz, Senior Counsel, Capital
Research and Management Company (Aug. 7, 2018) (``Capital Group
Letter''); Letter from Andrew Stoltmann, President, Public Investors
Arbitration Bar Association (``PIABA'') (Aug. 7, 2018) (``PIABA
Letter''); SIFMA August 2018 Letter; NASAA Letter; Letter from
Robert K. Shaw, President, Individual Markets, Great-West Financial
(Aug. 7, 2018) (``Great-West Letter''); NAIFA Letter; Transamerica
August 2018 Letter; Letter from Tim Rouse, Executive Director, The
SPARK Institute (Aug. 7, 2018) (``SPARK Letter''); Letter from Robin
C. Swope, Director, Global Product Governance & Support, Invesco
(Aug. 7, 2018) (``Invesco Letter''); Letter from R. Keith Overly,
President, National Association of Government Defined Contribution
Administrators (``NAGDCA'') (Aug. 7, 2018) (``NAGDCA Letter'');
Letter from Kevin R. Keller, Chief Executive Officer, CFP Board, et
al., Financial Planning Coalition (``FPC'') (Aug. 7, 2018) (``FPC
Letter''); Letter from Dennis Simmons, Executive Director, Committee
on Investment of Employee Benefit Assets, Committee on Investment of
Employee Benefit Assets (``CIEBA'') (Aug. 6, 2018) (``CIEBA
Letter'').
\44\ See, e.g., SIFMA August 2018 Letter; Letter from Lisa D.
Crossley, Executive Director, National Society of Compliance
Professionals (``NSCP'') (Aug. 7, 2018) (``NSCP Letter''); PIABA
Letter; FPC Letter; Better Markets August 2018 Letter; Letter from
Karen L. Barr, President and CEO, Investment Adviser Association
(``IAA'') (Aug. 6, 2018) (``IAA August 2018 Letter'').
We also received comments addressing when a broker-dealer's
advisory services are ``solely incidental to the conduct of his
business as a broker or dealer'' under the ``broker-dealer
exclusion'' from the definition of investment adviser--and thus from
the application of the Advisers Act--provided in Section
202(a)(11)(C) of the Advisers Act. We have addressed these comments
in the context of the Solely Incidental Interpretation.
\45\ See, e.g., Letter from Carl B. Wilkerson, Vice President
and Chief Counsel, American Council of Life Insurers (``ACLI'')
(Aug. 3, 2018) (``ACLI Letter''); Letter from Brian H. Graff,
Executive Director and CEO, Craig P. Hoffman, General Counsel, Dough
Fisher, Director of Retirement Policy, and Joseph A. Caruso,
Government Affairs Counsel, American Retirement Association
(``ARA'') (Aug. 3, 2018) (``ARA August 2018 Letter''); Letter from
Anne Tennant, Managing Director and General Counsel, Morgan Stanley
(Aug. 7, 2018) (``Morgan Stanley Letter''); CCMC Letters; Letter
from Thomas Roberts, Groom Law Group (Aug. 7, 2018) (``Groom
Letter''); Letter from Catherine J. Weatherford, President and CEO,
Insured Retirement Institute (``IRI'') (Aug. 7, 2018) (``IRI
Letter''); NSCP Letter; Letter from Raymond J. Manista, Executive
Vice President, Chief Legal Officer and Secretary, Northwestern
Mutual (Aug. 7, 2018) (``Northwestern Mutual Letter''); State
Attorneys General Letter; Letter from Mari-Anne Pisarri, Pickard
Djinis and Pisarri LLP (Aug. 14, 2018) (``Pickard Letter''); SIFMA
August 2018 Letter; Invesco Letter; Letter from Tom Clark, Managing
Director, Sean Murphy, Vice President, Blackrock (Aug. 7, 2018)
(``Blackrock Letter'').
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[[Page 33324]]
In addition, most commenters from both industry and consumer
advocate groups requested modifications to each of the Disclosure,
Care, and Conflict of Interest Obligations, and also called for more
specific examples of conduct that would--or would not--satisfy these
obligations. With respect to the Disclosure Obligation, most commenters
generally sought greater clarity or made suggestions regarding what
material facts and material conflicts would need to be disclosed, the
form and manner (e.g., written versus oral, individualized versus
standardized, and the use of electronic and/or layered) and the timing
and frequency of the disclosure (e.g., whether the disclosure should be
prior to, at the time of, or could be after a recommendation), as well
as whether the Disclosure Obligation could be satisfied by complying
with other existing disclosure requirements.\46\ In particular, several
commenters recommended that the Commission require broker-dealers
provide ``full and fair'' disclosure.\47\
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\46\ See, e.g., Ameriprise Letter; Great-West Letter; Letter
from Ram Subramaniam, Head of Brokerage and Investment Solutions,
David Forman, Chief Legal Officer, Fidelity Investments (Aug. 7,
2018) (``Fidelity Letter''); Morgan Stanley Letter; CCMC Letters;
Letter from Bret C. Hester, Senior Managing Director, Head of
Regulatory Affairs, Teachers Insurance and Annuity Association of
America (``TIAA'') (Aug. 7, 2018) (``TIAA Letter''); Letter from
James Sonne, Assistant Vice President, Federal Government Relations,
Mass Mutual (Feb. 19, 2019) (``Mass Mutual Letter''); Letter from
Edmund F. Murphy III, President, Empower Retirement (Aug. 2, 2018)
(``Empower Retirement Letter''); IRI Letter; Letter from Paul Schott
Stevens, President and CEO, Investment Company Institute (``ICI'')
(Aug. 7, 2018) (``ICI Letter''); SIFMA August 2018 Letter; Edward
Jones Letter; Letter from Michelle Bryan Oroschakoff, Chief Legal
Officer, LPL Financial (Aug. 7, 2018) (``LPL August 2018 Letter'');
NASAA August 2018 Letter; AARP August 2018 Letter; PIABA Letter;
Letter from Ann M. Kappler, Senior Vice President, Deputy General
Counsel, Prudential Financial (Aug. 7, 2018) (``Prudential
Letter''), CFA Institute Letter; State Attorneys General Letter; CFA
August 2018 Letter; Letter from Jason Chandler, Group Managing
Director, Co-Head Investment Platforms and Solutions, and Michael
Crowl, Group Managing Director, General Counsel, UBS (Aug. 7, 2018)
(``UBS Letter''), Letter from William F. Galvin, Secretary of the
Commonwealth of Massachusetts (Aug. 7, 2018) (``Galvin Letter'');
Letter from David T. Bellaire, Executive Vice President & General
Counsel, Financial Services Institute (``FSI'') (Aug. 7, 2018)
(``FSI August 2018 Letter''); Mass Mutual Letter; Schwab Letter;
Letter from Michael F. Anderson, Senior Vice President and Chief
Legal Officer, CUNA Mutual (Aug. 7, 2018) (``CUNA Letter'');
Transamerica August 2018 Letter.
\47\ See, e.g., CFA August 2018 Letter; Better Markets August
2018 Letter; Pace Letter.
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Regarding the Care Obligation, commenters from certain investor
groups supported incorporating a ``prudence'' standard,\48\ while a
number of industry commenters expressed concern about including this
standard.\49\ Numerous commenters requested further clarity on what
would be required to meet the Care Obligation, including what factors a
broker-dealer should consider in developing a retail customer's
investment profile and when making a recommendation, and in particular
the role of cost and other relevant factors when making a
recommendation, and also asked for more specific examples of how to
weigh costs against other factors when making a recommendation.\50\ A
majority of the IAC and other commenters requested clarification on how
to consider ``reasonably available alternatives'' when making a
recommendation and suggested clarifying the scope of the inquiry into
potential reasonably available alternatives when a broker-dealer offers
a limited product menu versus when the broker-dealer has an ``open
architecture'' model.\51\ Several industry commenters made
recommendations regarding the application of proposed Regulation Best
Interest to recommendations of specific categories of securities, such
as variable annuities or leveraged exchange-traded products.\52\
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\48\ See, e.g., AARP August 2018 Letter; CFA August 2018 Letter;
FPC Letter.
\49\ See, e.g., Letter from Karen L. Sukin, Executive Vice
President, Deputy General Counsel, Primerica (Aug. 7, 2018)
(``Primerica Letter''); Transamerica August 2018 Letter; IPA Letter;
Cetera August 2018 Letter.
\50\ See, e.g., Letter from Felice R. Foundos, Partner, Chapman
and Cutler (Aug. 6, 2018) (``Chapman Letter''); Vanguard Letter; ICI
Letter; Morgan Stanley Letter; Wells Fargo Letter; Primerica Letter;
Great-West Letter; NASAA August 2018 Letter; Cambridge Letter;
Blackrock Letter.
\51\ See, e.g., IAC 2018 Recommendation; Fidelity Letter; ICI
Letter; SIFMA August 2018 Letter; Prudential Letter; LPL August 2018
Letter; Morningstar Letter. See also AFL-CIO April 2019 Letter
(stating that the rule ``must make clear that brokers are required
to recommend the investments they reasonably believe are the best
match for the investor from among the reasonably available
investment options'').
\52\ See, e.g., Letter from Brian Winikoff, Senior Executive
Director and Head of U.S. Life, Retirement and Wealth Management,
AXA (Aug. 7, 2018) (``AXA Letter''); Letter from Clifford Kirsch,
Susan Krawczyk, Eversheds Sutherland, Committee of Annuity Insurers
(Aug. 7, 2018) (``Committee of Annuity Insurers Letter''); Pacific
Life August 2018 Letter; Letter from Angela Brickl, General Counsel,
Rafferty Asset Management (``Direxion'') (Aug. 7, 2018) (``Direxion
Letter''); Letter from Mark F. Halloran, VP Managing Director,
Business Development, Transamerica (Nov. 9, 2018) (``Transamerica
November 2018 Letter'').
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With respect to the Conflict of Interest Obligation, many
commenters questioned the distinction between financial incentives that
would have to be mitigated and other conflicts that would only need to
be disclosed, and recommended generally that the distinction be
eliminated.\53\ In addition, some commenters suggested that the
obligation to establish policies and procedures to mitigate conflicts
should apply to material conflicts at the level of the natural person
who is an associated person (as opposed to the firm).\54\ Commenters
also asked for more clarity and examples of what conflicts must be
mitigated versus eliminated and more guidance on appropriate mitigation
methods.\55\ Some commenters also expressed the view that by requiring
mitigation of financial incentives, proposed Regulation Best Interest
would require more of broker-dealers than what is required of
investment advisers under their fiduciary duty, which could create a
competitive disadvantage for broker-dealers that could further
encourage migration from the broker-dealer to investment adviser
business model and result in a loss of retail investor access (in terms
of choice and cost) to differing types of investment services and
products.\56\
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\53\ See, e.g., CFA August 2018 Letter; SIFMA August 2018
Letter; Primerica Letter; Letter from Jeff Hartney, Executive
Director, Bank Insurance and Securities Association (``BISA'') (Aug.
7, 2018) (``BISA Letter''); Committee of Annuity Insurers Letter;
IPA Letter; CFA Institute Letter; Morgan Stanley Letter; CCMC
Letters.
\54\ See, e.g., Primerica Letter; TIAA Letter; ICI Letter;
Letter from Craig D. Pfeiffer, President and CEO, Money Management
Institute (Aug. 7, 2018) (``Money Management Institute Letter'').
\55\ See, e.g., AALU Letter; CFA August 2018 Letter; Letter from
Quinn Curtis, Professor of Law, University of Virginia School of Law
(``UVA''), (Aug. 3, 2018) (``UVA Letter''); Primerica Letter;
Committee of Annuity Insurers Letter; Cetera August 2018 Letter;
Wells Fargo Letter; NASAA August 2018 Letter; Morningstar Letter.
\56\ See, e.g., Letter from Craig S. Tyle, Executive Vice
President and General Counsel, Franklin Templeton Investments, (Aug.
6, 2018) (``Franklin Templeton Letter''); Primerica Letter; LPL
August 2018 Letter; CCMC Letters; UBS Letter; ICI Letter; Letter
from Christopher A. Iacovella, Chief Executive Officer, American
Securities Association (``ASA'') (Aug. 7, 2018) (``ASA Letter'');
Schwab Letter.
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In addition, a number of commenters agreed with the Commission's
statement that it was not intended to create a private right of action,
but many requested that the Commission explicitly state in the final
rule that Regulation Best Interest does not confer a private right of
action.\57\ One
[[Page 33325]]
commenter requested that the Commission elaborate and make clear the
remedies available to investors when broker-dealers violate Regulation
Best Interest and emphasize that scienter is not required to establish
a violation of Regulation Best Interest.\58\
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\57\ See, e.g., Letter from Paul C. Reilly, Chairman and CEO,
Raymond James Financial (Aug. 7, 2018) (``Raymond James Letter'');
NAIFA Letter; ASA Letter; CCMC Letters; UBS Letter; LPL August 2018
Letter; Cambridge Letter. Contra Letter from Elise Sanguinetti,
President, American Association for Justice (Aug. 6, 2018)
(``American Association for Justice Letter'').
\58\ NASAA August 2018 Letter.
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Finally, numerous commenters urged the Commission to coordinate
with other regulators, in particular the DOL \59\ and state securities
and insurance regulators,\60\ and several commenters opined that the
Commission should preempt (or avoid preempting) state law.\61\
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\59\ See, e.g., ICI Letter; Franklin Templeton Letter;
Morningstar Letter; Wells Fargo Letter; Edward Jones Letter; IRI
Letter; Letter from Cynthia Lo Bessette, Executive Vice President
and General Counsel, Letter from Oppenheimer Funds (Aug. 7, 2018)
(``Oppenheimer Letter''); Vanguard Letter.
\60\ See, e.g., CCMC Letters; Letter from Robert Reynolds,
President and CEO, Putnam Investments (Aug. 7, 2018) (``Putnam
Letter''); Letter from Will H. Fuller, Executive Vice President,
President, Annuity Solutions, Lincoln Financial Group (Nov. 13,
2018) (``Lincoln Financial Letter''); Cetera August 2018 Letter;
Great-West Letter; Letter from Marc Cadin, Chief Operating Officer,
Association of Advanced Life Underwriting (``AALU'') (Aug. 7, 2018)
(``AALU Letter''); IRI Letter; Pacific Life August 2018 Letter;
Vanguard Letter; Fidelity Letter; Letter from Andrew J. Bowden,
Senior Vice President and General Counsel, Jackson National Life
Insurance Company (Aug. 7, 2018) (``Jackson National Letter'');
Invesco Letter; Lincoln Letter; CUNA Mutual Letter; Great-West
Letter.
\61\ See, e.g., Cetera August 2018 Letter; ICI Letter; Franklin
Templeton Letter; Putnam Investments Letter; but see NASAA August
2018 Letter; PIABA Letter; Letter from Teresa J. Verges, Director,
Investor Rights Clinic, University of Miami School of Law (Aug. 2,
2018) (``U. of Miami Letter''); Letter from Kayla Martin, Legal
Intern, Christine Lazaro, Director and Professor Clinical Legal
Education, Securities Arbitration Clinic, St. John's University
School of Law (Aug. 7, 2018) (``St. John's U. Letter''); Letter from
Kevin M. Carroll, Managing Director & Associate General Counsel,
SIFMA (Mar. 29, 2019) (``SIFMA March 2019 Letter''); Letter from
Michael Pieciak, NASAA President and Commissioner, Vermont
Department of Regulation, NASAA (Apr. 25, 2019); Letter from Tom
Quaadman, Executive Vice President, CCMC (May 16, 2019) (``CCMC May
2019 Letter''); AFL-CIO April 2019 Letter.
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After carefully reviewing the comments on the proposed rule, we
have determined to retain its overall structure and scope. However, we
have modified the proposed rule in a number of respects and are also
providing additional interpretations and guidance to address and
clarify issues raised by commenters. Summarized below are the key
modifications from the proposal, as well as the interpretations and
guidance provided.
Retail Customer Definition: We are modifying the
definition of ``retail customer'' to include any natural person who
receives a recommendation from the broker-dealer for the natural
person's own account (but not an account for a business that he or she
works for), including individual plan participants.\62\ We are
interpreting ``legal representative of such natural person'' to include
the nonprofessional legal representatives of such a natural person
(e.g., nonprofessional trustee who represents the assets of a natural
person).
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\62\ As discussed in Section II.B.3.a, Retail Customer, Focus on
Natural Persons and Legal Representatives of Natural Persons, to the
extent a plan representative who decides service arrangements for a
workplace retirement plan is a sole proprietor or other self-
employed individual who will participate in the plan, the plan
representative will be a retail customer to the extent that the sole
proprietor or self-employed individual receives recommendations
directly from a broker-dealer primarily for personal, family or
household purposes.
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Implicit Hold Recommendations: While broker-dealers will
not be required to monitor accounts, in instances where a broker-dealer
agrees to provide the retail customer with specified account monitoring
services, it is our view that such an agreement will result in buy,
sell or hold recommendations subject to Regulation Best Interest, even
when the recommendation to hold is implicit.\63\
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\63\ See Section II.B.2.b, Interpretation of Any Securities
Transaction or Investment Strategy Involving Securities.
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Recommendations of account types, including
recommendations to roll over or transfer assets from one type of
account to another: We are modifying Regulation Best Interest to
expressly apply to account recommendations including, among others,
recommendations to roll over or transfer assets in a workplace
retirement plan account to an IRA, recommendations to open a particular
securities account (such as brokerage or advisory), and recommendations
to take a plan distribution for the purpose of opening a securities
account.\64\ We are also providing guidance under the Care Obligation
on what factors a broker-dealer generally should consider when making
such recommendations.
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\64\ See id.
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Dual-Registrants: We are providing additional guidance on
how dual-registrants can comply with Regulation Best Interest, and
confirming that Regulation Best Interest does not apply to advice
provided by a broker-dealer that is dually registered as an investment
adviser (``dual-registrant'') when acting in the capacity of an
investment adviser, and that a dual-registrant is an investment adviser
solely with respect to accounts for which a dual-registrant provides
advice and receives compensation that subjects it to the Advisers
Act.\65\
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\65\ See Section II.B.3.d, Retail Customers, Treatment of Dual-
Registrants.
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We are also clarifying the relationship between the General
Obligation and the specific component obligations, and in particular,
what it means to ``act in the best interest'' of the retail customer.
As is the case with the fiduciary duty applicable to investment
advisers under the Advisers Act, we are not expressly defining in the
rule text the term ``best interest,'' and instead are providing in
Regulation Best Interest and through interpretations, what ``acting in
the best interest'' means.\66\ Whether a broker-dealer has acted in the
retail customer's best interest in compliance with Regulation Best
Interest will turn on an objective assessment of the facts and
circumstances of how the specific components of Regulation Best
Interest--including its Disclosure, Care, Conflict of Interest, and
Compliance Obligations--are satisfied at the time that the
recommendation is made (and not in hindsight). In response to
commenters, we are addressing, among other things, what the General
Obligation does and does not require (for example, that it does not
impose a continuing duty beyond a particular recommendation), providing
specific examples of what would violate Regulation Best Interest, and
its application to certain scenarios, particularly in the context of
satisfying the Care Obligation.
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\66\ In the investment adviser context, an investment adviser's
fiduciary duty under the Advisers Act comprises a duty of care and a
duty of loyalty. This combination of care and loyalty obligations
has been characterized as requiring the investment adviser to act in
the ``best interest'' of its client at all times. See Fiduciary
Interpretation.
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We are also modifying and clarifying the component obligations that
a broker-dealer would be required to satisfy in order to meet the
General Obligation:
Disclosure Obligation. We are refining the treatment of conflicts
of interest by: (1) Defining in the rule text a ``conflict of
interest'' for purposes of Regulation Best Interest (as opposed to
interpreting the phrase ``material conflict of interest'' as in the
Proposing Release) as an interest that might incline a broker-dealer--
consciously or unconsciously--to make a recommendation that is not
disinterested; and (2) revising the Disclosure Obligation to require
disclosure of ``material facts'' regarding conflicts of interest
associated with the recommendation.\67\ Similar to the proposal, all
such conflicts of interest will be covered by Regulation Best
[[Page 33326]]
Interest (e.g., subject to the Conflict of Interest Obligation),
however, only ``material facts'' regarding these conflicts would be
required to be disclosed under the Disclosure Obligation.
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\67\ See Section II.C.1.b, Disclosure Obligation, Material Facts
Regarding Conflicts of Interest.
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Furthermore, we are modifying the Disclosure Obligation to
explicitly require broker-dealers to provide ``full and fair''
disclosure of material facts, rather than requiring broker-dealers to
``reasonably disclose'' such information. We are providing the
Commission's view regarding what it means to provide ``full and fair''
disclosure to retail customers, including the level of specificity of
disclosure required, and the form and manner and timing and frequency
of such disclosure.\68\ We are explicitly requiring the disclosure of
material facts relating to the scope and terms of the relationship that
were specifically identified in the proposal (i.e., capacity, material
fees and charges, and type and scope of services).\69\ In connection
with disclosure requirements regarding the type and scope of services,
we are also clarifying that at a minimum, a broker-dealer needs to
disclose whether or not account monitoring services will be provided
(and if so, the scope and frequency of those services), account
minimums, and any material limitations on the securities or investment
strategies involving securities that may be recommended to the retail
customer.\70\ Also we conclude that the basis for a broker-dealer's
recommendations as a general matter (i.e., what might commonly be
described as the firm's investment approach, philosophy, or strategy)
and the risks associated with a broker-dealer's recommendations in
standardized (as opposed to individualized) terms are material facts
relating to the scope and terms of the relationship that should be
disclosed.\71\ Below, we outline a method to address oral disclosure
and written disclosure provided after the fact.\72\
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\68\ See Section II.C.1.c, Disclosure Obligation, Full and Fair
Disclosure.
\69\ See Section II.C.1.a, Disclosure Obligation, Material Facts
Regarding Scope and Terms of the Relationship.
\70\ Id.
\71\ Id.
\72\ See Section II.C.1, Disclosure Obligation, Oral Disclosure
or Disclosure After a Recommendation.
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Care Obligation. We are adopting the Care Obligation largely as
proposed; however, we are expressly requiring that a broker-dealer
understand and consider the potential costs associated with its
recommendation, and have a reasonable basis to believe that the
recommendation does not place the financial or other interest of the
broker-dealer ahead of the interest of the retail customer.\73\
Nevertheless, we emphasize that while cost must be considered, it
should never be the only consideration. Cost is only one of many
important factors to be considered regarding the recommendation and
that the standard does not necessarily require the ``lowest cost
option.'' Relatedly, we are emphasizing the need to consider costs in
light of other factors and the retail customer's investment profile.
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\73\ See generally Section II.C.2, Care Obligation.
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We are also providing additional guidance on what it means to make
a recommendation in a retail customer's ``best interest.'' As in the
Proposing Release, determining whether a broker-dealer's recommendation
satisfies the Care Obligation will be an objective evaluation turning
on the facts and circumstances of the particular recommendation and the
particular retail customer. We recognize that a facts and circumstances
evaluation of a recommendation makes it difficult to draw bright lines
around whether a particular recommendation will meet the Care
Obligation. Accordingly, we focus on how a broker-dealer could
establish a reasonable basis to believe that a recommendation is in the
best interest of its retail customer and does not place the broker-
dealer's interest ahead of the retail customer's interest, and the
circumstances under which a broker-dealer could not establish such a
reasonable belief.
We are clarifying that an evaluation of reasonably available
alternatives does not require an evaluation of every possible
alternative (including those offered outside the firm) nor require
broker-dealers to recommend one ``best'' product, and what this
evaluation will require in certain contexts (such as a firm with open
architecture). Furthermore, we clarify that, when a broker-dealer
materially limits its product offerings to certain proprietary or other
limited menus of products, it must still comply with the Care
Obligation--even if it has disclosed and taken steps to prevent the
limitation from placing the interests of the broker-dealer ahead of the
retail customer, as required by the Disclosure and Conflict of Interest
Obligation--and thus could not use its limited menu to justify
recommending a product that does not satisfy the obligation to act in a
retail customer's best interest.
Conflict of Interest Obligation. We are revising the Conflict of
Interest Obligation by: (1) Similar to the proposal, establishing an
overarching obligation to establish written policies and procedures to
identify and at a minimum disclose (pursuant to the Disclosure
Obligation), or eliminate, all conflicts of interest associated with
the recommendation; \74\ and (2) setting forth explicit requirements to
establish written policies and procedures reasonably designed to
mitigate or eliminate certain identified conflicts of interest,
specifically:
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\74\ This obligation achieves greater consistency with the
treatment of conflicts under the Advisers Act. As discussed in the
Fiduciary Interpretation, in seeking to meet its duty of loyalty, an
adviser must make full and fair disclosure to its clients of all
material facts relating to the advisory relationship. An adviser
must eliminate or at least expose through full and fair disclosure
all conflicts of interest which might incline an investment
adviser--consciously or unconsciously--to render advice which was
not disinterested. See Fiduciary Interpretation.
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Mitigation of Associated Person Conflicts of Interest. We
are revising the proposal's mitigation requirement to: (1) Eliminate
the distinction between financial incentives and all other conflicts of
interest; and (2) focus on mitigating conflicts of interest associated
with recommendations that create an incentive for the associated person
of the broker-dealer to place the interest of the firm or the
associated person ahead of the interest of the retail customer.\75\ We
are providing further guidance regarding the types of incentives
covered by this revised obligation, in particular focusing on
compensation or employment related incentives and other incentives
provided to the associated person (whether by the broker-dealer or
third-parties). We are also confirming, clarifying and expanding on the
proposal's guidance on potential mitigation methods to further promote
compliance with this obligation.
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\75\ See generally Section II.C.3.e, Conflict of Interest
Obligation, Mitigation of Certain Incentives to Associated Persons.
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Address Any Material Limitations on Recommendations to
Retail Customers. To address the conflicts of interest presented when
broker-dealers place any material limitations on the securities or
investment strategies involving securities that may be recommended to a
retail customer (i.e., only make recommendations of proprietary or
other limited range of products), we are requiring broker-dealers to
establish, maintain and enforce written policies and procedures
reasonably designed to: (1) Identify and disclose any material
limitations placed on the securities or investment strategies involving
securities that may be recommended and any associated conflicts of
interest; and (2) prevent the limitations and associated conflicts of
[[Page 33327]]
interest from causing the broker-dealer or their associated persons to
make recommendations that place the interest of the broker-dealer or
associated person ahead of the interest of the retail customer (for
example, a broker-dealer could establish product review processes or
establish procedures addressing which retail customers would qualify
for the product menu).\76\
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\76\ See generally Section II.C.3.f, Conflict of Interest
Obligation, Mitigation of Material Limitations on Recommendations to
Retail Customers.
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Elimination of Certain Conflicts. We are requiring broker-
dealers to establish written policies and procedures reasonably
designed to identify and eliminate any sales contests, sales quotas,
bonuses, and non-cash compensation that are based on the sale of
specific securities or the sale of specific types of securities within
a limited period of time.\77\ By explicitly focusing on policies and
procedures to eliminate these incentives, it does not mean that all
other incentives are presumptively compliant with Regulation Best
Interest. Rather, such other incentives and practices that are not
explicitly prohibited are permitted provided that the broker-dealer
establishes reasonably designed policies and procedures to disclose and
mitigate the incentive created to the representative, and the broker-
dealer and its associated persons comply with the Care Obligation and
the Disclosure Obligation.
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\77\ See generally Section II.C.3.g, Conflict of Interest
Obligation, Elimination of Certain Conflicts of Interest.
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General Compliance Obligation. We are establishing a new, general
``Compliance Obligation'' to require broker-dealers to establish
policies and procedures to achieve compliance with Regulation Best
Interest in its entirety.\78\
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\78\ See generally Section II.C.4, Compliance Obligation.
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Books and Records. In addition to adopting Regulation Best
Interest, we are also adopting the record-making and recordkeeping
requirements largely as proposed, with certain explanations and
clarifications regarding the scope of these requirements and the extent
to which new obligations have been created.\79\
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\79\ See generally Section II.D, Record-Making and
Recordkeeping.
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Interaction with Other Standards, Waivers and Private Right of
Action. Compliance with Regulation Best Interest will not alter a
broker-dealer's obligations under the general antifraud provisions of
the federal securities laws. Regulation Best Interest applies in
addition to any obligations under the Exchange Act, along with any
rules the Commission may adopt thereunder, and any other applicable
provisions of the federal securities laws and related rules and
regulations.\80\
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\80\ For example, any transaction or series of transactions,
whether or not subject to the provisions of Regulation Best
Interest, remain subject to the antifraud and anti-manipulation
provisions of the securities laws, including, without limitation,
Section 17(a) of the Securities Act of 1933 (``Securities Act'') [15
U.S.C. 77q(a)] and Sections 9, 10(b), and 15(c) of the Exchange Act
[15 U.S.C. 78i, 78j(b), and 78o(c)] and the rules thereunder.
---------------------------------------------------------------------------
Scienter will not be required to establish a violation of
Regulation Best Interest. We note that the preemptive effect of
Regulation Best Interest on any state law governing the relationship
between regulated entities and their customers would be determined in
future judicial proceedings based on the specific language and effect
of that state law. We believe that Regulation Best Interest, Form CRS,
and the related rules, interpretations and guidance that the Commission
is concurrently issuing will serve as focal points for promoting
clarity, establishing greater consistency in the level of retail
customer protections provided, and easing compliance across the
regulatory landscape and the spectrum of investment professionals and
products. In addition, under Section 29(a) of the Exchange Act, a
broker-dealer will not be able to waive compliance with Regulation Best
Interest, nor can a retail customer agree to waive her protections
under Regulation Best Interest.
Furthermore, we do not believe Regulation Best Interest creates any
new private right of action or right of rescission, nor do we intend
such a result.
D. Overview of Key Enhancements
With these modifications and clarifications, Regulation Best
Interest is designed to improve investor protection by:
Requiring broker-dealers to have a reasonable basis to
believe that recommendations are in the retail customer's best
interest, which enhances existing suitability obligations by: Requiring
compliance not only with the explicit Care Obligation, but also with
Disclosure, Conflict of Interest, and Compliance Obligations; expressly
requiring consideration of cost in evaluating a recommendation as part
of the Care Obligation; expressing our views regarding the
consideration of reasonably available alternatives when making a
recommendation as part of the Care Obligation; applying Regulation Best
Interest to recommendations of account types and rollovers and to any
recommendations resulting from agreed-upon account monitoring services
(including implicit hold recommendations); and, applying the Care
Obligation to a series of recommended transactions (currently referred
to as ``quantitative suitability'') irrespective of whether a broker-
dealer exercises actual or de facto control over a customer's account;
requiring broker-dealers to establish, maintain, and
enforce written policies and procedures reasonably designed to mitigate
(and in some cases, eliminate) certain identified conflicts of interest
that create incentives to make recommendations that are not in the
retail customer's best interest; these new requirements are a
significant and critical enhancement as existing requirements under the
federal securities laws largely center upon conflict disclosure rather
than conflict mitigation;
requiring disclosure under the Disclosure Obligation of
the material facts relating to the scope of terms of a broker-dealer's
relationship with the retail customer and the conflicts of interest
associated with a broker-dealer's recommendations, which will foster
retail customers' understanding of their relationship with the broker-
dealer and help them to evaluate the recommendations received; and
requiring broker-dealers to establish, maintain and
enforce written policies and procedures reasonably designed to achieve
compliance with Regulation as a whole, which will further promote
broker-dealer compliance with Regulation Best Interest.
Through these new requirements, we believe that Regulation Best
Interest will improve investor protection by enhancing the quality of
broker-dealer recommendations to retail customers and reducing the
potential harm to retail customers that may be caused by conflicted
brokerage recommendations. We also believe Regulation Best Interest
achieves these enhancements in a manner that is workable for the
transaction-based relationship offered by broker-dealers, thus
preserving, to the extent possible, retail investor access (in terms of
choice and cost) to different types of quality investment services and
products. As discussed above, Regulation Best Interest will complement
Form CRS and related rules, interpretations, and guidance that the
Commission is concurrently issuing.
[[Page 33328]]
II. Discussion of Regulation Best Interest
A. General Obligation
As in the Proposing Release, Regulation Best Interest is set forth
in two subparagraphs: (1) An overarching provision setting forth a
general best interest obligation (``General Obligation''); and (2) a
second provision requiring compliance with specific obligations in
order to satisfy the overarching standard (discussed below in Section
II.C).\81\ Specifically, as in the Proposing Release, the General
Obligation requires that a broker-dealer ``shall act in the best
interest of the retail customer at the time the recommendation is made,
without placing the financial or other interest of [the broker-dealer]
. . . ahead of the interest of the retail customer.'' \82\
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\81\ See Proposing Release at 21585 et seq.
\82\ See Paragraph (a)(1) of Regulation Best Interest.
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Most commenters, including a majority of the IAC, expressed
opinions on this approach, and in particular on the General Obligation,
including whether the obligation should be a ``fiduciary'' standard,
whether it should be a uniform standard for broker-dealers and
investment advisers,\83\ and whether the standard should be more
principles-based or more prescriptive (in particular, whether to define
``best interest'').\84\
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\83\ See IAC 2018 Recommendation; Letter from Rob Foregger, Co-
Founder, NextCapital (Aug. 7, 2018) (``NextCapital Letter'')
(recommending that the Commission adopt a uniform fiduciary standard
of conduct applicable to both broker-dealers and investment
advisers); Letter from Sharon Cheever, Senior Vice President and
General Counsel, Pacific Life Insurance Company (May 28, 2019)
(``Pacific Life May 2019 Letter'') (recommending that the Commission
adopt a single `best interest' standard of care for all financial
professionals).
See also Letter from R. Scott Henderson, Bank of America (Aug.
7, 2018) (``Bank of America Letter''); Letter from Christopher
Jones, Chief Investment Officer, Financial Engines (Aug. 6, 2018)
(``Financial Engines Letter''); State Attorneys General Letter;
Letter from Jill I. Gross, Associate Dean, Academic Affairs,
Elisabeth Haub School of Law, Pace University (Mar. 11, 2019)
(``Gross Letter''). Relatedly, one commenter expressed concern that
a court or arbitration panel would determine that Regulation Best
Interest would control, rather than existing case law, which would
apply a fiduciary duty in certain circumstances. See Gross Letter.
See also AFL-CIO April 2019 Letter.
\84\ See, e.g., Ameriprise Letter; Cambridge Letter; CCMC
Letters; Edward Jones Letter; NAIFA Letter; Morningstar Letter; NY
Life Letter; Letter from Kevin T. Reynolds, Senior Vice President,
Penn Mutual Life Insurance Company (Aug. 1, 2018) (``Penn Mutual
Letter''); SIFMA August 2018 Letter; Vanguard Letter; Letter from
Kent. A Mason, Davis & Harman LLP (Jul. 20, 2018) (``Davis Harman
Letter'').
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The views of commenters on the approach to an enhanced standard of
conduct for broker-dealers varied widely. A number of commenters
supported a broker-dealer specific standard of conduct.\85\ Several of
these commenters supported the Commission's approach as proposed, with
certain modifications to the specific component obligations discussed
below.\86\ Some commenters urged the Commission to change the standard
from what the commenters called ``suitability-plus'' to what the
commenters called a ``true best interest standard,'' including the
avoidance of certain conflicts,\87\ and urged the Commission to change
the name of Regulation Best Interest unless it required firms to always
be responsible for acting in the retail customer's best interest (as
opposed to at the time of the recommendation).\88\ Other commenters
advocated for the adoption of a broker-dealer standard modeled after
FINRA suitability rules,\89\ and some suggested that the Commission
create a safe harbor from liability for compliance with Regulation Best
Interest.\90\
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\85\ See, e.g., SIFMA August 2018 Letter; Cetera August 2018
Letter; Vanguard Letter; Edward Jones Letter; Ameriprise Letter; NY
Life Letter; NAIFA Letter; CCMC Letters; Penn Mutual Letter;
Cambridge Letter; PIABA Letter; Letter from Ronald J. Kruszewski,
Chairman and Chief Executive Officer, Stifel Financial (Aug. 7,
2018) (``Stifel Letter''); Financial Engines Letter.
\86\ See, e.g., SIFMA August 2018 Letter; Vanguard Letter;
Edward Jones Letter; Ameriprise Letter; NY Life Letter; NAIFA
Letter; CCMC Letters; Penn Mutual Letter; Cambridge Letter; PIABA
Letter.
\87\ See, e.g., CFA Institute Letter.
\88\ See, e.g., Letter from Jean-Luc Bourdon, CPA/PFS, Chair,
Personal Financial Planning Legislative and Regulatory Task Force,
and Charles R. Kowal, Chair, Personal Financial Planning Executive
Committee, AICPA (Aug. 7, 2018) (``AICPA Letter''); Betterment
August 2018 Letter; NASAA August 2018 Letter.
\89\ See, e.g., National Society of Compliance Professionals
Letter; Cetera August 2018 Letter.
\90\ See Cambridge Letter; BISA Letter; IPA Letter.
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By contrast, other commenters recommended that the Commission adopt
a uniform standard of conduct for investment advisers and broker-
dealers, in varying forms.\91\ Commenters expressed differing views on
the form of such a uniform standard of conduct, including that the
Commission should adopt: a fiduciary standard for broker-dealers
similar to, or no less stringent than, the fiduciary duty under the
Advisers Act; \92\ a uniform fiduciary standard as articulated in
Section 913(g) of the Dodd-Frank Act \93\ and/or consistent with the
recommendations of the staff's Section 913 Study; \94\ or a uniform
standard similar to the DOL standard as reflected in the BIC Exemption;
\95\ harmonized requirements and guidance for broker-dealers and
investment advisers offering services to retail customers; \96\ or a
new uniform best interest standard, with common core elements.\97\
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\91\ See, e.g., Betterment Letter; AARP August 2018 Letter; AFR
Letter; Galvin Letter; State Attorneys General Letter.
\92\ See, e.g., Betterment Letter; Warren Letter; Fein Letter;
Letter from Joseph M. Torsella, Pennsylvania State Treasurer, et al.
(Aug. 7, 2018) (``State Treasurers Letter''); AARP August 2018
Letter.
\93\ See, e.g., FPC Letter; Letter from Maxine Waters, Ranking
Member, Committee on Financial Services, U.S. House of
Representatives, et al. (Sep. 12, 2018) (``Waters Letter''); Fein
Letter.
\94\ See, e.g., ACLI Letter; Schwab Letter.
\95\ See, e.g., Galvin Letter. See supra footnote 32.
\96\ See, e.g., AARP August 2018 Letter.
\97\ See, e.g., Pacific Life August 2018 Letter.
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In this vein, a number of commenters suggested specific revisions
to the text of the General Obligation to clarify what the standard
requires with respect to broker-dealer conflicts of interest, including
that the Commission change the proposed ``without placing the financial
or other interest [of the broker-dealer] ahead'' language to a standard
that requires a recommendation be made ``without regard to'' a broker-
dealer's interest \98\ and/or requires the broker-dealer to ``place the
customer's interest first'' or ahead of its own.\99\ These commenters
stated that changing the proposed language to a ``without regard to''
and/or ``place the customer's interest first'' phrasing would result in
a stronger standard, whereas the proposed phrasing would allow a
broker-dealer to act in its own interests as long as the broker-dealer
does not put its interests ahead of its customers' interest.\100\ These
commenters stated that broker-dealers must put aside their own interest
when determining what is best for the retail customer, that broker-
dealers must ensure that conflicts do not taint recommendations.\101\
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\98\ See, e.g., CFA August 2018 Letter; FPC Letter; PACE Letter;
Better Markets August 2018 Letter.
\99\ See, e.g., Invesco Letter; Schwab Letter; Better Markets
August 2018 Letter; CFA Institute Letter.
\100\ See, e.g., CFA August 2018 Letter; FPC Letter; Pace
Letter.
\101\ See, e.g., CFA August 2018 Letter.
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Some commenters challenged the Commission's concern that the
``without regard to'' language ``could be inappropriately construed to
require a broker-dealer to eliminate all of its conflicts,'' arguing
that their position is supported by the plain meaning of the language
and the context of 913(g) (which explicitly recognizes conflicts in
certain areas), and the interpretations by others (such as the DOL) who
have used it.\102\ Highlighting what commenters viewed as
inconsistencies in the Proposing Release's interpretation of the
proposed ``without placing . . . ahead'' phrasing, such as statements
that the obligation would require broker-dealers to ``put aside their
interests'' when
[[Page 33329]]
making a recommendation versus others suggesting that a broker-dealer's
interests cannot ``predominantly motivate'' or be the ``sole basis''
for the recommendation, some commenters suggested we either adopt the
``without regard to'' phrasing or state that the proposed phrasing
requires a broker-dealer to put aside its interests.\103\ Some
commenters further stated that the ``without regard to'' phrasing,
which is used in Section 913(g) of the Dodd-Frank Act, is the stronger
standard of conduct that Congress intended, and challenged the
Commission's reliance on the authority provided in Section 913(f).\104\
In this vein, some commenters suggested that the Commission should
adopt a uniform standard of conduct for broker-dealers and investment
advisers that was authorized under Section 913(g), and recommended by
the staff in the Section 913 Study.\105\
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\102\ See, e.g., CFA August 2018 Letter; Waters Letter.
\103\ See, e.g., CFA August 2018 Letter. See also Waters Letter
(stating that the proposal fails to adequately explain just what it
would require of brokers that is different from the status quo, that
the standard should clearly differ from the current ``suitability''
standard, and that any final rule must clearly explain the standard,
what it requires and prohibits, and how it differs from the status
quo).
\104\ See, e.g., CFA August 2018 Letter; State Attorneys General
Letter; Waters Letter; FPC Letter; Better Markets August 2018
Letter.
\105\ See, e.g., Waters Letter; FPC Letter.
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Other commenters, however, supported the proposal's ``without
placing . . . ahead'' formulation.\106\ These commenters expressed
concern that a ``without regard to'' standard would require ``conflict
free'' recommendations, which would limit compensation structures and
the offering of certain products.\107\ Instead, commenters stated that
the appropriate role of a best interest standard is to require
disclosure and management of conflicts of interest.\108\ Others
generally supported, or did not object to, the Commission's decision
not to proceed under its 913(g) authority in its current proposal.\109\
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\106\ See, e.g., AALU Letter; Cetera August 2018 Letter; NAIFA
Letter; Pickard Letter.
\107\ See, e.g., AALU Letter; Cetera August 2018 Letter; NAIFA
Letter; Pickard Letter.
\108\ See, e.g., AALU Letter; Cetera August 2018 Letter.
\109\ See, e.g., Invesco Letter; IAC 2018 Recommendation
(stating ``we recognize that the Commission has chosen not to
proceed under its 913(g) authority in its current proposal, and it
is not our intent to derail that proposal by advocating that the
Commission change the legal basis for its rulemaking. Moreover, we
believe the clarifications we have outlined above to the meaning of
best interest, if implemented, have the potential to deliver
immediate benefits to customers of broker-dealers and investment
advisers alike. Should the Commission determine, however, that it
cannot enforce the clarified best interest standard under the
Advisers Act, a majority of the Committee believes the Commission
should reconsider rulemaking under its 913(g) authority to close
that regulatory gap.''). As noted above, Regulation Best Interest
draws from key principles underlying fiduciary obligations,
including those that apply to investment advisers under Advisers
Act. Accordingly, as discussed below, the Commission has chosen to
enhance existing obligations for broker-dealers when they make
recommendations to a retail customer, while, in a separate
interpretation, reaffirming and in some cases clarifying an
investment adviser's fiduciary duty. See Fiduciary Interpretation.
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A common theme across many comments was the need for additional
guidance on what ``best interest'' means, with some commenters
recommending that the Commission codify its interpretation of ``best
interest'' or provide a more specific definition of what it means to
act in the ``best interest.'' \110\ Several commenters suggested that
the ``best interest'' standard should require the ``best'' or most
beneficial product available,\111\ while others (including a majority
of the IAC) requested that the Commission clarify that there is no
single ``best'' recommendation and that the obligation is to adhere to
a professional standard of conduct when making a recommendation.\112\
Some commenters suggested defining ``best interest'' as including a
duty of loyalty and care.\113\ Several also suggested that the
Commission incorporate best execution and fair pricing and compensation
as factors for determining compliance with the standard.\114\
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\110\ See, e.g., NASAA August 2018 Letter.
\111\ See, e.g., Financial Engines Letter; CFA August 2018
Letter.
\112\ See, e.g., Wells Fargo Letter; see also IAC 2018
Recommendation (``[T]he Commission should recognize there will often
not be a single best option and that more than one of the available
options may satisfy this standard.'').
\113\ See, e.g., TIAA Letter; Morningstar Letter.
\114\ See, e.g., CFA Institute Letter; Letter from Mark Heckert,
Vice President, Pricing and Analytics, ICE Data Services, (Aug. 7,
2018) (``ICE Letter''); FPC Letter.
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Several commenters recommended that the Commission adopt a
definition of best interest that is consistent with the best interest
obligation described by the DOL in the BIC Exemption's Impartial
Conduct Standards,\115\ and supported a standard which would require a
broker-dealer to act ``solely'' in the interest of the retail customer
when making a recommendation.\116\ Conversely, other commenters
recommended that the ``best interest'' standard could be satisfied even
if the recommendations are in part influenced by ``self-promotion.''
\117\
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\115\ See, e.g., AARP August 2018 Letter; Wells Fargo Letter;
Schwab Letter; NASAA August 2018 Letter.
\116\ See, e.g., Galvin Letter.
\117\ See, e.g., LPL August 2018 Letter.
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Finally, in lieu of a prescribed definition of ``best interest,'' a
number of commenters advocated for a facts-and-circumstances or
``totality of the circumstances approach'' for determining compliance
with the ``best interest'' standard.\118\ A majority of the IAC
recommended that the meaning of the best interest obligation should be
clarified to require ``broker-dealers, investment advisers, and their
associated persons to recommend the investments, investment strategies,
accounts or services, from among those they have reasonably available
to recommend, that they reasonably believe represent the best available
options for the investor.'' \119\
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\118\ See, e.g., AAJ Letter; CFA August 2018 Letter.
\119\ IAC 2018 Recommendation.
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After careful consideration of these comments, we continue to
believe that our proposed approach for enhancing the standards of
conduct that apply to broker-dealers' recommendations to retail
customers is the appropriate approach, and therefore we are adopting as
proposed the structure and scope of Regulation Best Interest, including
the phrasing of the General Obligation, and are not expressly defining
``best interest'' in the rule text.\120\ However, in consideration of
these comments, we are providing our views on what the standard
generally requires, what it is intended to achieve, and its alignment
in many respects with fiduciary principles.
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\120\ Another commenter stated that any modification to the
proposed rules and guidance that would make them ``more
restrictive'' should be reproposed for additional public comment.
See ACLI Letter. Because we have provided notice and the changes we
are making are based on comments we received, reproposal is not
necessary.
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1. Commission's Approach
After extensive consideration, and for the reasons discussed in the
Proposing Release and further below, we are adopting a rule to enhance
the existing broker-dealer conduct obligations when they make
recommendations to a retail customer.\121\ At the same time, we seek to
preserve retail investor access (in terms of choice and cost) to
differing types of investment services and products.
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\121\ See Proposing Release at 21575. In particular, we
considered the recommendations made by our staff in 2011 and the
recommendations of the IAC. See Staff of the U.S. Securities and
Exchange Commission, Study on Investment Advisers and Broker-Dealers
As Required by Section 913 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Jan. 2011) (``913 Study''), at 9-10,
available at www.sec.gov/news/studies/2011/913studyfinal.pdf;
Recommendation of the Investor Advisory Committee: Broker-Dealer
Fiduciary Duty (Nov. 2013) (``IAC 2013 Recommendation''), available
at https://www.sec.gov/spotlight/investor-advisory-committee-2012/fiduciary-duty-recommendation-2013.pdf; IAC 2018 Recommendation.
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The Commission is adopting Regulation Best Interest pursuant to the
[[Page 33330]]
express and broad grant of rulemaking authority in Section 913(f) of
the Dodd-Frank Act.\122\ As some commenters noted, Section 913(g)
expressly authorizes the Commission to adopt rules that would hold
broker-dealers to the same standard of conduct as investment advisers.
However, the availability of overlapping, yet distinct, rulemaking
power under Section 913(g) does not negate the grant of authority under
Section 913(f). The plain text of Section 913(f) authorizes the
Commission to promulgate this rule addressing the legal and regulatory
standards of care for broker-dealers, and their associated persons.
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\122\ Section 913(f) of the Dodd-Frank Act provides the
Commission discretionary authority to ``commence a rulemaking, as
necessary or appropriate to the public interest and for the
protection of retail customers (and such other customers as the
Commission may by rule provide), to address the legal or regulatory
standards of care for brokers, dealers . . . [and] persons
associated with brokers or dealers . . . for providing personalized
investment advice about securities to such retail customers.'' In
addition to Section 913(f), the Commission is promulgating
Regulation Best Interest pursuant to other provisions of the
Exchange Act, including Section 15(c)(6) and Section 17.
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The Commission is utilizing its authority under 913(f) in order to
adopt an enhanced investor-protection standard for broker-dealers that
maintains the availability of both the broker-dealer model and the
investment adviser model. The Commission has chosen not to apply the
existing fiduciary standard under the Advisers Act to broker-dealers in
part because of concerns that such a shift would result in fewer
broker-dealers offering transaction-based services to retail customers,
which would in turn reduce choice and may raise costs for certain
retail customers.
Moreover, the Commission has chosen not to create a new uniform
standard applicable to both broker-dealers and investment advisers
which, among other things, would discard decades of regulatory and
judicial precedent and experience with the fiduciary duty for
investment advisers that has generally worked well for retail clients
and our markets. We believe that adopting a ``one size fits all''
approach would not appropriately reflect the fact that broker-dealers
and investment advisers play distinct roles in providing
recommendations or advice and services to investors, and may ultimately
harm retail investors. Instead, the Commission has chosen to enhance
existing obligations for broker-dealers when they make recommendations
to a retail customer, while, in a separate interpretation, reaffirming
and in some cases clarifying an investment adviser's fiduciary
duty.\123\
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\123\ Although we are not adopting a uniform fiduciary standard
of conduct, we note that our rules are designed to achieve many of
the key goals advocated for by supporters of a uniform standard of
conduct. For example, in advocating for a uniform standard of
conduct former Commission Chair Elisse B. Walter (then a
Commissioner) stated that (1) ``[t]o appreciate fully what a
fiduciary standard means, and what it really means to act in the
best interest of an investor, it is absolutely necessary to drill
down and determine what duties and obligations flow from a fiduciary
standard,'' (2) ``a fiduciary standard is not a substitute for
business practice rules . . . [r]ather, the two are complementary .
. . and can be used by the Commission] to prohibit certain
conflicted behavior or to require mitigation or management of the
conflict,'' (3) ``what a fiduciary duty requires depends on the
scope of the engagement,'' and (4) ``[m]ost important, whatever
gloss and guidance the Commission provides, it should not deviate
from the basic principle that financial professionals should always
act in the best interests of investors, both large and small.''
Commissioner Elisse B. Walter, Regulating Broker-Dealers and
Investment Advisers: Demarcation or Harmonization? (May 5, 2009),
available at https://www.sec.gov/news/speech/2009/spch050509ebw.htm.
In our Fiduciary Interpretation and in this release, we are
providing our views on the duties and obligations that flow from the
fiduciary duty and Regulation Best Interest. In this release, we
discuss the specific obligations of broker-dealers under the
Disclosure, Care and Conflicts of Interest Obligations, which
include requirements to establish policies and procedures that
comply with the Conflict of Interest Obligation, specifically to
disclose and mitigate (i.e., reasonably reduce), or eliminate,
certain conflicts. As discussed below, these specific obligations
are tailored to address particular concerns that arise as a result
of the broker-dealer model. For that reason, as well as the other
reasons set forth above, the Commission does not believe that it is
necessary to adopt a uniform standard in order to ensure that these
specific obligations also apply to investment advisers, as the IAC
suggests. See IAC 2018 Recommendation. In our Fiduciary
Interpretation, we state that ``the application of the investment
adviser's fiduciary duty will vary with the scope of the
relationship,'' and here we have noted that we are not expressly
defining in the rule text the term ``best interest,'' and instead
are providing in the rule and through interpretations what ``best
interest'' means. Compliance with each of the specific component
obligations will turn on an objective assessment of the facts and
circumstances of how the specific components of Regulation Best
Interest are satisfied at the time that the recommendation is made.
Finally, regardless of whether a retail investor chooses a broker-
dealer or an investment adviser (or both), the retail investor will
be entitled to a recommendation (from a broker-dealer) or advice
(from an investment adviser) that is in the best interest of the
retail investor and that does not place the interests of the firm or
the financial professional ahead of the interests of the retail
investor.
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Regulation Best Interest considers and incorporates (to the extent
appropriate) obligations that apply to investment advice in other
contexts, with the goal of fostering greater consistency and clarity in
the level of protection provided to retail customers at the time that a
recommendation is made. We are tailoring these principles to the
structure and characteristics of the broker-dealer relationship with
retail customers and building upon existing regulatory obligations. As
a result, Regulation Best Interest protects investors who seek access
to the services, products, and payment options offered by broker-
dealers.
Although we are not applying the existing fiduciary standard under
the Advisers Act to broker-dealers, key elements of the standard of
conduct that applies to broker-dealers under Regulation Best Interest
will be substantially similar to key elements of the standard of
conduct that applies to investment advisers pursuant to their fiduciary
duty under the Advisers Act \124\ at the time that a recommendation is
made. Regulation Best Interest's regulatory structure is unique to
broker-dealers--and is tailored to the broker-dealer business model--
but regardless of whether a retail investor chooses a broker-dealer or
an investment adviser (or both), the retail investor will be entitled
to a recommendation (from a broker-dealer) or advice (from an
investment adviser) that is in the best interest of the retail investor
and that does not place the interests of the firm or the financial
professional ahead of the interests of the retail investor.
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\124\ Specifically, an investment adviser's fiduciary duty under
the Advisers Act comprises a duty of care and a duty of loyalty.
This combination of care and loyalty obligations has been
characterized as requiring the investment adviser to act in the
``best interest'' of its client at all times. See Fiduciary
Interpretation.
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As discussed in the proposal, and in the discussion below,
Regulation Best Interest, as adopted, incorporates Care and Conflict of
Interest Obligations substantially similar to the fiduciary duties of
care and loyalty under Section 206(1) and (2) of the Advisers Act, even
if not in the same manner as the 913 Study recommendations or identical
to the duties under the Advisers Act.\125\ We extensively considered
the 913 Study as part of developing Regulation Best Interest, as
discussed in the Proposing Release, and believe that the enhancements
to the broker-dealer standard of conduct incorporate, and in many
aspects (such as the concept of mitigation, and the detailed Care
Obligation), build upon and go beyond the recommendations in the 913
Study.
---------------------------------------------------------------------------
\125\ See Proposing Release at 21590.
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Although key elements are substantially similar, the Commission
notes that the obligations of a broker-dealer under Regulation Best
Interest and the obligations of an investment adviser pursuant to its
fiduciary duty under the Advisers Act differ in certain respects,
taking into account the scope of the services and relationships
typically offered by broker-dealers and
[[Page 33331]]
investment advisers. For example, an investment adviser's duty of care
encompasses the duty to provide advice and monitoring at a frequency
that is in the best interest of the client, taking into account the
scope of the agreed relationship. This difference reflects the
generally ongoing nature of the advisory relationship, and the
Commission's view that, within the scope of the agreed adviser-client
relationship, investment advisers' fiduciary duty generally applies to
the entire relationship. In contrast, the provision of recommendations
in a broker-dealer relationship is generally transactional and
episodic, and therefore the final rule requires that broker-dealers act
in the best interest of their retail customers at the time a
recommendation is made and imposes no duty to monitor a customer's
account following a recommendation.
As noted above, Regulation Best Interest also generally imposes
more specific obligations on broker-dealers under the Disclosure, Care
and Conflict of Interest Obligations (each of which is discussed in
detail below) than the principles-based requirements of investment
advisers' fiduciary duty under the Advisers Act. This approach is
intended to tailor the application of principles that have developed in
the context of a different business model over the course of almost 80
years. Moreover, this more specific and tailored approach drawing on
key fiduciary principles (1) is consistent with the generally rules-
based regulatory regime that applies to broker-dealers, (2)
acknowledges that certain relevant obligations may already be addressed
by existing broker-dealer requirements (e.g., broker-dealers are
already subject to a duty of best execution), (3) allows us to impose
requirements that we are believe are more appropriately tailored to
address the specific conflicts raised by the transaction-based nature
of the broker-dealer model, and (4) recognizes that it would be
inappropriate to apply to certain generally applicable obligations of
investment advisers (e.g., duty to monitor) in the context of a
transaction-based relationship.
These specific obligations include express requirements relating to
the Care Obligation, requiring that a broker-dealer exercise reasonable
diligence, care, and skill to: (1) Understand the risks, rewards and
costs of a recommendation; (2) have a reasonable basis to believe that
the recommendation is in the best interest of a particular retail
customer, based on the retail customer's investment profile, and that
the recommendation does not place the broker-dealer's interest ahead of
the retail customer's interest; and (3) have a reasonable basis to
believe that a series of transactions is in the best interest of the
retail customer and does not place the interest of the broker-dealer
ahead of the retail customer's interests. Regulation Best Interest
imposes a duty of care that enhances existing suitability obligations
(as discussed further below). It also includes a requirement under the
Care Obligation to specifically address the risk that a broker-dealer's
transaction-based recommendations and compensation could result in a
series of recommendations that are not in the best interest or a retail
customer--a ``churning'' risk unique to the broker-dealer model of
providing recommendations and resulting transaction-based compensation.
Regulation Best Interest also includes a requirement under the
Conflict of Interest Obligation for broker-dealers to establish,
maintain, and enforce written policies and procedures reasonably
designed to (1) mitigate conflicts of interest at the associated person
level, (2) specifically address the conflicts of interest presented
when broker-dealers place material limitations on the securities or
products that may be recommended (i.e., only make recommendations of
proprietary or other limited range of products), and (3) eliminate
sales contests, bonuses, and non-cash compensation that are based on
the sales of specific securities or specific types of securities within
a limited period of time. The conflicts of interest associated with
incentives at the associated person level and limitations on the
securities or products that may be recommended to retail customers have
raised particular concerns in the context of the broker-dealer,
transaction-based relationship. Accordingly, the Commission believes
specific disclosure and additional mitigation requirements are
appropriate to address those conflicts. Sales contests, sales quotas,
bonuses and non-cash compensation that are based on the sales of
specific securities within a limited period of time create high-
pressure situations for associated persons to increase the sales of
specific securities or specific types of securities within a limited
period of time and thus compromise the best interests of their retail
customers. The Commission does not believe such conflicts of interest
can be reasonably mitigated and, accordingly, they must be eliminated.
Phrasing of Standard
We are adopting the phrasing ``act in the best interest of the
retail customer at the time the recommendation is made, without placing
the financial or other interest of the [broker-dealer] ahead of the
interest of the retail customer'' as it was proposed.\126\ In response
to comments, we are clarifying our views on what this standard entails
and how it compares to the ``without regard to'' language of Section
913.
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\126\ See paragraph (a)(1) of Regulation Best Interest. As
discussed in Section II.C.2, we are also adding the phrasing ``does
not place the financial or other interest of the broker, dealer, or
such natural person . . . ahead of the retail customer'' to certain
provisions of the Care Obligation.
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By replacing the ``without regard to'' language of Section 913(g)
and the 913 Study with the ``without placing the financial or other
interest of the [broker-dealer] . . . ahead of the interest of the
retail customer'' phrasing, we did not intend to create a ``lower'' or
``weaker'' standard compared to the language of Section 913(g) and the
913 Study. Rather, we are adopting a standard that reflects that a
broker-dealer should not put its interests ahead of the retail
customer's interest, and thereby aligns with (and in certain areas
imposes more specific obligations than) the investment adviser
fiduciary duty, at the time a broker-dealer makes a recommendation to a
retail customer.
As discussed in the Proposing Release, we do not intend for our
standard to require a broker-dealer to provide conflict-free
recommendations. For example, under Regulation Best Interest, a broker-
dealer could recommend a more expensive or more remunerative security
or investment strategy if the broker-dealer has a reasonable basis to
believe there are other factors about the security or investment
strategy that make it in the best interest of the retail customer,
based on that retail customer's investment profile.\127\
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\127\ See Section II.C.2, Care Obligation.
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We also agree with commenters that we do not believe that is the
intent behind the ``without regard to'' phrase, as included in Section
913 of the Dodd-Frank Act or recommended in the 913 Study, as is
evident both from other provisions of Section 913 that acknowledge and
permit the existence of financial interests under that standard, and
how our staff articulated the recommended uniform fiduciary standard in
the 913 Study.\128\
[[Page 33332]]
Nevertheless, we are concerned that there is a risk that the ``without
regard to'' language would be inappropriately construed to require a
broker-dealer to eliminate all of its conflicts when making a
recommendation (i.e., require recommendations that are conflict free),
which we believe could ultimately harm retail investors by reducing
their access to differing types of investment services and products and
by increasing their costs.
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\128\ See Proposing Release at 21590. As noted in the proposal,
among other things, Dodd-Frank Act Section 913(g) expressly provides
that the receipt of commission-based compensation, or other standard
compensation, for the sale of securities shall not, in and of
itself, violate any uniform fiduciary standard promulgated under
that subsection's authority as applied to a broker-dealer. Moreover,
Section 913(g) does not itself require the imposition of the
principal trade provisions of Advisers Act Section 206(3) on broker-
dealers. In addition, Dodd-Frank Act Section 913 provides that
offering only proprietary products by a broker-dealer shall not, in
and of itself, violate such a uniform fiduciary standard, but may be
subject to disclosure and consent requirements. See Exchange Act
Section 15(k)(1) and Advisers Act Section 211(g)(1). See also 913
Study at 113; Proposing Release at 21590.
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The potential for a range of different meanings to be given to the
phrase ``without regard to'' was heightened by the DOL's use of this
same language for purposes of the Impartial Conduct Standards set forth
in the BIC Exemption. We recognize, as noted by some commenters, that
the DOL interpretation of this phrase does not require ``conflict-
free'' recommendations. Nevertheless, because of the differences in the
approach to the treatment of conflicts under ERISA and under the
federal securities laws--ERISA starts by prohibiting conflicts and then
through exemptions permits certain conflicts, whereas the federal
securities laws generally start with disclosure and become more
restrictive--we share commenters' concerns that DOL's use of the
``without regard to'' language could alter the way in which conflicts
are viewed and cause a substantial portion of conduct that is currently
permitted, and reasonably accepted and desired by retail customers, to
be limited or eliminated. Based on market participant experience with
the implementation of--and reaction to the subsequent overturning of--
the DOL Fiduciary Rule, in particular the BIC Exemption,\129\ we
continue to believe that it is better to use language that provides
similar investor protections, but does not raise these legal
ambiguities.
---------------------------------------------------------------------------
\129\ See supra footnotes 33 and 34 (citing reduction in
services and increase in costs following DOL).
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The ``without placing the financial or other interest . . . ahead
of the interest of the retail customer'' phrasing recognizes that while
a broker-dealer will inevitably have some financial interest in a
recommendation--the nature and magnitude of which will vary--the
broker-dealer's interests cannot be placed ahead of the retail
customer's interest.\130\ Accordingly, we believe this phrasing
establishes a standard that enhances investor protection by prohibiting
a broker-dealer from placing its interests ahead of the retail
customer's interests, and preserves investor access (in terms of both
choice and cost) to differing types of investment services and
products.
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\130\ In this vein, we believe that a broker-dealer's
``financial interest'' is broad, and that a broker-dealer is
unlikely to have an ``other interest'' that is not a ``financial
interest.'' See, e.g., Proposing Release at 21618 (noting ``. . .
our interpretation of the types of material conflicts of interest
arising from financial incentives is broad. . .'').
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The phrasing also aligns with an investment adviser's fiduciary
obligation. As discussed in the Fiduciary Interpretation, an investment
adviser's fiduciary duty under the Advisers Act comprises a duty of
care and a duty of loyalty.\131\ The fiduciary duty requires that an
adviser ``adopt the principal's goals, objectives, or ends.'' \132\
This means the adviser must, at all times, serve the best interest of
its clients and not subordinate its client's interest to its own. In
other words, the investment adviser cannot place its own interests
ahead of the interests of its client.\133\ This combination of care and
loyalty obligations has been characterized as requiring the investment
adviser to act in the ``best interest'' of its client at all
times.\134\
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\131\ See, e.g., Proxy Voting by Investment Advisers, Advisers
Act Release No. 2106 (Jan. 31, 2003) (``Investment Advisers Release
No. 2106''). See also Fiduciary Interpretation.
\132\ Arthur B. Laby, The Fiduciary Obligations as the Adoption
of Ends, 56 Buffalo Law Review 99 (2008); see also Restatement
(Third) of Agency, Sec. 2.02 Scope of Actual Authority (2006)
(describing a fiduciary's authority in terms of the fiduciary's
reasonable understanding of the principal's manifestations and
objectives). See Fiduciary Interpretation.
\133\ See Fiduciary Interpretation.
\134\ Id. See also Amendments to Form ADV, Advisers Act Release
No. 3060 (Jul. 28, 2010) (adopting amendments to Form ADV and
stating that ``under the Advisers Act, an adviser is a fiduciary
whose duty is to serve the best interests of its clients, which
includes an obligation not to subrogate clients' interests to its
own,'' citing Investment Advisers Act Release 2106). See SEC v.
Tambone, 550 F.3d 106, 146 (1st Cir. 2008) (``Section 206 imposes a
fiduciary duty on investment advisers to act at all times in the
best interest of the fund. . .''); SEC v. Moran, 944 F. Supp. 286,
297 (S.D.N.Y 1996) (``Investment advisers are entrusted with the
responsibility and duty to act in the best interest of their
clients.'').
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Language that would require a broker-dealer to put the retail
customer's interest ``first'' arguably raises many of the same concerns
as the ``without regard to'' language. Accordingly, we are adopting a
formulation in Regulation Best Interest that is consistent with how we
describe the duty of loyalty for investment advisers in the Fiduciary
Interpretation--that is, a requirement not to place the adviser's
interests ahead of the interests of its client.\135\
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\135\ See Fiduciary Interpretation at footnote 54 (stating that,
in practice, referring to putting a client's interest first is a
plain English formulation commonly used by investment advisers to
explain their duty of loyalty in a way that may be more
understandable to retail clients).
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While we are not revising this phrasing of the standard, we
appreciate concerns raised by commenters about clarifying whether this
standard permits broker-dealers to allow their conflicts to taint their
recommendations or to allow broker-dealers to make recommendations that
are motivated by their own interests or to put their interests first.
We discuss below what it means to ``act in the best interests,''
particularly in the context of satisfying the Care and Conflict of
Interest Obligations. Specifically, we clarify that the obligations set
forth in Regulation Best Interest are intended to require broker-
dealers to take steps to reduce the effect of (and in some cases
eliminate) conflicts that create an incentive to place a broker-
dealer's or an associated person's interest ahead of the retail
customer's interest when making a recommendation, and to make
recommendations in the best interest of the retail customer even where
conflicts continue to exist. We believe that this approach will result
in a standard of conduct that is consistent with what a reasonable
retail customer would expect.\136\
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\136\ See, e.g., Brian Scholl, et al., SEC Office of the
Investor Advocate and RAND Corporation, The Retail Market for
Investment Advice (2018), available at https://www.sec.gov/comments/s7-07-18/s70718-4513005-176009.pdf (``OIAD/RAND''). OIAD/RAND
summarized the results of focus groups, indicating that in the
context of discussing expectations for standards of conduct, ``the
groups typically expected that a financial professional who is
acting in a client's best interest'' to, among other things,
``disclose payments they receive that might influence their advice
[and] avoid taking higher compensation for selling one product over
a similar but less costly product.'' Further, OIAD/RAND summarized
focus group comments on professionals' form of compensation, noting
that ``although many participants prefer that a professional be
compensated by the client alone, some might not rule out using a
professional who is receiving other compensation, for example if the
compensation is openly disclosed and they are comfortable with the
professional.'' The SEC's Office of Investor Advocate and the RAND
Corporation prepared this research report regarding the retail
market of investment advice prior to, and separate from, our
rulemaking proposals. This report was included in the comment file
at https://www.sec.gov/comments/s7-07-18/s70718-4513005-176009.pdf.
See also, e.g., Washington, DC Roundtable at 49 (``So it seems to me
that there is a tight connection between the obligation that you
have, and our obligations down below here to the conflicts of
interest, that it's really important that advisers or brokers spell
out what conflicts of interest they have, and what that means in
real terms to the person before they make a choice, for example'').
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[[Page 33333]]
Finally, although our standard draws from key fiduciary principles,
for various reasons, including to emphasize that Regulation Best
Interest is tailored to the broker-dealer relationship and distinct
from the investment adviser fiduciary duty, we are not referring to
Regulation Best Interest as a ``fiduciary'' standard, and we emphasize
that Regulation Best Interest is separate from any common law analysis
of whether a broker-dealer has fiduciary duties.\137\ As noted in the
proposal, fiduciary standards vary, for example, for investment
advisers, banks acting as trustees or fiduciaries, and fiduciaries to
ERISA plans. As we have learned through our consideration of the
Relationship Summary Proposal, and from various investor studies, using
the term ``fiduciary'' to describe the standard may not sufficiently
convey meaning regarding the specific substance of the standard.\138\
In addition, we appreciate commenters' concerns that using the term in
the context of a different relationship may introduce further legal or
compliance ambiguity.\139\
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\137\ In addition to the antifraud provisions of the federal
securities laws, courts interpreting state common law have imposed
fiduciary obligations on broker-dealers in certain circumstances.
See Proposing Release at 21584. Generally, courts have found that
broker-dealers that exercise discretion or control over customer
assets, or have a relationship of trust and confidence with their
customers, owe customers a fiduciary duty. Id. In developing
proposed Regulation Best Interest, the Commission has drawn from
principles that apply to investment advice under other regulatory
regimes, including state common law fiduciary principles, among
others. By doing so, we hope to establish greater consistency in the
level of retail customer protections and to make it easier to comply
with Regulation Best Interest where other legal regimes, such as
state common law drawing upon comparable fiduciary principles, might
also apply.
\138\ See, e.g., RAND 2018 (``Some participants had never heard
of the word, whereas others had heard it but did not know what it
meant in this context. Others thought the word ``fiduciary implies
acting in best interest . . .''). We have modified the standard of
conduct disclosure required by Form CRS to eliminate technical
words, such as ``fiduciary,'' and describe the standards of conduct
of broker-dealers, investment advisers, or dual-registrants using
similar terminology in a plain-English manner. In particular, Form
CRS uses the term ``best interest'' to describe how broker-dealers,
investment advisers, and dual-registrants must act regarding their
retail customers or clients when providing recommendations as a
broker-dealer or acting as an investment adviser. See Relationship
Summary Adopting Release.
\139\ See, e.g., Stifel Letter.
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As articulated in the Proposing Release, we appreciate the desire
for clarity about the requirements imposed by Regulation Best Interest,
and we have sought to provide such clarity by specifying by rule the
specific components with which a broker-dealer is required to comply to
satisfy its best interest obligation. The changes we are making from
the Proposing Release to this final Regulation Best Interest and the
additional interpretations and guidance we are providing are intended
to further clarify how a broker-dealer could comply with these
requirements.
As noted above and discussed in the Fiduciary Interpretation, an
investment adviser's fiduciary duty under the Advisers Act requires the
adviser to act in the best interests of its clients. We have chosen to
describe the standard by referring directly to what the standard
requires at the time a recommendation is made.\140\ Furthermore, while
key elements of the standard of conduct that applies to broker-dealers
under Regulation Best Interest will be substantially similar to key
elements of the standard of conduct that applies to investment advisers
pursuant to their fiduciary duty under the Advisers Act at the time
that a recommendation is made, we are concerned that using the term
``fiduciary'' to describe a broker-dealer's obligations under
Regulation Best Interest may create confusion by suggesting that the
standards of conduct are identical in all respects, when there are key
differences as noted above, including the scope of the of the duty
(e.g., the application of the adviser's fiduciary duty to the entire
relationship versus Regulation Best Interest's recommendation-specific
application, and the application of an adviser's fiduciary duty to all
clients as opposed to Regulation Best Interest's application to retail
customers).\141\
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\140\ As discussed in the Relationship Summary Adopting Release,
we are adopting a requirement in Form CRS for a description of a
firm's applicable standard of conduct using prescribed wording.
\141\ See Fiduciary Interpretation.
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Similarly, while we are not harmonizing the phrasing of the best
interest standard with the DOL's definition of ``best interest'' as
reflected in the BIC Exemption's Impartial Conduct Standards, as
suggested by some commenters,\142\ or otherwise adopting some or all
conditions of the BIC Exemption, we gave careful consideration to the
DOL Fiduciary Rule in developing Regulation Best Interest.\143\
Regulation Best Interest takes into account both market participant
experience with the implementation of--and reaction to the subsequent
overturning of the DOL Fiduciary Rule, in particular the BIC Exemption.
As discussed in the Proposing Release, we believe Regulation Best
Interest is consistent with many of the key components of the DOL's
Impartial Conduct Standards. Regulation Best Interest incorporates
principles underlying the DOL Fiduciary Rule--such as the concept of
conflict mitigation--that, based on our expertise in regulating the
broker-dealer industry, we believe would further our goal of reducing
the effect of conflicts on recommendations and would promote
recommendations in the best interest of the retail customer even where
conflicts continue to exist.
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\142\ See AARP August 2018 Letter; Wells Fargo Letter; Schwab
Letter; NASAA August 2018 Letter.
\143\ On March 15, 2018, the DOL Fiduciary Rule was vacated by
the United States Court of Appeals for the Fifth Circuit. Chamber of
Commerce v. U.S. Dep't of Labor, 885 F.3d 360 (5th Cir. 2018).
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2. General Obligation To ``Act in Best Interest''
We agree with commenters that further clarity should be provided on
what it means to ``act in the best interest'' of a retail customer and
particularly what it means to make a recommendation in a retail
customer's ``best interest'' under the Care Obligation. In the guidance
that follows and in the detailed discussion of each of the Disclosure,
Care, Conflict of Interest, and Compliance Obligations in Section II.C
below, we provide further clarity on how a broker-dealer acts in a
retail customer's best interest when making a recommendation.
First, in response to comments, we are clarifying the relationship
between the General Obligation and the specific component obligations
described in Section II.C. These specific component obligations
expressly set forth what it means to ``act in the best interest'' of
the retail customer in accordance with the General Obligation. As
articulated in the proposal, and discussed in more detail in the
relevant sections specifically addressing these obligations, these
specific component obligations draw on principles underlying the
fiduciary duties of care and loyalty interpreted under the Advisers Act
and as recommended in the 913 Study. However, we believe that adopting
specific regulatory obligations for broker-dealers appropriately
reflects the structure and characteristics of broker-dealer
relationships with retail customers and the extensive existing
regulatory regime applicable to broker-dealers. Regulation Best
Interest does not establish a ``safe harbor.'' The specific component
obligations of Regulation Best Interest are mandatory, and failure to
comply with any of the components would violate the General Obligation.
By contrast, compliance with a safe harbor is optional, and failure to
comply with the terms of the safe harbor does not necessarily violate
the relevant legal requirement.
Second, while we are declining to expressly define ``best
interest'' in the
[[Page 33334]]
rule text as suggested by some commenters, we are providing
interpretations and guidance regarding the application of the specific
component obligations and in particular what it means to make a
recommendation in the retail customer's ``best interest.'' Consistent
with the proposal, compliance with each of the specific component
obligations of Regulation Best Interest, including the ``best
interest'' requirement in the Care Obligation, will be applied in a
principles-based manner. This principles-based approach to determining
what is in the ``best interest'' is similar to an investment adviser's
fiduciary duty, which has worked well for advisers' retail clients and
our markets. As proposed, whether a broker-dealer has acted in the
retail customer's best interest will turn on an objective assessment of
the facts and circumstances of how the specific components of
Regulation Best Interest are satisfied at the time that the
recommendation is made (and not in hindsight). In particular, whether a
broker-dealer's recommendation satisfies the requirements of the Care
Obligation is an objective evaluation that is not susceptible to a
bright line test; rather it turns on the facts and circumstances of the
particular recommendation and the particular retail customer, at the
time the recommendation is made. This facts-and-circumstances approach
recognizes that one size does not fit all, and what is in the best
interest of one retail customer may not be in the best interest of
another.
We understand that markets evolve and we encourage broker-dealers
to have an open dialogue with the Commission and Commission's staff as
questions arise.
As a general matter, however, in response to comments, we are
changing guidance in the Proposing Release stating that under
Regulation Best Interest, a broker-dealer's financial interests cannot
be the ``predominant motivating factor behind'' a recommendation, and
that a ``broker-dealer would violate proposed Regulation Best
Interest's Care Obligation and Conflict of Interest Obligations, if any
recommendation was predominantly motivated by the broker-dealer's self-
interest.'' \144\ Many commenters expressed concerns regarding and
requested removal of the ``predominantly motivated'' language, stating
that it contradicted statements that there was no scienter requirement
under Regulation Best Interest by requiring a consideration of intent,
creating ambiguity as to what extent a broker-dealer's interests could
influence its recommendations or requiring a weighing of the broker-
dealer's interests against the retail customer's interests.\145\ Some
commenters, however, indicated support for the ``predominantly
motivated language'' in the context of agreeing with the Commission's
proposed ``without placing the financial or other interest . . .
ahead'' phrasing of the best interest standard.\146\
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\144\ See Proposing Release at 21588.
\145\ See CFA August 2018 Letter; Better Markets August 2018
Letter; Wells Fargo Letter.
\146\ See AXA Letter; FSI August 2018 Letter.
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In consideration of these comments, we are modifying these
statements to remove this language and to clarify our intent.
Specifically, Regulation Best Interest recognizes that while a broker-
dealer will inevitably have some financial interest in a
recommendation--the nature and magnitude of which will vary--the
broker-dealer's interests cannot be placed ahead of the retail
customer's interest.\147\ Accordingly, Regulation Best Interest will
not per se prohibit a broker-dealer from making recommendations where
conflicts of interest are present.\148\ Instead, Regulation Best
Interest includes specific requirements for broker-dealers to address
their conflicts of interest.\149\ These specific requirements are
designed to promote recommendations that are in the best interest of
the retail customer despite the existence of these conflicts of
interest. In other words, recommendations involving conflicts of
interest between the broker-dealer and the retail customer will be
permissible under Regulation Best Interest only to the extent that the
broker-dealer satisfies the specific requirements of Regulation Best
Interest.
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\147\ See id. See infra Section II.C.2.
\148\ Such conflicts of interest may include: Charging
commissions or other transaction-based fees; receiving or providing
differential compensation based on the product sold; receiving
third-party compensation; recommending proprietary products,
products of affiliates or a limited range of products; recommending
a security underwritten by the broker-dealer or a broker-dealer
affiliate, including initial public offerings (``IPOs'');
recommending a transaction to be executed in a principal capacity;
allocating trades and research, including allocating investment
opportunities (e.g., IPO allocations or proprietary research or
advice) among different types of customers and between retail
customers and the broker-dealer's own account; considering cost to
the broker-dealer of effecting the transaction or strategy on behalf
of the customer (for example, the effort or cost of buying or
selling a complex or an illiquid security); or accepting a retail
customer's order that is contrary to the broker-dealer's
recommendations. While these practices will not be per se prohibited
by Regulation Best Interest, we are also not saying that these
practices are per se consistent with Regulation Best Interest or
other obligations under the federal securities laws. See also
Proposing Release at 21587.
\149\ Id at 21588.
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Further, for the reasons discussed in the proposal, we confirm that
Regulation Best Interest is not intended to limit or eliminate
recommendations that encourage diversity in a retail customer's
portfolio through investment in a wide range of products, including,
when appropriate, products that may involve higher risks or cost to the
retail customer, as these products may be in the best interest of
certain retail customers at certain times or in certain
circumstances.\150\ Regulation Best Interest will not necessarily
obligate a broker-dealer to recommend the ``least expensive'' or the
``least remunerative'' security or investment strategy, provided the
broker-dealer complies with the specific component obligations.\151\ In
other words, Regulation Best Interest will allow a broker-dealer to
recommend products that entail higher costs or risks for the retail
customer, or that result in greater compensation to the broker-dealer,
or that are more expensive, than other products, provided that the
broker-dealer complies with the specific component obligations detailed
below,\152\ including the requirement to make these recommendations
exercising reasonable diligence, care, and skill to have a reasonable
basis to believe that the recommendation is in the retail customer's
best interest and does not place the broker-dealer's interest ahead of
the retail customer's interest.
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\150\ Id.
\151\ See id.
\152\ See id.
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Finally, some commenters sought additional clarity whether
Regulation Best Interest would extend beyond a particular
recommendation, impose a duty to monitor the retail customer's account,
or apply to unsolicited orders.\153\ We confirm that, consistent with
the Proposing Release and as discussed further below, Regulation Best
Interest would not: (1) Extend beyond a particular recommendation \154\
or generally require a broker-dealer to have a continuous duty to a
retail customer or impose a duty to monitor; \155\ (2) require the
broker-dealer
[[Page 33335]]
to refuse to accept a customer's order that is contrary to the broker-
dealer's recommendation; or (3) apply to self-directed or otherwise
unsolicited transactions by a retail customer, whether or not she also
receives separate recommendations from the broker-dealer.
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\153\ See, e.g., SIFMA August 2018 Letter; Transamerica August
2018 Letter; see also generally CFA August 2018 Letter; Better
Markets August 2018 Letter.
\154\ However, paragraph (a)(2)(iii)(C) of Regulation Best
Interest addresses a series of recommended transactions. See Section
II.C.2.d.
\155\ However, as discussed below, it is our position that when
a broker-dealer agrees with a retail customer to provide account
monitoring services: (1) The broker-dealer would be required to
disclose the material facts (including scope and frequency) of those
services pursuant to the Disclosure Obligation, and (2) such agreed-
upon account monitoring services involve an implicit recommendation
to hold (i.e., an implicit recommendation not to buy, sell, or
exchange assets pursuant to that securities account review) at the
time agreed-upon monitoring occurs, which is a recommendation ``of
any securities transaction or investment strategy involving
securities'' covered by Regulation Best Interest.
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B. Key Terms and Scope of Best Interest Obligation
1. Natural Person Who Is an Associated Person
In the Proposing Release, we stated that a ``natural person who is
an associated person'' is a natural person who is an associated person
as defined in Section 3(a)(18) of the Exchange Act: ``any partner,
officer, or director or branch manager of such broker or dealer (or any
person occupying a similar status or performing similar functions); any
person directly or indirectly controlling, controlled by, or under
common control with such broker or dealer; or any employee of such
broker or dealer, except that any person associated with a broker or
dealer whose functions are solely clerical or ministerial shall not be
included in the meaning of such term for purposes of Section 15(b) of
this title (other than paragraph 6 thereof).'' \156\ In limiting the
term to only a ``natural person who is an associated person,'' we
sought to exclude affiliated entities of the broker-dealer that are not
themselves broker-dealers, as they are not the intended focus of
Regulation Best Interest.\157\
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\156\ Proposing Release at 21592-21593.
\157\ Id.
---------------------------------------------------------------------------
We solicited comment on whether the application of the definition
was appropriate, alternative definitions should be considered, or the
scope should be broadened or narrowed. We received no comments and, for
the reasons discussed in the Proposing Release, are using the term
``natural person who is an associated person,'' consistent with the
definition in Section 3(a)(18) of the Exchange Act.\158\
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\158\ Id.
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2. Recommendation of Any Securities Transaction or Investment Strategy
Involving Securities
We proposed to apply Regulation Best Interest to broker-dealer
recommendations of any securities transaction or investment strategy
involving securities to a retail customer. We believed that by applying
Regulation Best Interest to a ``recommendation,'' as that term is
currently interpreted under broker-dealer regulation, we would make
clear when the obligation applied and would maintain efficiencies for
broker-dealers that have already established infrastructures to comply
with suitability obligations, which are recommendation-based.\159\
Moreover, we believed that focusing on each recommendation would
appropriately capture and reflect the various types of recommendations
that broker-dealers make to retail customers, whether on an episodic,
periodic, or more frequent basis and would help ensure that retail
customers receive the protections that Regulation Best Interest is
intended to provide. We received numerous comments supporting our
general proposed approach to what is a ``recommendation,'' while
several commenters suggested modifications regarding the scope of a
recommendation or sought additional clarity regarding particular
scenarios.\160\
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\159\ Id.
\160\ See generally SIFMA August 2018 Letter; Financial Engines
Letter; IPA Letter; Putnam Letter; Cambridge Letter (recommending
the Commission adopt FINRA's approach to determining whether a
communication is a ``recommendation''). But see NASAA August 2018
Letter; BlackRock Letter; FSI August 2018 Letter (recommending
modifications or clarifications to ``recommendation'').
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As we indicated in the Proposing Release, in our view, the
determination of whether a broker-dealer has made a recommendation that
triggers application of Regulation Best Interest should turn on the
facts and circumstances of the particular situation and therefore,
whether a recommendation has taken place is not susceptible to a bright
line definition. Factors considered in determining whether a
recommendation has taken place include whether the communication
``reasonably could be viewed as a `call to action''' and ``reasonably
would influence an investor to trade a particular security or group of
securities.'' \161\ The more individually tailored the communication to
a specific customer or a targeted group of customers about a security
or group of securities, the greater the likelihood that the
communication may be viewed as a ``recommendation.'' We continue to
believe this general framework regarding what is a recommendation is
appropriate, and for the reasons discussed in the Proposing Release,
are taking this approach.\162\
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\161\ See Proposing Release at 21592-21593; see also NASD Notice
to Members 01-23, Online Suitability--Suitability Rules and Online
Communications (Apr. 2001); Notice of Filing Proposed Rule Change to
Adopt FINRA Rule 2090 (Know Your Customer) and FINRA Rule 2111
(Suitability) in the Consolidated FINRA Rulebook, Exchange Act
Release No. 62718 (Aug. 13, 2010), 75 FR 51310 (Aug. 19, 2010), as
amended, Exchange Act Release No. 67218A (Aug. 20, 2010), 75 FR
52562 (Aug. 26, 2010) (discussing what it means to make a
``recommendation'').
\162\ See Proposing Release at 21592-21593.
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While certain commenters recommended formally defining the term
``recommendation,'' including what does not come within that term,\163\
other commenters maintained there is no need to define
``recommendation'' and expressed support for harmonizing the term in
accordance with existing broker-dealer guidance and case law.\164\ We
agree with commenters that clarity is important, and we continue to
believe that the current principles-based approach underlying existing
Commission precedent and guidance will provide effective clarity. Being
more prescriptive could result in a definition that is over inclusive,
under inclusive, or both.\165\ We believe that what constitutes a
recommendation is highly fact-specific and not conducive to an express
definition in the rule text. Furthermore, we believe that the existing
framework has worked well, that broker-dealers generally are familiar
with the existing framework, and therefore, that this approach should
continue. Accordingly, we are taking the approach as set forth in the
Proposing Release, which we believe provides a workable framework and
clarity for broker-dealers regarding the contours of a recommendation.
To provide further clarity, in response to comments, we describe below
the types of communications that we generally view
[[Page 33336]]
as falling outside of the scope of a recommendation.
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\163\ See, e.g., Prudential Letter (recommending an express
definition of ``recommendation'' that would codify guidance).
\164\ See, e.g., SIFMA August 2018 Letter (``Similarly, the SEC
refers to the FINRA concept of `recommendation' rather than
prescribing a specific definition. We believe this is appropriate,
and we believe that a carve-out for educational materials would be
consistent with that approach.''); Edward Jones Letter (``We do not
believe it is necessary for the SEC to define the phrase `at the
time the recommendation is made,' because its meaning is plain.'');
Cambridge Letter (``FINRA Rule 2111 sets forth an explicit standard
for what constitutes a recommendation and recognizes `call to
action' as the hallmark. Cambridge believes this definition is fully
understood and in use by the industry.'' Cambridge also states that
harmonizing the final rule with existing FINRA rules and guidance
will provide clarity to firms, financial professionals, and
investors).
\165\ See id.; Proposing Release at 21592-21593. Similarly,
FINRA has stated that ``defining the term `recommendation' is
unnecessary and would raise many complex issues in the absence of
specific facts of a particular case.'' Exchange Act Release No.
37588, 1996 SEC LEXIS 2285, at *29 (Aug. 20, 1996), 61 FR 44100,
44107 (Aug. 27, 1996).
---------------------------------------------------------------------------
We are also generally confirming our interpretation in the
Proposing Release of the phrase ``any securities transaction or
investment strategy involving securities.'' However, in response to
comments regarding the coverage of certain securities or investment
strategies, we are providing further clarity regarding our
interpretation of this phrase, and in certain instances, refining our
interpretation. For example, as discussed more fully below, we are
confirming our interpretation that recommendations of ``any securities
transaction'' (purchase, sale, or exchange) and any ``investment
strategy'' involving securities (including an explicit hold
recommendation) are recommendations ``of any securities transaction or
investment strategy involving securities.''
In addition, we are generally confirming our interpretation that a
broker-dealer may agree with a retail customer to take on additional
obligations beyond those imposed by Regulation Best Interest, for
example, by agreeing with a retail customer to provide monitoring of
the retail customer's investments on a periodic basis for purposes of
recommending changes in investments.\166\ In response to comments, it
is our position that when a broker-dealer agrees \167\ with a retail
customer to monitor that customer's account: (1) The broker-dealer is
required to disclose the terms of such account monitoring services
(including the scope and frequency of those services) pursuant to the
Disclosure Obligation \168\ and (2) such agreed-upon monitoring
involves an implicit recommendation to hold (i.e., recommendation not
to buy, sell, or exchange assets pursuant to that securities account
review) at the time the agreed-upon monitoring occurs, which is a
recommendation ``of any securities transaction or investment strategy
involving securities'' covered by Regulation Best Interest.\169\ As
discussed further below, in our view, a recommendation of ``an
investment strategy'' includes implicit hold recommendations in this
context, where the broker-dealer has agreed to monitor a retail
customer's account.\170\ We are interpreting the phrase ``any security
transaction or investment strategy'' to include instances where there
is an agreement to monitor because in this context there is an implicit
recommendation to hold at the time the agreed-upon monitoring occurs
when the broker-dealer does not provide an express recommendation to
buy, sell, or hold.\171\
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\166\ Proposing Release at 21594-21595. The Proposing Release
referred to ``ongoing'' monitoring of the retail customer's
investments for purposes of recommending changes in investments. Id.
In the discussion that follows and the Solely Incidental
Interpretation, we are clarifying our views regarding broker-dealer
account monitoring services, and the application of Regulation Best
Interest to such services. As discussed in the Solely Incidental
Interpretation, a broker-dealer that agrees to monitor a retail
customer's account on a periodic basis for purposes of providing
buy, sell, or hold recommendations may still be considered to
provide advice in connection with and reasonably related to
effecting securities transactions. Broker-dealers may choose to
adopt policies and procedures that, if followed, would help
demonstrate that any agreed-upon monitoring is in connection with
and reasonably related to the broker-dealer's primary business of
effecting securities transactions. See Solely Incidental
Interpretation.
\167\ An agreement to provide account monitoring services to a
retail customer is not required to be in writing (although whether
or not the broker-dealer is providing account monitoring services,
and, if so, the scope and frequency of such monitoring services,
must be disclosed in writing pursuant to the Disclosure Obligation).
For example, a broker-dealer's oral undertaking that the broker-
dealer will monitor the retail customer's account on a periodic
basis would create an agreement to monitor the account on the terms
specified orally. Whether an agreement with the retail customer has
been established in the absence of a written agreement or express
oral undertaking will depend on an objective inquiry of the
particular facts and circumstances, including reasonable retail
customer expectations arising from the broker-dealer's course of
conduct. In cases where a broker-dealer does not intend to create an
implied agreement to monitor the retail customer's account through
course of conduct or otherwise, and to avoid ambiguity over whether
an implied agreement has been formed, broker-dealers should take
steps to ensure that all communications with the retail customer are
consistent with its disclosures required under the Disclosure
Obligation, which in this case would require the broker-dealer to
clearly disclose that the broker-dealer does not monitor the retail
customer's account.
\168\ To avoid ambiguity over whether or when an implicit hold
recommendation has been made, this disclosure should identify with
specificity when the agreed upon monitoring will occur. See also
FINRA Regulatory Notice 12-25 at Q14.
\169\ See IAC 2018 Recommendation; NAIFA Letter; AFL-CIO April
2019 Letter; see also FINRA Regulatory Notice 12-25, Suitability--
Additional Guidance on FINRA's New Suitability Rule (May 2012) at Q3
and accompanying footnotes.
\170\ See FINRA Rule 2111.03; FINRA Regulatory Notice 12-25. The
Commission recognizes that its position with respect to Regulation
Best Interest differs from that provided in FINRA guidance regarding
whether implicit hold recommendations are subject to the suitability
rule. This interpretation applies in the context of the protections
of Regulation Best Interest, and does not change the scope of the
application of the FINRA suitability rule. Further, while for
purposes of Regulation Best Interest implicit hold recommendations
are generally recommendations of ``any securities transaction or
investment strategy regarding securities'' where a broker-dealer
agrees to provide account monitoring services, we are not otherwise
addressing the treatment of implicit hold recommendations in other
contexts. In other words, except where a broker-dealer agrees to
provide account monitoring services as described, consistent with
existing FINRA guidance, Regulation Best Interest will only apply to
explicit hold recommendations. See FINRA Regulatory Notice 12-25 at
Q3 and accompanying footnotes.
\171\ Our interpretation is generally consistent with
commenters' views regarding the application of Regulation Best
Interest to implicit hold recommendations in the context of agreed-
upon account monitoring services. See IAC 2018 Recommendation (``we
believe the best interest standard should be applied to the broker-
dealer's monitoring of the customer account, where brokers provide
ongoing services to the account. In essence, this would apply the
best interest standard to the implicit ``no recommendation''
recommendation that a broker makes when reviewing the account and
recommending no change.''); NAIFA Letter (asserting broker-dealers
should be free to agree to, and define the nature of, any ongoing
relationship via contract, such as including monitoring services).
See also AFL-CIO April 2019 Letter (``adopt a principles-based
obligation to monitor the account, where the nature and extent of
the monitoring follows the contours of the relationship''). See also
supra footnote 166 (encouraging broker-dealers to adopt policies and
procedures that, if followed, would help demonstrate that any
agreed-upon monitoring is in connection with and reasonably related
to the broker-dealer's primary business of effecting securities
transactions in accordance with the Solely Incidental
Interpretation).
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We recognize that a broker-dealer may voluntarily, and without any
agreement with the customer, review the holdings in a retail customer's
account for the purposes of determining whether to provide a
recommendation to the customer. We do not consider this voluntary
review to be ``account monitoring,'' nor would it in itself create an
implied agreement with the retail customer to monitor the customer's
account. Any explicit recommendation made to the retail customer as a
result of any such voluntary review would be subject to Regulation Best
Interest.
Finally, in response to comments received, we have modified the
rule text to provide that an ``investment strategy involving
securities'' includes ``account recommendations.'' We interpret
``account recommendations'' to include recommendations of securities
account types generally, as well as recommendations to roll over or
transfer assets from one type of account to another (e.g., workplace
retirement plan to an IRA). As discussed in more detail below, we
believe that recommendations of securities account types are consistent
with the types of recommendations that have been treated as investment
strategies,\172\ because the
[[Page 33337]]
type of securities account recommended is an investment strategy that
has the potential to greatly affect retail customers' costs and
investment returns.\173\ For example, different types of securities
accounts can offer different features, products, or services, some of
which may--or may not--be in the best interest of certain retail
customers.\174\ Our interpretation is consistent with a majority of the
IAC and other commenters that stated that such important
recommendations relating to securities are ``investment strategies
involving securities'' and thus within the scope of Regulation Best
Interest.\175\ We note that, although we are specifically identifying
``account recommendations'' as an investment strategy involving
securities in the rule text, an account recommendation is just one
example of an investment strategy.
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\172\ Although FINRA has stated that a recommendation concerning
the type of workplace retirement plan account in which a customer
should hold his retirement investments typically involves a
recommended securities transaction, and thus is subject to
suitability requirements, FINRA did not address whether such a
recommendation would be an investment strategy in the absence of
such a recommended securities transaction. FINRA Regulatory Notice
13-45, Rollovers to Individual Retirement Accounts--FINRA Reminds
Firms of Their Responsibilities Concerning IRA Rollovers (Dec.
2013). Taking this approach is consistent with Commission precedent
finding a recommendation of a margin strategy to be unsuitable under
the NASD suitability rule, in light of the associated transactions
costs and the impact the strategy could have on customer returns.
See F.J. Kaufman & Co., 50 SEC. 164 (1989) (Commission Opinion)
(stating that a broker-dealer recommending the purchase of
securities using a margin strategy ``at a minimum . . . had an
obligation to understand that, in light of the applicable
transaction costs, the two components of his recommended strategy,
when combined, always would have produced returns inferior to those
that could have been obtained from one of those components
alone.'').
\173\ See SEC Office of Investor Education and Advocacy, Updated
Investor Bulletin: How Fees and Expenses Affect Your Investment
Portfolio (Sep. 2016).
\174\ In addition to brokerage versus investment advisory
accounts, there are also many options or account types within
brokerage accounts. For example, brokerage accounts can include:
Education accounts (e.g., 529 Plans and tax-free Coverdell
accounts); retirement accounts (e.g., IRA, Roth IRA, or SEP-IRA
accounts); and specialty accounts (e.g., cash or margin accounts,
and accounts with access to Forex or options trading). Different
brokerage accounts can also offer different levels of services, such
as access to online trading, or can offer different products, for
example, in higher dollar amount accounts (e.g., access to products
with break-points).
\175\ See, e.g., IAC 2018 Recommendation (``Decisions about
which type of account to open have the potential to greatly affect
their costs. Moreover, both rollover and account type
recommendations are recommendations of an `investment strategy
involving securities' that can have substantial potential long-term
impacts on investors. Both types of recommendations inherently
involve potential conflicts of interest, making it critical that
advisers and brokers put their clients' interests ahead of their own
in making such recommendations.''); Capital Group Letter (``Choosing
between a brokerage and an advisory account is an incredibly
impactful decision for investors. It is very important that these
recommendations be made in the best interest of the retail
[customer].'').
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a. Recommendation
We interpret whether a ``recommendation'' has been made to a retail
customer that triggers the best interest obligation consistent with
precedent under the anti-fraud provisions of the federal securities
laws as applied to broker-dealers, and with how the term has been
applied under the rules of self-regulatory organizations
(``SROs'').\176\ Several commenters supported this approach, and
specifically agreed with following the existing facts and circumstances
approach as understood under federal securities laws and SRO
rules.\177\
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\176\ See Proposing Release at 21592-21595. In this regard,
Regulation Best Interest does not extend beyond a particular
recommendation, for example, by imposing a general broker-dealer
duty to monitor a customer's account or by applying the duty to
unsolicited orders.
\177\ See, e.g., AXA Letter; SIFMA August 2018 Letter; IPA
Letter; Putnam Letter; FSI August 2018 Letter; Cetera August 2018
Letter.
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Commenters sought additional clarity regarding the scope of a
recommendation and in particular whether certain activities or
communications would constitute recommendations, and requested that the
Commission incorporate or specifically identify exceptions or
exclusions such as the exceptions recognized in FINRA Rule 2111.03
(Suitability) or acknowledged by the DOL.\178\ Some commenters also
sought an explicit carve out or confirmation that certain
communications, such as general education materials, general retirement
planning materials, or general retirement communications, including
``pure distribution recommendations,'' are not ``recommendations''
subject to Regulation Best Interest.\179\
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\178\ See, e.g., Prudential Letter; Transamerica August 2018
Letter; SPARK Letter; see also FINRA Rule 2111.03 (excluding the
following communications from the coverage of Rule 2111 as long as
they do not include (standing alone or in combination with other
communications) a recommendation of a particular security or
securities: (a) General financial and investment information,
including: (i) Basic investment concepts, such as risk and return,
diversification, dollar cost averaging, compounded return, and tax
deferred investment, (ii) historic differences in the return of
asset classes (e.g., equities, bonds, or cash) based on standard
market indices, (iii) effects of inflation, (iv) estimates of future
retirement income needs, and (v) assessment of a customer's
investment profile; (b) Descriptive information about an employer-
sponsored retirement or benefit plan, participation in the plan, the
benefits of plan participation, and the investment options available
under the plan; (c) Asset allocation models that are: (i) Based on
generally accepted investment theory, (ii) accompanied by
disclosures of all material facts and assumptions that may affect a
reasonable investor's assessment of the asset allocation model or
any report generated by such model, and (iii) in compliance with
Rule 2214 (Requirements for the Use of Investment Analysis Tools) if
the asset allocation model is an ``investment analysis tool''
covered by Rule 2214; and (d) Interactive investment materials that
incorporate the above).
The DOL took a similar approach, excluding from the term
``recommendation,'' among other things, general communications and
investment education (including plan information, general financial,
investment and retirement information, asset allocation models and
interactive investment materials). See DOL Interpretative Bulletin
96-1; Participant Investment Education, 29 CFR 2509.96-1, 61 FR
29588 (Jun. 11, 1996) (IB 96-1). See also DOL, Definition of the
Term ``Fiduciary''; Conflict of Interest Rule--Retirement Investment
Advice, 81 FR 20945, 20975 (Apr. 8, 2016) (noting that the now
vacated DOL Fiduciary Rule would have carved out investment
education from the definition of investment advice, incorporating
much of IB 96-1).
\179\ See SPARK Letter; NAGDCA Letter. Similarly, communications
regarding participation in a plan and communications to make or
increase plan contributions, without more, would generally not come
within ``recommendation.''
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The treatment of certain communications as ``education'' rather
than ``recommendations'' is well understood by broker-dealers. We
generally view the following types of communications as not being
recommendations of any securities transaction or investment strategy
involving securities as long as they do not include, standing alone or
in combination with other communications, a recommendation of a
particular security or securities or particular investment strategy
involving securities: \180\
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\180\ This concept also applies to investment strategies. See
FINRA Regulatory Notice 11-25, Know Your Customer and Suitability--
New Implementation Date for and Additional Guidance on the
Consolidated FINRA Rules Governing Know-Your-Customer and
Suitability Obligations (May 2011) at FAQ 9 (``It is important to
note, however, that the suitability rule would not apply to a firm's
explanation of a strategy falling outside the safe-harbor provision
if a reasonable person would not view the communication as a
recommendation. Accordingly, the suitability rule would cover a
firm's recommendation that a customer purchase securities using
margin, whereas the rule generally would not cover a firm's brochure
that simply explains the risks and benefits of margin without
suggesting that the customer take action.'').
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General financial and investment information, including:
[cir] Basic investment concepts, such as risk and return,
diversification, dollar cost averaging, compounded return, and tax
deferred investment,
[cir] historic differences in the return of asset classes (e.g.,
equities, bonds, or cash) based on standard market indices,
[cir] effects of inflation,
[cir] estimates of future retirement income needs, and
[cir] assessment of a customer's investment profile;
Descriptive information about an employer-sponsored
retirement or benefit plan, participation in the plan, the benefits of
plan participation, and the investment options available under the
plan; \181\
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\181\ While this descriptive information would be treated as
``education'' rather than a ``recommendation,'' we caution broker-
dealers to ensure that communications by their associated persons
intended as ``education'' do not cross the line into
``recommendations.'' See FINRA Regulatory Notice 13-45.
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[[Page 33338]]
Asset allocation models that are:
[cir] Based on generally accepted investment theory,
[cir] accompanied by disclosures of all material facts and
assumptions that may affect a reasonable investor's assessment of the
asset allocation model or any report generated by such model, and
[cir] in compliance with FINRA Rule 2214 (Requirements for the Use
of Investment Analysis Tools) if the asset allocation model is an
``investment analysis tool'' covered by FINRA Rule 2214; \182\ and
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\182\ In this regard, as an allocation recommendation becomes
narrower or more specific, the recommendation gets closer to
becoming a recommendation of particular securities and, thus,
subject to the suitability rule. See FINRA Regulatory Notice 12-25
at FAQ 8.
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Interactive investment materials that incorporate the
above.
Thus, for example, a general conversation about retirement
planning, such as providing a company's retirement plan options to a
retail customer, would not, by itself, rise to the level of a
recommendation. Similarly, where a broker-dealer informs a retail
customer that he or she needs to take a required minimum distribution
under the Internal Revenue Code, we would not interpret such
communication, by itself, to rise to the level of a recommendation.
Such a communication would be considered investment education or
descriptive information, provided it does not involve, for example, a
recommendation regarding specific securities to be sold or a
recommendation regarding specific securities to be purchased with the
proceeds of any sale.\183\ We agree with commenters that Regulation
Best Interest should not stifle investment education as a means to
encourage financial wellness, or otherwise restrict broker-dealers from
disseminating information about, for example, retirement plans, and the
approach we are taking to what is or is not considered a
``recommendation'' achieves this goal.\184\
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\183\ See, e.g., SPARK Letter (asking for confirmation that
``pure `distribution recommendations' involving retirement accounts,
such as those required under Internal Revenue Code section
401(a)(9), are not a `recommendation of any securities transaction
or investment strategy involving securities.' ''). However,
informing a retail customer about a required minimum distribution
may become a recommendation where a broker-dealer includes (standing
alone or in combination with other communications) a recommendation
of, or regarding, a particular security or securities or an
investment strategy involving securities. See FINRA Rule 2111
(Suitability) FAQ.
\184\ See SPARK Letter (suggesting expressly excluding
beneficial conversations about retirement savings and ``ensuring
that Regulation Best Interest does not discourage broker-dealers in
any way from having these important conversations with retirement
investors''); see also Transamerica August 2018 Letter (suggesting
the exclusion of various conversations designed to facilitate
retirement savings).
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b. Interpretation of Any Securities Transaction or Investment Strategy
Involving Securities
As proposed, Regulation Best Interest would apply to
recommendations of ``any securities transaction'' (purchase, sale, and
exchange) and any ``investment strategy'' involving securities
(including explicit recommendations to hold a security or regarding the
manner in which it is to be purchased or sold). In addition, the
Proposing Release stated that securities transactions or investment
strategies involving securities might also include recommendations to
roll over or transfer assets from one type of account to another, such
as recommendations to roll over or transfer assets from a retirement
plan.\185\ Finally, although we did not propose to cover account type
recommendations generally, we noted that evaluating the appropriateness
of the type of account is an issue that relates to both broker-dealers
and investment advisers, and requested comment on whether and how we
should address this type of recommendation.
---------------------------------------------------------------------------
\185\ See Proposing Release at 21595.
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In response to the Proposing Release, several commenters supported
the Commission's approach; however, several commenters also requested
modifications or clarifications regarding products or strategies
covered under Regulation Best Interest. For example, a majority of the
IAC and numerous commenters highlighted the conflicts of interest
associated with account type recommendations, and urged the Commission
to apply Regulation Best Interest to account type recommendations
generally, and to IRA rollovers.\186\ Relatedly, several commenters
sought clarity regarding whether and when a rollover or account type
recommendation would be a ``recommendation'' under Regulation Best
Interest.\187\
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\186\ See, e.g., IAC 2018 Recommendation (supporting the
``expan[sion] of the best interest obligation to cover rollover
recommendations and recommendations by dual registrant firms
regarding account types''); see also NASAA August 2018 Letter; SPARK
Letter; Financial Engines Letter; Cetera August 2018 Letter; AFL-CIO
April 2019 Letter. But see SIFMA August 2018 Letter (viewing
recommendations of an account type as not involving a recommendation
of a securities transaction or investment strategy involving
securities).
\187\ See, e.g., NAGDCA Letter; FPC Letter.
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After careful consideration of comments and feedback, the
Commission has modified the rule text to state that an ``investment
strategy involving securities'' includes ``account recommendations.''
We interpret ``account recommendations'' to include recommendations by
broker-dealers of securities account types generally,\188\ as well as
recommendations to roll over or transfer assets from one type of
account to another (e.g., workplace retirement plan account to an
IRA).\189\ In addition, the Commission is stating its view that ``any
securities transaction or investment strategy involving securities''
not only includes explicit hold recommendations, but also includes
implicit hold recommendations that are the result of agreed-upon
account monitoring between the broker-dealer and retail customer.\190\
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\188\ In the discussion of the Care Obligation in Section
II.C.2, we are also setting forth additional positions regarding the
application of the Care Obligation to account type recommendations,
as well as recommendations to roll over or transfer assets from one
account to another. See also Fiduciary Interpretation (explaining
that ``[a]dvice about account type includes advice about whether to
open or invest through a certain type of account (e.g., a
commission-based brokerage account or a fee-based advisory account)
and advice about whether to roll over assets from one account (e.g.,
a retirement account) into a new or existing account that the
adviser or an affiliate of the adviser manages'').
\189\ A majority of the IAC and numerous commenters expressed
the importance of account rollovers and the need for rollovers to be
covered under Regulation Best Interest. See, e.g., IAC 2018
Recommendation; Financial Engines Letter.
\190\ Several commenters stated that broker-dealers should be
able to contract with retail customers to provide additional
services, such as account monitoring, and that such agreed upon
services should be subject to Regulation Best Interest. See, e.g.,
NAIFA Letter; IAA August 2018 Letter; AFL-CIO April 2019 Letter.
---------------------------------------------------------------------------
Account Recommendations
The Proposing Release indicated that securities transactions or
investment strategies involving securities could include
recommendations to roll over or transfer assets from one type of
account to another, such as recommendations to roll over or transfer
assets in a workplace retirement plan account to an IRA, and requested
comment on whether and how to address account type recommendations.
Several commenters suggested expanding Regulation Best Interest to
explicitly cover rollover recommendations and recommendations by firms
regarding account types. For example, a majority of the IAC explained
that rollover recommendations ``are frequently provided at a critical
juncture in an investor's life--retirement--and are often irrevocable
decisions,'' and further noted that ``[d]ecisions about which type of
account to open have the
[[Page 33339]]
potential to greatly affect [retail customers'] costs'' and that both
rollovers and account type recommendations can ``have substantial
potential long-term impacts on investors.'' \191\ Another commenter
noted that ``[r]etirees have no practical ability to recoup lost
spending power by returning to work and setting aside additional
retirement savings, so they are particularly vulnerable to the adverse
consequences of poor advice and high expenses.'' \192\ Finally, a
majority of the IAC and several commenters noted that broker-dealers
and investment advisers alike have a strong economic incentive to
recommend investors roll over plan assets into an IRA or otherwise
transfer assets to open an account with the broker-dealer or investment
adviser.\193\
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\191\ IAC 2018 Recommendation. See also Letter from Brian H.
Graff, Executive Director and CEO, Craig P. Hoffman, General
Counsel, Doug Fisher, Director of Retirement Policy, American
Retirement Association (``ARA'') (Dec. 13, 2018) (``ARA December
2018 Letter''); Transamerica August 2018 Letter.
\192\ Fiduciary Benchmarks Letter.
\193\ See, e.g., IAC 2018 Recommendation; NASAA August 2018
Letter; Fiduciary Benchmarks Letter.
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After consideration of comments received, including concerns
expressed about the conflicts associated with recommendations of
account types, IRA rollovers and retirement advice more broadly, it is
our view that Regulation Best Interest should apply broadly to
recommendations of securities transactions and investment strategies
involving securities. Accordingly, the Commission is including in the
rule text account recommendations as recommendations that will be
covered by Regulation Best. ``Account recommendations'' include
recommendations of securities account types generally (e.g., to open an
IRA or other brokerage account), as well as recommendations to roll
over or transfer assets from one type of account to another (e.g., a
workplace retirement plan account to an IRA).
Although account recommendations, including recommendations of a
securities account type generally, as well as recommendations to roll
over assets from a workplace retirement plan account to an IRA or to
open an IRA held at the broker-dealer, will almost always involve a
``securities transaction'' (such as a securities purchase, sale, or
exchange), and thus would generally be subject to Regulation Best
Interest, we are modifying the rule text to provide that such
recommendations are ``investment strategies involving securities'' for
purposes of Regulation Best Interest, regardless of whether they are
tied to a specific securities transaction.\194\ Existing broker-dealer
regulation and guidance stresses that the term ``investment strategy''
is to be interpreted broadly, and would include, among others,
recommendations generally to use a bond ladder, day trading,
``liquefied home equity,'' or margin strategy involving securities,
irrespective of whether the recommendations mention particular
securities.\195\ This approach appropriately recognizes that customers
may rely on firms' and associated persons' investment expertise and
knowledge, and therefore the broker-dealer should be responsible for
such recommendations, regardless of whether those recommendations
result in transactions or generate transaction-based compensation.\196\
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\194\ A recommendation that a retail customer roll over or
transfer assets to an IRA held at the broker-dealer, or open an IRA
or another securities account with a broker-dealer, presumes that
the recommendation would involve transactions in securities, even if
the rollover or account recommendation does not result in
transactions or transaction-based compensation.
\195\ See FINRA Rule 2111.03; FINRA Regulatory Notice 12-25 at
Q7.
\196\ See FINRA Regulatory Notice 11-02, Know Your Customer and
Suitability--SEC Approves Consolidated FINRA Rules Governing Know-
Your-Customer and Suitability Obligations (Jan. 2011).
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Account recommendations, including recommendations of securities
account types generally (e.g., to open an IRA or other brokerage
account), and recommendations to roll over or transfer assets into an
IRA or another securities account, are consistent with the types of
recommendations that have been treated as investment strategies under
existing suitability rules.\197\ Specifically, like other investment
strategies, account recommendations are recommendations of an approach
or method (i.e., a ``strategy'') for how a retail customer should
engage in transactions in securities, involve conflicts of interest,
and can have long-term effects on investors' costs and returns from
their investments.\198\ In addition, we believe retail customers rely
on broker-dealers' and associated persons' investment expertise and
knowledge with respect to such recommendations. As a result, such
recommendations must be made consistent with the retail customer's
objectives and needs (i.e., investment profile), irrespective of
whether those recommendations are tied to a specific securities
transaction. Consistent with a majority of the IAC's and other
commenters' suggestions, we are modifying the rule text to state that
the term ``investment strategy involving securities'' includes
``account recommendations,'' which we interpret to include
recommendations of securities account types generally, as well as
recommendations to roll over or transfer assets.\199\
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\197\ See supra footnotes 172 and 173.
\198\ See Capital Group Letter; see also IAC 2018
Recommendation; NASAA August 2018 Letter.
\199\ See, e.g., IAC 2018 Recommendation; Capital Group Letter
(``Choosing between a brokerage and an advisory account is an
incredibly impactful decision for investors. It is very important
that these recommendations be made in the best interest of the
retail [customer].'').
---------------------------------------------------------------------------
Thus, such account recommendations will be subject to Regulation
Best Interest even if there is not a recommendation of a securities
transaction. Although we proposed only covering account type
recommendations that are tied to securities transactions, and not
account type recommendations generally, we agree with commenters and a
majority of the IAC that consistent with other investment strategies
involving securities, securities account type recommendations should be
covered under Regulation Best Interest regardless of whether those
recommendations result in transactions or generate transaction-based
compensation.\200\ In addition, as discussed in the Fiduciary
Interpretation, investment advisers' fiduciary duty applies to advice
to clients about account types, which satisfies the concerns about
parity set forth in the Proposing Release and protects retail customers
of broker-dealers and retail clients of investment advisers alike.\201\
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\200\ See, e.g., IAC 2018 Recommendation; NASAA August 2018
Letter.
\201\ See Fiduciary Interpretation.
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Where a financial professional who is dually registered (i.e., an
associated person of a broker-dealer and a supervised person of an
investment adviser (regardless of whether the professional works for a
dual-registrant, affiliated firm, or unaffiliated firm)) is making an
account recommendation to a retail customer,\202\ whether Regulation
Best Interest or the Advisers Act will apply will depend on the
capacity in which the financial professional making
[[Page 33340]]
the recommendation is acting.\203\ As discussed further in the Care
Obligation, if the individual is acting as a broker-dealer or
associated person thereof, he or she must comply with Regulation Best
Interest and will need to take into consideration all types of accounts
offered by the financial professional (i.e., both brokerage and
advisory accounts) when making the recommendation of an account that is
in the retail customer's best interest.
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\202\ As discussed in more detail below in Section II.B.3.b,
Regulation Best Interest applies to a retail customer who receives a
recommendation and uses the recommendation. Among other things, we
interpret a retail customer to use a recommendation when: (1) The
retail customer opens a brokerage account with the broker-dealer,
regardless of whether the broker-dealer receives compensation; (2)
the retail customer has an existing account with the broker-dealer
and receives a recommendation from the broker-dealer, regardless of
whether the broker-dealer receives or will receive compensation,
directly or indirectly, as a result of that recommendation; or (3)
the broker-dealer receives or will receive compensation, directly or
indirectly as a result of that recommendation, even if that retail
customer does not have an account at the firm.
\203\ See Section II.B.3.d, below for discussion of factors the
Commission will consider in determining capacity. See also Fiduciary
Interpretation at footnotes 42-44 and accompanying text. As
discussed in the Fiduciary Interpretation, while advice to
prospective clients about these matters is subject to the antifraud
provisions under section 206 of the Advisers Act, the adviser must
also satisfy its fiduciary duty with respect to any such advice
(e.g., regarding account type) once a prospective client becomes a
client. Thus, at the point in time at which the prospective client
becomes a client of the investment adviser (e.g., at account
opening), the fiduciary duty applies. Id.
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In the case of an account recommendation by a financial
professional who is only registered as an associated person of broker-
dealer (regardless of whether that broker-dealer entity is a dual-
registrant or affiliated with an investment adviser), Regulation Best
Interest will apply to the recommendation. Further, the associated
person can only recommend a brokerage account that the broker-dealer
offers when the associated person has a reasonable basis to believe
that the recommended brokerage account is in the best interest of the
retail customer and the broker-dealer otherwise complies with
Regulation Best Interest.
Regulation Best Interest would apply to account recommendations by
the dual-registrant firm, and consistent with the Conflict of Interest
Obligation, the firm would need to, among other things, establish,
maintain and enforce policies and procedures to identify, disclose, and
mitigate, any incentives for an associated person of the broker-dealer
to place the interest of the firm or the associated person ahead of the
interests of the retail customer.
In the discussion of the Care Obligation below, we discuss how a
broker-dealer and associated persons of a broker-dealer can make
recommendations of securities account types, including recommendations
to open an IRA or to roll over assets into an IRA, in the best interest
of the retail customer.
Hold Recommendations
The Proposing Release stated that Regulation Best Interest would
apply to any securities transaction or investment strategy involving
securities, including explicit recommendations to hold a security or
regarding the manner in which it is to be purchased or sold to retail
customers.\204\ The Proposing Release also recognized that broker-
dealers may agree with a retail customer by contract to take on
additional obligations beyond those imposed by Regulation Best
Interest, for example, by agreeing with a retail customer to provide
periodic or ongoing services, such as ongoing monitoring of the retail
customer's investments for purposes of recommending changes in
investments.\205\ To the extent that a broker-dealer takes on such
additional obligations, the Proposing Release indicated that Regulation
Best Interest would apply to any recommendations about securities or
investment strategies involving securities made to retail customers
resulting from such services.
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\204\ Proposing Release at 21593-21595.
\205\ Id. We also asked whether broker-dealers who provide
ongoing monitoring should be considered investment advisers. Id. at
21592.
---------------------------------------------------------------------------
Several commenters agreed that broker-dealers should be able to
contract with retail customers for additional services and be able to
expand the relationship on their own terms, while other commenters
recommended that a duty to monitor apply to broker-dealers depending on
the facts and circumstances.\206\ Other commenters suggested that the
Commission not impose a duty to monitor brokerage accounts.\207\
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\206\ See, e.g., NAIFA Letter (``Additionally, while the best
interest standard applies to each recommendation and may not be
waived or modified by contract as it applies to those
recommendations, it should not be interpreted to create obligations
with respect to other, expanded services (e.g., ongoing research and
monitoring services, regular in-person meetings, etc.). Again,
however, advisors and consumers may agree to expand the relationship
in these ways on their own terms.''); see also CFA August 2018
Letter; Better Markets August 2018 Letter (recommending the
Commission establish a duty to monitor depending on the facts and
circumstances); AFL-CIO April 2019 Letter.
We note that additional commenters maintained that if broker-
dealers agree with retail customers to provide ongoing monitoring
for purposes of recommending changes in investments, they should be
considered investment advisers. See NASAA August 2018 Letter; FPC
Letter. We have addressed these comments in the context of the
Solely Incidental Interpretation. See Solely Incidental
Interpretation.
\207\ See IAA August 2018 Letter.
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We are confirming that, consistent with existing broker-dealer
regulation, Regulation Best Interest will apply to explicit
recommendations to hold a security or securities.\208\ We are also
confirming that Regulation Best Interest does not impose a duty to
monitor a retail customer's account. We agree, however, with commenters
that Regulation Best Interest should apply to any recommendations that
result from the account monitoring services that a broker-dealer agrees
to provide.\209\ We believe that any monitoring service agreed to by
the broker-dealer, the scope and frequency of which would be required
to be disclosed pursuant to the Disclosure Obligation, would be covered
by Regulation Best Interest, as these activities will result in a
recommendation to purchase, sell, or hold a security, or the manner in
which to purchase, sell, or hold a security, at each time the agreed-
upon monitoring occurs.\210\ Thus, by agreeing to perform account
monitoring services, the broker-dealer is taking on an obligation to
review and make recommendations with respect to that account (e.g., to
buy, sell or hold) on that specified, periodic basis.\211\ For example,
if a broker-dealer agrees to monitor the retail customer's account on a
quarterly basis, the quarterly review and each resulting recommendation
to purchase, sell, or hold, will be a recommendation subject to
Regulation Best Interest. This is the case even in instances where the
broker-dealer does not communicate any recommendation to the retail
customer. We believe that such an ``implicit'' recommendation to hold
in this context should be covered under Regulation Best Interest in
addition to ``explicit'' recommendations to hold.\212\
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\208\ See FINRA Regulatory Notice 12-25.
\209\ See NAIFA Letter; IAA August 2018 Letter.
\210\ In agreeing to provide any account monitoring services,
broker-dealers need to consider whether the monitoring services fit
within the broker-dealer exclusion from the Advisers Act. See Solely
Incidental Interpretation.
\211\ The broker-dealer would also be required to disclose the
existence, scope, and frequency of such account monitoring services
pursuant to the Disclosure Obligation. To avoid ambiguity over
whether or when an implicit hold recommendation has been made, this
disclosure should identify with specificity when the agreed upon
monitoring will occur.
\212\ See FINRA Rule 2111.03 (noting ``[t]he phrase `investment
strategy involving a security or securities' used in this Rule is to
be interpreted broadly and would include, among other things, an
explicit recommendation to hold a security or securities.''); see
also NASAA August 2018 Letter.
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This position differs from FINRA guidance, which generally states
that the FINRA suitability rule does not cover an implicit
recommendation to hold.\213\ We believe that ``implicit'' hold
[[Page 33341]]
recommendations in this context, where the broker-dealer agrees to
provide specified account monitoring services, are similar to explicit
hold recommendations that are considered ``investment strategies''
because they would constitute the type of recommendations that retail
customers would be expected to rely upon and would be a ``call to
action'' in the sense of a recommendation that the customer stay the
course.\214\ We believe that, in this context, silence is tantamount to
an explicit recommendation to hold, and should be viewed as a
recommendation to hold the securities for purposes of Regulation Best
Interest.\215\ Our interpretation that the term ``investment strategy
involving securities'' includes implicit recommendations to hold that
result from an agreement to monitor, at the time the agreed-upon
monitoring occurs, is generally consistent with the treatment of
similar broker-dealer communications as ``investment strategies,'' and
applies the Regulation Best Interest protections to retail customers
relying on a broker-dealer's agreement to monitor the customer's
account.\216\
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\213\ FINRA Regulatory Notice 11-25 at Q7 (``The rule, for
instance, would not apply where an associated person remains silent
regarding, or refrains from recommending the sale of, securities
held in an account. That is true regardless of whether the
associated person previously recommended the purchase of the
securities, the customer purchased them without a recommendation, or
the customer transferred them into the account from another firm
where the same or a different associated person had handled the
account.''). See also id. at footnote 21 (``To the extent that a
customer account at a broker-dealer can be discretionary under
applicable federal securities laws, the suitability rule generally
would not apply where a firm refrains from selling a security. The
rule states that it applies to explicit recommendations to hold.
Unless the facts indicate that an associated person's failure to
sell securities in a discretionary account was intended as or
tantamount to an explicit recommendation to hold, FINRA would not
view the associated person's inaction or silence in such
circumstances as a recommendation to hold the securities for
purposes of the suitability rule.'').
\214\ See FINRA Regulatory Notice 11-25 at Q7 (``The rule would
apply, for example, when an associated person meets with a customer
during a quarterly or annual investment review and explicitly
advises the customer not to sell any securities in or make any
changes to the account or portfolio.''). While the FINRA guidance
goes on to state that the rule generally would not cover an implicit
recommendation to hold, it does not address the particular scenario
in which a broker-dealer agrees to monitor an account (such as a
quarterly review) and discloses the terms of that monitoring, and
then during that review is silent on whether the customer should
make any changes. Id.; see also FINRA Regulatory Notice 12-25 at Q3
and accompanying footnotes.
\215\ See FINRA Regulatory Notice 11-25 at footnote 21.
\216\ Our interpretation is generally consistent with a majority
of the IAC's and other commenters' views regarding application of
Regulation Best Interest to implicit hold recommendations in the
context of agreed-upon account monitoring services. See IAC 2018
Recommendation (``We believe the best interest standard should be
applied to the broker-dealer's monitoring of the customer account,
where brokers provide ongoing services to the account. In essence,
this would apply the best interest standard to the implicit ``no
recommendation'' recommendation that a broker makes when reviewing
the account and recommends no change.''); NAIFA Letter (asserting
broker-dealers should be free to agree to, and define the nature of,
any ongoing relationship via contract, such as including monitoring
services); AFL-CIO April 2019 Letter.
---------------------------------------------------------------------------
Although for purposes of Regulation Best Interest, implicit hold
recommendations will be considered a recommendation of ``any securities
transaction or investment strategy regarding securities'' where a
broker-dealer has agreed to provide account monitoring services, we are
not otherwise changing the treatment of implicit hold recommendations
in other contexts. In other words, unless the broker-dealer has agreed
to provide account monitoring services as described, Regulation Best
Interest would only apply to explicit--and not to implicit--hold
recommendations regarding security positions in an account.\217\ This
is consistent with the fact that Regulation Best Interest would not
impose a duty to monitor customer accounts.\218\
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\217\ FINRA Notice to Members 11-25 at Q7.
\218\ Our approach does not require broker-dealers to undertake
account monitoring, unless they choose to do so. See Solely
Incidental Interpretation.
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Finally, although certain commenters stated that account monitoring
services should only be performed by investment advisers,\219\ we
reiterate that Regulation Best Interest does not change the scope of
account monitoring that broker-dealers may agree to provide, nor does
it change the scope of activities that would come within the ``solely
incidental'' prong of the broker-dealer exclusion to the definition of
``investment adviser'' in the Advisers Act. We recognize that a broker-
dealer may voluntarily, and without any agreement with the customer,
review the holdings in a retail customer's account for the purpose of
determining whether to provide a recommendation to the customer. We
view this voluntary review--and any subsequent recommendation to the
customer--as in connection with and reasonably related to the broker-
dealer's primary business of effecting securities transactions.\220\
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\219\ See, e.g., NASAA August 2018 Letter; FPC Letter.
\220\ See Solely Incidental Interpretation. Absent an agreement
with the customer (which would be required to be disclosed pursuant
to the Disclosure Obligation), we do not consider this voluntary
review to be ``account monitoring'' nor would it in itself create an
obligation under Regulation Best Interest, provided of course that
any recommendation made to the customer as a result of any such
voluntary review would be subject to Regulation Best Interest.
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Recommendations Involving Retirement Accounts
Furthermore, based on comments, our position is that
recommendations to retail customers regarding retirement accounts would
also be subject to Regulation Best Interest where they involve
securities transactions or investment strategies involving securities.
We agree with commenters that recommendations to retail customers to
take distributions from proceeds of specific securities or to take in-
service loans from an employer-sponsored plan are recommendations of a
securities transaction, as they would involve a recommendation to sell
a security.\221\ However, while such recommendations to take plan
distributions are ``recommendations'' and thereby subject to Regulation
Best Interest, we reiterate that general communications by broker-
dealers relating to distributions in the context of a required minimum
distribution or education regarding a plan's options would not, by
themselves, constitute recommendations that would be subject to
Regulation Best Interest.\222\
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\221\ See supra footnotes 185-189 and accompanying text. See,
e.g., NASAA August 2018 Letter; Fiduciary Benchmarks Letter; IAC
2018 Recommendation.
\222\ For example, where a broker-dealer informs a retail
customer that based on age and other relevant factors, he or she
needs to take a required minimum distribution, but does not
otherwise recommend specifics, such as what securities to sell, or
where to place the proceeds, the communication would generally not
be a ``recommendation'' subject to Regulation Best Interest. As with
other communications subject to broker-dealer regulation, an inquiry
of whether a ``recommendation'' was made would depend on the facts
and circumstances relating to the communication, as discussed more
fully above. See supra Section II.B.2.a.
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3. Retail Customer
We proposed to define retail customer as: ``a person, or the legal
representative of such person, who: (1) Receives a recommendation of
any securities transaction or investment strategy involving securities
from a broker, dealer, or a natural person who is an associated person
of a broker or dealer, and (2) uses the recommendation primarily for
personal, family or household purposes.'' \223\ The definition was
generally intended to track the definition of ``retail customer'' under
Section 913(a) of the Dodd-Frank Act with some differences, as
described in the Proposing Release.\224\
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\223\ As we stated in the Proposing Release, we believe that
broker-dealers would generally be required to obtain sufficient
facts about a customer to determine an account's primary purpose for
purposes of Regulation Best Interest. See Proposing Release at
21595.
\224\ See Proposing Release at Section II.C.4. Section 913(a)
defines ``retail customer'' as a natural person, or the legal
representative of such natural person who: (1) Receives personalized
investment advice about securities from a broker or dealer or
investment adviser; and (2) uses such advice primarily for personal,
family, or household purposes.
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In proposing the definition, we intended to exclude recommendations
[[Page 33342]]
related to commercial or business purposes but for the definition to
remain sufficiently broad to capture recommendations related to the
various reasons retail customers may invest, such as saving for
retirement, education expenses and other savings purposes. As such, the
proposed definition applied to any persons who receive a recommendation
from a broker or dealer or a natural person who is an associated person
of a broker or dealer, provided that the recommendation is primarily
for personal, family or household purposes. In the case of dual-
registrants, the proposed definition was intended to apply only to
recommendations made by broker-dealers in their brokerage capacity,
based on a facts and circumstances analysis and consistent with
existing guidance.\225\ The proposed definition differed from the
definition of ``retail investor'' in the Relationship Summary Proposal
as the Relationship Summary was intended for a broader range of
investors.\226\
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\225\ Id.
\226\ Id.
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The Commission requested comment on the scope and definition of
retail customer and received a range of comments requesting:
modification of the definition to focus on natural persons;
clarification of the ``personal, family or household purposes''
qualification; harmonization with the definition in Form CRS; and
further guidance surrounding the treatment of dual-registrants. In
consideration of the comments received, the Commission is modifying the
definition of ``retail customer'' to mean a natural person, or the
legal representative of such natural person, who: (A) Receives a
recommendation of any securities transaction or investment strategy
involving securities from a broker, dealer, or a natural person who is
an associated person of a broker or dealer; and (B) uses the
recommendation primarily for personal, family, or household purposes.
The revised definition shifts the focus to natural persons, as
opposed to any persons, but otherwise it is adopted largely as
proposed. However, as discussed below, the Commission is providing
additional interpretations, guidance and clarification regarding: The
interpretation of the ``personal, family, or household purposes''
qualifier; the interaction of this definition with the definition of
``retail investor'' in Form CRS; what it means for a retail customer to
``use'' the recommendation; and the status of dual-registrants.
Furthermore, we are providing guidance on who would be considered to be
the legal representative of a natural person for purposes of this
definition.
a. Focus on Natural Persons and Legal Representatives of Natural
Persons
The Commission proposed to extend the definition of ``retail
customer'' in Regulation Best Interest beyond natural persons to any
persons to cover non-natural persons (e.g., trusts that represent the
assets of a natural person), which the Commission stated it believed
would benefit from the protections of Regulation Best Interest.
Commenters generally suggested that the definition of retail
customer be modified to focus on natural persons.\227\ To that end, a
number of commenters suggested eliminating the ``personal, family or
household purposes'' qualifier from the definition under Dodd-Frank
Section 913.\228\ Many commenters suggested excluding institutional
investors and professional advisers or fiduciaries, including
retirement plan representatives \229\ and family offices,\230\ while a
few stated that non-professional plan fiduciaries should have the same
protections as retail customers.\231\ Many commenters suggested
harmonizing the definition with FINRA's definition,\232\ in particular,
by excluding: (1) Institutional accounts that would be exempted from
certain suitability protections under FINRA Rule 2111 (Suitability)
\233\ or (2) institutional investors as defined in Rule 2210
(Communications with the Public),\234\ which is broader \235\ and would
include, among others, certain workplace retirement plans. Conversely,
a few commenters believed that Regulation Best Interest should apply to
both retail and institutional customers.\236\
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\227\ See, e.g., Cetera August 2018 Letter; Invesco Letter.
\228\ See FPC Letter; SIFMA August 2018 Letter; BlackRock
Letter. Contra ACLI Letter (supporting the provision in Section 913
and positing that Regulation Best Interest appropriately implements
this foundational threshold).
\229\ See, e.g., SIFMA August 2018 Letter; Vanguard Letter;
Prudential Letter; ICI Letter; Fidelity Letter.
\230\ See, e.g., TIAA Letter; SIFMA August 2018 Letter; Letter
from Stuart J. Kaswell, Executive Vice President and Managing
Director, Managed Funds Association, and Jiri Krol, Deputy CEO,
Global Head of Government Affairs, Alternative Investment Management
Association (Aug. 7, 2018) (``Managed Funds Association Letter'').
\231\ ARA August 2018 Letter; CFA August 2018 Letter.
\232\ See, e.g., UBS Letter; Bank of America Letter; Raymond
James Letter; TIAA Letter; Letter from Joseph Giovanniello,
Ladenburg Thalmann Financial Services Inc. (Jul. 30, 2018)
(``Ladenburg Letter'').
\233\ FINRA Rule 2111(b). Institutional accounts include banks,
savings and loan associations, insurance companies, registered
investment companies, state and Federal Registered investment
advisers, and other persons with total assets of at least $50
million.
\234\ FINRA Rule 2210(a)(4). Institutional investors include, in
addition to persons with institutional accounts, government entities
and their subdivisions, employee benefit plans, qualified plans as
defined in Exchange Act Section 3(a)(12)(C), broker-dealers and
registered representatives, and persons acting solely on behalf of
such institutional investors.
\235\ See, e.g., SIFMA August 2018 Letter; TIAA Letter; IPA
Letter.
\236\ NASAA August 2018 Letter, Better Markets August 2018
Letter; FPC Letter. But see Managed Funds Association Letter
(suggesting that sophisticated investors should not be treated as
retail customers).
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In response to comments, we are modifying the definition to focus
on natural persons and their legal representatives, and are clarifying
that we interpret ``legal representatives'' to mean non-professional
legal representatives of a natural person, as we discuss below. We
believe this change and clarification provides more certainty that
institutions and certain professional fiduciaries are not covered for
purposes of Regulation Best Interest. It would also retain, however,
coverage of certain legal entities (i.e., trusts that represent the
assets of a natural person) specifically identified in the Proposing
Release as ``retail customers'' within the scope of Regulation Best
Interest, but would not exclude certain high-net-worth natural persons,
as was suggested by some commenters \237\ to match the current FINRA
exclusion of such natural persons from customer-specific suitability
requirements.\238\
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\237\ See, e.g., Morgan Stanley Letter; FSI August 2018 Letter.
\238\ See FINRA Rule 4512(c), which includes within the
definition of ``institutional account'' any person (whether a
natural person, corporation, partnership, trust or otherwise) with
total assets of at least $50 million. Currently, under FINRA rules,
broker-dealers are exempt from the customer-specific suitability
obligations with respect to these ``institutional accounts'' if
certain conditions are met. FINRA Rule 2111(b).
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While the Commission recognizes commenters' concerns regarding
compliance costs and burdens if the definition of retail customer does
not align with FINRA's exclusion of certain institutional accounts and
institutional investors, we have decided not to align our definition
with FINRA's exclusion because we believe conflicted recommendations
can also result in harm to high net-worth individuals.\239\
[[Page 33343]]
We believe the benefits of Regulation Best Interest justify compliance
costs as these individuals could benefit from the protections included
in Regulation Best Interest regardless of their net worth, which may
not necessarily correlate to a particular level of financial
sophistication.\240\
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\239\ The Commission has brought numerous enforcement actions
against financial professionals engaged in schemes to defraud
certain high net-worth individuals, in particular, professional
athletes. See, e.g. SEC v. Charles A. Banks, IV, Civil Action No.
16-CV-3399-TWT (N.D. Ga. Nov. 2, 2018) (former investment adviser
who fraudulently induced a former professional athlete to invest
$7.5 million in a sports team and apparel merchandise company based
on a series of misrepresentations); SEC v. Ash Narayan, The Ticket
Reserve Inc. a/k/a Forward Market Media, Inc., Richard M. Harmon,
and John A. Kaptrosky, Civil Action No. 16-CV-1417-M (N.D. Tex. May
24, 2016) (investment adviser who misappropriated millions of
dollars from accounts he managed for professional athletes and
invested them in online sports and entertainment ticket business on
whose board he served).
In addition, reports indicate deficiencies in financial literary
among the general population of retail investors. See Federal
Research Division, Library of Congress, Financial Literacy Among
Retail Investors in the United States (Dec. 30, 2011) at 25,
available at https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part2.pdf (``Library of Congress Report'').
\240\ See Primerica Letter (noting challenges in using wealth
and education as proxies for investment sophistication).
In addition, the definition of ``retail customer'' under Section
913(a) of the Dodd-Frank Act did not make a distinction based on net
worth.
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In addition, we view a ``legal representative'' of a natural person
to only cover non-professional legal representatives (e.g., a non-
professional trustee that represents the assets of a natural person and
similar representatives such as executors, conservators, and persons
holding a power of attorney for a natural person),\241\ thereby
excluding certain institutions from Regulation Best Interest's
coverage. In capturing non-professional legal representatives within
the definition of retail customer, we are providing the protections of
Regulation Best Interest to non-professional persons who are acting on
behalf of natural persons but who are not regulated financial services
industry professionals retained by natural persons to exercise
independent professional judgment, such as registered investment
advisers and broker-dealers, corporate fiduciaries (e.g., banks, trust
companies and similar financial institutions) and insurance companies,
and the employees or other regulated representatives of such advisers,
broker-dealers, corporate fiduciaries and insurance companies.\242\ Our
definition is intended to capture natural persons and their legal
representatives who rely directly on the broker-dealer for the
recommendation. Accordingly, such non-professional legal
representatives would not include regulated financial industry
professionals. We believe this responds to commenters who stated that
it should not be necessary to provide the protections of Regulation
Best Interest to regulated professionals.\243\ Importantly, however,
this will not relieve firms or financial professionals retained to
represent the assets of natural persons from their own obligations to
retail customers.\244\
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\241\ A non-professional legal representative is covered
pursuant to this rule even if another person is a trustee or
managing agent of the trust.
\242\ See also Relationship Summary Adopting Release.
\243\ See, e.g., Bank of America Letter; Invesco Letter; Letter
from Bob Grohowski, Senior Legal Counsel, and Jon Siegel, Senior
Legal Counsel, T. Rowe Price (Aug. 10, 2018) (``T. Rowe Letter'');
Oppenheimer Letter; ICI Letter.
\244\ See also Relationship Summary Adopting Release.
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We retained the ``personal, family, or household purposes''
qualifier,\245\ but are providing additional guidance and clarification
on our interpretation of this phrase to address comments received. In
particular, we interpret ``personal, family or household purposes'' to
mean that any recommendation to a natural person for his or her account
would be subject to Regulation Best Interest, other than
recommendations to natural persons seeking these services for
commercial or business purposes. Accordingly, under this
interpretation, ``personal, family or household purposes'' would not
include, for example, an employee seeking services for an employer or
an individual who is seeking services for a small business or on behalf
of another non-natural person entity such as a charitable trust.\246\
As discussed above \247\ and pursuant to the Care Obligation,\248\ we
believe broker-dealers are able to obtain sufficient facts to determine
the purpose for which a recommendation will be used.
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\245\ Regulation Best Interest relies in part on the statutory
authority provided in Section 913 of the Dodd-Frank Act which
includes the statutory definition of ``retail customer.'' See
Section 913(a) of the Dodd-Frank Act.
\246\ As discussed below, to the extent a plan representative
who decides service arrangements for a workplace retirement plan is
a sole proprietor or other self-employed individual who will
participate in the plan, the plan representative will be a retail
customer to the extent that the sole proprietor or self-employed
individual receives recommendations directly from a broker-dealer
primarily for personal, family or household purposes.
\247\ See supra footnote 223 and accompanying text.
\248\ Pursuant to the Care Obligation, a broker-dealer is
required to ascertain the customer's investment profile which
considers, among other things, financial situation and needs and
investment objectives, in evaluating a recommendation and whether it
is in a retail customer's best interest.
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We also confirm that ``personal, family or household purposes''
would cover retirement accounts, as retirement savings is a personal,
household or family purpose. Accordingly, the definition of retail
customer will include a natural person receiving recommendations \249\
for his or her own retirement account, including but not limited to
IRAs and individual accounts in workplace retirement plans, such as
401(k) plans and other tax-favored retirement plans.\250\ For example,
plan participants receiving recommendations about whether to take a
distribution from a 401(k) plan or other workplace retirement plan and
how to invest that distribution would be covered as retail customers.
Similarly, a plan participant receiving recommendations for the
participant's individual account held in a 401(k) plan or other
workplace retirement plan would be a retail customer for purposes of
Regulation Best Interest.\251\
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\249\ See Section II.C.2 (describing what constitutes a
``recommendation'' for purposes of Regulation Best Interest).
\250\ Such IRAs include, for example, individual retirement
accounts and individual retirement annuities described by Internal
Revenue Code section 408(a) and (b), ``simplified employee
pensions'' (SEPs) described by Code section 408(k), and simple
retirement accounts described by Code section 408(p) (SIMPLE IRAs).
In response to commenters, we also clarify that workplace retirement
plans include any arrangement available at a workplace that provides
retirement benefits or allows saving for retirement, including, for
example, any 401(k) plans or other plan that meet requirements for
qualification under Code section 401(a), deferred compensation plans
of state and local governments and tax-exempt organizations
described by Code section 457, and annuity contracts and custodial
accounts described by Code section 403(b). Likewise, the definition
of retail investor includes natural persons seeking brokerage or
advisory services for other tax-favored savings arrangements such as
an Archer Medical Savings Account described by Code section 220(d),
a Health Savings Accounts described by Code section 223(d) and any
similar tax-favored health plan saving arrangement, a Coverdell
education savings account described by Code section 530 and a
qualified tuition program or ``529 plan'' established pursuant to
Code section 529.
\251\ For example, we understand that, although not common, some
401(k) plans and other individual account plans provide participants
total discretion to choose a broker-dealer to provide services for
their individual plan account. See, e.g., 29 CFR 2550. 404c-1(f),
Example 9.
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The Commission acknowledges concerns from some commenters that
workplace retirement plans and their representatives (e.g., plan
sponsors, trustees, other fiduciaries) and service providers should be
included in the definition of retail customer.\252\ However, we
understand that plan representatives of workplace retirement plans
typically are not receiving recommendations for their own account for
personal, family or household purposes when they engage a broker-dealer
to provide services to a retirement plan established, maintained,
[[Page 33344]]
and operated by an employer to provide pension or retirement savings
benefits to employees; and further, as a legal representative of a plan
participant, must comply with DOL rules.\253\ As such, the Commission
does not believe that workplace retirement plans or their
representatives and service providers generally fall within the
definition of retail customer for purposes of Regulation Best Interest
because the workplace retirement plan is not a natural person, and
therefore the workplace retirement plan representatives are not a non-
professional representative of a natural person that is receiving a
recommendation directly from a broker-dealer for ``personal, family, or
household purposes.'' \254\
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\252\ See, e.g., ARA December 2018 Letter; FPC Letter. But see
Empower Letter (``It would be helpful if the SEC could confirm that
the definition of `retail customer' under RBI does not include
advice to managers of retirement plans or to their fiduciaries or
representatives.'').
\253\ It is our understanding that the investment
responsibilities of plan representatives typically include, among
other things, selecting and monitoring a menu of plan investment
options and designating and monitoring ``default'' investments for
investing account balances of participants who do not make their own
investment elections, and that plan representatives typically make
these investment selections for a workforce with diverse investment
profiles. See ARA December 2018 Letter (describing obligations of
plan fiduciaries selecting an investment menu and qualified default
investment alternatives); Empower Letter (describing plan fiduciary
obligations to select investment menus). We also understand that
plan representatives may receive brokerage and advice services for
plans together with or complimentary with, other services supporting
the plan's establishment, maintenance and operation, such as plan
design, recordkeeping and other administrative services. See, e.g.,
Groom Letter (describing business models of firms offering brokerage
and advice services together with other services); SPARK Letter
(same). In this context, a plan representative would not be
receiving recommendations from a broker-dealer for his or her own
account and considerations material to the plan representative's
investment decisions differ from a situation in which a retail
customer receives a recommendation from a broker-dealer for his or
her own account.
Further, we note that DOL has rules currently in place (not
affected by the Fifth Circuit's decision vacating the DOL Fiduciary
Rule) that address how plan representatives operate participant-
directed plans and select investment menus for such plans, see 29
CFR 2550.404c-1, what actions, including disclosures, plan
representatives must take to be able to raise a defense or claim for
investment losses by a participant or beneficiaries, see 29 CFR
2550.404c-5, and also generally require broker-dealers making
investment alternatives available for a participant-directed plan to
disclose in writing (among other things) all direct and indirect
compensation received in connection with providing plan services.
See 29 CFR 2550.408b-2(c). See also Form 5500, Schedule C, requiring
after-the-fact reporting by certain plans of information regarding
direct and indirect compensation received by, among others, broker-
dealers and investment advisers, in connection with services
rendered or their position with the plan.
Accordingly, we agree with those commenters who recommended that
plan representatives should not be included in the definition of
retail customer. See Empower Letter; Groom Letter; Letter from Nora
M. Everett, President, Retirement and Income Solutions, Principal
Financial Group (Aug. 7, 2018) (``Principal Letter''); SPARK Letter;
T. Rowe Price Letter; Transamerica August 2018 Letter.
\254\ Although workplace retirement plans are not generally
covered by the definition of retail customer in by Regulation Best
Interest, based on preliminary discussions with DOL staff, we
understand that the DOL is considering regulatory options in light
of the Fifth Circuit's decision vacating the DOL Fiduciary Rule,
including the types of protections available to such workplace
retirement plans and their representatives. Department of Labor
Regulatory Agenda, Fiduciary Rule and Prohibited Transaction
Exemptions, Fall 2018, available at https://www.reginfo.gov/public/do/eAgendaViewRule?pubId=201810&RIN=1210-AB82.
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We note, however, that some plan representatives may participate
under their employer's workplace plan, for example, in the case of a
workplace IRA or other workplace retirement plan that is established
and maintained by a sole proprietor or other self-employed individual
that includes one or more employees in addition to the plan
representative. To the extent that a plan representative who decides
service arrangements for a workplace retirement plan is a sole
proprietor or other self-employed individual who will participate in
the plan, the plan representative would be a retail customer for
purposes of Regulation Best Interest to the extent the sole proprietor
or self-employed individual receives recommendations directly from a
broker-dealer primarily for personal, family or household purposes.
b. Retail Customer Use of the Recommendation
In the Proposing Release, the Commission did not specifically
address whether recommendations subject to Regulation Best Interest
needed to be for compensation, but did state that the proposed
definition of retail customer would only apply to a person who
``received a recommendation . . . from a broker or dealer or a natural
person who is an associated person of a broker or dealer, and used the
recommendation primarily for personal, family, or household purposes.''
We stated that this approach was appropriate because it builds upon the
guidance provided for FINRA's suitability rule.\255\ In response, a few
commenters recommended that the Commission limit the application of
Regulation Best Interest to recommendations made to retail customers
for compensation.\256\
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\255\ See Proposing Release at 21596, footnote 160.
\256\ See Morgan Stanley Letter; CCMC Letters.
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Regulation Best Interest applies to a retail customer that both
receives a recommendation of any securities transaction or investment
strategy involving securities by a broker-dealer and that uses that
recommendation primarily for personal, family, or household purposes,
and not simply those recommendations for which a broker-dealer receives
compensation.\257\ In response to commenters, we interpret that a
retail customer ``uses'' a recommendation of a securities transaction
or investment strategy involving securities when, as a result of the
recommendation: (1) The retail customer opens a brokerage account with
the broker-dealer, regardless of whether the broker-dealer receives
compensation,\258\ (2) the retail customer has an existing account with
the broker-dealer and receives a recommendation from the broker-dealer,
regardless of whether the broker-dealer receives or will receive
compensation, directly or indirectly, as a result of that
recommendation, or (3) the broker-dealer receives or will receive
compensation, directly or indirectly as a result of that
recommendation, even if that retail customer does not have an account
at the firm.\259\
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\257\ See paragraph (b)(1) of Regulation Best Interest.
\258\ As discussed in Section II.B.2.b below, account
recommendations, including recommendations of a securities account
type generally, and recommendations to open an IRA or to roll over
or transfer assets into an IRA, are covered by Regulation Best
Interest regardless of whether those recommendations result in
transactions or generate transaction-based compensation.
\259\ See Proposing Release at 21596, footnote 160 and
accompanying text. See also FINRA Regulatory Notice 12-55,
Suitability--Guidance on FINRA's Suitability Rule (Dec. 2012) at
Q6(b) (``The suitability rule would apply when a broker-dealer or
registered representative makes a recommendation to a potential
investor who then becomes a customer. Where, for example, a
registered representative makes a recommendation to purchase a
security to a potential investor, the suitability rule would apply
to the recommendation if that individual executes the transaction
through the broker-dealer with which the registered representative
is associated or the broker-dealer receives or will receive,
directly or indirectly, compensation as a result of the recommended
transaction.''); NASD Notice to Members 04-72, Transfers of Mutual
Funds and Variable Annuities--Impermissible Use of Negative Response
Letters for the Transfer of Mutual Funds and Variable Annuities
(Changes in Broker-Dealer of Record) (Oct. 2004).
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When a retail customer opens or has an existing account with a
broker-dealer the retail customer has a relationship with the broker-
dealer and is therefore in a position to ``use'' (i.e., accept or
reject) the broker-dealer's recommendation. In this context, tying
``use'' solely to a broker-dealer's receipt of compensation would
inappropriately result in Regulation Best Interest not applying to the
broker-dealer's recommendations to hold securities positions or to
maintain an investment strategy (such as account type), recommendations
to open an account, or recommendations that may
[[Page 33345]]
ultimately be rejected by the retail customer.
Whether the recommendation complies with Regulation Best Interest
will be evaluated based on the circumstances that existed at the time
the recommendation was made to the retail customer. Accordingly,
broker-dealers should carefully consider the extent to which associated
persons can make recommendations to prospective retail customers (i.e.,
that have received, but not yet ``used'' the recommendation as noted
above) in compliance with Regulation Best Interest, including having
gathered sufficient information that would enable them to comply with
Regulation Best Interest at the time the recommendation is made, should
the prospective retail customer use the recommendation.\260\
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\260\ See FINRA Regulatory Notice 12-55 at Q6(b).
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c. Conformity With Form CRS
The proposed definition of ``retail customer'' differed from the
definition of ``retail investor'' proposed in the Relationship Summary
Proposal, which was a prospective or existing client or customer who is
a natural person (an individual), regardless of the individual's net
worth, including a trust or other similar entity that represents
natural persons.\261\ The proposed definition was different from the
definition of ``retail investor'' because the Relationship Summary was
intended for an earlier state of the relationship between an investor
and a financial professional, was intended to be required regardless of
whether the investor would receive investment advice primarily for
personal, family, or household purposes, and was designed to be
delivered by investment advisers as well as broker-dealers.\262\ Many
commenters recommended that we use the same definition to facilitate
compliance for firms and avoid investor confusion.\263\
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\261\ See Relationship Summary Proposal.
\262\ See Relationship Summary Proposal, Section II, footnote
29.
\263\ See, e.g., Invesco Letter; BlackRock Letter; ICI Letter;
Committee of Annuity Insurers Letter; Bank of America Letter; CFA
August 2018 Letter; Cetera August 2018 Letter; Fidelity Letter;
Morgan Stanley Letter; Oppenheimer Letter; Raymond James Letter;
SIFMA August 2018 Letter; TIAA Letter; Transamerica August 2018
Letter.
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The Commission agrees with commenters that using a similar
definition would provide consistency in the protections, and ease the
compliance burden, of the package of rulemakings. Therefore, the
definitions in Form CRS and Regulation Best Interest have been revised
to generally conform to each other, consistent with our respective
goals in each of these rulemakings.\264\ As discussed above, the
definition of ``retail customer'' for purposes of Regulation Best
Interest has been revised to apply only to natural persons, not all
persons, in line with the definition of ``retail investor'' for
purposes of Form CRS. In addition, the definition in Form CRS as
adopted now includes the ``personal, family or household purposes''
qualifier.
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\264\ See Relationship Summary Adopting Release.
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While the definitions have generally been harmonized across the
package of rulemakings,\265\ they differ to reflect differences between
the Relationship Summary delivery requirement and the obligations of
broker-dealers under Regulation Best Interest, including that the
Relationship Summary is required whether or not there is a
recommendation and covers any prospective and existing clients and
customers (i.e., a person who ``seeks to receive or receives
services'') of investment advisers as well as broker-dealers.\266\ For
the reasons discussed in the Proposing Release and in response to
commenters who requested clarification on whether Regulation Best
Interest applies to prospective customers,\267\ we would like to
clarify that the definition of ``retail customer'' does not apply to
prospective customers who do not receive and use recommendations from a
broker-dealer,\268\ as discussed above. This distinction reflects
differences between the point in time the Relationship Summary is
delivered to an investor and when the obligations of broker-dealers
pursuant to Regulation Best Interest attach.
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\265\ Id.
\266\ Id.
\267\ See, e.g., SIFMA August 2018 Letter; Prudential Letter;
Money Management Institute Letter.
\268\ See Section II.B.3.b.
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d. Treatment of Dual-Registrants
In the Proposing Release, the Commission stated that Regulation
Best Interest applies only in the context of a brokerage relationship
with a brokerage customer, and specifically, when a broker-dealer is
making a recommendation in the capacity of a broker-dealer. In
particular, for dual-registrants (for purposes of this section, a
broker-dealer that is dually registered as an investment adviser with
the Commission), the obligations associated with Regulation Best
Interest were intended to apply only when they are acting in the
capacity as a broker-dealer.\269\ The Commission recognized the issues
surrounding the determination of whether a dual-registrant is acting in
the capacity of a broker-dealer or an investment adviser, and asserted
that such a determination requires a facts and circumstances analysis,
with no one factor being determinative.\270\
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\269\ 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, as
a bank, a commodity trading advisor or a future commission
merchant).
\270\ Proposing Release at 21596.
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Many commenters requested that the Commission clarify the treatment
of dual-registrants and what is expected when offering products in both
types of accounts.\271\ Some commenters asserted that dually registered
financial professionals should be held to a fiduciary standard.\272\ A
few commenters requested clarification on how Regulation Best Interest
applies to particular scenarios, some of which involved dual-
registrants.\273\
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\271\ See, e.g., SIFMA August 2018 Letter; CCMC Letters; NASAA
August 2018 Letter.
\272\ See PIABA Letter; AICPA Letter.
\273\ See SIFMA August 2018 Letter; Letter from Michael Pieciak,
NASAA President, Commissioner Vermont Department of Financial
Regulation, NASAA (Feb. 19, 2019) (``NASAA February 2019 Letter'').
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In response, the Commission is reaffirming the guidance provided in
the proposal and providing further clarification on when and how
Regulation Best Interest would apply to dual-registrants. As stated in
the proposal, Regulation Best Interest would not apply to investment
advice provided to a retail customer by a dual-registrant when acting
in the capacity of an investment adviser, even if the retail customer
has a brokerage relationship with the dual-registrant or the dual-
registrant executes the transaction in its brokerage capacity.\274\
Similarly, as proposed, we are confirming that 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 Advisers Act.\275\
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\274\ This analysis would apply even if the dual-registrant
receives transaction-based compensation for executing the
transaction because the dual-registrant did not provide a
recommendation in its capacity as a broker-dealer. While Regulation
Best Interest would not apply in this situation, other provisions of
the federal securities laws and SRO rules would apply to the actions
taken or services provided by the broker-dealer.
\275\ See Proposing Release at 21596; see also Certain Broker-
Dealers Deemed Not To Be Investment Advisers, Exchange Act Release
No. 51523 (Apr. 12, 2005) at 8 (``Release 51523''); Interpretive
Rule Under the Advisers Act Affecting Broker-Dealers, Advisers Act
Release No. 2652 (Sep. 24, 2007). See also Fiduciary Interpretation.
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While we acknowledge that some commenters believe all dual-
registrants
[[Page 33346]]
should be held to a fiduciary standard, for the reasons discussed in
Section II.A, the Commission believes that Regulation Best Interest
enhances the obligations that apply when a broker-dealer makes a
recommendation to a retail customer by drawing from key principles
underlying the fiduciary obligation that applies to investment advisers
under the Advisers Act, while being tailored to the broker-dealer
model.\276\
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\276\ See Section I.
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As stated in the proposal, determining the capacity in which a
dual-registrant is making a recommendation is a facts and circumstances
test, with no one factor being determinative, but the Commission
considers, among other factors, the type of account, how the account is
described, the type of compensation and the extent to which the dual-
registrant made clear to the customer or client the capacity in which
it was acting.\277\
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\277\ Proposing Release at 21596.
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In addition and in response to a commenter's presentation \278\ of
particular scenarios in its comment letter,\279\ we would like to
confirm or correct the commenter's understanding of Regulation Best
Interest in practice to provide further guidance to firms as it relates
to their examples of dual-registrants.\280\ For example, in the
commenter's explanation of a scenario related to a recommendation to
open a fee-based account, we agree that Regulation Best Interest would
not apply when a dually registered financial professional of a dually
registered broker-dealer and investment adviser, who is acting in the
capacity of an investment adviser, recommends a fee-based account. We
note, however, that the dually registered financial professional would
need to comply with the Advisers Act as well as the requirements with
respect to Form CRS for the firm.\281\ In response to another scenario
in which a financial professional who is dually registered provides a
holistic review of the overall performance of a family's accounts,
which are both brokerage and advisory, whether Regulation Best Interest
applies depends on a facts and circumstances analysis. Regulation Best
Interest would apply if the financial professional in her brokerage
capacity (disclosed pursuant to the Disclosure Obligation), provides a
recommendation of a securities transaction or investment strategy
involving securities to the family in the course of the holistic
review.\282\
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\278\ See SIFMA August 2018 Letter. For purposes of the
presented scenarios, SIFMA has assumed that the customer is a
``retail customer.''
\279\ Id.
\280\ For purposes of this section, we have only addressed the
scenarios applicable to dual-registrants and have not confirmed or
rejected the commenter's analysis of the other scenarios.
\281\ See Fiduciary Interpretation at Section II.B.1. In
providing advice about account type, the adviser should consider
both types of accounts (i.e., brokerage and advisory accounts) when
determining whether the advice is in the client's best interest. See
also NASAA February 2019 Letter (stating that Regulation Best
Interest would not apply but instead that the fiduciary duty under
the Advisers Act would apply).
\282\ But see NASAA February 2019 Letter (stating that ``a full
fiduciary duty'' should be imposed on the financial adviser as to
all accounts in this case as the family has probably entrusted their
entire financial well-being to one financial professional).
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C. Component Obligations
As proposed Regulation Best Interest's obligation to ``act in the
best interest of the retail customer . . . without placing the
financial or other interest of the [broker-dealer] ahead of the retail
customer'' would have been satisfied by complying with four specified
obligations: A Disclosure Obligation, a Care Obligation, and two
Conflict of Interest Obligations.\283\ Failure to comply with any of
these proposed requirements would have violated Regulation Best
Interest.\284\
---------------------------------------------------------------------------
\283\ Proposing Release at 21598.
\284\ Id.
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As discussed above, we have determined to retain the overall
structure and scope of the proposed rule, but are modifying and
clarifying the component obligations that a broker-dealer must satisfy
in order to meet the General Obligation. As adopted, the General
Obligation is satisfied only if the broker-dealer complies with four
specified component obligations: (1) The Disclosure Obligation; (2) the
Care Obligation; (3) the Conflict of Interest Obligation; and (4) the
Compliance Obligation. Each of these component obligations is discussed
below. Whether a broker-dealer has acted in the retail customer's best
interest under the General Obligation will turn on an objective
assessment of the facts and circumstances of how these specific
components of Regulation Best Interest are satisfied at the time that
the recommendation is made (and not in hindsight). The specific
component obligations of Regulation Best Interest are mandatory, and
failure to comply with any of the components would violate Regulation
Best Interest.
1. Disclosure Obligation
We proposed a Disclosure Obligation that would require a broker-
dealer ``to, prior to or at the time of [a] recommendation, reasonably
disclose to the retail customer, in writing, the material facts
relating to the scope and terms of the relationship with the retail
customer and all material conflicts of interest associated with the
recommendation.'' The Proposing Release states that, for purposes of
the Disclosure Obligation, we would consider the following to be
examples of material facts relating to the scope and terms of the
relationship with the retail customer: (1) That the broker-dealer was
acting in a broker-dealer capacity with respect to the recommendation;
(2) fees and charges that would apply to the retail customer's
transactions, holdings, and accounts; and (3) type and scope of
services provided by the broker-dealer, including, for example,
monitoring the performance of the retail customer's account.
As stated in the Proposing Release, we understand that broker-
dealers typically provide information about their services and
accounts, which may include disclosures concerning the broker-dealer's
capacity, fees, services, and conflicts, on their firm websites and in
their account opening agreements.\285\ Furthermore, while broker-
dealers are subject to a number of specific disclosure obligations when
they effect certain customer transactions, and are subject to the
antifraud provisions of the federal securities laws, broker-dealers are
not currently subject to an explicit and broad disclosure requirement
under the Exchange Act regarding the scope and terms of the broker-
dealer relationship.\286\ To promote broker-dealer recommendations that
are in the best interest of retail customers, we determined it was
necessary to impose a more explicit and broader disclosure obligation
on broker-dealers than that which currently exists under the federal
securities laws and SRO rules.\287\
---------------------------------------------------------------------------
\285\ Proposing Release at 21599.
\286\ Proposing Release at 21599-21600.
\287\ Proposing Release at 21600.
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We solicited comment on the Disclosure Obligation and commenters
addressed several aspects of this proposed obligation, including the
interpretation of each required element, as discussed in the relevant
sections below.\288\ In consideration of these comments, we are
revising the Disclosure Obligation to require a broker-dealer, prior to
or at the time of the recommendation, to provide to the retail
customer, in writing, full and fair disclosure \289\ of all material
facts related to the scope and terms of the
[[Page 33347]]
relationship with the retail customer and all material facts relating
to conflicts of interest that are associated with the
recommendation.\290\ We are explicitly requiring in the rule text the
disclosure of examples in the Proposing Release of the ``material facts
relating to the scope and terms of the relationship with the retail
customer:'' (1) That the broker, dealer or such natural person is
acting as a broker, dealer or an associated person of a broker-dealer
with respect to the recommendation; (2) the material fees and costs
that apply to the retail customer's transactions, holdings, and
accounts; and (3) the type and scope of services provided to the retail
customer, including: any material limitations on the securities or
investment strategies involving securities that may be recommended to
the retail customer.
---------------------------------------------------------------------------
\288\ See, e.g., Better Markets August 2018 Letter; CCMC
Letters; LPL August 2018 Letter; Schwab Letter; Morgan Stanley
Letter; CFA August 2018 Letter; IPA Letter; NASAA Letter; SIFMA
August 2018 Letter.
\289\ See Section II.C.1.c, Disclosure Obligation, Full and Fair
Disclosure.
\290\ As discussed in more detail below, aspects of the
Disclosure Obligation may be satisfied by other regulatory
requirements.
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The Disclosure Obligation requires the disclosure of all material
facts related to the scope and terms of the relationship with the
retail customer. The material facts identified in Regulation Best
Interest are the minimum of what must be disclosed. Similar to what was
proposed, broker-dealers will need to disclose in writing prior to or
at the time of a recommendation any material facts that relate to the
``scope and terms of the relationship.'' As to what constitutes a
``material'' fact related to the ``scope and terms of the
relationship,'' the standard for materiality for purposes of the
Disclosure Obligation is consistent with the one the Supreme Court
articulated in Basic v. Levinson.\291\ Specifically, a fact is material
if there is ``a substantial likelihood that a reasonable shareholder
would consider it important.'' In the context of Regulation Best
Interest, the standard is the retail customer, as defined in the rule.
---------------------------------------------------------------------------
\291\ Basic, Inc. v. Levinson, 485 U.S. 224 (1988).
---------------------------------------------------------------------------
In response to comments, we are also refining and clarifying the
treatment of conflicts of interest under Regulation Best Interest by:
(1) Generally consistent with the fiduciary duty under the Advisers
Act, adopting for purposes of Regulation Best Interest, the definition
of ``conflict of interest'' associated with a recommendation as ``an
interest that might incline a broker, dealer, or a natural person who
is an associated person of a broker or dealer--consciously or
unconsciously--to make a recommendation that is not disinterested'';
\292\ and (2) revising the Disclosure Obligation to require disclosure
of ``material facts'' relating to such conflicts of interest that are
associated with the recommendation. Under this approach, all conflicts
of interest as so defined will be covered by Regulation Best Interest
(and thus, will be subject to the Conflict of Interest Obligation
described below). However, only ``material facts'' regarding these
conflicts of interest are required to be disclosed under the Disclosure
Obligation.\293\
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\292\ This is the same as the definition of ``material conflict
of interest'' discussed in the Proposing Release but eliminates
``material'' and ``a reasonable person would expect'' for the
reasons discussed below.
\293\ The Conflict of Interest Obligation requires, among other
things, that a broker-dealer establish written policies and
procedures reasonably designed to identify and disclose all
conflicts of interest associated with a recommendation. Such
disclosure is required to be provided in accordance with the
Disclosure Obligation. See Section II.C.3.d.
---------------------------------------------------------------------------
As discussed above, we are adopting a new set of disclosure
requirements designed to reduce retail investor confusion in the
marketplace for brokerage and advisory services and to assist retail
investors with the process of deciding whether to engage a particular
firm or financial professional and whether to establish an investment
advisory or brokerage relationship.\294\ Specifically, we are requiring
broker-dealers and investment advisers to deliver to retail investors a
Relationship Summary.\295\ The Relationship Summary will provide
succinct information about the relationships and services the firm
offers to retail investors, fees and costs that retail investors will
pay, specified conflicts of interest and standards of conduct, and
disciplinary history, among other things.\296\ The Relationship Summary
has a distinct purpose: It is intended to summarize information about a
particular broker-dealer or investment adviser in a format that allows
for comparability among the enumerated items, encourages investors to
ask questions, and highlights additional sources of information.
---------------------------------------------------------------------------
\294\ See Relationship Summary Adopting Release.
\295\ See Relationship Summary Adopting Release.
\296\ See Relationship Summary Adopting Release at Section I.
For purposes of Form CRS, ``retail investor'' is defined as ``a
natural person, or the legal representative of such natural person,
who seeks to receive or receives services primarily for personal,
family, or household purposes.''
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As a general matter, the Relationship Summary reflects an initial
layer of disclosure, with the Disclosure Obligation reflecting more
specific and additional, detailed layers of disclosure.\297\ We believe
the Relationship Summary and the Disclosure Obligation, while separate
obligations with significant individual value, will complement each
other and, consistent with our layered approach to disclosure, are
designed to build upon each other to provide different levels of key
information and may be required to be delivered at different times. In
addition, we believe the Relationship Summary and Disclosure Obligation
will improve the quality and consistency of disclosures and thus: (1)
Reduce the information asymmetry that may exist between a retail
customer and their broker-dealer, and (2) facilitate customer
comparisons of different broker-dealers which we expect will, in turn,
increase competition among broker-dealers, including with respect to
fees and costs.\298\
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\297\ Nevertheless, as discussed below where relevant, in some
instances disclosures made pursuant to Form CRS may be sufficient to
satisfy some aspects of the Disclosure Obligation.
\298\ See infra footnote 1192 and accompanying text.
---------------------------------------------------------------------------
As discussed below, we have identified those items of information
that we consider to be ``material facts'' under the Disclosure
Obligation. Though there are disclosures in the Relationship Summary
that could satisfy the Disclosure Obligation, in most instances the
Relationship Summary will not be sufficient.\299\ Moreover, as
discussed below, we believe the Disclosure Obligation can be satisfied
to varying degrees with existing documents provided to retail
customers, such as account opening documents, with a standalone
document, or by some combination. However, we encourage broker-dealers,
in deciding whether to rely on such an existing disclosure document or
whether to include or repeat information from existing disclosures, to
consider the usefulness and ease of understanding for retail customers
of any existing disclosure document.
---------------------------------------------------------------------------
\299\ For example, as noted below, a standalone broker-dealer
will be able to satisfy the Disclosure Obligation's requirement to
disclose the broker-dealer's capacity by delivering the Relationship
Summary to the retail customer.
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Oral Disclosure or Disclosure After a Recommendation
As discussed in more detail below, a number of commenters
highlighted practical difficulties associated with delivering
disclosure either in writing, or prior to or at the time of a
recommendation in some instances. Although Regulation Best Interest
requires that the Disclosure Obligation be made ``in writing,'' we
recognize the challenges associated with providing written disclosure
in each instance that disclosure may be required. For example, a
broker-dealer may need to supplement, clarify or update written
disclosure it has previously made before
[[Page 33348]]
or at the time it provides a customer with a recommendation. As we
stated in the Proposing Release, we recognized that broker-dealers may
provide recommendations by telephone and may need to offer clarifying
disclosure orally in some instances subject to certain conditions, such
as a dual-registrant informing a retail customer of the capacity in
which the dual-registrant is acting in conjunction with a
recommendation. We stated that a broker-dealer could orally clarify the
capacity in which it is acting at the time of the recommendation if it
had previously provided written disclosure to the retail customer
beforehand disclosing its capacity as well as the method it planned to
use to clarify its capacity at the time of the recommendation.
Similarly, although Regulation Best Interest requires a broker-
dealer to disclose, prior to or at the time of a recommendation, all
material facts relating to the scope and terms of the relationship with
the retail customer and relating to conflicts of interest that are
associated with the recommendation, we recognize that in some instances
a broker-dealer may not have all the material facts at the time of the
recommendation, or that such disclosure is provided to the retail
customer pursuant to an existing regulatory obligation, such as the
delivery of a product prospectus or a trade confirmation, after the
execution of the trade.\300\ In the Proposing Release we stated that in
circumstances where a broker-dealer determines to provide an initial,
more general disclosure (such as a relationship guide) followed by
specific information in a subsequent disclosure that is provided after
the recommendation (e.g., a trade confirmation) the initial disclosure
should address when and how a broker-dealer would provide more specific
information regarding the material fact or conflict in a subsequent
disclosure (e.g., after the trade in the trade confirmation). We noted
also that whether there is sufficient disclosure in both the initial
disclosure and any subsequent disclosure would depend on the facts and
circumstances.
---------------------------------------------------------------------------
\300\ See infra footnote 525.
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We continue to believe that some flexibility with respect to the
provision by broker-dealers of written and oral disclosure, as well as
with respect to the timing that disclosure is made, is appropriate in
certain circumstances, such as when a broker-dealer updates its written
disclosures orally in order to reflect facts not reasonably known at
the time the written disclosure is provided. In such circumstances, a
broker-dealer may satisfy its Disclosure Obligation by making
supplemental oral disclosure not later than the time of the
recommendation, provided that the broker-dealer maintains a record of
the fact that oral disclosure was provided to the retail customer.\301\
In addition, in the limited instances where existing regulations permit
disclosure after the recommendation is made (e.g., trade confirmation,
prospectus delivery), a broker dealer may satisfy its Disclosure
Obligation regarding the information contained in the applicable
disclosure document by providing such document to the retail customer
after the recommendation is made. Before supplementing, clarifying or
updating written disclosures in the limited circumstances described
above, broker-dealers must provide an initial disclosure in writing
that identifies the material fact and describes the process through
which such fact may be supplemented, clarified or updated.
---------------------------------------------------------------------------
\301\ See Section II.D, Record-Making and Recordkeeping.
---------------------------------------------------------------------------
For example, with regard to product-level fees, a broker-dealer
could provide an initial standardized disclosure of product-level fees
generally (e.g., reasonable dollar or percentage ranges), noting that
further specifics for particular products appear in the product
prospectus, which will be delivered after a transaction in accordance
with the delivery method the retail customer has selected, such as by
mail or electronically.\302\ Similarly, with regard to the disclosure
of a broker-dealer's capacity, a dual-registrant could disclose that
recommendations will be made in a broker-dealer capacity unless
otherwise expressly stated at the time of the recommendation, and that
any such statement will be made orally. Or, a broker-dealer could
disclose that its associated persons may have conflicts of interest
beyond than those disclosed by the broker-dealer, and that associated
persons will disclose, where appropriate, any additional material
conflicts of interest not later than the time of a recommendation, and
that any such disclosure will be made orally.
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\302\ While using a percentage or dollar range to describe a fee
can be appropriate, that range should be designed to reasonably
reflect the actual fees to be charged. For example, if the firm
offers in almost all instances funds with up-front sales charges of
between 5% and 5.5%, but the disclosure states that mutual fund up-
front sales charges may ``range from 0.0% to 5.5%,'' then the
broker-dealer would need to evaluate whether the disclosure should
be revised to more accurately describe the sales charge. See
discussion in Section II.C.1.a, Disclosure Obligation, Material
Facts Regarding Scope and Terms of the Relationship, Fees and Costs,
Particularly of Fees and Costs Disclosed.
---------------------------------------------------------------------------
We believe it is in the public interest and consistent with the
protection of investors to permit such flexibility in the delivery of
information pursuant to the Disclosure Obligation. Providing retail
customers written summary information about material facts relating to
a recommendation and indicating that additional information will be
forthcoming, the point at which the additional information will be
delivered, and the method by which it will be conveyed, highlights for
retail customers a useful summary of information while allowing for the
practical realities of the process by which securities recommendations
are made and transactions are executed and leaving longstanding
existing disclosure regimes, particularly those relating to product
issuer disclosure, undisturbed.
Other Liabilities Under the Federal Securities Laws
Further, the requirements under Regulation Best Interest that
particular information be disclosed is not determinative of a broker-
dealer or associated person's other potential liabilities under the
general antifraud provisions of the federal securities laws for failure
to disclose material information to a customer at the time of a
recommendation.\303\ In addition, we
[[Page 33349]]
remind broker-dealers that even full and fair disclosure of the
information required by the Disclosure Obligation is not sufficient,
standing alone, to satisfy the Care Obligation, and that even
sufficient disclosure cannot cure a violation of the Care Obligation.
---------------------------------------------------------------------------
\303\ Broker-dealers are liable under the antifraud provisions
for failure to disclose material information to their customers when
they have a duty to make such disclosure. See Basic v. Levinson, 485
U.S. 224, 239 footnote 17 (1988) (``Silence, absent a duty to
disclose, is not misleading under Rule 10b-5.''); Chiarella v. U.S.,
445 U.S. 222, 228 (1980) (explaining that a failure to disclose
material information is only fraudulent if there is a duty to make
such disclosure arising out of ``a fiduciary or other similar
relation of trust and confidence''); SEC v. Monarch Funding Corp.,
192 F.3d 295, 308 (2d Cir. 1999) (explaining that defendant is
liable under Section 10(b) and Rule 10b-5 for material omissions
``as to which he had a duty to speak''). Generally, under the
antifraud provisions, a broker-dealer's duty to disclose material
information to its customer is based upon the scope of the
relationship with the customer, which is fact intensive. See, e.g.,
Conway v. Icahn & Co., Inc., 16 F.3d 504, 510 (2d Cir. 1994) (``A
broker, as agent, has a duty to use reasonable efforts to give its
principal information relevant to the affairs that have been
entrusted to it.''). For example, where a broker-dealer processes
its customers' orders, but does not recommend securities or solicit
customers, then the material information that the broker-dealer is
required to disclose is generally narrow, encompassing only the
information related to the consummation of the transaction. See,
e.g., Press v. Chemical Inv. Servs. Corp., 166 F.3d 529, 536 (2d
Cir. 1999). However, courts have found that a broker-dealer's duty
to disclose material information under the antifraud provisions is
broader when the broker-dealer is making a recommendation to its
customer. See, e.g., Hanly, 415 F.2d 589, 597 (2d Cir. 1969). When
recommending a security, broker-dealers generally are liable under
the antifraud provisions if they do not give ``honest and complete
information'' or disclose any material adverse facts or material
conflicts of interest, including any economic self-interest. See,
e.g., De Kwiatkowski v. Bear, Stearns & Co., 306 F.3d 1293, 130 (2d
Cir. 2002); Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2d
Cir. 1970). See Proposing Release at 21599 footnote 176.
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Disclosures by Natural Persons Associated With a Broker-Dealer
The Disclosure Obligation applies to a broker, dealer, or natural
person who is an associated person of a broker or dealer.\304\ As
stated in the Proposing Release, we are requiring not only the broker-
dealer entity, but also individuals who are associated persons of a
broker-dealer (e.g., registered representatives) to comply with
specified components of Regulation Best Interest when making
recommendations to retail customers.\305\ One commenter requested
guidance on how an associated person should comply with the Disclosure
Obligation.\306\ In response, we believe that a natural person who is
an associated person of a broker-dealer may in many instances rely on
the disclosures provided by the broker-dealer with which he or she is
associated to satisfy the Disclosure Obligation. However, when an
associated person knows or should have known that the broker-dealer's
disclosure is insufficient to describe ``all material facts,'' the
associated person must supplement that disclosure. For example, if an
associated person of a broker-dealer that offers a full range of
securities products is licensed solely as a Series 6 Registered
Representative,\307\ and can sell only mutual funds, variable annuities
and other enumerated products, that limitation on the scope of services
provided by the particular associated person must be sufficiently clear
in the broker-dealer's disclosures; otherwise additional clarifying
disclosure by the associated person would be necessary.
---------------------------------------------------------------------------
\304\ Rule 15l-1(a)(2)(i).
\305\ Proposing Release at 21592.
\306\ See NASAA August 2018 Letter (recommending that the
Commission provide specific instructions on how associated persons
should disclose capacity in which they are acting).
\307\ A candidate who passes the Series 6 exam is qualified for
the solicitation, purchase and/or sale of the following securities
products: Mutual funds (closed-end funds on the initial offering
only), Variable annuities, Variable life insurance, Unit investment
trusts (UITs), Municipal fund securities (e.g., 529 savings plans,
local government investment pools (LGIPs)). FINRA, Series 6--
Investment Company and Variable Contracts Products Representative
Exam, Permitted Activities, available at: http://www.finra.org/industry/series6#permitted-activities.
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a. Material Facts Regarding Scope and Terms of the Relationship
As discussed above, the proposed Disclosure Obligation would
require a broker-dealer to, among other things, ``prior to or at the
time of such recommendation, reasonably disclose to the retail
customer, in writing, the material facts relating to the scope and
terms of the relationship with the retail customer.'' We proposed to
consider the following to be examples of material facts relating to the
scope and terms of the relationship with the retail customer: (i) That
the broker-dealer was acting in a broker-dealer capacity with respect
to the recommendation; (ii) fees and charges that would apply to the
retail customer's transactions, holdings, and accounts; and (iii) the
type and scope of services provided by the broker-dealer, including,
for example, monitoring the performance of the retail customer's
account.
Commenters requested that we clarify which facts a broker-dealer
would be required to disclose about the scope and terms of the
relationship it has with a customer under Regulation Best
Interest.\308\ In particular, several commenters recommended that the
Commission clarify how a dual-registrant should disclose its capacity
regarding its recommendations.\309\ Other commenters recommended that
the Commission define the scope of fees a broker-dealer must disclose
\310\ and the form that disclosure should take.\311\ In addition, some
commenters requested clarity on the types of services that a broker-
dealer would be required to disclose, including limitations on
securities offered \312\ and account monitoring services.\313\
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\308\ See, e.g., SIFMA August 2018 Letter; Edward Jones Letter;
NASAA August 2018 Letter; AARP August 2018 Letter; PIABA Letter;
Prudential Letter.
\309\ See, e.g., SIFMA August 2018 Letter; Edward Jones Letter.
\310\ See, e.g., Bank of America Letter (recommending that the
Commission apply a ``materiality'' threshold to determine which fees
should be disclosed).
\311\ See, e.g., SIFMA August 2018 Letter (stating that a
broker-dealer's disclosure of a range of customer costs per product
should be sufficient); CFA August 2018 Letter (stating a broker-
dealer's disclosure of percentages or ranges of cost information
would do little to enlighten investors about the true costs of
brokers' advice services).
\312\ See, e.g., NY Life Letter (stating that an insurer may
appropriately focus its career agents on the distribution of
variable insurance products that the insurer manufactures, so long
as limitations on the universe of available products are disclosed
to consumers and supervisory procedures are in place to ensure that
a variable insurance product is in the client's best interest); CFA
Institute Letter (stating that the Disclosure Obligation should
complement the information presented in Form CRS and provide greater
specificity about, among other things, the type and scope of
services offered by the broker-dealer).
\313\ See, e.g., IAA August 2018 Letter (recommending that the
Commission clarify that Regulation Best Interest would apply to all
advisory activities that broker-dealers agree to provide (e.g.,
ongoing monitoring for purposes of recommending changes in
investments)).
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As discussed below, in response to comments, we have revised the
Disclosure Obligation to require disclosure of ``all material facts
relating to the scope and terms of the relationship with the retail
customer, including: (i) That the broker, dealer or such natural person
is acting as a broker, dealer or an associated person of a broker-
dealer with respect to the recommendation; (ii) the material fees and
costs that apply to the retail customer's transactions, holdings, and
accounts; and (iii) the type and scope of services provided to the
retail customer, including any material limitations on the securities
or investment strategies involving securities that may be recommended
to the retail customer.'' \314\ In addition, we are clarifying the
scope of the obligation.
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\314\ Rule 15l-1(a)(2)(i)(A).
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As we did in the Proposing Release, we emphasize that although we
have explicitly identified the capacity in which the broker-dealer is
acting, material fees and costs, and the type and scope of services, as
what would at a minimum be required to be disclosed as ``material facts
relating to the scope and terms of the relationship with the retail
customer,'' the Disclosure Obligation requires broker-dealers and
associated persons to disclose ``all material facts relating to the
scope of the terms of the relationship,'' (emphasis added) and broker-
dealers and such associated persons thus will need to consider, based
on the facts and circumstances, whether there are other material facts
relating to the scope and terms of the relationship with the retail
customer that need to be disclosed. This analysis generally should
include consideration of whether information in the Relationship
Summary constitutes a ``material fact'' that could appropriately be
expanded upon in satisfying the Disclosure Obligation. It would be
possible, but would be unlikely for most
[[Page 33350]]
broker-dealers, for the abbreviated format of the Relationship Summary
to sufficiently disclose ``all material facts'' regarding the scope and
terms of the relationship such that no further information would be
required to satisfy the Disclosure Obligation.
Capacity In Which the Broker-Dealer Is Acting
In the Proposing Release, the Commission identified that the
capacity in which a broker-dealer is acting is a material fact relating
to the scope and terms of a customer relationship subject to the
Disclosure Obligation.\315\ In so identifying this critical element of
information, we hoped to promote greater awareness among retail
customers of the capacity in which their financial professional or firm
acts with respect to recommendations.
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\315\ Proposing Release at 21601.
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Several commenters requested additional guidance on how dual-
registrants and their associated persons could comply with the proposed
Disclosure Obligation in this respect.\316\ Some commenters stated that
repeated disclosures of capacity would distract customers from more
important disclosures related to a recommendation and could lead to
confusion.\317\ While we received comments expressing concerns that our
proposed approach might lead to investor confusion,\318\ many of these
commenters were seeking clarity regarding this requirement and not its
elimination.\319\
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\316\ See, e.g., NASAA August 2018 Letter (requesting that the
Commission provide guidance to associated persons of dual-
registrants explaining how they should disclose the capacity in
which they are acting and whether they are providing a
recommendation or advice); Better Markets August 2018 Letter; CFA
August 2018 Letter; Fidelity Letter; IPA Letter; SIFMA August 2018
Letter; Edward Jones Letter; CCMC Letters.
\317\ See, e.g., Edward Jones Letter (recommending that the
Commission not require repeated capacity disclosures to customers
because it would be redundant and potentially confuse customers);
SIFMA August 2018 Letter (stating that disclosure of capacity should
not be required at the time of the recommendation as it would cause
unnecessary delay and distract customers from more important
disclosures regarding account features and recommendations); Better
Markets August 2018 Letter (stating that one-time written disclosure
about a dual-registrant's advisory capacity, followed by future oral
disclosures when they change roles when making recommendations would
be confusing).
\318\ See, e.g., Better Markets August 2018 Letter; CFA August
2018 Letter (stating that flexibility in disclosure will result in
disclosures that do not effectively convey key information
especially for dual-registrants as customers will not understand the
capacity the dual-registrant is acting in at the particular time or
its significance).
\319\ See, e.g., SIFMA August 2018 Letter (requesting that the
Commission clarify the application of the Disclosure Obligation to
dually registered firms and personnel, including what, and how
frequently, disclosure is required to put customer on notice of
their capacity); Edward Jones Letter; IPA Letter; CCMC Letters.
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In response to commenters, we are revising Regulation Best Interest
to explicitly require disclosure of capacity, which the Proposing
Release addressed in guidance. Therefore, Rule 15l-1(a)(2)(i)(A)
requires that the broker, dealer, or natural person who is an
associated person of a broker or dealer, prior to or at the time of the
recommendation, provide the retail customer, in writing, full and fair
disclosure of all material facts relating to the scope and terms of the
relationship with the retail customer, including that the broker-dealer
or such natural person is acting as a broker-dealer or an associated
person of a broker-dealer with respect to the recommendation.
This disclosure is designed to improve awareness among retail
customers of the capacity in which their financial professional or
broker-dealer acts when it makes recommendations so that the retail
customer can more easily identify and understand their relationship, a
goal shared with the Relationship Summary.\320\ Form CRS requires a
firm to state the name of the broker-dealer or investment adviser and
whether the firm is registered with the Commission as a broker-dealer,
investment adviser, or both.\321\ A standalone broker-dealer (i.e., a
broker-dealer not also registered as an investment adviser) will
generally be able to satisfy the Disclosure Obligation's requirement to
disclose the broker-dealer's capacity by delivering the Relationship
Summary to the retail customer.
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\320\ See Relationship Summary Proposal at 21420.
\321\ See Relationship Summary Adopting Release at Section II.C.
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For broker-dealers who are dually registered, and for associated
persons who are either dually registered or, who are not dually
registered but only offer broker-dealer services through a firm that is
dually registered, the information contained in the Relationship
Summary will not be sufficient to disclose their capacity in making a
recommendation. Although some commenters expressed concerns about
potential investor confusion caused by ``additional'' disclosure
regarding a dual-registrant's capacity, we believe that the Disclosure
Obligation will not duplicate or confuse, but instead will provide
clarifying detail on capacity to supplement the information contained
in the Relationship Summary. Accordingly, we are clarifying that 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 with the Commission or with
a state, must disclose whether they are acting (or, in the case of the
latter, that they are only acting) as an associated person of a broker-
dealer to satisfy the Disclosure Obligation.\322\ An associated person
of a dual-registrant who does not offer investment advisory services
must disclose that fact as a material limitation in order to satisfy
the Disclosure Obligation.
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\322\ Financial professionals with registrations to offer
services as a representative of a broker-dealer and investment
adviser may offer services through a dual-registrant, affiliated
firms, or unaffiliated firms, or only offer one type of service
notwithstanding their dual licensing. Financial professionals who
are not dually registered may offer one type of service through a
firm that is dually registered. See Relationship Summary Adopting
Release at Section II.B.4.
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Furthermore, as discussed in greater detail below, we would presume
the use of the terms ``adviser'' and ``advisor'' by (1) a broker-dealer
that is not also registered as an investment adviser or (2) a financial
professional that is not also a supervised person of an investment
adviser to be a violation of the Disclosure Obligation under Regulation
Best Interest. Disclosure of capacity may, in part, be made orally
under the circumstances outlined in Section II.C.1, Oral Disclosure or
Disclosure After a Recommendation. For example, a broker-dealer may
disclose that: ``All recommendations will be made in a broker-dealer
capacity unless otherwise expressly stated at the time of the
recommendation; any such statement will be made orally.'' In this case,
no further oral or written disclosure would be required until a
recommendation is made in a capacity other than as a broker-dealer.
Similarly, a broker-dealer may disclose that: ``All recommendations
regarding your brokerage account will be made in a broker-dealer
capacity, and all recommendations regarding your advisory account will
be in an advisory capacity. When we make a recommendation to you, we
will expressly tell you orally which account we are discussing''). In
this instance, no further disclosure of capacity is necessary.
Capacity in the Context of Names, Titles, and Marketing Practices
The Relationship Summary Proposal included a proposed rule that
would have restricted broker-dealers and their associated persons
(unless they were registered as, or supervised persons of, an
investment adviser), when communicating with a retail investor,
[[Page 33351]]
from using the term ``adviser'' or ``advisor'' as part of a name or
title (``Titling Restrictions'').\323\ After further consideration of
our policy goals and the comments we received, and in light of the
disclosure requirements under Regulation Best Interest, we do not
believe that adopting a separate rule restricting these terms is
necessary, because we presume that the use of the term ``adviser'' and
``advisor'' in a name or title by (1) a broker-dealer that is not also
registered as an investment adviser or (2) an associated person that is
not also a supervised person of an investment adviser, to be a
violation of the capacity disclosure requirement under the Disclosure
Obligation as discussed further below.\324\
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\323\ See Relationship Summary Proposal, supra footnote 12, at
21461-63. We also requested comment on whether we should explicitly
restrict other terms, including ``wealth manager'' and ``financial
consultant.'' Additionally, we requested comment on whether we
should restrict terms that are synonymous with ``adviser'' or
``advisor.''
\324\ We recognize that, in adopting the fee-based brokerage
rule in 2005, we declined to place any limitations on how a broker-
dealer may hold itself out or the titles it may employ. Certain
Broker-Dealers Deemed Not to Be Investment Advisers, Advisers Act
Release No. 2376 (Apr. 12, 2005). However, as we noted in the
Relationship Summary Proposal, comments we received in response to
Chairman Clayton's request for comment and our experience prompted
us to revisit our approach from 2005. In addition, given that the
new disclosure requirements under Regulation Best Interest and Form
CRS will and should necessitate a reassessment of a broker-dealer's
names, titles, and communications with its customers, we believe it
is necessary to re-evaluate the appropriateness of these practices
in light of these new obligations. See also generally Relationship
Summary Proposal, supra footnote 12, at 21459-61 (citing commenters
and studies by the Siegel and Gale Consulting Group and the RAND
Corporation that document investor confusion in the marketplace, all
of which were conducted subsequent to the 2005 fee-based brokerage
rule); Public Comments from Retail Investors and Other Interested
Parties on Standards of Conduct for Investment Advisers and Broker-
Dealers, Chairman Jay Clayton (Jun. 1, 2017), available at https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31. We also proposed rules (the ``Affirmative Disclosures'') that
would have required a broker-dealer and an investment adviser to
prominently disclose that it is registered as a broker-dealer or
investment adviser, as applicable, with the Commission in print or
electronic retail investor communications. As we discuss in a
concurrent rulemaking, we are not adopting the Affirmative
Disclosures. See Relationship Summary Adopting Release, supra
footnote 12, at Section III.
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We received several comments on the proposed Titling Restrictions,
which we have also considered when determining to presume use of such
names and titles to be a violation of the capacity disclosure.\325\
Some commenters supported a restriction on the terms ``adviser'' and
``advisor,'' noting, for example, that these particular terms are often
associated with the statutory term ``investment adviser,'' \326\ or
that investors ``typically associate'' these terms with registered
investment advisers.\327\ A few commenters generally noted that the
title ``financial advisor'' prevents investors from understanding
whether they are engaging a financial professional who provides
advisory services or who sells brokerage services.\328\ Moreover, other
commenters generally stated that names and titles containing
``adviser'' or ``advisor'' create investor confusion and/or could
mislead investors about the differences between broker-dealers and
investment advisers including the applicable standard of care \329\ and
the services to be provided.\330\
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\325\ See, e.g., CFA August 2018 Letter; IAA August 2018 Letter;
LPL August 2018 Letter; Letter from Dennis M. Kelleher, President
and CEO, et al., Better Markets (Aug. 7, 2018) (``Better Markets CRS
Letter'').
\326\ See Letter from Lexie Pankratz, Owner, Trailhead
Consulting, LLC (Aug. 7, 2018) (``Trailhead Letter'').
\327\ See, e.g., Letter from Kurt N. Schacht, Managing Director,
et al., CFA Institute (Aug. 7, 2018) (``CFA Institute CRS Letter'');
Pickard Letter.
\328\ See, e.g., Letter from Gerald Lopatin (Jul. 30, 2018)
(``Lopatin Letter''); Letter from Paula Hogan (Aug. 6, 2018)
(``Hogan Letter''); Letter from Arlene Moss (Jul. 31, 2018) (``Moss
Letter''); Letter from Daniel Wrenne (Jul. 31, 2018) (``Wrenne
Letter'').
\329\ See, e.g., FSI August 2018 Letter; Schwab Letter; CFA
Institute CRS Letter; Betterment Letter.
\330\ See, e.g., NASAA August 2018 Letter (stating that ``[t]his
rule change will help forestall retail investors' confusion about
the different roles and duties owed by broker-dealers/agents and
investment advisers/investment adviser Representatives''); CFA
Institute CRS Letter (stating that ``[i]nvestor confusion about the
roles and duties of different financial services providers who use
``adviser/advisor'' in their titles has become problematic from both
an investor protection and trust standpoint. Use of the proposed
CRS, alone, will not allay the substantial investor confusion in the
marketplace about the differences between broker-dealers and
investment advisers.'')
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Other commenters did not support the proposed Titling Restrictions,
believing that the terms ``adviser'' and ``advisor'' are more
generically used and understood, and refer to financial professionals
who provide advice and financial services more generally.\331\ Several
of these commenters stated that the restriction adds little additional
investor protection when taken together with Regulation Best Interest
and Form CRS (i.e., it is duplicative).\332\ Additionally, some
commenters stated that Form CRS alone provides similar investor
protections that alleviate the need for the restriction.\333\ Along
similar lines, one commenter stated that certain fraud-based securities
laws and FINRA rules provide the same protections that the proposed
restriction seeks to add, making it unnecessary.\334\
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\331\ See LPL August 2018 Letter (stating that ``restricting use
of `advisor' and `adviser' is contrary to the plain English meaning
the average investor associates with those terms . . . regardless of
the legal contours of the service relationship.''); NAIFA Letter
(stating that ``[m]any financial professionals are recognized as
and/or refer to themselves as `advisors/advisers' or `financial
advisors/advisers.' These words are (aptly) used by professionals
who offer advice on any number of financial topics.''); Letter from
Investments & Wealth Institute (``IWI'') (Aug. 6, 2018) (``IWI
August 2018 Letter'') (stating that an outright ban on the use of
the terms ``adviser'' and ``advisor'' by broker-dealers would raise
First Amendment concerns).
\332\ See, e.g., Letter from Robert D. Oros, Chief Executive
Officer, HD Vest Financial Services (Aug. 7, 2018) (``HD Vest
Letter''); LPL August 2018 Letter; SIFMA August 2018 Letter. But see
Pickard Letter (supporting the restriction and our proposed
alternative holding out approach by noting that ``[w]e do not think
that Reg BI or Form CRS as currently proposed is sufficient.'')
\333\ See, e.g., LPL August 2018 Letter; Morgan Stanley Letter;
Raymond James Letter.
\334\ See Cambridge Letter.
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We also received several comments on the following alternative
approaches to the Titling Restrictions on which we sought comment: (i)
A broker-dealer that used the terms ``adviser'' or ``advisor'' as part
of a name or title would not be considered to provide investment advice
solely incidental to the conduct of its business as a broker-dealer,
and (ii) a broker-dealer would not be providing investment advice
solely incidental to its brokerage business if it ``held itself out''
as an investment adviser to retail investors.\335\ This second
alternative approach would have resulted in a restriction generally
broader in scope than the Titling Restrictions, as it would also have
encompassed communications and sales practices in addition to the use
of names and titles.
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\335\ See Relationship Summary Proposal, supra footnote 12, at
21463-64. We are not adopting the proposed alternative approach that
would have restricted a broker-dealer from availing itself of the
solely incidental exclusion if it ``held itself out'' as an
investment adviser. Use of the terms ``adviser'' or ``advisor,''
however, could support a conclusion depending on other facts and
circumstances, that the primary business of the firm is advisory in
nature, in which case the advice provided by the broker-dealer would
not be solely incidental to the conduct of its brokerage business.
See Solely Incidental Interpretation, supra footnote 12, at Section
II.B (providing the Commission's interpretation of the solely
incidental prong of the broker-dealer exclusion from the Advisers
Act).
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In response to these alternatives, several commenters stated that
the Titling Restrictions were too narrow in meeting the Commission's
intended objective of mitigating the risk that investors could be
misled by the use of certain names and titles because the Titling
Restrictions did not address other confusing names or titles,\336\ and,
[[Page 33352]]
more specifically, because the Titling Restrictions did not address the
broker-dealers who ``hold themselves out'' as investment advisers.\337\
Several of these commenters instead advocated for precluding reliance
on the solely incidental prong by any broker-dealer that holds itself
out as an investment adviser.\338\ Some commenters stated that certain
marketing practices indicate that advice is the main function of the
broker-dealer's service.\339\ Additionally, one commenter stated that
``the potential for investor confusion is at its greatest when dealing
with broker-dealers and dual-registrants that routinely market their
services as advisory in nature. . . .'' \340\
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\336\ See e.g., Letter from Barbara Roper, Director of Investor
Protection, and Micah Hauptman, Financial Services Counsel, (Dec. 7,
2018) (``CFA December 2018 Letter''); State Treasurers Letter;
Waters Letter (noting that the Titling Restrictions are too narrow
of a fix for investor confusion because they fail ``to address the
numerous other titles professionals use. . . . As a result, most
retail investors cannot easily distinguish between financial
advisers who are mere salespeople and those that are investment
advisers that must provide advice that is in the best interests of
the investor.''). See also NAIFA Letter (noting that restricting
these terms for broker-dealers and their financial professionals
only ``and not for numerous other professionals using those words
and delivering advice on a wide variety of financial topics creates
more consumer confusion and does not enhance consumers'
understanding of the specific obligations and standards that apply
to their advisor(s).'')
Additionally, several of the commenters who supported the
restriction recommended modifications such as broadening the
restriction to include other terms, including ``wealth manager'' and
``financial consultant.'' See, e.g., Financial Engines Letter;
Comment Letter of Altruist Financial Advisors LLC (Aug. 7, 2018)
(``Altruist Letter''); Letter from David John Marotta (April 22,
2018) (``Marotta Letter''); Galvin Letter; Letter from Pamela Banks,
Senior Policy Counsel, Consumers Union (Oct. 19, 2018) (``Consumers
Union Letter'').
\337\ See, e.g., CFA August 2018 Letter; FPC Letter; IAA August
2018 Letter; Letter from Michael Kitces (Aug. 2, 2018) (``Kitces
Letter''); LPL August 2018 Letter; MarketCounsel Letter; Waters
Letter.
\338\ See, e.g., IAA August 2018 Letter (noting that ``[w]hile
names or titles are contributing factors to investor confusion and
the potential for investors to be misled, we believe that other
factors should be considered as well. In particular, previous
studies noted the confusion arising from `we do it all'
advertisements and `marketing efforts which depicted an ongoing
relationship between the broker-dealer and the investor.' '');
Betterment Letter; CFA August 2018 Letter; LPL August 2018 Letter.
\339\ See CFA August 2018 Letter (citing to Micah Hauptman and
Barbara Roper, Financial Advisor or Investment Salesperson? Brokers
and Insurers Want to Have it Both Ways, January 18, 2017). See also
Better Markets CRS Letter (stating that titles present a
professional as not ``only an expert in financial matters but also
someone who will offer advice and recommendations''); Letter from
Michael Palumbo (Aug. 7, 2018) (``Palumbo Letter''); Kitces Letter.
\340\ See CFA August 2018 Letter. See also CFA Institute CRS
Letter (stating that the proposal should address ``those who may not
expressly refer to themselves as `adviser/[advis]or' but through
their actions convey that meaning to investors. . . .'').
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Use of Terms ``Adviser'' or ``Advisor''
Financial firms and their professionals, including broker-dealers
and investment advisers, seek to acquire new customers and to retain
existing customers by marketing their services, including through the
use of particular terms in names and titles. Firms often spend time and
money to market, brand, and create intellectual property by using these
terms in an effort to shape investor expectations.\341\ A name or title
is generally used, and is designed to have significance, on its own
without any additional context as to what it means. Given that the
titles ``adviser'' and ``advisor'' are closely related to the statutory
term ``investment adviser,'' their use by broker-dealers can have the
effect of erroneously conveying to investors that they are regulated as
investment advisers, and have the business model, including the
services and fee structures, of an investment adviser.\342\ Such
potential effect undermines the objective of the capacity disclosure
requirement under Regulation Best Interest to enable a retail customer
to more easily identify and understand their relationship.
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\341\ See, e.g., Letter from Barbara Roper, Director of Investor
Protection, and Micah Hauptman, Financial Services Counsel, CFA
(Sep. 14, 2017) (``CFA September 2017 Letter'') (``[O]ur study
documents how everything from the titles brokers use to the way they
describe their services is designed to send the message that they
are in the business of `providing expert investment advice,
comprehensive financial planning, and retirement planning that is
based on their clients' needs and goals and that is designed to
serve their best interests.' '')
\342\ See Relationship Summary Proposal, supra footnote 12, at
21461.
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As discussed above, the Disclosure Obligation requires broker-
dealers to make full and fair disclosure of all material facts relating
to the scope and terms of the relationship with a retail customer,
including the capacity in which they are acting with respect to a
recommendation. The capacity disclosure requirement is designed to
improve awareness among retail customers of the capacity in which their
firm and/or financial professional acts when it makes recommendations
so that a retail customer can more easily identify and understand their
relationship.\343\ We believe that in most cases broker-dealers and
their financial professionals cannot comply with the capacity
disclosure requirement by disclosing that they are a broker-dealer
while calling themselves an ``adviser'' or ``advisor.'' Under the
Disclosure Obligation, a broker-dealer, or an associated person, must,
prior to or at the time of the recommendation, disclose that the
broker-dealer or that associated person is acting as a broker or dealer
with respect to the recommendation.\344\ When a broker-dealer or an
associated person uses the name or title ``adviser'' or ``advisor''
there are few circumstances \345\ in which that broker-dealer or
associated person would not violate the capacity disclosure requirement
because the name or title directly conflicts with the information that
the firm or professional would be acting in a broker-dealer
capacity.\346\ Therefore, use of the titles ``adviser'' and ``advisor''
by broker-dealers and their financial professionals would undermine the
objectives of the capacity disclosure requirement by potentially
confusing a retail customer as to type of firm and/or professional they
are engaging, particularly since ``investment adviser'' is defined by
statute separately from ``broker'' or ``dealer.''
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\343\ Similarly, Form CRS is designed to reduce retail investor
confusion in the marketplace for brokerage and investment advisory
services and to assist retail investors with the process of deciding
whether to engage, or to continue to engage, a particular firm or
financial professional and whether to establish, or to continue to
maintain, an investment advisory or brokerage relationship. A
broker-dealer firm or financial professional's use of ``adviser'' or
``advisor'' in its name or title would inhibit a customer's full
understanding of the contours of his or her relationship with the
firm and financial professional, undermining Form CRS.
\344\ See Rule 15l-1(a)(2)(i)(A)(i).
\345\ See infra footnotes 349-351 and accompanying text.
\346\ In the Relationship Summary Proposal, we stated that our
proposed restriction on the terms ``adviser'' and ``advisor'' would
not have applied to broker-dealers when communicating with
institutions. See Relationship Summary Proposal, supra footnote 12,
at 21462. Given that Regulation Best Interest and the Relationship
Summary apply only to retail customers and retail investors,
respectively, our presumption would only apply to the use of
``adviser'' and ``advisor'' in such contexts. Therefore, we do not
believe that further clarification of communications by non-retail
focused broker-dealers is necessary.
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As a result,\347\ we presume that the use of the terms ``adviser''
and ``advisor'' in a name or title by (i) a broker-dealer that is not
also registered as an investment adviser or (ii) an associated person
that is not also a supervised person of an investment adviser to be a
violation of the capacity disclosure requirement under Regulation Best
Interest.\348\
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\347\ Specifically, in the Proposing Release we stated that a
standalone broker-dealer would satisfy the capacity disclosure by
complying with the proposed Relationship Summary and Affirmative
Disclosure requirements. We provided this proposed guidance in the
context of concurrently proposing the Titling Restrictions. For the
reasons discussed herein, we believe a presumption against the use
of these titles by standalone broker-dealers is more appropriate
than a restriction.
\348\ If a financial professional is a registered representative
of a broker-dealer that is a dual-registrant but the professional is
not also a supervised person of an investment adviser, this
professional would similarly be presumptively in violation of the
capacity disclosure requirement if the financial professional uses
the title ``adviser'' or ``advisor.'' However, this financial
professional may continue to use either the dual-registrant's
materials or may use the firm's name in the financial professional's
communications even if the firm's name includes the title
``adviser'' or ``advisor'' because such firm is dually registered as
an investment adviser and broker-dealer and is not presumptively
violating the capacity disclosure requirement under Regulation Best
Interest. Moreover, we believe it would be consistent for dual-
registrants and dually registered financial professionals to use
these terms as they would be accurately describing their
registration status as an investment adviser.
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[[Page 33353]]
Although using these names or titles creates a presumption of a
violation of the Disclosure Obligation in Regulation Best Interest, we
are not expressly prohibiting the use of these names and titles by
broker-dealers because we recognize that some broker-dealers use them
to reflect a business of providing advice other than investment advice
to retail clients. A clear example is a broker-dealer (or associated
person) that acts on behalf of a municipal advisor \349\ or commodity
trading adviser,\350\ or as an advisor to a special entity,\351\ as
these are distinct advisory roles specifically defined by federal
statute that do not entail providing investment advisory services. We
also recognize that a broker-dealer may provide advice in other
capacities outside the context of investment advice to a retail
customer that would present a similarly compelling claim to the use of
these terms. In these circumstances, firms and their financial
professionals may in their discretion use the terms ``adviser'' or
``advisor.'' \352\ In most instances, however, when a broker-dealer
uses these terms in its name or title in the context of providing
investment advice to a retail customer, they will generally violate the
capacity disclosure requirement under Regulation Best Interest.
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\349\ 15 U.S.C. 78o-4(e)(4).
\350\ 15 U.S.C. 80b-2(a)(29).
\351\ 15 U.S.C. 78o-8(h)(2)(A).
\352\ Some commenters raised concerns that the proposed
restriction would not permit financial professionals to indicate
that they maintain particular certifications that include in the
name or title ``adviser'' or ``advisor.'' See, e.g., IWI August 2018
Letter; Letter from IWI (Oct. 9, 2018) (``IWI October 2018
Letter''). Cf. Letter from John Robinson (Aug. 6, 2018) (``Robinson
Letter'') (suggesting that the Commission limit the use of the term
``financial planner'' to investment adviser representatives); FPC
Letter (suggesting that the Commission clarify which certifications
or professional designations may be used for financial planners). We
recognize that these designations are intended to convey adherence
to particular standards that financial professionals have met.
However, these designations are not rooted in any statutory
construct (as are the titles ``commodity trading advisor'' and
``municipal advisor'') and given that the terms ``adviser'' and
``advisor'' are still associated with the statutory term
``investment adviser,'' even if used in a designation, a broker-
dealer or associated person that uses these designations would
similarly be in presumptive violation of the capacity disclosure
requirement in Regulation Best Interest.
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Marketing Communications
As discussed above, several commenters on the Titling Restrictions
raised concerns that restricting the use of names and titles would be
insufficient to address what they viewed as the larger issue of broker-
dealer marketing communications where a broker-dealer and/or its
financial professional appears to be holding itself out as an
investment adviser. Marketing communications provide additional context
to investors and are designed to persuade potential customers to obtain
and pay for the firm's services and products.\353\ They communicate to
customers what services firms understand themselves to be providing--
including, for broker-dealers, recommendations in connection with and
reasonably related to effecting securities transactions.
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\353\ Affiliated firms may market advisory and brokerage
services in a single set of communications. A dually registered firm
also may seek to market the primary services provided by its
advisory and brokerage business lines in a single set of
communications. We believe this combined approach to providing
customers with information about investment services enhances
customer choice, and we understand that many such firms market in
this way in an effort to provide a comprehensive picture of the
firm's services.
See also Instructions to Form CRS, General Instruction 5.
(Encouraging dual-registrants to prepare one relationship summary
discussing both its brokerage and investment advisory services, but
stating that they may prepare two separate relationship summaries
for brokerage services and investment advisory services. Whether the
firm prepares one relationship summary or two, the firm must present
the brokerage and investment advisory information with equal
prominence and in a manner that clearly distinguishes and
facilitates comparison of the two types of services.).
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The way in which a broker-dealer markets itself may have regulatory
consequences. As noted above, Form CRS requires, among other items,
broker-dealers (and investment advisers) to state clearly key facts
about their relationship, including their registration status and the
services they provide.\354\ Broker-dealers (and investment advisers)
will also be required through Form CRS to provide information to assist
retail investors in deciding whether to engage in an investment
advisory or brokerage relationship.\355\ Additionally and as discussed
above, we are adopting the capacity disclosure requirement under
Regulation Best Interest, which requires broker-dealers and their
financial professionals to affirmatively disclose the capacity (e.g.,
brokerage) in which they are acting with respect to their
recommendations.\356\ These obligations are designed to improve
awareness among retail customers of the capacity in which their firm or
financial professional acts when it makes recommendations so that the
retail customer can more easily identify and understand their
relationship.
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\354\ See Relationship Summary Adopting Release, supra footnote
12.
\355\ Id.
\356\ See Rule 15l-1(a)(2)(i)(A)(i).
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As noted above, we are not adopting the Commission's proposed
alternative holding out approach that would have addressed broker-
dealer marketing communications through the lens of the solely
incidental exclusion.\357\ However, under our interpretation of the
solely incidental prong of the broker-dealer exclusion from the
definition of investment adviser, a broker-dealer's investment advisory
services do not fall within that prong if the broker-dealer's primary
business is giving investment advice or if its investment advisory
services are not offered in connection with and are not reasonably
related to the broker-dealer's business of effecting securities
transactions.\358\ By more clearly delineating when a broker-dealer's
performance of advisory activities renders it an investment adviser,
this interpretation provides guidance that may be informative to
broker-dealers when designing marketing communications that accurately
reflect their activities.
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\357\ See supra footnote 335 and accompanying text.
\358\ See Solely Incidental Interpretation, supra footnote 12,
Section II.B (providing the Commission's interpretation of the
solely incidental prong of the broker-dealer exclusion from the
Advisers Act.)
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Broker-dealers, dual-registrants, and affiliated broker-dealers of
investment advisers that market their services together should consider
whether modifications are needed in their marketing communications in
light of these new obligations. As we noted in the Relationship Summary
Proposal, broker-dealers can, and do, provide investment advice so long
as such advice comports with the broker-dealer exclusion under Advisers
Act section 202(a)(11)(C). While broker-dealers and their financial
professionals may state that they provide ``advice'' in their marketing
communications, those and other statements should not be made in a
manner that contradicts the disclosures made pursuant to Regulation
Best Interest and Form CRS, and should be reviewed in light of the
Solely Incidental Interpretation.\359\ We believe that the combination
of new disclosure obligations and requirements and firms'
implementation of these new obligations will appropriately address
commenters' concerns regarding broker-dealers that hold themselves out
as
[[Page 33354]]
investment advisers, particularly those who can change capacities when
serving retail investors in a dual capacity.\360\
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\359\ See Relationship Summary Proposal, supra footnote 12, at
21461.
\360\ See, e.g., IAA August 2018 Letter; FPC Letter; Better
Markets CRS Letter.
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In addition to these new obligations, FINRA Rule 2210 (regarding
its members' communications with the public) is designed to ensure that
broker-dealer communications with the public are fair, balanced, and
not misleading.\361\ This rule includes general standards, such as a
requirement to not make any false or misleading statements, and
specific content standards, such as requirements on how to disclose the
broker-dealer's name in marketing communications.\362\ Accordingly, we
anticipate that FINRA will be reviewing the application of these rules
in light of these new disclosure obligations. The Commission staff also
will evaluate broker-dealer marketing communications to consider
whether additional measures may be necessary.
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\361\ See FINRA Rule 2210.
Additionally, broker-dealers and their financial professionals
should keep in mind the applicability of the antifraud provisions of
the federal securities laws, including section 17(a) of the
Securities Act, and Exchange Act Section 10(b) and Rule 10b-5
thereunder, to their marketing practices.
\362\ See, e.g., FINRA Rule 2210(d)(1) and (d)(3).
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Fees and Costs
In the Proposing Release, we stated that fees and charges
applicable to the retail customer's transactions, holdings, and
accounts would also be examples of ``material facts relating to the
terms and scope of the relationship'' \363\ As such, these fees and
charges would generally have needed to be disclosed in writing prior
to, or at the time of, the recommendation. While we did not propose to
mandate the form, specific content, or method for delivering fee
disclosure, we stated that we would generally expect that, to meet the
Disclosure Obligation, broker-dealers would build upon the proposed
Relationship Summary by disclosing, among other things, additional
detail regarding the types of fees and charges described in the
proposed Relationship Summary.\364\
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\363\ See Proposing Release at 21601.
\364\ See Proposing Release at 21600.
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We received a number of comments on the proposed Disclosure
Obligation relating to fees and charges. As discussed in more detail in
the relevant sections below, these comments generally sought clarity on
the scope of fees and charges to be disclosed, including the
particularity of the fees and charges to be disclosed (i.e., whether
standardized or individualized disclosure would be required). In
consideration of the comments received, and in light of the obligations
being imposed by the Relationship Summary, we are revising Regulation
Best Interest to explicitly require the disclosure of fees and costs,
and are providing additional clarifying guidance. In addition, we are
revising the Regulation Best Interest rule text to refer to ``fees and
costs'' instead of ``fees and charges,'' consistent with the approach
taken in the Relationship Summary. Specifically, we are revising the
Disclosure Obligation to require disclosure of ``all material facts
relating to the scope and terms of the relationship with the retail
customer, including [. . .] the material fees and costs that apply to
the retail customer's transactions, holdings and accounts.'' \365\
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\365\ Rule 15l-1(a)(2)(i)(A)(ii).
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We are also providing additional guidance addressing the scope of
fees and costs to be disclosed. Namely, the Disclosure Obligation
requires disclosure of material fees and costs relating to the retail
customer's transactions, holdings and accounts. This obligation would
not require individualized disclosure for each retail customer. Rather,
the use of standardized numerical and other non-individualized
disclosure (e.g., reasonable dollar or percentages ranges) is
permissible, as discussed below.\366\
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\366\ See Section II.C.1.a, Disclosure Obligation, Fees and
Costs, Particularity of Fees and Costs Disclosed; Individualized
Disclosure.
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Scope of Fees and Costs To Be Disclosed
Several commenters asked for clarification about whether all fees
and charges must be disclosed, or only those that are ``material.''
\367\ In response, we are revising Regulation Best Interest to make
explicit that a material fact regarding the scope and terms of the
relationship includes material fees and costs that apply to the retail
customer's transactions, holdings and accounts. As noted above, the
standard for materiality for purposes of the Disclosure Obligation is
consistent with the one the Supreme Court articulated in Basic v.
Levinson; fees and costs are material and must be disclosed, if there
is ``a substantial likelihood that a reasonable shareholder would
consider it important.'' \368\ As noted above, in the context of this
Regulation Best Interest, the standard of materiality is based on the
retail customer, as defined in the rule.
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\367\ See, e.g., Bank of America Letter (recommending that the
Commission: (i) Provide greater specificity regarding the fees to be
disclosed under Regulation Best Interest, and (ii) apply a
``materiality'' threshold to those fees).
\368\ Basic, Inc. v. Levinson, 485 U.S. 224, 224 (1988).
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We would generally expect that, to satisfy the Disclosure
Obligation, broker-dealers would build upon the material fees and costs
identified in the Relationship Summary, providing additional detail as
appropriate. These descriptions could include, for example, an
explanation of how and when the fees are deducted from the customer's
account (e.g., such as on a per-transaction basis or quarterly).
Although the fees and costs identified in the Relationship Summary may
provide a useful starting point for the identification of the material
fees and costs that may be disclosed pursuant to the Disclosure
Obligation, there may be other categories of fees and costs that are
material under the facts and circumstances of a broker-dealer's
business model that must be disclosed pursuant to the Disclosure
Obligation.
Particularity of Fees and Costs Disclosed; Individualized Disclosure
Several commenters recommended that the Commission not require that
broker-dealers provide individualized fee disclosures to retail
customers. Specifically, they recommended that the Commission clarify
that broker-dealers could meet the Disclosure Obligation if they
provide a range of fees and costs or use standardized and hypothetical
amounts rather than requiring disclosure of actual dollar amounts based
on proposed amounts to be invested (i.e., individualized fees).\369\
These commenters cited concerns about cost and practicality associated
with generating individualized disclosures.\370\ With regard to
product-level fees in particular, several commenters expressed concern
that
[[Page 33355]]
broker-dealers could not easily calculate individualized fees and
charges associated with the securities about which they provide
recommendations and that doing so might lead to inadvertently providing
inconsistent or inaccurate fee estimates to their retail
customers.\371\ In this vein, several commenters recommended that
broker-dealers should be able to satisfy the Disclosure Obligation
regarding product-level fees by providing retail customers with or
referring them to an issuer's offering materials, such as a
prospectus.\372\ Other commenters, on the other hand, stated that the
Commission should not allow the use of percentages or ranges because
such a presentation does not adequately inform investors of the fees
and charges they will incur.\373\
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\369\ See, e.g., Vanguard Letter (recommending that the
Disclosure Obligation could be satisfied by relaying the types and
ranges of costs associated with a recommendation, or by using
standardized and hypothetical investments, rather than requiring
computation of actual dollar amounts based on proposed amounts to be
invested); Capital Group Letter (stating that customized mutual fund
fee and expense disclosures for investors at the time of the
recommendation would be impractical); SIFMA August 2018
(recommending the Commission permit disclosure of a range of
customer costs per product); NASAA August 2018 Letter (suggesting
that the Commission mandate its Model Fee Table along with
disclosure of other fees paid for services and any other third party
remuneration).
\370\ See, e.g., TIAA Letter (stating that broker-dealers would
need to expend significant resources to build new systems and new
compliance programs in order to provide individualized fee
disclosure); ICI Letter (recommending that the Commission confirm
that the Disclosure Obligation would not require a broker-dealer to
separately calculate fund fees and expenses); Capital Group Letter
(stating that individualized disclosures raise significant
operational burdens and compliance issues in exchange for, at best,
inconsistent utility).
\371\ See, e.g., TIAA Letter (stating that calculating
individualized fee information for any retail customer would be
difficult and might lead to inadvertently providing inconsistent or
inaccurate fee estimate); Capital Group Letter.
\372\ See TIAA Letter (stating that broker-dealers should not be
obligated to provide fund-level fee disclosure outside of a fund
prospectus or to provide individualized fee disclosure to retail
customers); ICI Letter (stating that when making a recommendation of
a fund, a broker-dealer should be permitted to direct customers to
the fund's prospectus as the source of information about fund fees
and expenses); Oppenheimer Letter (stating that the fund, not the
broker-dealer, is in a better position to provide these disclosures,
in a manner that is accurate, consistent and complete).
\373\ See, e.g., CFA August 2018 Letter (stating that the
Commission should not allow for percentages or ranges because it
would do little to inform investors); PIABA Letter (stating that
broker-dealers should disclose the specific charges that their
customers will incur as a result of the particular recommendation);
UMiami Letter (stating that customers should be provided with clear
and concise information that fully and fairly discloses the specific
charges the customer will incur as a result of a particular
recommendation).
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As adopted, the Disclosure Obligation does not mandate
individualized fee disclosure particular to each retail customer.
Instead, broker-dealers may disclose ``material facts'' about material
fees and costs in terms of more standardized numerical and narrative
disclosures, such as standardized or hypothetical amounts, dollar or
percentage ranges, and explanatory text where appropriate. The
disclosure should accurately convey why a fee is being imposed and when
the fee is to be charged. Further, as discussed below,\374\ a broker-
dealer will need to supplement this standardized disclosure with more
particularized information if the broker-dealer concludes that such
information is necessary to fully and fairly disclose the material
facts associated with the fee or charge. For example, a broker-dealer
might initially disclose a range of product fees, and later supplement
that information with more particularized information by delivering the
product prospectus.\375\
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\374\ See Section II.C.1.c, Disclosure Obligation, Full and Fair
Disclosure, Layered Disclosure.
\375\ See supra footnote 302.
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Consistent with this approach, and also in response to comments, we
are further clarifying that a broker-dealer recommending a securities
transaction or an investment strategy involving securities can meet the
Disclosure Obligation regarding fees and costs assessed at the product
level by describing those fees and costs in initial, standardized terms
and providing subsequent particularized disclosure as necessary. To the
extent that such subsequent information regarding product-level fees
and costs appears in a currently mandated disclosure document, such as
a trade confirmation or a prospectus, delivery of that information in
accordance with existing regulatory obligations will be deemed to
satisfy the Disclosure Obligation, even if delivery occurs after the
recommendation is made, under the circumstances outlined in Section
II.C.1. Although it is not required by Regulation Best Interest,
broker-dealers may refer the customer to any issuer disclosure of the
security being recommended, such as a prospectus, private placement
memorandum, or offering circular, where more particular information may
be found.
We acknowledge that the desire for greater fee transparency was a
consistent theme of our investor engagement and we believe that the
Disclosure Obligation, in conjunction with the Relationship Summary,
significantly advances that goal. Individualized fee disclosure may be
helpful to some retail customers, but it can also be costly, prone to
errors, and cause delays in trade execution. In addition, in some cases
the precise amount of the fee may be based on the dollar value of the
transaction, and would not be known prior to or at the time of the
recommendation, meaning that it could only be expressed in more general
terms, such as a percentage value or range, as an initial matter. We
believe that adopting the Disclosure Obligation that allows for the use
of standardized disclosure furthers our goal of informing investors
about fees and costs by the time of a recommendation in a workable
manner. Nothing in Regulation Best Interest prevents a broker-dealer
from providing such individualized disclosure to its customers should
it wish to do so, and we encourage firms to assist retail customers in
understanding the specific fees and costs that apply, and to provide
more individualized disclosure where appropriate, or in response to a
retail customer's request. As a best practice, firms may also consider
reviewing with their retail customers the effect of fees and costs on
the retail customer's account(s) on a periodic basis.\376\ The costs,
errors, delays, and other practical obstacles to individualized fee
disclosure are likely to fall over time. We will continue to consider
whether to require more personalized fee disclosure, particularly as
technology evolves to address operational and technological costs.
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\376\ Although we encourage firms to have this conversation with
their retail customers, we are not suggesting that engaging in such
a best practice would, by itself, create any implied or explicit
obligation to monitor such fees and costs.
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With regard to the disclosure of product-level fees in particular,
while we support the goal of bringing greater transparency to all fees
incurred, we are seeking to supplement, not supplant, the existing
regulatory regime currently applicable to product-level fees with the
adoption of Regulation Best Interest. We acknowledge that if a broker-
dealer highlights such fees with particularity, it may raise a
customer's awareness of them, and we encourage as a best practice that
broker-dealers do so.\377\ We acknowledge also that the nature and
extent of product-level disclosures may vary. However, we do not
believe that requiring broker-dealers to deliver product disclosures
earlier than is currently required, to generate fee disclosure not
currently required of issuers, or to recalculate or highlight specific
product-level fees already disclosed in an issuer's offering materials
will meaningfully improve fee disclosure and it may, in fact, be unduly
burdensome and raise the possibility of errors if broker-dealers were
to be obligated to project or calculate product fees based on product
issuer information. Accordingly, we believe that allowing broker-
dealers to meet the Disclosure Obligation with regard to product-level
fees by describing those fees in standardized terms with further
detailed, particularized information related to the recommendation
provided either prior to or at the time of the recommendation or
afterwards under the circumstances outlined in Section II.C.1, Oral
Disclosure or Disclosure After a Recommendation, strikes an
[[Page 33356]]
appropriate balance between costs to firms and benefits to retail
customers.\378\
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\377\ With regard to product-level fees, in particular, broker-
dealers may wish to highlight certain categories of fees such as
distribution fees, platform fees, shareholder servicing fees and
sub-transfer agency fees, in order to enhance retail customers'
understanding of these fees to the extent applicable to the
customer's transactions, holdings, and accounts.
\378\ See Section II.C.1, Disclosure Obligation, Oral Disclosure
or Disclosure After a Recommendation.
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We believe this approach is bolstered by the existence of
complementary obligations protective of retail customers that are
imposed by Regulation Best Interest. For example, to the extent fees
and costs incurred related to these products create conflicts of
interest associated with a recommendation, we believe they are
appropriately highlighted and addressed in the context of the conflicts
and incentives they create to make a recommendation, and must be
addressed as part of the obligation to disclose material facts about
conflicts of interest associated with a recommendation, as discussed
below.\379\
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\379\ See Section II.C.1.b, Disclosure Obligation, Material
Facts Regarding Conflicts of Interest.
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Moreover, under the Care Obligation, a broker-dealer recommending a
securities transaction or investment strategy involving securities to a
retail customer must consider costs associated with that recommendation
when determining whether it is in the best interest of that retail
customer. As a result, disclosure of product-level fees and costs to
satisfy the Disclosure Obligation will be supplemented by other aspects
of Regulation Best Interest.
While the Disclosure Obligation provides broker-dealers with
flexibility in describing the material fees and costs that apply, the
disclosure should accurately convey why the fee or charge is being
imposed and when the fee or charge is to be assessed. For example,
describing a commission or markup as a fee for ``handling services''
could inappropriately disguise the fee's true nature. Furthermore,
while using a percentage or dollar range to describe a fee can be
appropriate, that range should be designed to reasonably reflect the
actual fee to be charged. For example, a statement that a charge may be
``between 5 and 100 basis points'' would not be accurate if the fee is
in almost all instances between 85 and 100 basis points. However, in
this case, a broker-dealer could accurately describe the fee, for
example, as ``generally being between 85 and 100 basis points,
sometimes lower, but never above.'' In some cases, actual dollar values
based on a hypothetical transaction may facilitate customer
understanding.
A material fact about fees and costs could also include informing a
retail customer of a fee's triggering event, such as a fee imposed
because an account minimum falls below a threshold and whether fees are
negotiable or waivable.
Type and Scope of Services Provided
In the Proposing Release, we provided guidance that the type and
scope of services a broker-dealer provides its retail customers would
also be an example of what typically would be ``material facts relating
to the terms and scope of the relationship,'' that would require
disclosure pursuant to the Disclosure Obligation.\380\ Specifically, we
stated that broker-dealers should build upon their disclosure in the
Relationship Summary, and provide additional information regarding the
types of services that will be provided as part of the relationship
with the retail customer and the scope of those services.\381\
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\380\ See Proposing Release at 21602.
\381\ Id.
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In particular, we noted that under proposed Form CRS broker-dealers
would provide high-level disclosures concerning services offered to
retail investors, including, for example, recommendations of
securities, assistance with developing or executing an investment
strategy, monitoring the performance of the retail investor's account,
regular communications, and limitations on selections of products.\382\
We recognized that a broker-dealer that offers different account types,
or offers varying additional services to the retail customer may not be
able, within the content and space constraints of the Relationship
Summary, to provide ``all material facts relating to the scope and
terms of the relationship'' with the retail customer.\383\ Thus, we
stated that pursuant to the proposed Disclosure Obligation, we would
have generally expected broker-dealers to disclose these types of
material facts concerning the actual services offered as part of the
relationship with the retail customer separately from the Relationship
Summary.
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\382\ See Relationship Summary Proposing Release at 31426.
\383\ See Section II.C.1.a, Disclosure Obligation, Standard of
Conduct.
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Commenters generally agreed that it was important for broker-
dealers to disclose to their customers material facts about the type
and scope of services they provide to their customers.\384\ However,
commenters sought clarity regarding the application of this proposed
guidance, and raised questions about whether firms would be
specifically required to disclose certain services (e.g., monitoring
account performance and providing financial education) pursuant to
Regulation Best Interest,\385\ as discussed below, and the level of
disclosure required under Regulation Best Interest.\386\
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\384\ See, e.g., Pacific Life August 2018 Letter; Cetera August
2018 Letter.
\385\ See, e.g., Betterment Letter (recommending that the
Commission ensure that dual-registrants communicate which of their
services are advisory in nature); Northwestern Mutual Letter.
\386\ See, e.g., Cetera August 2018 Letter (stating that a best
interest standard should include a requirement to deliver a summary
description of the relationship between the firm and customer,
including the scope of services); Committee of Annuity Insurers
Letter (recommending the Commission clarify that a broker-dealer
could satisfy the Disclosure Obligation by disclosing the products
and services available to its retail customers and does not need to
disclose information particularized to a recommendation).
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Consistent with our approach in the Proposing Release, we continue
to believe that the type and scope of services a broker-dealer provides
to its retail customers are ``material facts relating to the scope and
terms of the relationship.'' Accordingly, we are revising the rule text
to explicitly require the disclosure of the ``type and scope of
services provided to the retail customer, including any material
limitations on the securities or investment strategies involving
securities that may be recommended to the retail customer,'' as part of
the ``material facts relating to the scope and terms of the
relationship'' that must be disclosed pursuant to the Disclosure
Obligation.\387\
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\387\ Rule 15l-1(a)(2)(i)(A)(iii).
---------------------------------------------------------------------------
We are interpreting the Disclosure Obligation to only require
disclosure of material facts relating to the type of services provided
(e.g., the fact that the broker-dealer monitors securities transactions
and investment strategies) and the scope of services (e.g., information
about the frequency and duration of the services). In response to
comments, we are also specifically addressing the disclosure of
information regarding whether or not the broker-dealer provides account
monitoring services and whether the broker-dealer has account minimums
or similar requirements.
In addition, in response to comments, we are clarifying that
pursuant to the Disclosure Obligation, broker-dealers need to disclose
only material information relating to the ``type and scope of services
provided.'' As discussed in the context of the disclosure of fees and
costs above, the standard for materiality of the type and scope of
services to be disclosed is consistent with the standard articulated in
Basic v. Levinson: Information related to the type and scope of
services provided is material, and must be disclosed, if there is ``a
substantial likelihood that a reasonable shareholder
[[Page 33357]]
would consider it important.'' \388\ As noted above, in the context of
Regulation Best Interest, this standard would apply in the context of
retail customers, as defined.
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\388\ Basic, Inc. v. Levinson, 485 U.S. 224, 224 (1988).
---------------------------------------------------------------------------
We believe the information included in the Relationship Summary may
provide a useful starting point for the identification of the type and
scope of services that must be disclosed pursuant to the Disclosure
Obligation. For example, in the Relationship Summary a broker-dealer
must describe its principal brokerage services offered, including
buying and selling securities, and whether or not it offers
recommendations to retail investors.\389\ Additionally, in the
Relationship Summary, if applicable, the broker-dealer must address
whether or not the firm offers monitoring of investments.
---------------------------------------------------------------------------
\389\ See Form CRS, Item 2.B. (Description of Services).
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We believe that broker-dealers will generally need to build upon
the disclosures made in the Relationship Summary as appropriate, and to
provide additional information regarding the types of services that
will be provided as part of the relationship with the retail customer
and the scope of those services (e.g., the frequency and duration of
the services), as necessary, in order to meet the Disclosure
Obligation's requirement to disclose ``all material facts'' regarding
the type and scope of services provided. Broker-dealers may be able to
satisfy this aspect of the Disclosure Obligation by relying on their
existing disclosures about the type and scope of their services,
typically reflected in their account opening agreement or other account
opening related documentation, so long as the disclosure as a whole
addresses the material facts relating to the type and scope of services
offered to the retail customer.
Disclosure of Material Limitations on Securities and Investment
Strategies
In the Proposing Release, we included any limitations on the
products and services offered as an example of a material fact relating
to the terms and scope of the relationship that would need to be
disclosed pursuant to the Disclosure Obligation. We agree with
commenters who advocated for helping investors to understand whether a
broker-dealer limits its product offerings, and to what extent, before
entering into a relationship with a broker-dealer.\390\ We continue to
believe that broker-dealers that place material limitations on the
securities or investment strategies involving securities that may be
recommended to retail customers--such as recommending only proprietary
products or a specific asset class--need to describe the material facts
relating to those limitations.\391\
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\390\ See CFA Institute Letter (stating that if a broker-dealer
only offers proprietary products, it should clearly call attention
to the higher product cost and the potential cost to the investor of
such a limited offering); SIFMA August 2018 Letter (stating that a
firm should be able to limit its offerings to a particular subset of
its customers to proprietary product or revenue sharing products as
long as: (1) The broker-dealer discloses that it is limiting its
recommendation to a specific set of securities and (2) the specific
set of securities contains appropriate securities to meet the
customer's needs); SPARK Letter (recommending that the Commission
permit broker-dealers that only offers proprietary products or a
limited menu of investments to satisfy the conflict mitigation
requirements by: (1) Disclosing any material limitations on the
investment products being offered and (2) reasonably concluding that
the limitations will not violate the Care Obligation).
\391\ See Form CRS, Item 2.B.(iii).
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Therefore, in response to comments, we are revising Regulation Best
Interest to explicitly require that, as part of the disclosure of the
type and scope of services provided to the retail customer, a broker-
dealer must include ``any material limitations on the securities or
investment strategies involving securities that may be recommended to
the retail customer.'' \392\ For purposes of this requirement, a
``material limitation'' placed on the securities or investment
strategies involving securities could include, for example,
recommending only proprietary products (e.g., any product that is
managed, issued, or sponsored by the broker-dealer or any of its
affiliates), a specific asset class, or products with third-party
arrangements (e.g., revenue sharing, mutual fund service fees).\393\
Similarly, the fact that the broker-dealer recommends only products
from a select group of issuers, or makes IPOs available only to certain
clients, could also be considered a material limitation. To cite
another example, if an associated person of a dually registered broker-
dealer only offers brokerage services, and is not able to offer
advisory services, the fact that the associated person's services are
materially narrower than those offered by the broker-dealer would
constitute a material limitation.
---------------------------------------------------------------------------
\392\ Rule 15l-1(a)(2)(A). See also Section II.C.1 for a
discussion of the materiality standard under Basic, Inc. v.
Levinson, 485 U.S. 224 (1988).
\393\ This is consistent with the approach we are taking in the
Relationship Summary Adopting Release.
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We recognize that, as a practical matter, all broker-dealers limit
their offerings of securities and investment strategies to a greater or
lesser degree. We do not believe that disclosing the fact that a
broker-dealer does not offer the entire possible range of securities
and investment strategies would convey useful information to a retail
customer, and therefore we would not consider this fact, standing
alone, to constitute a material limitation.\394\
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\394\ See Basic, Inc. v. Levinson, 485 U.S. 224, 224 (1988).
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In addition, we believe that there are a number of reasonable
practices by which appropriate limitations are determined, including
processes for the selection of a ``menu'' of products that will be
available for recommendations to retail customers. We further recognize
that these limitations can be beneficial, such as by helping ensure
that a broker-dealer and its associated persons understand the
securities they are recommending, as required by paragraph
(a)(2)(ii)(A) of the Care Obligation. We have also explicitly stated
that Regulation Best Interest would not prohibit a broker-dealer from
recommending, for example, a limited range of products, or only
proprietary products, provided the broker-dealer satisfies the
component obligations of Regulation Best Interest. Nonetheless, because
these firm-wide threshold decisions have such a significant effect on
the subsequent recommendations ultimately made to a retail customer, we
are requiring disclosure of the material limitations on the securities
or investment strategies involving securities that may be recommended--
by the broker-dealer and its associated persons--as well as any
associated conflicts of interest.
Explicitly requiring disclosure of these limitations is also
consistent with our approach in the Care and Conflict of Interest
Obligations. As discussed below, despite the potential beneficial
aspects of some limitations, we are concerned that such limitations and
any associated conflicts of interest can negatively affect the
securities or investment strategies recommended to a retail
customer.\395\ In recognition of this concern, we have revised the
Conflict of Interest Obligation to specifically require the
establishment of policies and procedures to identify, disclose, and
address that risk.\396\ Furthermore, we reiterate that even if a
broker-dealer discloses and addresses any material limitations on the
securities or investment strategies involving securities recommended to
a retail customer, and any associated conflicts of interest, as
required by the Disclosure
[[Page 33358]]
and Conflict of Interest Obligations, it would nevertheless need to
satisfy the Care Obligation in recommending such products.\397\
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\395\ See Section II.C.3, Conflicts of Interest. See Proposing
Release at 21608 (asking commenters to comment on whether, and, if
so why, the Commission should require specific disclosure on product
limitations).
\396\ See Section II.C.4.
\397\ See Section II.C.2.
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Account Monitoring Services
In the Proposing Release, we identified as a material fact relating
to the scope and terms of the relationship with the retail customer the
type and scope of services provided by the broker-dealer, including,
for example, monitoring the performance of the retail customer's
account.\398\ Additionally, the Proposing Release stated that to the
extent that the broker-dealer agrees with a retail customer by contract
to provide periodic or ongoing monitoring of the retail customer's
investments for purposes of recommending changes in investments,
Regulation Best Interest would apply to, and a broker-dealer would be
liable for not complying with the proposed rule with respect to, any
recommendations about securities or investment strategies made to
retail customers resulting from such services.\399\
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\398\ Proposing Release at 21600.
\399\ Id. at 21594.
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Commenters suggested that broker-dealers should be required to
clearly define the nature of account monitoring services offered, with
some commenters pointing to retail customer confusion on this
topic.\400\ One commenter stated that disclosure will not help a retail
customer of a dual-registrant who has both brokerage and advisory
accounts, who is unlikely to remember which accounts his or her
financial advisor is responsible for monitoring, and for which accounts
the customer bears that responsibility. Accordingly, the commenter
recommends that we require broker-dealers to monitor all retail
customers' accounts.\401\
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\400\ See, e.g., NAIFA Letter (asserting broker-dealers should
be free to agree to, and define the nature of, any ongoing
relationship via contract, such as including monitoring services);
see also RAND 2018 (stating that participants demonstrated a lack of
clarity on how a financial professional would monitor an account);
OIAD/RAND (stating that some participants perceived that continuous
monitoring of a client's account is consistent with acting in the
client's best interest).
\401\ AFL-CIO April 2019 Letter.
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As discussed in the Solely Incidental Interpretation, we disagree
with commenters who suggested that any monitoring of customer accounts
would require a broker-dealer to register as an investment adviser and
we believe that it is important for retail customers to understand: (1)
The types of account monitoring services (if any) a particular broker-
dealer provides, and (2) whether or not the broker-dealer will be
providing monitoring services for the particular retail customer's
account. Accordingly, we believe that whether or not the broker-dealer
will monitor the retail customer's account and the scope and frequency
of any account monitoring services that a broker-dealer agrees to
provide are material facts relating to the type and scope of services
provided to the retail customer and must be disclosed pursuant to the
Disclosure Obligation. This disclosure could indicate, for example,
that the broker-dealer will monitor the account or investments at a
stated frequency in light of the retail customer's investment
objectives for the purpose of recommending an asset reallocation where
appropriate, or that the broker-dealer will monitor the account
periodically to determine whether a brokerage account continues to be
in the retail customer's best interest. Or, broker-dealers that offer
no account monitoring services could disclose that they will not
monitor the account or consider whether any recommendations may be
appropriate unless the retail customer specifically requests that they
do so.\402\
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\402\ As discussed in footnote 167, we recognize that a broker-
dealer may voluntarily, and without any agreement with the customer,
review the holdings in a retail customer's account for the purposes
of determining whether to provide a recommendation to the customer.
We do not consider this voluntary review to be ``account
monitoring,'' nor would it in and of itself on its own to create an
implied agreement with the retail customer to monitor the customer's
account. Any explicit recommendation made to the retail customer as
a result of any such voluntary review would be subject to Regulation
Best Interest.
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The Relationship Summary requires broker-dealers to explain whether
or not they monitor retail investors' investments, including the
frequency and any material limitations.\403\ However, as noted above,
because the Relationship Summary provides high-level disclosure, in
most cases it generally would not be sufficiently specific to inform
investors about the scope and frequency of any account monitoring
services applicable to the particular retail customer's account. The
Disclosure Obligation is designed to provide investors with an expanded
description of the material information relating to such services.
Furthermore, as discussed in Section 2.B.2.b., Regulation Best Interest
applies to recommendations resulting from agreed-upon account
monitoring services (including implicit hold recommendations).
Requiring disclosure of whether or not the broker-dealer will monitor
the retail customer's account, and the scope and frequency of such
monitoring, will help retail customers understand the terms applicable
to the particular retail customer's account. While retail customers
with multiple accounts will have to keep track of the accounts for
which their broker-dealer has agreed to monitor, we believe that
requiring disclosure of this service will provide those retail
customers with sufficient clarity about the monitoring services they
may expect. Requiring all broker-dealers to monitor all retail customer
accounts, as one commenter suggested, would diminish the options
available to retail customers, who may wish to have their accounts
monitored to a greater or lesser degree (including not at all).
---------------------------------------------------------------------------
\403\ See Form CRS, Item 2.B.(i).
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Account Balance Requirements
The Proposing Release did not address whether a broker-dealer
offering brokerage accounts subject to account balance requirements is
a ``material fact relating to the scope and terms of the
relationship.'' However, several commenters to the Form CRS proposal
suggested that the Commission require firms to disclose any account
balance requirements in the Relationship Summary.\404\ We believe that
account balance requirements are a material fact relating to the terms
and scope of the relationship. Consequently, we are interpreting the
Disclosure Obligation to include disclosure of whether a broker-dealer
has any requirements for retail customers to open or maintain an
account or establish a relationship, such as a minimum account size. We
believe that if a broker-dealer will only open a brokerage account for
a retail customer with a specific account minimum, such a basic
operational aspect of the account is a material fact relating to the
type and scope of services provided. If dollar thresholds or other
requirements apply to a retail customer's ability to maintain an
existing account, or to avoid additional fees when the threshold is
crossed (for example, a ``low account balance'' fee), such requirements
also would likely be of importance to a retail customer.\405\ We
further believe retail customers can use facts about different account
size requirements for both current and future planning and decision-
making purposes. Accordingly,
[[Page 33359]]
the Commission believes this information constitutes a ``material
fact'' that must be disclosed pursuant to the Disclosure Obligation.
---------------------------------------------------------------------------
\404\ See, e.g., NASAA Letter (stating that ``Form CRS should
specify minimum account size and include information on
miscellaneous fees different categories of investors can expect to
pay.''); Cetera August 2018 Letter (stating that Form CRS should
include ``[w]hether or not the firm has established standards for
the minimum or maximum dollar amount of various account types;'' and
submitting mock-up form that include disclosures of account
minimums); Primerica Letter. See Relationship Summary Adopting
Release.
\405\ See Relationship Summary Adopting Release.
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Other Material Facts Related to the Scope and Terms of the Relationship
In the Proposing Release, although we identified the broker-
dealer's capacity, fees and charges, and type and scope of services
provided as examples of what would generally be considered ``material
facts relating to the scope and terms of the relationship with the
retail customer,'' we noted that the Disclosure Obligation would also
require broker-dealers and their associated persons to determine, based
on the facts and circumstances, whether there are other material facts
relating to the scope and terms of the relationship that would need to
be disclosed.\406\ We also asked for comment on whether examples of
other information relating to scope and terms of the relationship
should be highlighted by the Commission as likely to be considered a
material fact relating to the scope and terms of the relationship that
would need to be disclosed.\407\
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\406\ See Proposing Release at 21600-21601.
\407\ See Proposing Release at 21607.
---------------------------------------------------------------------------
A number of commenters provided suggestions of additional examples
of such material facts that the Commission should highlight or
explicitly require to be disclosed as a ``material fact relating to the
scope and terms of the relationship.'' Specifically, commenters raised
whether a broker-dealer's basis for,\408\ and risks associated
with,\409\ a recommendation, or the standard of conduct applicable to a
broker-dealer making a recommendation,\410\ should be material facts
relating to the scope and terms of the relationship.
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\408\ See infra footnote 411.
\409\ See infra footnote 412.
\410\ See infra footnote 417.
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Basis for and Risks Associated With the Recommendation
The Proposing Release did not address whether a broker-dealer's
basis for a recommendation is a ``material fact relating to the scope
and terms of the relationship.'' However, several commenters requested
that the Commission treat a broker-dealer's basis for a recommendation
as a ``material fact relating to the scope and terms of the
relationship'' that would likely need to be disclosed prior to, or at
the time of the recommendation, pursuant to the Disclosure
Obligation.\411\ Similarly, several commenters suggested that the
Commission should treat risks associated with a broker-dealer's
recommendation as ``material facts relating to the scope and terms of
the relationship'' that would likely need to be disclosed prior to, or
at the time of the recommendation.\412\ Other commenters opposed
requiring particularized disclosure of the basis of individual
recommendations, stating that it is sufficient to disclose that
different products are available with different features rather than
require firms specify why the broker-dealer recommended one product
over another.\413\
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\411\ See, e.g., PIABA Letter (recommending that broker-dealers
be required to provide a clear and understandable explanation as to
the other lower cost investments which are available, and why the
higher cost investment is being recommended); Morningstar Letter
(recommending that the Commission require a firm to disclose its
analysis of the reasons it is recommending a rollover from an ERISA-
covered retirement plan to an IRA and why it is in the participant's
best interest).
\412\ See, e.g., PIABA Letter (recommending that the Commission
extend the Disclosure Obligation to include the risks, benefits, and
ramifications of a recommendation).
\413\ See, e.g., LPL August 2018 Letter (stating that a broker-
dealer could satisfy the Care Obligation if it recommends a more
expensive investment product so long as it discloses that the
recommended product is not the least expensive among the
alternatives and is otherwise in the investor's best interest);
Committee of Annuity Insurers Letter (recommending that the
Commission clarify that a broker-dealer could satisfy the Disclosure
Obligation through the use of a disclosure describing the products
and services available to its retail customers and related conflicts
of interest, and that a broker-dealer or associated person need not
provide a disclosure particularized to a recommendation). See also
CCMC Letters (requesting that the SEC confirm that it is sufficient
to disclose that different products are available with different
features rather than require firms to also document why the firm
recommended one product over another); IPA Letter (requesting
additional guidance regarding specificity of disclosure needed to
demonstrate why a broker-dealer recommended one of multiple
different products (with different terms, cost structures and
conditions) that each meet the customer's investment objective).
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Our view is that the general basis for a broker-dealer's or an
associated person's recommendations (i.e., what might commonly be
described as the firm's or associated person's investment approach,
philosophy, or strategy) is a material fact relating to the scope and
terms of the relationship with the broker-dealer that must be disclosed
pursuant to the Disclosure Obligation. The process by which a broker-
dealer and an associated person develop their recommendations to retail
customers is of fundamental importance to the retail customer's
understanding of what services are being provided, and whether those
services are appropriate to the retail customer's needs and goals. We
believe that such a description can be made in standardized or summary
form; however the disclosure should also address circumstances of when
the standardized disclosure does not apply and how the broker-dealer
will notify the customer when that is the case. For example, if an
associated person has a distinct investment approach, as may be the
case with persons associated with an independent contractor broker-
dealer, the broker-dealer's standardized disclosure should indicate how
its associated persons will notify retail customers of their own
investment approach.
While the general basis for the recommendation is a material fact
for purposes of the Disclosure Obligation, we decline to require
disclosure of the basis for each recommendation, an approach that could
involve significant costs and in many cases may simply repeat the more
standardized disclosure that we are already requiring. With regard to
how conflicts of interest may affect the basis for a particular
recommendation, we note that the Disclosure Obligation requires
disclosure of the material facts relating to the conflicts of interest
associated with the recommendation, which will help retail customers
evaluate the incentives a broker-dealer or associated person may have
in making a recommendation; and the Conflict of Interest Obligation
requires a broker-dealer to have policies and procedures to mitigate,
and in certain instances, eliminate, specified conflicts of interest.
Accordingly, to the extent the basis for any recommendation is subject
to any conflicts of interest, the Commission believes that the Care
Obligation's substantive requirement to have a reasonable basis for the
recommendation, combined with the Disclosure, Conflict of Interest and
Compliance Obligations, provides sufficient protections to broker-
dealers' retail customers.
Similarly, we are interpreting disclosure of the risks associated
with a broker-dealer's or associated person's recommendations in
standardized terms as a material fact related to the scope and terms of
the relationship that needs to be disclosed. For example, a broker-
dealer could disclose: ``While we will take reasonable care in
developing and making recommendations to you, securities involve risk,
and you may lose money. There is no guarantee that you will meet your
investment goals, or that our recommended investment strategy will
perform as anticipated. Please consult any available offering documents
for any security we recommend for a discussion of risks associated with
the product. We can provide those documents to you, or help you to find
them.'' This example is purely illustrative. Whether any
[[Page 33360]]
particular disclosure by a broker-dealer is sufficient to meet the
Disclosure Obligation will depend on the facts and circumstances.
The risks associated with a particular recommendation would be
relevant to a retail customer. However, we believe that broker-dealers
may rely on the existing disclosure regime governing securities issuers
to disclose the risks associated with any issuer, security or
offering,\414\ and it is not our intent to require the broker-dealer to
duplicate or expand on those disclosures. Consistent with our approach,
discussed above, to disclosure of product-level fees and costs, we
believe that describing product-level risks in standardized terms, with
additional information in any available issuer disclosure documents
delivered in accordance with existing regulatory requirements would
satisfy the Disclosure Obligation. As noted above, we are not seeking
to supplant the developed regulatory regime currently applicable to
offering disclosure with the adoption of Regulation Best Interest.
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\414\ See, e.g., Item 503(c) of Reg. S-K (requiring disclosure
of the ``most significant'' factors that make an offering
``speculative or risky,'' as well as an explanation of how each risk
``affects the issuer or the securities being offered.'' See also
Form 10-K (requiring a description of the 503(c) risk factors that
are ``applicable to the registrant''). In some cases, SRO Rules
applicable to recommendations of particular securities may also
require disclosure of risks. See, e.g., FINRA Rule 2330 (requiring a
FINRA member or its associated persons recommending deferred
variable annuity to have a reasonable belief that the customer has
been informed of, among other things, market risk). See also FINRA
Rule 2210(d), requiring, among other things, that statements in
member communications ``are clear and not misleading within the
context in which they are made, and that they provide balanced
treatment of risks and potential benefits.''
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While we believe that a standardized discussion of risks is a
material fact that must be disclosed to satisfy the Disclosure
Obligation, we decline to impose a disclosure requirement specific to
each recommendation. As with regard to the disclosure of the
individualized basis for each recommendation, we believe that such
specific disclosure could involve significant costs and in many cases
simply repeat the more standardized disclosure that we are requiring,
which we believe will sufficiently inform retail customers, in broad
terms, of the nature of the risks associated with a recommendation.
In addition, under the Care Obligation, a broker-dealer making a
recommendation of a securities transaction or investment strategy
involving securities to a retail customer must consider the risks when
determining whether it has a reasonable basis for believing that the
recommended transaction or investment strategy could be in the best
interest of at least some retail customers, and is in the best interest
of a particular retail customer. Moreover, under paragraph (a)(2)(B) of
Regulation Best Interest, discussed below, broker-dealers need to
disclose ``all material facts relating to conflicts of interest that
are associated with the recommendation,'' which will require disclosure
of what we believe to be a significant risk associated with a broker-
dealer's recommendations--the broker-dealer's conflicts of interest.
For these reasons, we believe that standardized written disclosure of
this information in general terms is sufficient.
Consistent with the Compliance Obligation, broker-dealers should
consider developing policies and procedures that address the
circumstances under which the basis for a particular recommendation
would be disclosed to a retail customer. As a best practice, firms also
should encourage their associated persons to discuss the basis for any
particular recommendation with their retail customers, including the
associated risks, particularly where the recommendation is significant
to the retail customer. For example, the decision to roll over a 401(k)
into an IRA may be one of the most significant financial decisions a
retail investor could make. Thus, a broker-dealer should discuss the
basis of such recommendations with the retail customer. Similarly, we
encourage broker-dealers to record the basis for their recommendations,
especially for more complex, risky or expensive products and
significant investment decisions, such as rollovers and choice of
accounts, as a potential way a broker-dealer could demonstrate
compliance with the Care Obligation.
Standard of Conduct \415\
---------------------------------------------------------------------------
\415\ See Section II.C.1.a, Disclosure Obligation, Capacity in
Which the Broker-Dealer is Acting.
---------------------------------------------------------------------------
As stated in the Proposing Release, the Commission intended the
Relationship Summary to touch on issues that are also contemplated
under the Disclosure Obligation, such as facilitating greater awareness
of key aspects of a relationship with a firm or financial professional,
such as the applicable standard of conduct.\416\ Several commenters on
Regulation Best Interest also requested that the Commission treat the
standard of conduct applicable to a broker-dealer making the
recommendation to its retail customer as a ``material fact relating to
the scope and terms of the relationship'' that would likely need to be
disclosed prior to, or at the time of the recommendation under the
Disclosure Obligation.\417\ Specifically, these commenters requested
that the Commission require a firm to disclose whether it is providing
a recommendation subject to Regulation Best Interest or advice subject
to a fiduciary duty.\418\
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\416\ See Proposing Release at 21600.
\417\ See, e.g., NASAA 2018 Letter (recommending that the
Commission provide specific instructions on how associated persons
of dually registered firms should disclose capacity in which they
are acting and whether the information they are providing is a
recommendation subject to ``best interest'' or advice subject to a
fiduciary duty). See also Betterment Letter (recommending that the
Commission require broker-dealers to disclose that they are
``salespeople who are providing sales recommendations and not
advice'' in lieu of the adoption of a fiduciary duty on broker-
dealers).
\418\ Id.
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The Commission also carefully considered numerous comments
concerning the standard of conduct disclosure in proposed Form CRS,
along with the results of investor testing and the Commission's
Feedback Form.\419\ As discussed more fully in the Relationship Summary
Adopting Release, we are adopting a requirement in Form CRS for a
description of a firm's applicable standard of conduct using prescribed
wording.\420\ This ``standard of conduct'' disclosure (as modified from
proposed Form CRS) both eliminates technical words, such as
``fiduciary,'' and describes the legal obligations of broker-dealers,
investment advisers, or dual-registrants using similar terminology in
plain English. The prescribed wording
[[Page 33361]]
also highlights when a firm must satisfy its legal obligation--
specifically, in the case of a broker-dealer, when making a
recommendation.
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\419\ Most commenters did not object to the proposal's
requirement that broker-dealers and investment advisers provide
disclosure regarding their standards of conduct or that such
disclosure be standardized. See, e.g., CFA Institute Letter (urging
the Commission to require disclosure of the standard of conduct
under which broker-dealers operate); IAA August 2018 Letter. In
addition, results of investor studies and surveys indicate that
retail investors view this information as helpful. See RAND 2018
(almost one third of survey respondents selected this section as one
of the two most useful; Letter from Mark Quinn, Director of
Regulatory Affairs, Cetera (Nov. 19, 2018) (``Cetera November 2018
Letter'') (88% of survey respondents somewhat or strongly agreed
``the firm's obligations to you'' is an important topic''). See also
Schwab Letter I (Hotspex) (``obligations the firm and its
representatives owe me'' ranked third where survey participants were
asked to identify four topics as most important for a firm to
communicate''). Similarly, commenters on Feedback Forms found this
information to be useful. See Feedback Forms Comment Summary (38% of
commenters on Feedback Forms graded the ``Our Obligations to You''
section of the relationship summary as ``very useful'' and 46%
graded this section as ``useful'').
\420\ Form CRS, Item 3.B.(i).a (stating that ``If you are a
broker-dealer that provides recommendations subject to Regulation
Best Interest, include: `When we provide you with a recommendation,
we have to act in your best interest and not put our interest ahead
of yours' '').
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We believe the standard of conduct owed to a retail customer under
Regulation Best Interest is a material fact relating to the scope and
terms of the relationship. However, given that Form CRS requires firms
to disclose in prescribed language the applicable standard of conduct
and, as discussed above, the Disclosure Obligation requires broker-
dealers to disclose the capacity (i.e., brokerage) in which they are
acting with respect to a recommendation, we believe this disclosure to
be sufficient and thus requiring any additional disclosure would be
duplicative.
b. Material Facts Regarding Conflicts of Interest
As noted above, in addition to requiring disclosure of the
``material facts relating to the scope and terms of the relationship,''
the proposed Disclosure Obligation would have required a broker-dealer
to disclose ``all material conflicts of interest associated with the
recommendation.'' We proposed to interpret a ``material conflict of
interest'' as a conflict of interest that a reasonable person would
expect might incline a broker-dealer--consciously or unconsciously--to
make a recommendation that is not disinterested.'' \421\ We generally
modeled this proposed interpretation on the Advisers Act approach to
identifying conflicts of interest for which investment advisers may
face antifraud liability in the absence of full and fair
disclosure.\422\ We expressed our preliminary belief that a material
conflict of interest that generally should be disclosed would include
material conflicts associated with recommending: Proprietary products,
products of affiliates, or a limited range of products, or one share
class versus another share class of a mutual fund; securities
underwritten by the broker-dealer or an affiliate; the rollover or
transfer of assets from one type of account to another (such as a
recommendation to roll over or transfer assets in an ERISA account to
an IRA); and allocation of investment opportunities among retail
customers (e.g., IPO allocation).\423\
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\421\ Proposing Release at 21602.
\422\ See id. (citing Capital Gains (stating that as part of its
fiduciary duty, an adviser must fully and fairly disclose to its
clients all material information in accordance with Congress's
intent ``to eliminate, or at least expose, all conflicts of interest
which might incline an investment adviser--consciously or
unconsciously--to render advice which was not disinterested'')).
\423\ See Proposing Release at 21603.
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While commenters supported the disclosure of conflicts of interest,
some sought clarity on the standard for determining which conflicts
should be disclosed,\424\ and others requested clarity on whether
conflicts involving certain actions (e.g., rollovers) \425\ and
products (e.g., proprietary products) \426\ should be disclosed.\427\
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\424\ See, e.g., SIFMA August 2018 Letter, Edward Jones Letter
(requesting clarity on the definition of materiality with regards to
conflicts); Ameriprise Letter (stating that the definition of
``material conflicts of interest'' should follow well known and
understood principles); Fidelity Letter (stating that the Commission
should not distinguish between conflicts of interest based on
financial incentives and all other conflicts of interest); Morgan
Stanley Letter; CCMC Letters; TIAA Letter; Mass Mutual Letter;
Empower Letter. See also IRI Letter (stating that requiring a
registered representative to predict what a hypothetical reasonable
person might think is confusing); ICI Letter (stating that rather
than focusing on what a ``reasonable person would expect . . .'' the
standard should focus on that nature of the incentive and its effect
on a broker-dealer's conduct).
\425\ See, e.g., CFA Institute Letter.
\426\ See, e.g., SIFMA August 2018 Letter; State Attorneys
General Letter; CFA Institute Letter.
\427\ See, e.g., Ameriprise Letter; State Attorneys General
Letter; CFA August 2018 Letter.
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Several commenters urged the Commission to define ``conflicts of
interest'' without a reference to the terms ``consciously or
unconsciously.'' \428\ These commenters claim that discerning a
broker's conscious or unconscious state of mind is ``confusing and
inherently unknowable.'' \429\ Similarly, one commenter stated that a
broker-dealer would be unable to draft adequate policies and procedures
that address an individual's mindset, noting that it would be
impossible for a broker-dealer to anticipate an individual's
unconscious conflicts.\430\ Instead, these commenters suggested revised
language that eliminates the notion of conscious or unconscious
inclination.\431\ Similarly, several commenters opposed the
Commission's use of the term ``not disinterested.'' \432\ These
commenters believe that the term is not clear and could, among other
things, suggest the elimination of all conflicts.\433\ One of these
commenters recommended that the Commission eliminate the term ``not
disinterested'' \434\ while another suggested that the Commission
clarify whether ``material'' and ``not disinterested'' are intended to
be identical or different standards for brokers and advisers.\435\
Other commenters opposed the proposed standard, arguing that it was not
as broad as the disclosure obligation applicable to investment
advisers. In particular, some commenters urged the Commission to apply
the standard for disclosure applicable to investment advisers as
articulated by the Supreme Court in SEC. v. Capital Gains Research
Bureau.\436\ Specifically, commenters requested that the Commission
require disclosure of not only material conflicts but also the material
facts related to a recommendation.\437\
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\428\ See, e.g., Edward Jones Letter (urging the Commission to
articulate a definition of materiality that does not refer to a
person's unconscious activity); Empower Letter; Ameriprise Letter.
\429\ Id.
\430\ See Great-West Letter.
\431\ See, e.g., Edward Jones Letter (suggesting that the
Commission define ``material conflict'' as an activity that: (i)
Affects financial compensation of a person making a recommendation;
and (ii) a reasonable investor would likely view as important to the
total mix of information available when considering that
recommendation); Ameriprise Letter (suggesting that the Commission
define ``material conflict of interest'' as a conflict of interest
that a reasonable person might conclude has the potential to
influence the recommendation); Pacific Life August 2018 Letter
(suggesting the Commission define ``material conflict of interest''
as a financial interest of the financial professional making a
recommendation that a reasonable person would expect to affect the
impartiality of such recommendation).
\432\ See, e.g., IPA Letter (stating that the use of the term
``not disinterested'' may require unnecessary legal interpretation);
Empower Letter.
\433\ See, e.g., Empower Letter.
\434\ See id.
\435\ See IPA Letter.
\436\ 375 U.S. 180 (1963). See, e.g., CFA August 2018 Letter;
Schnase Letter.
\437\ See, e.g., CFA August 2018 Letter.
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We are adopting the obligation to disclose conflicts of interest,
with several modifications and clarifications to the Proposing Release.
Specifically, Paragraph (a)(2)(i)(B) of Regulation Best Interest
requires that broker-dealers disclose ``material facts relating to
conflicts of interest that are associated with the recommendation.''
\438\
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\438\ This supplements the disclosure required in the
Relationship Summary regarding ways in which the broker-dealer and
its affiliates make money from brokerage or investment advisory
services they provide to retail investors, and about the related
material conflicts of interest. The Relationship Summary requires
firms to disclose, if applicable, conflicts related to compensation
it could receive from proprietary products, third-party payments,
revenue sharing, or principal trading. If firms do not have any of
these conflicts, the firm must disclose at least one other material
conflict of interest that affects retail investors. As described in
the Relationship Summary Adopting Release, we declined to make a
change pursuant to comments that suggested that Regulation Best
Interest's and Form CRS's conflicts disclosures be coordinated, and
that any conflict disclosure obligations under Regulation Best
Interest should be satisfied upon delivery of the Relationship
Summary. We recognize that broker-dealers may need to disclose
additional conflicts at a point in time other than at the beginning
of the relationship with a retail investor. Broker-dealers also may
need to include additional information about conflicts of interest
summarized in the Relationship Summary. The Relationship Summary
will provide a high-level summary for retail investors so that they
can engage in a conversation with their financial professional about
investment advisory or brokerage services, and so that the retail
investors can choose the type of service that best meets their
needs, but will not necessarily include all material facts related
to a particular conflict of interest. We believe many firms may not
be able to capture all of the necessary disclosures about their
conflicts in this short standardized disclosure.
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[[Page 33362]]
However, as discussed in more detail below, in response to comments
and in the light of the Relationship Summary, we are: (1) Adopting for
purposes of Regulation Best Interest a definition of ``conflict of
interest'' associated with a recommendation ``as an interest that might
incline a broker, dealer, or a natural person who is an associated
person of a broker or dealer--consciously or unconsciously--to make a
recommendation that is not disinterested;'' and (2) revising the
Disclosure Obligation to require disclosure of ``material facts''
regarding such conflicts of interest. Under this approach, all
conflicts of interest as interpreted under the Proposing Release will
be covered by Regulation Best Interest.
We believe distinguishing between ``conflicts of interest'' and
``material facts'' regarding such conflicts that would be disclosed
would make the Disclosure Obligation more consistent with the
proposal's intent. In the Proposing Release, the Commission discussed
limiting the disclosure of conflicts under the Disclosure Obligation
``consistent with case law under the antifraud provisions, which limit
disclosure obligations to ``material facts.''
After considering the comments, we have determined to retain the
proposed approach to conflicts of interest as described in Capital
Gains. In particular, we acknowledge commenter concerns about
discerning a broker's conscious or unconscious state of mind. However,
the description of conflicts of interest in Capital Gains is well
established, familiar to many in the industry, particularly dual-
registrants, and guidance already exists regarding what constitutes a
conflict of interest under this standard. To provide clarity that this
interpretation is limited to Regulation Best Interest, however, we are
revising Regulation Best Interest to explicitly provide that a
``conflict of interest'' ``means an interest that might incline a,
broker, dealer, or natural person who is an associated person of a
broker-dealer--consciously or unconsciously--to make a recommendation
that is not disinterested,'' \439\ consistent with the scope of the
meaning of ``conflict of interest'' for investment advisers under
Capital Gains.\440\
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\439\ Rule 15l-1(b)(3).
\440\ For the same reasons, we have eliminated the phrase ``a
reasonable person would expect'' that was included in the definition
of ``material conflict of interest'' discussed in the Proposing
Release at 21602.
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Several commenters also made suggestions regarding the Commission's
interpretation of the term ``material'' as used in the proposed
Disclosure Obligation (i.e., the proposed requirement to disclose ``all
material conflicts of interest that are associated with the
recommendation'').\441\ Many commenters agreed with the Commission's
decision to use a ``materiality'' standard to determine those facts
about conflicts of interest that must be disclosed.\442\ However,
several other commenters asked the Commission to clarify the meaning of
``material.'' \443\ These latter commenters stated, among other things,
that the term ``material'' in proposed Regulation Best Interest was not
clearly defined and would be subjectively interpreted.\444\
Accordingly, many of these commenters recommended that the Commission
adopt a materiality standard based on the standard articulated in Basic
v. Levinson.\445\
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\441\ See, e.g., Transamerica August 2018 Letter; Fidelity
Letter; SIFMA August 2018 Letter; Morgan Stanley Letter; IPA Letter;
Great-West Letter.
\442\ See, e.g., Morgan Stanley Letter; Great-West Letter.
\443\ See, e.g., FSI August 2018 Letter (recommending the
Commission publish examples of when a conflict is material); Wells
Fargo Letter; Cetera August 2018 Letter; IPA Letter.
\444\ See, e.g., Great-West Letter (stating that the Commission
appears to have created a very subjective standard to determine
materiality).
\445\ See, e.g., Mass Mutual Letter; SIFMA August 2018 Letter;
Bank of America Letter; CCMC Letters; TIAA Letter; Cetera August
2018 Letter; Fidelity Letter.
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The Supreme Court in Basic articulated a standard for materiality,
stating that information is material if there is ``a substantial
likelihood that a reasonable shareholder would consider it important.''
\446\ This definition of ``material'' is well established and thus
limiting disclosure to material facts in the Disclosure Obligation will
eliminate confusion and reduce the compliance burden on broker-dealers
in fulfilling the Disclosure Obligation. It will also help focus the
information made available to retail customers.\447\ Accordingly, we
interpret ``material facts'' consistent with the Basic standard.
Moreover, while the Regulation Best Interest definition of ``conflict
of interest'' is modeled on the regulatory regime applicable to
investment advisers, and is not by its terms explicitly limited to
``material'' conflicts of interest, it would be difficult to envision a
``material fact'' that must be disclosed pursuant to the Disclosure
Obligation that is not related to a conflict of interest that is also
material under the Basic standard.\448\
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\446\ Basic v. Levinson.
\447\ As stated in the Proposing Release, we are sensitive to
the potential that broker-dealers could adopt an approach that
results in lengthy disclosures that undermine the Commission's goal
of facilitating meaningful disclosure to assist retail customers in
making informed investment decisions. Proposing Release at 21604.
\448\ See Fiduciary Interpretation.
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Interpretation of Disclosure of Material Facts Relating to Conflicts of
Interest
In response to comments, we are providing our view regarding what
we would consider ``material facts relating to conflicts of interest
that are associated with a recommendation'' that would need to be
disclosed under the Disclosure Obligation. We believe the conflicts of
interest identified in the Relationship Summary may provide a useful
starting point for the identification of material facts that need to be
disclosed pursuant to the Disclosure Obligation.\449\ In addition, we
also view how a broker-dealer's investment professionals are
compensated, and the conflicts associated with those arrangements, as
material facts relating to conflicts of interest that are associated
with a recommendation.\450\ While these conflicts of interest must be
summarized in the Relationship Summary to the extent they are
applicable, we believe that additional details regarding many of these
conflicts need to be disclosed under the Disclosure Obligation as
``material facts'' relating to conflicts of interest associated with a
recommendation.
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\449\ See, e.g., Form CRS, Item 3 (Fees, Costs, Conflicts, and
Standard of Conduct).
\450\ See Form CRS, Item 3.C.(i) (``Description of How Financial
Professionals Make Money: Summarize how your financial professionals
are compensated, including cash and non-cash compensation, and the
conflicts of interest those payments create.'').
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Disclosure of Compensation
Broker-dealers receive compensation that typically varies depending
on what securities transaction or investment strategy involving
securities is being recommended. The source of the compensation may
also vary, for example being paid directly by the investor, or by a
product sponsor, or a combination of both. A broker-dealer may also pay
its associated persons different rates of compensation depending on the
type of security they sell.\451\ Similarly, broker-dealers can receive
different payments from
[[Page 33363]]
different product providers (e.g., mutual funds) for a variety of
reasons, such as payments for inclusion on a broker-dealer's menu of
products offered (sometimes referred to as shelf space). These
compensation arrangements create a variety of conflicts of interest
that must be addressed under both Form CRS and the Disclosure
Obligation.
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\451\ See NASD NTM 03-54.
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We believe that compensation associated with recommendations to
retail customers and related conflicts of interest--whether at the
broker-dealer or the associated person level--is a conflict of interest
about which material facts must be disclosed as part of the Disclosure
Obligation. This disclosure should summarize how the broker-dealer and
its financial professionals are compensated for their recommendations
and, as importantly, the conflicts of interest that such compensation
creates. This summary should include the sources and types of
compensation received, and may include the fact that fees and costs
disclosed pursuant to Paragraph (a)(2)(i)(A) of Regulation Best
Interest that a retail customer may pay directly or indirectly are a
source of compensation, if that is the case. For example, if a broker-
dealer receives compensation derived from the sale of securities or
other investment products held by retail customers of the firm,
including asset-based sales charges or service fees on mutual funds,
that fact and the conflicts associated with the receipt of such
compensation should be fully and fairly described.
Broker-dealers could meet the Disclosure Obligation by making
certain required disclosures of information regarding conflicts of
interest to their customers at the beginning of a relationship, and
this form of disclosure may be standardized. However, if standardized
disclosure, provided at such time, does not sufficiently identify the
material facts relating to conflicts of interest associated with any
particular recommendation, the disclosure would need to be supplemented
so that such disclosure is tailored to the particular recommendation.
For example, with regard to mutual fund transactions and holdings, a
broker-dealer might disclose broadly that it is compensated by funds
out of product fees or by the funds' sponsors, and that such
compensation gives it an incentive to recommend certain products over
other products for which the broker-dealer receives less compensation;
later, when a broker-dealer recommends a particular fund, it could
provide more specific detail about compensation arrangements, for
example revenue sharing associated with the fund family. In the
alternative, so long as the ``material facts'' regarding the conflicts
associated with a recommendation of a mutual fund were disclosed at the
outset of the relationship, no further disclosure need be made at the
time of recommendation; we are not requiring that information regarding
conflicts be disclosed on a recommendation-by-recommendation basis.
The Disclosure Obligation also does not require specific written
disclosure of the amounts of compensation received by the broker-dealer
or the financial representative. For example, we are not requiring
broker-dealers to disclose the amount, if any, they compensate their
financial professionals per transaction, or for year-end bonuses. We
believe that disclosure of the material facts regarding conflicts of
interest associated with a recommendation need not entail such
individualized numerical disclosure, and that in any event such a level
of detail may be difficult and costly to calculate with accuracy, and
also confusing to investors in many instances. Instead, disclosure
regarding conflicts must reasonably inform investors so that the
investor may use the information to evaluate the recommendation, and
that can be done without specific disclosure of the amount of the
compensation. Although disclosure of specific compensation amounts is
not required, depending on facts and circumstances, full and fair
disclosure may require disclosure of the general magnitude of the
compensation.\452\
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\452\ See, e.g., Advantage Investment Management, Advisers Act
Release No. 4455 (Jul. 18, 2016) (settled order) (the Commission
brought an enforcement action against an adviser for failing to
disclose the existence, nature and magnitude of a forgivable loan
from a broker-dealer that the adviser had engaged to provide
services to the adviser's clients); Taberna Capital Management LLC,
Advisers Act Release No. 4186 (Sep. 2, 2015) (settled order) (the
Commission brought an enforcement action against an adviser for
failing to disclose the existence, nature, and extent of a conflict
of interest raised by the adviser's receipt of certain fees from
issuers); BISYS Fund Services, Inc., Advisers Act Release No. 2554
(Sep. 26, 2006) (settled order) (the Commission brought an
enforcement action against a mutual fund administrator for failure
to disclose information concerning the existence or magnitude of the
conflicts of interest created by a marketing arrangement that called
for BISYS to rebate a portion of its administrative fees to 27
mutual fund advisers so that the fund advisers would continue to
recommend BISYS as an administrator).
---------------------------------------------------------------------------
We are also clarifying that while product fees and costs can be a
significant source of compensation received by broker-dealers and
associated persons, no disclosure regarding the particular amounts of
these fees and costs is required under Regulation Best Interest with
regard to conflicts of interest. Instead, what must be disclosed under
Paragraph (a)(2)(i)(B) of Regulation Best Interest are the ``material
facts relating to conflicts of interest'' created by compensation
sourced from product fees and costs, rather than the fees and costs
themselves.
Differences in Compensation and Proprietary Products
Several commenters recommended that required conflict disclosure
address recommendations where a less expensive alternative is
available, or condition the ability to recommend a more expensive
product on the adequacy of a broker-dealer's conflict disclosures.\453\
Similarly, several commenters expressed differing views on how payment
of varying compensation should be handled under the ``best interest''
standard of Regulation Best Interest and how related conflicts should
be disclosed.\454\ For example, one commenter identified compensation
differences within product lines as an example of a conflict that
should be disclosed.\455\ Several commenters also recommended that the
Commission require disclosure of conflicts of interest related to use
of proprietary products, and whether the broker-dealer offers
alternatives to proprietary products.\456\ Similarly, several
commenters requested that the Commission clarify that broker-dealers
can limit their offerings to proprietary products or products that make
revenue sharing payments if, among other
[[Page 33364]]
things, appropriate disclosure is made.\457\
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\453\ See PIABA Letter (stating that where less expensive
alternatives are available, disclosure should include an explanation
of why the recommendation is nevertheless in the best interest given
other factors associated with the recommendation); LPL August 2018
Letter (recommending that the Commission clarify that a broker-
dealer can recommend a product involving costs and charges that are
within a range of reasonableness that has been disclosed to the
investor in advance provided the recommendation is otherwise in the
investor's best interest); UMiami Letter; SIFMA August 2018 Letter.
\454\ See, e.g., CFA August 2018 Letter (recommending that the
Commission include compensation differences within product lines as
an example of a conflict that should be disclosed); Ameriprise
(stating that differential compensation for diverse products aligns
with Regulation Best Interest provided the firm mitigates the
potential related conflicts); Pacific Life August 2018 Letter
(stating that the definition of ``material conflicts of interest''
must encompass, among other things, the types of compensation
received by the person making the recommendation).
\455\ See CFA August 2018 Letter.
\456\ See, e.g., Money Management Institute Letter (recommending
the SEC allow firms to meet the Conflict of Interest Obligation with
respect to their preference for proprietary products through
disclosure); CFA Institute Letter; IRI Letter; SIFMA August 2018
Letter.
\457\ See, e.g., SIFMA August 2018 Letter (stating that a firm
should be allowed to limit its offerings to proprietary products or
revenue sharing products, as long as: (a) The broker-dealer
discloses to its customer that it is limiting the recommendation to
a specific set of securities, and (b) the specific set of securities
contains appropriate securities to meet the customer's needs); CFA
Institute Letter (stating that when a firm only offers proprietary
products it should disclose not only the higher product cost, but
the potential cost to the investor of such a limited offering).
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As discussed above, we agree with commenters who stated that it may
be compatible with the Care Obligation to recommend a more expensive
product that is otherwise in a retail customer's best interest when
there are less expensive alternatives available, to receive
compensation that varies among products, and to recommend proprietary
products.\458\ However, we also believe that the conflicts of interest
associated with such practices constitute ``material facts'' relating
to conflicts of interest that must be disclosed under the Disclosure
Obligation.
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\458\ See generally Section II.A.1, Commission's Approach.
---------------------------------------------------------------------------
The receipt of higher compensation for recommending some products
rather than others, whether received by the broker-dealer, the
associated person, or both, is a fundamental and powerful incentive to
favor one product over another.\459\ While we are requiring firms to
establish policies and procedures reasonably designed to mitigate the
conflicts of interest that create an incentive for financial
professionals to place the interest of the professional or broker-
dealer ahead of the interest of the retail customer, we believe also
that full and fair disclosure of the material facts concerning
conflicts raised by variable compensation schemes is of particularly
critical importance for an investor seeking to evaluate a
recommendation under such circumstances, a concern further underscored
by our approach under the Conflict of Interest Obligation of requiring
policies and procedures to mitigate or eliminate certain
conflicts.\460\
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\459\ See Proposing Release at 21578 (referencing the
Commission's long-held concerns about the incentives that
commission-based compensation provides to churn accounts, recommend
unsuitable securities, and engage in aggressive marketing of
brokerage services); FINRA Report on Conflicts of Interest (Oct.
2013), available at https://www.finra.org/sites/default/files/Industry/p359971.pdf (``FINRA Conflicts Report'') at p. 4.
\460\ See generally Section II.C.3.
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The benefits that accrue to a broker-dealer and its financial
professionals from recommending proprietary products also raise
conflicts of interest that must be disclosed. Material facts relating
to the conflicts of interest associated with recommending proprietary
products could include, as relevant, that the broker-dealer owns the
product, and that in addition to any commission associated with
purchasing the product, the broker-dealer or an affiliate may receive
additional fees and compensation \461\ related to that product.\462\
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\461\ For example, a broker-dealer's sale of proprietary
products potentially generates a compensation stream for the broker-
dealer, in addition to commissions, which may need to be disclosed
under paragraph (a)(2)(i)(A).
\462\ As discussed further in Section II.C.3, in addition to
disclosure of such conflicts, broker-dealers are also required under
the Conflict of Interest Obligation to establish, maintain, and
enforce written policies and procedures reasonably designed to
mitigate or address the conflicts presented.
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c. Full and Fair Disclosure
As proposed, the Disclosure Obligation would have required broker-
dealers to ``reasonably disclose'' material facts relating to the scope
and terms of the relationship with the retail customer, including all
material conflicts of interest associated with the recommendation. The
Commission used this formulation in order to give flexibility to
broker-dealers in determining the most appropriate way to meet the
proposed Disclosure Obligation depending on their individual business
practices. The Commission also provided preliminary guidance on what it
believed would be to ``reasonably disclose'' in accordance with the
Disclosure Obligation by setting forth the aspects of effective
disclosure, including the form and manner of disclosure and the timing
and frequency of disclosure.
In this regard, the Commission requested comment on whether broker-
dealers should be required to ``reasonably disclose'' and whether
additional guidance as to how broker-dealers could meet this standard
should be provided. The Commission also requested comment on whether
disclosure should explicitly be required to be ``full and fair.'' In
response, some commenters raised questions about using the term
``reasonably disclose'' \463\ and whether broker-dealers should be
subject to less rigorous disclosure obligations for recommendations
made to retail customers than investment advisers.\464\ These
commenters recommended that the Commission explicitly require broker-
dealers to provide full and fair disclosure of material facts.\465\ One
commenter reasoned that the Commission should not make Regulation Best
Interest any more stringent than in the Proposing Release, stating that
``full and fair'' is both inapplicable and unnecessary given the
proposed standard under the Disclosure Obligation.\466\
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\463\ See, e.g., CFA August 2018 Letter (stating that a
``reasonable'' disclosure standard gives firms too much discretion
to determine how the disclosures will be presented); Galvin (arguing
that the proposed standard would give broker-dealers more
opportunities to argue that they acted ``reasonably'' under the
rules).
\464\ See, e.g., CFA August 2018 Letter (stating that ``[t]he
Commission offers no explanation for why broker-dealers should be
subject to less rigorous disclosure obligations than investment
advisers'').
\465\ See, e.g., Pace Investor Rights Clinic August 2018 Letter
(urging the Commission to require broker-dealers to provide full and
fair disclosure of any conflicts that are not eliminated or
mitigated); Better Markets August 2018 Letter (urging the Commission
to further enhance the Disclosure Obligations by requiring broker-
dealers to make full and fair disclosure of all information required
to be disclosed); State Attorneys General Letter; NASAA August 2018
Letter.
\466\ See SIFMA August 2018 Letter.
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After careful consideration of the comments received, the
Commission is adopting the Disclosure Obligation with revisions to
require ``full and fair disclosure'' of all material facts relating to
the scope and terms of the relationship with the retail customer and
all material facts relating to conflicts of interest associated with
the recommendation for the reasons described below.
While we do not believe that adopting a ``full and fair
disclosure'' standard is significantly different from the proposed
requirement to ``reasonably disclose,'' we believe that the Regulation
Best Interest serves the Commission's goal of facilitating disclosure
to assist retail customers in making informed investment
decisions.\467\ In addition,
[[Page 33365]]
Regulation Best Interest will more closely align the Disclosure
Obligation with existing requirements for investment advisers \468\ and
is consistent with disclosure standards in other contexts under the
federal securities laws.\469\
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\467\ This approach is consistent with the rationale articulated
in the Fiduciary Interpretation. See Fiduciary Interpretation at
Section II.C (stating, ``In order for disclosure to be full and
fair, it should be sufficiently specific so that a client is able to
understand the material fact or conflict of interest and make an
informed decision whether to provide consent. For example, it would
be inadequate to disclose that the adviser has `other clients'
without describing how the adviser will manage conflicts between
clients if and when they arise, or to disclose that the adviser has
`conflicts' without further description. Similarly, disclosure that
an adviser `may' have a particular conflict, without more, is not
adequate when the conflict actually exists.'' [However,] ``[t]he
word `may' could be appropriately used to disclose to a client a
potential conflict that does not currently exist but might
reasonably present itself in the future.''). See also In the Matter
of The Robare Group, Ltd., et al., Advisers Act Release No. 4566
(Nov. 7, 2016) (Commission Opinion) (finding, among other things,
that adviser's disclosure that it may receive a certain type of
compensation was inadequate because it did not reveal that the
adviser actually had an arrangement pursuant to which it received
fees that presented a potential conflict of interest); aff'd in part
and rev'd in part on other grounds Robare Group, Ltd., et al. v.
SEC, 922 F.3d 468 (D.C. Cir. 2019); SEC v. Blavin, 760 F.2d 706, 711
(6th Cir. 1985) (disclosure that investment adviser ``may'' trade in
recommended securities for its own account was false and misleading
where the adviser actually invested in 10%-25% of the publicly
available stock of the companies it recommended); ICI Letter
(commenting on the Fiduciary Interpretation proposing release).
\468\ See Fiduciary Interpretation at Section II.A (stating that
``[t]he [investment adviser's] fiduciary duty follows the contours
of the relationship between the adviser and its client, and the
adviser and its client may shape that relationship by agreement
provided that there is full and fair disclosure and informed
consent'' (emphasis added)).
\469\ For instance, the Municipal Securities Rulemaking Board
requires that municipal advisors provide full and fair disclosure of
material conflicts of interest and material legal or disciplinary
events. See MSRB Rule G-42. In addition, the registration and
disclosure requirements of the Securities Act of 1933 (``Securities
Act'') are based on the concept that investors in a public offering
should be provided with full and fair disclosure of material
information needed for an informed investment decision. See
Securities Act Concepts and Their Effects on Capital Formation,
Securities Act Release No. 7314 (Jul. 25, 1996); 61 FR 40044 (Jul.
31, 1996) at text accompanying footnote 13; see also SEC v. Ralston
Purina Co., 346 U.S. 119, 124 (1953). Finally, Regulation FD under
the Securities Act was ``designed [in part] to promote the full and
fair disclosure of information by issuers.'' See Selective
Disclosure and Insider Trading, Securities Act Release No. 7881
(Aug. 15, 2000), 65 FR 51715 (Aug. 24, 2000).
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The full and fair disclosure standard that the Commission is
adopting for broker-dealers under the Disclosure Obligation is
generally similar to the disclosure standard applicable to investment
advisers under the Advisers Act.\470\ Similar to the Proposing
Release's interpretation of the phrase ``reasonably disclose,'' broker-
dealers' obligation to provide full and fair disclosure should give
sufficient information to enable a retail investor to make an informed
decision with regard to the recommendation.\471\
---------------------------------------------------------------------------
\470\ See supra footnote 468. See also Fiduciary Interpretation,
stating that the disclosure ``should be sufficiently specific so
that a client is able to understand the material fact or conflict of
interest and make an informed decision whether to provide consent.''
\471\ See Proposing Release at 21604, footnote 208.
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We disagree with commenters who believe the ``full and fair''
standard is too stringent. While the general standard for broker-
dealers under the Disclosure Obligation will be generally similar to
the disclosure requirements applicable to investment advisers, the
scope of the required disclosure is not as broad. For example, the
Disclosure Obligation only requires disclosure of material facts
relating to the scope and terms of the relationship with the broker-
dealer, and material facts relating to conflicts of interest associated
with a broker-dealer's recommendations, and not of all material facts
relating to the relationship. In addition, the Disclosure Obligation
only applies to retail customers. In contrast, the disclosure
requirements imposed by the fiduciary duty under the Advisers Act
generally and Form ADV in particular are broader (e.g., Form ADV
requires disclosure of the adviser's principal owner(s) and certain
financial industry activities and affiliations, which are not
explicitly required under the Disclosure Obligation; Form ADV and the
fiduciary duty also go to disclosure of the entire relationship while
the Disclosure Obligation is tailored to the recommendation and also
given at relevant points in time). We designed our approach to avoid
having retail customers receive overwhelming amounts of
information.\472\
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\472\ Commenters pointed out that requiring too much information
regarding conflicts of interest would go beyond the standard of
materiality set forth under Basic. See, e.g., SIFMA August 2018
Letter; Cetera August 2018 Letter (citing Basic at 231, noting that
``an avalanche of trivial information'' would not be ``conducive to
informed decision making.''). See also Letter from David Schwartz,
President and CEA, Florida International Bankers Association
(``FIBA'') (Feb. 8, 2019) FIBA (``February 2019 Letter'') (stating
that ``the amount of required disclosure may overwhelm rather than
educate'').
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Some commenters suggested that disclosure and informed consent
should be required in order to comply with the obligations under
Regulation Best Interest, similar to the approach taken under the
fiduciary duty under the Advisers Act.\473\ We have carefully
considered these comments. As noted above, under the Disclosure
Obligation, broker-dealers are required to provide full and fair
disclosure such that a retail customer can make an informed decision
with regard to the recommendation (i.e., whether to accept (or reject)
that recommendation). In making such an informed decision after being
provided with full and fair disclosure, we believe that the retail
customer has provided ``informed consent'' in a manner that is
analogous to the informed consent required to be provided by a client
in the context of an investment adviser-client relationship.\474\ An
investment advisory client must provide informed consent to the
adviser's conflicts of interest in the context of the entire
relationship, which can be broader than the informed consent provided
by a retail customer when making an informed decision to accept or
reject a particular recommendation by a broker-dealer. We believe this
is appropriate because the investment-adviser client relationship is
generally broader and can include, for example, unlimited investment
discretion by the investment adviser to conduct securities transactions
on behalf of the client. The broker-dealer customer relationship on the
other hand is generally transaction-based and the retail customer must
accept (or reject) each recommendation by a broker-dealer after the
broker-dealer has provided full and fair disclosure as required under
the Disclosure Obligation. Thus, in this regard, Regulation Best
Interest will more closely align the Disclosure Obligation with the
existing requirements for investment advisers, as noted above, but is
tailored to the broker-dealer relationship.\475\ The Commission
believes that the final Disclosure Obligation along with the
protections provided by the requirements of Regulation Best Interest,
including the Care Obligation and Conflict of Interest Obligation, will
further serve to enhance the protections available to retail customers.
---------------------------------------------------------------------------
\473\ See, e.g., ASA Letter (stating that the Commission should
reaffirm that broker-dealers can address conflicts of interest by
disclosing them and obtaining informed consent); Primerica Letter
(suggesting that the Commission clarify that broker-dealers can
effectively address all material conflicts by providing full and
fair disclosure and obtaining customer consent); Morgan Stanley
Letter.
\474\ As discussed in the Fiduciary Interpretation, a client's
informed consent can be either explicit or, depending on the facts
and circumstances, implicit. See Fiduciary Interpretation at Section
II.C. Under Regulation Best Interest, however, assuming the retail
customer has been provided with full and fair disclosure, the retail
customer will be considered to have provided informed consent by
affirmatively accepting a recommendation.
\475\ See Fiduciary Interpretation (describing an investment
adviser's obligation to provide disclosure designed to put a
reasonable client in a position to be able to understand and provide
informed consent).
---------------------------------------------------------------------------
One commenter recommended that the Commission clarify what a
broker-dealer is required to deliver to a retail customer in order to
permit the retail customer to make an ``informed decision,'' and asked
the Commission to confirm that it does not require a case-by-case
analysis of what is reasonable to permit the retail customer to make an
informed decision.\476\ In addition, other commenters underscored the
importance of providing retail customers with sufficient time to review
and comprehend the disclosed information prior to making an informed
decision about a recommendation.\477\ Other commenters
[[Page 33366]]
questioned whether providing ``sufficient information'' to enable a
retail customer to make an informed decision broadens the Disclosure
Obligation beyond ``material facts'' and ``material conflicts.'' \478\
---------------------------------------------------------------------------
\476\ See, e.g., CCMC Letters.
\477\ See, e.g., Financial Planning Coalition Letter (stating
that disclosures should be made prior to the recommendation so a
retail customer has sufficient time to review and understand them,
as well as to ask questions); CFA August 2018 Letter (stating that
if the Commission wants to give investors time to consider the
information and make an informed choice disclosure should be
provided as soon as reasonably feasible and, when possible, no later
than the point of recommendation).
\478\ See, e.g., IPA Letter (requesting clarification on whether
providing sufficient information to enable a retail investor to make
an informed decision broadens the disclosure obligation beyond
material facts); CCMC Letters.
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We have considered the issues raised by the commenters and in the
sections that follow are providing guidance on what we believe
constitutes ``full and fair disclosure'' for purposes of the Disclosure
Obligation, including the form and manner, and the timing and
frequency, of the disclosure. Similar to the proposal, in lieu of
setting explicit requirements by rule for what constitutes full and
fair disclosure of all material facts, we are providing broker-dealers
flexibility in determining the most appropriate way to meet the
Disclosure Obligation depending on each broker-dealer's specific
business practices.
As we noted in the Proposing Release, while we are providing
flexibility to broker-dealers to meet the Disclosure Obligation, we
continue to be sensitive to the potential that broker-dealers could opt
to disclose all facts, including those that do not meet the materiality
threshold.\479\ We are cognizant of the likelihood that some broker-
dealers could provide lengthy disclosures that do not meaningfully
convey the material facts regarding the scope and terms of the
relationship and material facts regarding conflicts of interest, an
outcome that could undermine the Commission's goal of facilitating
disclosure to assist retail customers in making an informed investment
decision. To this end, broker-dealers will only be required to disclose
material facts about the scope and terms of the relationship or
conflicts of interest.
---------------------------------------------------------------------------
\479\ Id.
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Although we are adopting the requirement with revisions to require
full and fair disclosure of all material facts, we still believe it is
important to clarify that broker-dealers' compliance with the
Disclosure Obligation will be measured against a negligence standard,
not against a standard of strict liability, consistent with the
Proposing Release. The Commission has taken this position in other
contexts where full and fair disclosure is required, including under
the fiduciary duty under the Advisers Act.\480\
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\480\ While establishing scienter is a requirement to establish
violations of Section 206(1) of the Advisers Act, it is not required
to establish a violation of Section 206(2); a showing of negligence
is adequate. See SEC v. Capital Gains Research Bureau, Inc., 375
U.S. 180, 195 (1963); see also SEC v. Steadman, 967 F.2d at 643 and
footnote 5; Steadman v. SEC, 603 F.2d 1126, 1132-34 (5th Cir. 1979),
aff'd on other grounds, 450 U.S. 91 (1981). See also Prohibition of
Fraud by Advisers to Certain Pooled Investment Vehicles, Advisers
Act Release No. 2628 (Aug. 3, 2007). In its adoption of Rule 206(4)-
8 under the Advisers Act, the Commission stated that it would not
need to demonstrate that an adviser violating the rule acted with
scienter.
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Form and Manner
In the Proposing Release, the Commission noted that it was not
proposing to specify by rule the form (e.g., narrative v. graphical/
tabular) or manner (e.g., relationship guide or other written
communications) of disclosure required under the Disclosure Obligation.
The Commission stated that disclosure should be concise, clear and
understandable to promote effective communication between a broker-
dealer and a retail customer.\481\ We also stated that broker-dealers
would be able to deliver disclosure required pursuant to Regulation
Best Interest consistent with the Commission's guidance regarding
electronic delivery of documents.\482\ Although we preliminarily
believed that broker-dealers should have the flexibility to make
disclosures by any means, as opposed to requiring a standard written
document at the outset of the relationship, we stated our belief that
any such disclosure should be provided in writing.\483\
---------------------------------------------------------------------------
\481\ See Proposing Release at 21604, footnote 211.
\482\ Id. at 21604 and footnote 214.
\483\ Id. at 21604 and footnote 213.
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Commenters sought further guidance in a number of areas relating to
disclosure, including the extent to which the Relationship Summary or
other disclosures may satisfy the Disclosure Obligation,\484\ the
circumstances under which standardized disclosure could be sufficient,
as well as how, and the extent to which, disclosures made pursuant to
the Disclosure Obligation should be made in writing.\485\ In response
to comments we are providing additional guidance. We are also
reaffirming guidance that we provided in the Proposing Release.
---------------------------------------------------------------------------
\484\ See, e.g., Cambridge Letter (arguing that the Relationship
Summary and Disclosure Obligation are duplicative requirements);
CUNA Mutual Letter (seeking greater clarification regarding the
extent to which information provided in other documents could
satisfy the Disclosure Obligation); Financial Services Institute
August 2018 Letter (arguing that providing the Relationship Summary
should be deemed to satisfy the requirements of the broker-dealer's
Disclosure Obligation); Morningstar Letter (arguing that due to the
brevity of the Relationship Summary, additional broker-dealer
disclosures would be necessary); Wells Fargo Letter (recommending
that the requirements of the Disclosure Obligation be incorporated
into Form CRS).
\485\ See, e.g., Schwab Letter (arguing that because most
recommendations occur over the phone and through various digital
means, the Commission should remove the ``in writing'' requirement
and allow firms to determine the best method for disclosure
depending on the situation); SIFMA August 2018 Letter (seeking
clarification that oral disclosure at the time of the recommendation
may be sufficient to satisfy the Disclosure Obligation in certain
circumstances). But see AARP August 2018 Letter (stating that oral
disclosures should never be permitted).
---------------------------------------------------------------------------
Prescribed Form of Disclosure
As noted in the Proposing Release, we believe it is important to
provide broker-dealers with flexibility in determining the most
appropriate and effective way to meet the Disclosure Obligation to
reflect the structure and characteristics of their relationships with
retail customers.\486\ Many commenters agreed with this reasoning,
arguing that there was a need to preserve flexibility for broker-
dealers to comply with the Disclosure Obligation as proposed.\487\
Other commenters believed, however, that the proposed Disclosure
Obligation gave broker-dealers too much discretion.\488\
---------------------------------------------------------------------------
\486\ See Proposing Release at 21604.
\487\ See, e.g., Prudential Letter; SIFMA August 2018 Letter;
TIAA Letter; UBS Letter.
\488\ See, e.g., Better Markets August 2018 Letter (arguing that
proving broker-dealer discretion in this area will virtually assure
a failure to communicate helpfully with investors); CFA August 2018
Letter (arguing that the flexibility the Commission provides will
result in disclosure that does not effectively convey key
information). See also Morningstar Letter (supporting the expansion
of disclosures, but arguing that ``publicly available disclosures
with a standard taxonomy work best because they empower third
parties such as ``fintech'' and ``reg-tech'' firms to analyze and
contextualize critical information and amplify a call to action for
ordinary investors'').
---------------------------------------------------------------------------
After careful consideration of these comments, the Commission has
decided not to require any standard written disclosures (other than the
Relationship Summary) at this time. Although we recognize the potential
value to retail customers of standardizing the disclosures required
pursuant to the Disclosure Obligation, we believe that retail customers
can derive value from disclosures that accommodate the structure and
characteristics of the particular broker-dealer. On balance, we
recognize the wide variety of business models and practices and we
continue to believe it is important to provide broker-dealers with
flexibility to enable them to better tailor disclosure and information
that their retail customers can understand and may be more likely to
read at relevant points in time, rather
[[Page 33367]]
than, for example, mandating a standardized all-inclusive (and likely
lengthy) disclosure.\489\
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\489\ With respect to the length of disclosure documents,
investor testing of proposed Form CRS examined retail investors'
likelihood of reading only longer documents (such as Form ADV Part
II or an account opening agreement), only a short document (Form
CRS), both, or neither when choosing a financial professional,
account type or firm. Although the context was specific to Form CRS
and the retail investor's initial determination regarding a
financial professional, account type or firm, the survey suggests
that retail investors may be more likely to read either both longer
and shorter disclosures or just shorter disclosures. See RAND 2018
(``Whereas Figure 2.20 shows that half of all investors reported
having reviewed neither a Form ADV nor an account opening agreement
in the past and another 20 percent reported not knowing whether they
had ever done so, Figure 2.21 shows that about 70 percent of all
respondents and of all investors reported that they would be likely
to read either both types of documents or only the Relationship
Summary when choosing a financial professional in the future. Just 2
percent of investors and 1 percent of noninvestors reported being
likely to read only the longer documents, whereas 29 percent of
investors and 13 percent of noninvestors were likely to read only
the Relationship Summary.'' More specifically, Figure 2.21 shows
that over 40% of all respondents indicated they would read both and
under 30% indicated that they would read only the Relationship
Summary.)
---------------------------------------------------------------------------
We disagree that flexibility will prevent investors from obtaining
information necessary to make an informed investment decision and do
not believe that requiring a standard written disclosure beyond the
Relationship Summary is necessary at this time. We emphasize, however,
that the adequacy of the disclosure will depend on the facts and
circumstances. We intend to evaluate broker-dealer disclosure practices
in response to Regulation Best Interest over time to determine whether
additional disclosure initiatives may be appropriate.
Relying on Other Disclosures and Standardized Documents
In the Proposing Release, we described how the Disclosure
Obligation builds upon the requirements of Form CRS and the disclosures
in the Relationship Summary.\490\ We also stated that we anticipated
that broker-dealers may elect to use other documents to satisfy
elements of the Disclosure Obligation, such as an account agreement, a
relationship guide, or a fee schedule.\491\
---------------------------------------------------------------------------
\490\ See Proposing Release at 21600.
\491\ See id. at 21605.
---------------------------------------------------------------------------
Several commenters requested guidance on their ability to use other
documents to meet the requirements of the Disclosure Obligation. For
example, some commenters recommended that the Commission harmonize the
Disclosure Obligation with the broad, firm-level disclosure obligations
of Form CRS so that firms can use the Relationship Summary to help
satisfy the Disclosure Obligation.\492\ Commenters also recommended
that broker-dealers should be permitted to satisfy the Disclosure
Obligation by using standardized language generally to describe the
broker-dealer's products and services available to their retail
customers and related conflicts of interest, including the ranges of
remuneration payable to a broker-dealer in connection with its
recommendation of different products.\493\ Several commenters also
suggested that the Commission should clarify that the Disclosure
Obligation should not apply where an existing disclosure regime already
exists.\494\ Similarly, other commenters recommended that the
Commission clarify whether broker-dealers could meet the Disclosure
Obligation by referencing information required to be disclosed pursuant
to other regulatory requirements such as FINRA disclosure rules.\495\
---------------------------------------------------------------------------
\492\ See, e.g., Cambridge Letter (recommending that providing
the Form CRS should fulfill the broker-dealer's Disclosure
Obligation under Regulation Best Interest); ACLI Letter (noting that
a single disclosure fulfilling Regulation Best Interest and Form CRS
would reduce the disclosure burdens and increase the likelihood
consumers will read the required information); FSI August 2018
Letter; Mutual of America Letter; Northwestern Mutual Letter; IPA
Letter; Transamerica August 2018 Letter; NAIFA Letter.
\493\ See, e.g., LPL August 2018 Letter (recommending that all
investors be provided with general disclosures setting forth the
ranges of remuneration payable to broker-dealers in connection with
its recommendations of different products); Committee of Annuity
Insurers (urging the Commission to clarify that a broker-dealer can
satisfy the Disclosure Obligation through disclosure describing
products and services available to its retail customers and need not
provide a disclosure particularized to a recommendation).
\494\ See, e.g., SIFMA August 2018 Letter (asking the Commission
to clarify that the Disclosure Obligation does not apply in contexts
where there is an existing regime, such as for equity and debt
research); Transamerica August 2018 Letter (recommending that the
Commission recognize that existing disclosure regimes suffice to
meet certain disclosure requirements).
\495\ See, e.g., Transamerica August 2018 Letter (stating that
the disclosure obligation should expressly take into consideration
existing disclosures).
---------------------------------------------------------------------------
After careful consideration of the comments, the Commission is
providing guidance to permit a broker-dealer to utilize existing
disclosures and standardized documents, such as a product prospectus,
relationship guide, account agreement, or fee schedule to help satisfy
the Disclosure Obligation. The Commission recognizes that broker-
dealers are subject to disclosure requirements other than the
Disclosure Obligation and Form CRS, and believes utilizing such
existing disclosures where appropriate is a reasonable and cost-
effective way to satisfy the requirements of the Disclosure Obligation,
and can also help avoid duplicative or voluminous disclosure by not
requiring the creation of new disclosure documents.\496\ We recognize
also that in many instances, information necessary to satisfy the
Disclosure Obligation may be broadly applicable to a broker-dealer's
retail customers, and therefore the use of standardized disclosure may
be appropriate.
---------------------------------------------------------------------------
\496\ See Proposing Release at 21599, footnotes 175 and 176. For
example, broker-dealers must disclose information about a
transaction on trade confirmations pursuant to Exchange Act Rule
10b-10. 17 CFR 240.10b-10. See also Morgan Stanley Letter (noting
that the securities laws and FINRA rules already require firms to
provide significant disclosures to clients at natural touchpoints in
the client relationship).
---------------------------------------------------------------------------
However, while broker-dealers may choose to standardize certain
forms of their disclosure, whether such materials would be sufficient
to satisfy the Disclosure Obligation will depend on the facts and
circumstances.\497\ For example, disclosures may need to be tailored to
a particular recommendation if the standardized disclosure does not
sufficiently identify the material facts about a conflict of interest
presented by a particular recommendation. Accordingly, a broker-dealer
remains responsible for disclosing all material facts relating to the
scope and terms of the relationship with the retail customer (as
discussed above), as well as all material facts relating to conflicts
of interest that are associated with a recommendation whether or not
the firm relies on other materials to fulfill that obligation.
---------------------------------------------------------------------------
\497\ Similarly, we also note that a number of broker-dealers
are modeling their disclosure of fees other than transaction-based
fees on the NASAA Schedule of Miscellaneous Account and Service
Fees. See NASAA August 2018 Letter. A broker-dealer may use this
schedule to comply in part with its obligation to disclose fees and
costs pursuant to the Disclosure Obligation. We note, however, that
the NASAA Schedule may recommend the disclosure of certain fees that
may not be required under the Disclosure Obligation depending on the
facts and circumstances, for example those that are not ``material
facts'' for purposes of Regulation Best Interest.
---------------------------------------------------------------------------
With regard to commenters' request that the Relationship Summary be
considered sufficient to satisfy the Disclosure Obligation, we note
that the Relationship Summary will provide succinct information and is
designed to assist retail investors with the process of deciding
whether to engage, or to continue to engage, a particular firm or
financial professional, deciding whether to establish or continue to
maintain a brokerage or investment advisory relationship, and asking
questions and easily finding additional information.
[[Page 33368]]
We recognize that additional details regarding many of the topics
(e.g., services, fees and conflicts of interest) would in many cases be
necessary to satisfy the Disclosure Obligation. Thus, although a
broker-dealer could use a Relationship Summary and other standardized
disclosures about its products and services to help satisfy the
Disclosure Obligation, these disclosures may not be sufficient to
satisfy the Disclosure Obligation. Whether the Relationship Summary
standing alone, or any additional or existing disclosures, satisfy any
of these required disclosures in full would depend on the facts and
circumstances. In most instances, broker-dealers will need to provide
additional information beyond that contained in the Relationship
Summary in order to satisfy the Disclosure Obligation.
In Writing
We proposed requiring that disclosures be provided in writing.\498\
We also stated that requiring written disclosures would help facilitate
investor review of the disclosure, promote compliance by firms,
facilitate effective supervision, and facilitate more effective
regulatory oversight to help ensure and evaluate whether the disclosure
complies with the requirements of Regulation Best Interest.\499\ We
also stated that the ``in writing'' requirement could be satisfied
either through paper or electronic means consistent with existing
Commission guidance on electronic delivery of documents. We also
provided guidance on how broker-dealers could comply with the ``in
writing'' requirement when recommendations are given over the
telephone.\500\
---------------------------------------------------------------------------
\498\ See Proposing Release at 21604.
\499\ Id.
\500\ Id.
---------------------------------------------------------------------------
A number of commenters supported the ``in writing''
requirement.\501\ Other commenters, however, recommend that the
Commission also permit the use of oral disclosure.\502\ For example,
several commenters recommend that the Commission permit broker-dealers
to orally disclose information to their customers provided they later
follow-up in writing.\503\ Other commenters highlighted concerns
associated with such oral disclosure.\504\
---------------------------------------------------------------------------
\501\ See, e.g., Vanguard Letter (recommending that the
Commission require a consolidated written disclosure of all material
conflicts); CFA August 2018 Letter.
\502\ See Schwab Letter (recommending that the Commission
eliminate the ``in writing'' requirement and allow firms to design
and document the best method depending on the situation); SIFMA
August 2018 Letter; TIAA Letter. But see AARP August 2018 Letter
(stating that oral disclosures should never be permitted).
\503\ See PIABA Letter (recommending that the Commission allow
broker-dealers to discharge their disclosure obligations by: (i)
Orally explaining the relationship, any conflicts, how the broker-
dealer is paid, and the features, benefits and risks of the
recommendation; and (ii) confirming the discussion by letter or
email, which is signed or confirmed as being accurate by the
customer, and retained in customer's file); SIFMA August 2018 Letter
(recommending that the Commission clarify that oral disclosure at
the time of the recommendation may satisfy the Disclosure Obligation
if: (1) The associated person documents that the oral disclosure was
made, or (2) the firm provides written disclosure after the trade);
USAA Letter (suggesting that the Commission could allow oral
product-level disclosures, while providing the client the choice to
request confirming disclosure in writing at her option).
\504\ See Edward Jones Letter (expressing concern that the
Commission is implying that a dual-registrant would need to provide
an oral point of sale disclosure regarding the capacity in which it
is acting when it makes a recommendation, and that such oral
disclosure would be difficult to supervise and of little value);
CCMC Letters (stating that a dual-registrant should not have to make
an oral disclosure of the capacity for each and every conversation
it has with retail customers).
---------------------------------------------------------------------------
After carefully considering the comments, we are adopting the ``in
writing'' requirement as proposed, subject to discussion in Section
II.C.1, Oral Disclosure or Disclosure After a Recommendation. As stated
above, we believe that retail customers would benefit from receiving a
written disclosure to assist their investment decisions and form the
basis of an informed investment decision.\505\ However, we also believe
that broker-dealers require flexibility to make proper written
disclosures to their customers. Accordingly, the Commission is not
requiring a specific form or method of written disclosure.
---------------------------------------------------------------------------
\505\ One commenter stated that certain foreign laws do not
permit firms to provide their customers with written materials prior
to entering into a contractual relationship. See FIBA February 2019
Letter. In response, we note that the Disclosure Obligation requires
disclosure to be provided prior to or at the time of the
recommendation and is not tied to a contractual relationship. In
addition, the staff will continue to evaluate the application of the
Disclosure Obligation in circumstances such as the one raised by
this commenter. Interested parties are invited to provide further
feedback on issues involving non-U.S.- resident retail customers.
---------------------------------------------------------------------------
Although we are requiring that disclosure be made ``in writing,''
we recognize that a broker-dealer may need to supplement, clarify or
update written disclosure it has previously made before it provides a
retail customer with a recommendation. For instance, as we stated in
the Proposing Release, we recognized that broker-dealers may provide
recommendations by telephone and offer clarifying disclosure orally in
some instances subject to certain conditions,\506\ such as a dual-
registrant informing a retail customer of the capacity in which the
dual-registrant is acting in conjunction with a recommendation.\507\ In
such instances, we believe that it may be necessary as a practical
matter to provide oral disclosure of a material fact to supplement,
clarify, or update written disclosure made previously.\508\ Therefore,
firms may make oral disclosures under the circumstances outlined in
Section II.C.1, Oral Disclosure or Disclosure After a
Recommendation.\509\
---------------------------------------------------------------------------
\506\ See Proposing Release at 21604, footnote 213.
\507\ See id. at 21605, footnote 216. We stated that a broker-
dealer could orally clarify the capacity in which it is acting at
the time of the recommendation if it had previously provided written
disclosure to the retail customer beforehand disclosing its capacity
as well as the method it planned to use to clarify its capacity at
the time of the recommendation.
\508\ For more discussion on guidance relating to updating
disclosures, see Section II.C.1.d, Disclosure Obligation, Updating
Disclosure.
\509\ See Section II.C.1, Disclosure Obligation, Oral Disclosure
or Disclosure After a Recommendation.
---------------------------------------------------------------------------
When making such an oral disclosure, firms must maintain a record
of the fact that oral disclosure was provided to the retail
customer.\510\ We are not explicitly requiring broker-dealers to create
a record documenting the substance of the oral disclosure itself, but
rather a record of the fact that such oral disclosure was made.\511\
This record should include documentation sufficient to demonstrate that
disclosure was made to the retail customer, which could include, for
example, recordings of telephone conversations or contemporaneous
written notations. Nonetheless, although it is not required by
Regulation Best Interest, as a best practice we encourage broker-
dealers that make oral disclosures to subsequently provide to their
retail customers in a timely manner written disclosure summarizing the
information conveyed orally.
---------------------------------------------------------------------------
\510\ See Section II.D.
\511\ See Section II.C.1, Disclosure Obligation, Oral Disclosure
or Disclosure After a Recommendation.
---------------------------------------------------------------------------
Plain English
In the Proposing Release, we stated that broker-dealers should
apply plain English principles to written disclosures including, among
other things, the use of short sentences and active voice, and
avoidance of legal jargon, highly technical business terms, or multiple
negatives.\512\ Similarly, several commenters recommended that whatever
format broker-dealers use for their disclosure, they should be written
in plain English and easy to understand.\513\ Accordingly, although it
[[Page 33369]]
is not required, the Commission encourages broker-dealers to use plain
English in preparing any disclosures they make in satisfaction of the
Disclosure Obligation.
---------------------------------------------------------------------------
\512\ Proposing Release at 21604, footnote 213.
\513\ See State Attorneys General Letter (stating that all
disclosures must be in plain language and easily understood by
investors); CFA Institute (recommending that the Commission require
a clear English listing of all conflicts of interest in which a
broker-dealer engages). One commenter requested that the Commission
consider clarifying that the Plain English standard in the
Disclosure Obligation is not an English-only requirement to address
the needs of certain non-U.S. customers. See FIBA February 2019
Letter. In response, we note that any disclosure should be made
consistent with Plain English principles.
---------------------------------------------------------------------------
Electronic Delivery
In the Proposing Release, we took the position that broker-dealers
could deliver written disclosures required by Regulation Best Interest
in accordance with the Commission's existing guidance regarding
electronic delivery of documents.\514\ This framework consists of the
following elements: (1) Notice to the investor that information is
available electronically; (2) access to information comparable to that
which would have been provided in paper form and that is not so
burdensome that the intended recipients cannot effectively access it;
and (3) evidence to show delivery (i.e., reason to believe that
electronically delivered information will result in the satisfaction of
the delivery requirements under the federal securities laws).\515\ We
have furthermore clarified that one method to satisfy the evidence of
delivery element is to obtain informed consent from investors.\516\
---------------------------------------------------------------------------
\514\ See Proposing Release at 21604. We cited to a number of
prior Commission releases on electronic delivery in the Proposing
Release, including Use of Electronic Media by Broker-Dealers,
Transfer Agents, and Investment Advisers for Delivery of
Information, Exchange Act Release No. 37182 (May 9, 1996), 61 FR
24644 (May 15, 1996) (``1996 Release'') (providing Commission views
on electronic delivery of required information by broker-dealers,
transfer agents and investment advisers) and Use of Electronic
Media, Exchange Act Release No. 42728 (Apr. 28, 2000), 65 FR 25843
(May 4, 2000) (``2000 Release'') (providing updated interpretive
guidance on the use of electronic media to deliver documents on
matters such as telephonic and global consent; issuer liability for
website content; and legal principles that should be considered in
conducting online offerings).
\515\ See 1996 Release at 24646-47; see also Relationship
Summary Proposing Release at 21454.
\516\ See 2000 Release at 25845-46 (clarifying how market
intermediaries and other market participants can obtain consent for
electronic delivery).
---------------------------------------------------------------------------
Several commenters agreed with this approach.\517\ These commenters
typically supported the use of electronic disclosure and recommended
various methods (e.g., hyperlinks to web-based documents) but
recommended paper delivery as the default option.\518\ Other commenters
recommended permitting electronic delivery for required
disclosures.\519\ While investor testing on the proposed Relationship
Summary indicated that some retail investors generally support some
form of electronic copies, most participants in the study ``generally
liked having a paper version of the Relationship Summary.'' \520\
Similarly, as stated in the Form CRS adopting release, the IAC has
cited one study indicating that nearly half of investors (49%) still
prefer to receive paper disclosures through the mail, compared with
only 33% who prefer to receive disclosures electronically, either
through email (27%) or accessing them online (6%).\521\
---------------------------------------------------------------------------
\517\ See, e.g., CFA August 2018 Letter (stating that giving
firms discretion to choose the delivery mechanism would all but
ensure that many investors would never see the disclosures); AARP
August 2018 Letter (recommending that the Commission prohibit firms
from solely providing electronic access to disclosures and require
delivery of paper copies).
\518\ Id. See also LPL August 2018 Letter (noting that modern
communication practices underscore the need for the Commission to
provide more flexibility to broker-dealers to satisfy their document
delivery obligations; and requesting that the Commission confirm
that broker-dealers can deliver disclosures in compliance with
existing guidance regarding electronic delivery of documents (which
requires paper delivery as a default)).
\519\ See, e.g., IPA Letter (urging the Commission to confirm
that all required disclosures may be delivered electronically); see
also AXA Letter (urging the Commission to encourage the use of
appropriate electronic disclosures, which can make information
available to consumers more quickly and in a more digestible
format); Prudential Letter (recommending that electronic delivery be
deemed to comply with the Disclosure Obligation).
\520\ See RAND 2018.
\521\ Relationship Summary Adopting Release at Section II.D.3.a
(citing Investor Advisory Committee, Recommendation of the Investor
as Purchaser Subcommittee: Promotion of Electronic Delivery and
Development of a Summary Disclosure Document for Delivery of
Investment Company Shareholder Reports (Dec. 7, 2017), available at
https://www.sec.gov/spotlight/investor-advisory-committee-2012/recommendation-promotion-of-electronic-delivery-and-development.pdf
(citing FINRA Investor Education Foundation, ``Investors in the
United States 2016,'' December 2016, available at http://bit.ly/2hMrppX).
---------------------------------------------------------------------------
After considering investor testing results and commenters' concerns
and recommendations, the Commission reaffirms the application of
existing Commission guidance relating to paper and electronic delivery
of disclosure documents to broker-dealers in meeting the Disclosure
Obligation. Specifically, we believe that broker-dealers should be able
to satisfy the Disclosure Obligation by using electronic delivery.\522\
However, if a broker-dealer is providing its customers with electronic
delivery (upon their consent) it cannot solely offer electronic
delivery and must make paper delivery available, upon request. Both
Regulation Best Interest and Form CRS require firms to provide
electronic delivery of documents within the framework of the
Commission's existing guidance regarding electronic delivery.\523\
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\522\ See 1996 Release (stating that ``the Commission believes
that broker-dealers . . . similarly should have reason to believe
that electronically delivered information will result in the
satisfaction of the delivery requirements under the federal
securities laws. Thus, whether using paper or electronic media,
broker-dealers . . . should consider the need to establish
procedures to ensure that applicable delivery obligations are
met''); see also 2000 Release.
\523\ See Relationship Summary Adopting Release, Section II.C.3.
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d. Timing and Frequency
We proposed requiring broker-dealers to provide the disclosures
required by the Disclosure Obligation ``prior to or at the time of''
the recommendation. We noted the importance of determining the
appropriate timing and frequency of disclosure that may be effectively
provided ``prior to or at the time of'' the recommendation.\524\ In
cases where a broker-dealer determines that disclosure may be more
effectively be provided in an initial, more general disclosure (such as
a relationship guide) followed by specific information in a subsequent
disclosure that is provided at a later time, the initial disclosure
would address when and how a broker-dealer would provide more specific
information regarding the material fact or conflict in a subsequent
disclosure. We stated also that in circumstances where a broker-dealer
determines to provide an initial, more general disclosure (such as a
relationship guide) followed by specific information in a subsequent
disclosure that is provided after the recommendation (such as a trade
confirmation), the initial disclosure must address when and how a
broker-dealer would provide more specific information regarding the
material fact or conflict in a subsequent disclosure (e.g., after the
trade in the trade confirmation).\525\ We also stated
[[Page 33370]]
that disclosure after the recommendation, such as in a trade
confirmation for a particular recommended transaction would not, by
itself, satisfy the Disclosure Obligation, because the disclosure would
not be ``prior to, or at the time of the recommendation.'' We noted
also that whether there is sufficient disclosure in both the initial
disclosure and any subsequent disclosure would depend on the facts and
circumstances.\526\
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\524\ See Proposing Release at 21605.
\525\ The Commission has granted exemptions to certain dual-
registrants, subject to a number of conditions, from the written
disclosure and consent requirements of Advisers Act Section 206(3)
(which makes it unlawful for an adviser to engage in a principal
trade with an advisory client, unless it discloses to the client in
writing before completion of the transaction the capacity in which
the adviser is acting and obtains the consent of the client to the
transaction). The exemptions are subject to several conditions,
including conditions to provide disclosures at multiple points in
the relationship, including disclosure that the entity may be acting
in a principal capacity in a written confirmation at or before
completion of a transaction. See, e.g., In the matter of Merrill
Lynch Pierce Fenner & Smith, Incorporated, Investment Advisers Act
Release No. 4595; (Dec. 28, 2016); In the matter of Robert W. Baird
& Co., Incorporated, Advisers Act Release No. 4596 (Dec. 28, 2016);
In the matter of UBS Financial Services, Inc., Advisers Act Release
No. 4597 (Dec. 28, 2016); In the matter of Wells Fargo Advisors,
LLC, Wells Fargo Advisors Financial Network, LLC, Advisers Act
Release No. 4598 (Dec. 28, 2016).
\526\ See Proposing Release at 21605.
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Several commenters supported the Commission's proposal to require
broker-dealers to make disclosure prior to or at the time of the
recommendation, but disagreed about the precise timing with which
disclosure should be provided.\527\ For example, some commenters
recommended that the Commission require or allow broker-dealers to meet
the Disclosure Obligation prior to or at account opening.\528\
Similarly, several commenters recommended that the Commission require
broker-dealers to provide disclosure prior to a recommendation or
investment decision.\529\ Specifically, commenters recommended that the
Commission require disclosures to be made with enough time prior to a
recommendation that a retail customer has sufficient time to review and
understand them, as well as ask questions.\530\
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\527\ See, e.g., CFA August 2018 Letter (stating that any
information that can be provided before the transaction is entered
into should be provided to give investor time to consider it); AARP
August 2018 Letter (stating that all key disclosures should be made
significantly in advance of an investment decision; disclosure made
at the time of or immediately prior to investing is not adequate);
Bank of America Letter (stating that disclosure of material
conflicts of interest can be satisfied in advance of a particular
recommendation on a one-time basis); Pacific Life August 2018 Letter
(stating that disclosure of material conflicts of interest must be
disclosed at or prior to the point of sale or at the time the
recommendation is made); FPC Letter.
\528\ See, e.g., TIAA Letter (recommending that the Commission
require firms to meet their Regulation Best Interest and CRS
disclosure obligations at or before the point the investor: (i)
Opens a brokerage account; or (ii) engages the broker-dealer to
provide advice services (including for recommendations provided by
phone)).
\529\ See, e.g., Better Markets August 2018 Letter (stating that
disclosure should be provided in a timely fashion so investors have
a meaningful opportunity to read, digest, understand, and discuss
them); FPC Letter; AARP August 2018 Letter.
\530\ See, e.g., NAIFA Letter (recommending that disclosure be
provided at or before the time of a recommendation because it helps
consumers better understand and evaluate the recommendations they
receive and preserves flexibility for professionals who may be
interacting with clients of various levels of financial
sophistication, duration of relationship, and investment history);
CFA August 2018 Letter (recommending that transaction-specific
information should be provided, whenever possible, at the point of
recommendation rather than at the point of sale); Groom Letter
(recommending that the Commission require disclosure of material
conflicts of interest related to investing plan distribution
proceeds at the inception of any discussions of the matter); PIABA
Letter (recommending that the Commission require firms to provide
specific charges prior to or at the time the recommendation is
made); FPC Letter (stating that disclosures should be made prior to
the recommendation so the retail customer has sufficient time to
review and understand them, as well as to ask questions); Better
Markets August 2018 Letter; AARP August 2018 Letter; Bank of America
Letter.
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Several other commenters, however, recommended that the Commission
clarify whether broker-dealers could meet the Disclosure Obligation at
the point of sale \531\ or after a recommendation is made.\532\
Conversely, several commenters recommended that the Commission clarify
that it will not require point of sale or point of recommendation
disclosure obligations.\533\
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\531\ See Pacific Life August 2018 Letter (stating that material
conflicts of interest must be disclosed at or prior to the point-of-
sale or at the time the recommendation is made).
\532\ See, e.g., LPL August 2018 Letter (suggesting that the
Commission permit a broker-dealer to satisfy the Disclosure
Obligation by directing an investor in writing to review the
recommended product's offering documents, along with hyperlinks to
those documents, prior to the recommendation or shortly thereafter
via a trade confirmation); SIFMA August 2018 Letter (recommending
that the Commission confirm that firms would be permitted to provide
disclosures on a website or on a post-trade basis, provided
customers have been informed in advance of the timing of those
disclosures).
\533\ See, e.g., SIFMA August 2018 Letter (requesting the
Commission clarify that there is no requirement for a point of sale
or point of recommendation disclosure, as such a requirement would
be unworkable for the industry); Morgan Stanley Letter (noting that
point-of-sale disclosures pose operational issues and may not afford
clients sufficient time to adequately consider and understand them);
HD Vest Letter (recommending that the Commission not mandate written
point of recommendation or point of sale disclosure); Prudential
Letter (requesting that the Commission clarify that it is not
mandating a point of sale or point of recommendation disclosure
obligation). But see NASAA August 2018 Letter (stating that only a
transaction-by-transaction disclosure obligation will ensure that
broker-dealers are meeting their ``best interest'' duties and
provide investors the level of protection they deserve); AARP August
2018 Letter (recommending that the Commission require firms to
disclose their fees any time a recommendation is made).
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After carefully considering the comments received, we are providing
our view on what it means for broker-dealers to provide the required
disclosures in writing ``prior to or at the time of'' the
recommendation. As with the ``form and manner'' of making disclosures,
the Commission continues to believe that broker-dealers should have
flexibility with respect to the ``timing and frequency'' of providing
disclosure to determine the most appropriate and effective way to meet
the Disclosure Obligation. Accordingly, the Commission has decided not
to provide any prescriptive requirements for the timing and frequency
of written disclosures, other than requiring disclosure prior to or at
the time of the recommendation.
In order to make an informed decision about a securities
recommendation, retail customers must have appropriate information at
the time or before a recommendation is made. Being in possession of
relevant information gives investors the tools with which to judge the
merits of acting on a particular recommendation. As stated in the
Proposing Release, the Commission believes that broker-dealers should
provide retail customers information early enough in the process to
give them adequate time to consider the information and promote the
investor's understanding in order to make informed investment
decisions.\534\ Similarly, the Commission believes that broker-dealers
should not provide information so early that the disclosure fails to
provide meaningful information (e.g., does not sufficiently identify
material conflicts presented by a particular recommendation, or
overwhelms the retail customer with disclosures related to a number of
potential options that the retail customer may not be qualified to
pursue).\535\ Nevertheless, in order to provide broker-dealers the
flexibility to determine how and when to make relevant disclosures
pursuant to the Disclosure Obligation, we are not mandating a
requirement that disclosures be made within a certain timeframe
preceding a recommendation. However, we continue to encourage broker-
dealers to consider whether it would be helpful to repeat or highlight
disclosures already made pursuant to the Disclosure Obligation at the
time of the recommendation.
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\534\ Proposing Release at 21605.
\535\ Id.
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We are also clarifying the ability of a broker-dealer to
supplement, clarify, or update information after making a
recommendation.\536\ In particular, if a broker-dealer determines to
disclose information, in part, after the recommendation, such as in a
prospectus or trade confirmation, that disclosure may be used to
supplement, clarify, or update the initial, general disclosure. For
example, any necessary
[[Page 33371]]
information in a product offering document, such as information about
product risks or fees, may be provided in accordance with existing
disclosure mechanisms that occur after a transaction, such as the
delivery of a trade confirmation or a prospectus, private placement
memorandum, or offering circular.\537\ However, the broker-dealer must
comply with the circumstances outlined in Section II.C.1, Oral
Disclosure or Disclosure After a Recommendation, in order to make any
such disclosure after the recommendation.
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\536\ See id. In the proposal, we noted that there may be
material information that the broker-dealer may not be in a position
to disclose at or prior to the recommendation that may be revealed
following the transaction, such as the final transaction information
contained in a trade confirmation.
\537\ In instances where a recommended transaction is not acted
upon by the retail customer, and therefore there is no subsequent
delivery of disclosure otherwise required by the transaction, the
fact that such information is not provided would not be a violation
of the Disclosure Obligation.
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Layered Disclosure
We proposed to require broker-dealers to provide disclosure prior
to or at the time of the recommendation but gave guidance on a number
of approaches they could take to achieve this requirement, including
providing layered disclosure, in which more general information is
supplemented by more detailed information provided either at the same
time or subsequently.\538\ We received a number of comments supporting
our proposed guidance concerning a layered approach to the Disclosure
Obligation.\539\ In addition, investor testing illustrates that many
retail investors support a layered approach as well.\540\
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\538\ See Proposing Release at 21605 (suggesting the Disclosure
Obligation could be satisfied, for example, at multiple points in
the relationship or through a layered approach to disclosure, such
as an initial disclosure conveying more general information
regarding the material fact or conflict followed by more specific
information in a subsequent disclosure).
\539\ See, e.g., Commonwealth Letter (supporting a layered
disclosure approach that includes (i) the Relationship Summary at
the inception of the relationship; (ii) the traditional disclosures
included in account-opening agreements; (iii) product-specific
point-of-sale disclosures (e.g., prospectuses and alternative
investment offering documents); and (iv) more detailed disclosures
on the firm's website); IRI Letter (supporting a principles-based
disclosure regime, which leverages the benefits of layered
disclosure to combat information overload); Morgan Stanley Letter
(concurring with the Commission's proposed layered approach to
disclosure of material facts regarding the scope of the relationship
with the client and fees, as well as material conflicts of interest
associated with the recommendation); Stifel Letter; Mass Mutual
Letter; Triad Advisors Letter; Investacorp Letter; Ladenburg Letter.
\540\ See, e.g., Study Regarding Financial Literacy Among
Investors As Required by Section 917 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, August 2012 at iv. A key finding
of the SEC staff's 917 study was that Investors favor ``layered''
disclosure and, wherever possible, the use of a summary document
containing key information about an investment product or service.
That study described layered disclosure as an ``approach to
disclosure in which key information is sent or given to the investor
and more detailed information is provided online and, upon request,
is sent in paper or by email.'' See Enhanced Disclosure and New
Prospectus Delivery Option for Registered Open-End Management
Investment Companies, Securities Act Release No. 8998 (Jan. 13,
2009). This layered approach is ``intended to provide investors with
better ability to choose the amount and type of information to
review, as well as the format in which to review it (online or
paper).'' Id. Other studies that considered the use of hyperlinks
for layered disclosure in proposed Form CRS suggested that retail
investors are generally interested in receiving additional
information, but recognized the possibility that retail investors
may not click on a hyperlink. See, e.g., RAND 2018 (finding 58% of
participants selecting ``very likely'' and another 32% selecting
``somewhat likely'' to click on a hyperlink relating to fees;
although no other potential hyperlink generated a majority with
``very likely'' usage, other potential hyperlinks concerning
services, conflicts and investor education generated a majority when
combining responses of ``very likely'' and ``somewhat likely'' to
click on the hyperlink). See also Kleimann Communication Group,
Inc., Report on Development and Testing of Model Client Relationship
Summary, Presented to AARP and Certified Financial Planner Board of
Standards, Inc. (Dec. 5, 2018), available at https://www.sec.gov/comments/s7-07-18/s70718-4729850-176771.pdf (indicating that while
some participants were interested in additional information, others
admitted they would not follow the links because it was extra
effort, they were uninterested, or the link did not itself suggest
what would be there).
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We have considered these comments and results of investor testing
and will continue to permit broker-dealers to use a layered approach to
disclosure. We acknowledge that different investors have different
preferences for the type and length of disclosures they receive, and
that some investors may not read additional information provided in any
particularized disclosure that supplements initial, standardized
disclosure. Nonetheless, we believe that permitting broker-dealers to
provide their retail customers with a standardized summary of
information supplemented by more particularized information will help
avoid the likelihood that retail customers receive a single,
potentially voluminous disclosure document, and enable the many
investors who prefer a shorter, summary document to have it available
to them, with additional information available should they wish to have
it. This approach to layering information is also consistent with our
concurrent effort in Form CRS to provide retail investors with high
level information and context concerning key material facts,
supplemented by additional layers of information regarding their
relationship.
We also continue to believe that broker-dealers should have
flexibility in determining when to make disclosures and whether, in
light of their retail customer base, certain material facts would be
more effectively conveyed in a more general manner in an initial
written disclosure accompanied or followed by more specific information
in a separate disclosure. Similarly, we believe that providing broker-
dealers with flexibility to best target their disclosures to their
particular retail customer base will increase the likelihood that
investors will view them.
The Commission is not prescribing specific procedures obligating
broker-dealers to fulfill the Disclosure Obligation in a particular
way. Rather, Regulation Best Interest as adopted provides broker-
dealers with flexibility to provide disclosures that are consistent
with the various ways in which broker-dealers may already provide
disclosure to their customers.\541\ This could include, for example,
providing multiple or ``layered'' disclosures either initially or over
time, but that in total constitute full and fair disclosure of the
information required by the Disclosure Obligation. While we are not
setting forth a prescriptive approach regarding exactly when
disclosures should be made as suggested by some commenters, we believe
that a broker-dealer may determine that certain disclosures are most
effective if they are made at multiple points of the relationship, or
alternatively, certain material facts may be conveyed in a more general
manner in an initial written disclosure accompanied or followed by more
specific information.\542\
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\541\ See Proposing Release at 21605.
\542\ See id.
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Updating Disclosures
Several commenters recommend that the Commission clarify under what
circumstances a broker-dealer would be required to update prior
disclosures made pursuant to the Disclosure Obligation.\543\ Among the
suggestions are to only require broker-dealers to update their
disclosures when there are material changes to the disclosed
[[Page 33372]]
information; \544\ require broker-dealers to update their disclosures
at least 30 days before raising or imposing new fees; \545\ and require
broker-dealers to update their disclosures when changes are made, as
well as annually.\546\
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\543\ See, e.g., LPL August 2018 Letter (recommending that the
Commission provide additional guidance with respect to the updating
and amendment requirements that apply to the Disclosure Obligation);
CFA Institute Letter (recommending that the Commission require
broker-dealers to provide updated disclosures at least 30 days
before raising or imposing new fees); Bank of America Letter
(recommending that the Commission require firms to update existing
disclosures when there are changes to material conflicts of
interest, as well as annually); NAIFA Letter (recommending that the
Commission not require regular disclosure (e.g., quarterly, annual,
etc.) of any new information items, unless the information has
materially changed).
\544\ See NAIFA Letter.
\545\ See CFA Institute Letter.
\546\ See Bank of America Letter.
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The Commission has carefully considered the commenters' suggestions
and is providing guidance on a broker-dealer's duty to update
disclosures made to customers under Regulation Best Interest. The
Disclosure Obligation requires broker-dealers to provide their retail
customers with full and fair disclosure of material facts related to
several aspects of their relationship with their customers. Therefore,
a broker-dealer cannot provide customers with full and fair disclosure
if the disclosures contain materially outdated, incomplete, or
inaccurate information. Additional disclosure will be necessary when
any previously provided information becomes materially inaccurate, or
when there is new relevant material information (e.g., a new material
conflict of interest has arisen that is not addressed by the
standardized disclosure).\547\ Therefore, a broker-dealer's duty to
update disclosures made to its customers under Regulation Best Interest
is based on the facts and circumstances.
---------------------------------------------------------------------------
\547\ See Proposing Release at 21605.
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While we are not prescribing an explicit timeframe in which
required updates must be made, generally the Commission encourages
broker-dealers to update their disclosures to reflect material changes
or inaccuracies as soon as practicable, and thus generally should be no
later than 30 days after the material change; in the meantime, broker-
dealers are encouraged to provide, supplement, or correct any written
disclosure with oral disclosure as necessary prior to or at the time of
the recommendation.\548\ However, if updated information is to be
provided either orally, or after a recommendation, such disclosure must
be made under the circumstances outlined in Section II.C.1, Oral
Disclosure or Disclosure After a Recommendation.
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\548\ The 30-day period aligns with other requirements to update
disclosures in similar contexts. For instance, NASD Notice to
Members 92-11, Fees and Charges for Services (Feb. 1992) states that
its member firms need to provide written notification to customers
of all service charges when accounts are opened, and . . . written
notification at least 30 days prior to the implementation or change
of any service charge. Failure to do so could be construed as
conduct inconsistent with just and equitable principles of trade
under FINRA Rule 2010 (Standards of Commercial Honor and Principles
of Trade).
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2. Care Obligation
We proposed the Care Obligation to require a broker-dealer, when
making a recommendation of any securities transaction or investment
strategy involving securities to a retail customer, to exercise
reasonable diligence, care, skill, and prudence to: (1) 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; (2) 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 (3) have a reasonable basis to
believe that a series of recommended transactions, even if in the
retail customer's best interest when viewed in isolation, is not
excessive and is in the retail customer's best interest when taken
together in light of the retail customer's investment profile. As we
indicated in the Proposing Release, the Care Obligation was intended to
incorporate and enhance existing suitability requirements applicable to
broker-dealers under the federal securities laws by, among other
things, imposing a ``best interest'' requirement that will require a
broker-dealer to not place its own interest ahead of the retail
customer's interest, when making recommendations.\549\
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\549\ As discussed in the Fiduciary Interpretation, the duty of
care of the investment adviser's fiduciary duty includes a duty to
provide investment advisory services that are in the best interest
of the client. See Fiduciary Interpretation at footnote 34.
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Commenters generally supported the proposed Care Obligation,
including its principles-based approach, but many commenters requested
additional guidance or clarification on how a broker-dealer could
satisfy the Care Obligation under different circumstances and regarding
specific products.\550\ Relatedly, several commenters requested further
guidance regarding the role of costs and other relevant factors when
making a best interest determination,\551\ while other commenters
expressed concern over the usage of the term ``prudence'' \552\ or
expressed concern that Regulation Best Interest is not a major change
from FINRA's suitability rule.\553\ Numerous commenters also requested
clarification on the meaning and scope of ``reasonably available
alternatives'' and ``otherwise identical securities,'' including how
the phrase ``reasonably available alternatives'' would apply in
situations where a broker-dealer operated in an open architecture
environment,\554\ or maintained a limited product menu such as where
broker-dealers limited available offerings to proprietary
products.\555\ Finally, several commenters recommended the Commission
include other factors in building a retail customer's investment
profile, such as longevity risk,\556\ market risk,\557\ or income
profile.\558\
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\550\ See, e.g., NASAA August 2018 Letter; Cambridge Letter;
BlackRock Letter.
\551\ See, e.g., Wells Fargo Letter; Primerica Letter; CFA
Institute Letter.
\552\ See, e.g., BISA Letter; Raymond James Letter; Transamerica
August 2018 Letter.
\553\ See, e.g., CFA August 2018 Letter (stating ``[n]owhere
does the Commission explain how the standard differs from, or even
whether it improves upon, the existing suitability standard under
FINRA rules''); AFL-CIO April 2019 Letter (stating ``that the intent
of [proposed Regulation Best Interest] is to codify, rather than
enhance, protections investors currently receive under FINRA's
suitability standard'').
\554\ For purposes of this requirement, we use the term ``open
architecture'' to mean a firm's product menu that includes both
third-party and proprietary products, or as a concept wherein a firm
offers a large range of products to their retail customers that are
not limited, for example, to a small list of approved managers or
funds (i.e., a product menu that is not limited to proprietary
products or otherwise constrained to certain retail customers or
registered representatives). See generally FINRA 2013 Conflicts
Report; Morgan Stanley Letter.
\555\ See, e.g., Fidelity Letter; ICI Letter; LPL August 2018
Letter; SIFMA August 2018 Letter; Prudential Letter; Morningstar
Letter.
\556\ See, e.g., CCMC Letters; Lincoln Financial Letter; Pacific
Life August 2018 Letter.
\557\ See, e.g., Jackson National Letter.
\558\ See, e.g., Lincoln Financial Letter.
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We are adopting the Care Obligation substantially as proposed, but
with certain modifications and additional guidance to address comments.
As discussed in more detail below, in response to comments, we are
revising the Care Obligation to remove the term ``prudence,'' as we
have concluded that its inclusion creates legal uncertainty and
confusion, and it is redundant of what we intended in requiring a
broker-dealer to exercise ``diligence, care, and skill,'' and its
removal does not change the requirements under the Care Obligation.
Accordingly, the Care Obligation will require broker-dealers to
``exercise reasonable diligence, care, and skill'' to meet the three
components of the Care Obligation.
In addition, after careful consideration of the comments received,
we are expressly adding cost to the rule text as a factor that a
broker-dealer must consider in fulfilling the Care Obligation. While
certain commenters expressed concerns about the prominence of cost and
how cost would be balanced against other factors under the Care
Obligation,\559\ other
[[Page 33373]]
commenters supported incorporating cost into the rule text.\560\ As
noted in the Relationship Summary Adopting Release, participants in
investor testing and roundtables also overwhelmingly supported
including fees in the Relationship Summary, and believed that the
``fees and costs'' section was the most important for determining which
type of investment accounts and services are right for that
person.\561\ We believe that while the factors that a broker-dealer
should understand and consider when making a recommendation may vary
depending upon the particular product or strategy recommended, cost--
along with potential risks and rewards--will always be a relevant
factor that will bear on the return of the security or investment
strategy involving securities.\562\ This would include, for example,
both costs associated with the purchase of the security, as well as any
costs that may apply to the future sale or exchange of the security,
such as deferred sales charges or liquidation costs. Elevating cost to
the rule text clarifies that this factor must always be considered when
making a recommendation. Thus, a broker-dealer, in fulfilling its
obligation to make a recommendation in the best interest of its retail
customer, must exercise reasonable diligence, care, and skill to
understand the ``potential risks, rewards, and costs'' associated with
the recommendation and have a reasonable basis to believe that the
recommendation is in the best interest of the retail customer based on
these factors.
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\559\ See, e.g., ICI Letter; Putnam Letter; Morgan Stanley
Letter; Letter from Eric R. Dinallo, Executive Vice President,
General Counsel, Guardian Life (Aug. 7, 2018) (``Guardian August
2018 Letter'') (cautioning against inclusion of ``costs'' into rule
text or overemphasizing its importance).
\560\ See, e.g., AFL-CIO April 2019 Letter (stating ``If, as has
been suggested, one goal is to ensure that brokers give greater
consideration to costs in determining what investments to recommend,
[Regulation Best Interest] should incorporate an explicit
requirement to consider costs in the rule text.''); NASAA August
2018 Letter; U. of Miami Letter (supporting addition of ``costs''
into rule text). See also CFA August 2018 Letter (supporting the
Commission's emphasis of cost and associated financial incentives as
more important factors, and stating ``[t]his requirement would be
clearer, however, if it were incorporated into the rule text, which
requires the broker to consider the `potential risks and rewards
associated with the recommendation,' rather than the material
characteristics, including costs, of the recommended investment or
investment strategy.'').
\561\ See Relationship Summary Adopting Release.
\562\ See Vanguard Letter (``We agree that costs and
remuneration should play a central role in meeting the revise best
interest standards. Cost is a critical factor because of its
compounding effect upon performance.'').
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Importantly, however, while cost, like potential risks and rewards,
is always a factor that a broker-dealer must consider in making a
recommendation, it is not a dispositive factor and its inclusion in the
rule text is not meant to limit or foreclose the recommendation of a
more costly or complex product that a broker-dealer has a reasonable
basis to believe is in the best interest of a particular retail
customer.\563\ Moreover, we are reiterating that the standard does not
necessarily require the lowest cost option, and that while cost is an
important factor that always needs to be taken into consideration in
making a recommendation, it is not the only one.\564\ Rather, as
explained more fully below, the evaluation of cost would be more
analogous to a broker-dealer's best execution analysis, which does not
require the lowest possible cost, but rather looks at whether the
transaction represents the best qualitative execution for the customer
using cost as one factor.\565\
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\563\ See Proposing Release at 21587-21589; 21610-21612.
\564\ See Proposing Release at 21610.
\565\ Under the antifraud provisions of the federal securities
laws and SRO rules, broker-dealers have a legal duty to seek to
obtain best execution of customer orders. See Regulation NMS,
Exchange Act Release No. 51808 (Jun. 9, 2005) (``Regulation NMS
Release''); FINRA Rule 5310 (Best Execution and Interpositioning). A
broker-dealer's duty of best execution requires a broker-dealer to
seek to execute customers' trades at the most favorable terms
reasonably available under the circumstances. See Regulation NMS
Release at 160; see also Proposing Release at 21615. Certain
commenters pointed to best execution analysis as an example of a
rule or guidance that is facts-and-circumstances-based. See, e.g.,
CFA August 2018 Letter (``Just as compliance with the best execution
standard will not always be met by sending trades to the exchange
where the lowest cost is displayed, compliance with a best interest
standard will not always be satisfied by recommending the lowest
cost option.'').
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Several commenters expressed concern over the emphasis of ``cost''
and suggested that, for example, more emphasis be placed on additional
or subjective factors beyond specific product attributes.\566\ Those
commenters stated that the emphasis on cost may discourage certain
products or investment strategies. Our intent is not to discourage or
otherwise limit the recommendation of products or investment strategies
where a broker-dealer concludes that the recommendation is in the best
interest of the retail customer. Instead, we believe that cost will
always be relevant to a recommendation and accordingly should be a
required consideration as set forth in the rule text. It should never
be the only consideration. Additional factors such as those cited by
commenters also should be taken into consideration as the broker-dealer
formulates a recommendation consistent with the best-interest
standard.\567\
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\566\ See, e.g., ICI Letter; BlackRock Letter; Putnam Letter;
Transamerica August 2018 Letter; Northwestern Mutual Letter; see
also Vanguard Letter (recognizing the importance of cost, but urging
the Commission to maintain a principles-based approach recognizing
the importance of ``holistic advice that necessarily contemplates
factors beyond cost.'').
\567\ See, e.g., BlackRock Letter (citing consideration of
investors' needs and desired outcomes relative to service offerings
of several different managers); Vanguard Letter (``considerations
include important factors such as product structure, investment
features, liquidity, volatility, issuer reputation, brand and
business practices (securities lending activities, portfolio
tracking error, or usage of derivatives in a portfolio)''); ICI
Letter (citing several subjective factors, such as the ``nature and
quality of a provider's services (including advantages to the
investor of consolidating investments as a single firm, such as
higher levels of service that may be offered), minimum initial
investments, and firm reputation''); FIBA February 2019 Letter
(citing ``highly personalized non-economic reasons underlying cross-
border investment'').
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Though we are declining to expressly define ``best interest'' in
the rule text, as discussed above,\568\ we are providing guidance
regarding the application of the Care Obligation and in particular what
it means to make a recommendation in the retail customer's ``best
interest.'' In addition, to emphasize the importance of determining
that each recommendation is in the best interest of the retail customer
and that it does not place the broker-dealer's interests ahead of the
retail customer's interests, we are expressly incorporating into the
rule text of Paragraph (a)(2)(ii)(B) and Paragraph (a)(2)(ii)(C) of
Regulation Best Interest that a broker-dealer must have a reasonable
basis to believe that the recommendation ``does not place the financial
or other interest of the [broker-dealer] . . . ahead of the interest of
the retail customer.'' While we acknowledge that a broker-dealer and an
associated person can and will have some financial interest in a
recommendation, as noted above, this addition to the Care Obligation
makes clear these interests cannot be placed ahead of the retail
customer's interests when making a recommendation.\569\
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\568\ See Section II.A.2.
\569\ See id. See also AFL-CIO April 2019 Letter (noting
``Adopting a standard that explicitly states that brokers are
prohibited form placing their own interests ahead of the retail
customer's interests reinforces [investors' reasonable expectations
that the financial professionals they rely on for investment advice
will put their interests first]'' and asserting that ``a requirement
to place the customer's interests ahead of the brokers' interests
must be included in the operational provisions of Reg BI. . . .'').
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Finally, we believe that by explicitly requiring in the rule text
that the broker-dealer have a reasonable basis to believe that a
recommendation is both in the retail customer's ``best interest'' and
[[Page 33374]]
does ``not place the financial or other interest'' of the broker-dealer
ahead of the retail customer's interests, we are enhancing the Care
Obligation by imposing obligations beyond existing suitability
obligations. Under existing suitability requirements, a broker-dealer
is required to make recommendations that are ``suitable'' for the
customer. While certain cases and guidance have interpreted FINRA's
suitability rule to require that ``a broker's recommendations must be
consistent with his customers' best interests,'' and FINRA has further
interpreted the requirement to be ``consistent with the customer's best
interest'' to prohibit a broker-dealer from placing his or her
interests ahead of the customer's interests, this obligation is not
explicitly required by FINRA's rule (or its supplementary material),
nor does the interpretation require recommendations to be in the best
interest (as opposed to ``consistent with the best interest'') of a
retail customer.\570\ We believe that requiring recommendations to be
in the best interest is declarative of what must be done, and therefore
stronger than, requiring recommendations to be ``consistent with'' the
best interest of the retail customer, which we believe at a minimum
creates ambiguity as to whether the recommendation must be in the
retail customer's best interest or something less.\571\
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\570\ See FINRA Regulatory Notice 12-25 at Q1. See also FINRA
Letter to Senators Warren, Brown, and Booker (Aug. 3, 2018) (``FINRA
2018 Letter'') (stating that ``[w]hile FINRA's suitability rule
implicitly requires a broker-dealer's recommendations to be
consistent with customer's best interests, the SEC's proposed best
interest standard explicitly establishes the customer's best
interest as an overarching standard of care for broker-dealers.''
(internal citations omitted)). Some commenters have also made this
point. See, e.g., CFA August 2018 Letter (``In enforcing that
standard, however, FINRA has only rarely and very narrowly enforced
the obligation to do what is best for the customer--typically in
cases that involve recommending the most appropriate share class of
a particular mutual fund. . . . Indeed, as we detailed in our July
2015 comment letter to the Department of Labor, most of the cases in
which FINRA and the Commission have asserted an obligation for
brokers to act in customers' best interest have involved egregious
frauds rather than questions of whether customers' best interests
were being served.'').
\571\ See, e.g., CFA August 2018 Letter.
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The Care Obligation significantly enhances the investor protection
provided as compared to current suitability obligations by: (1)
Explicitly requiring in Regulation Best Interest that recommendations
be in the best interest of the retail customer and do not place the
broker-dealer's interests ahead of the retail customer's interests; (2)
explicitly requiring by rule the consideration of costs when making a
recommendation; and (3) applying the obligations relating to a series
of recommended transactions (currently referred to as ``quantitative
suitability'') irrespective of whether a broker-dealer exercises actual
or de facto control over a customer's account.\572\ In addition, it is
our view that a broker-dealer should consider ``reasonably available
alternatives'' as part of having a ``reasonable basis to believe'' that
the recommendation is in the best interest of the retail customer,
which we also believe is an enhancement beyond existing suitability
expectations.\573\
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\572\ See FINRA 2018 Letter (noting that proposed Regulation
Best Interest augments and enhances current requirements by, among
other things: ``explicitly impos[ing] a `best interest' standard,
making clear that a broker-dealer cannot put its interests ahead of
the interests of its customers. While FINRA's suitability rule
implicitly requires a broker-dealer's recommendations to be
consistent with customers' best interests, the SEC's proposed best
interest standard explicitly establishes the customer's best
interest as an overarching standard of care for broker-dealers;''
``explicitly requir[ing] broker-dealers to consider `reasonably
available alternatives' to a recommended security and justify any
choice of a more costly product. . . . Although case law and FINRA
guidance establish cost and available alternatives as factors to
consider as part of a FINRA suitability assessment, particularly
regarding mutual fund share classes, proposed Reg Bl expressly
establishes the significance of these factors''; and ``remov[ing]
the `control' element for purposes of quantitative suitability,
which would make this obligation more enforceable.'') (internal
citations omitted).
\573\ See infra Section II.C.2.c, Application of the Care
Obligation--Reasonably Available Alternatives and Otherwise
Identical Securities.
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a. Exercise Reasonable Diligence, Care, and Skill
A broker-dealer is required to ``exercise reasonable diligence,
care, and skill'' to satisfy the three components of the Care
Obligation set forth in Regulation Best Interest. In the Proposing
Release, we included ``prudence,'' and explained that ``prudence''
``conveys the fundamental importance of conducting a proper evaluation
of any securities or investment strategy recommendation in accordance
with an objective standard of care.'' \574\ Further, we solicited
comment on all aspects of the Care Obligation, and also asked
specifically whether there was adequate clarity and understanding
regarding the term ``prudence,'' or whether other terms were more
appropriate in the context of broker-dealer regulation.
---------------------------------------------------------------------------
\574\ Proposing Release at 21609.
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Several commenters supported adopting a principles-based
obligation, thus requiring the broker-dealer to assess the adequacy of
a recommendation based on the facts and circumstances of each
recommendation.\575\ We also received numerous comments asking for
further guidance relating to recommendations of specific securities or
asking how the Care Obligation applies to certain factual
scenarios.\576\ With respect to the term ``prudence,'' a number of
comments requested removal of the term, stating that such language is
unnecessary given the other requirements to satisfy the Care
Obligation, as well as the fact that the term introduces legal
confusion and uncertainty.\577\ Other commenters supported the use of
the term ``prudence'' because they believed that Regulation Best
Interest's component obligations generally rested on a ``prudence''
standard or maintained that the Care Obligation ``echoes elements found
in the common law `prudent person rule,' '' and thus thought its
addition was appropriate to capture, or describe, these
obligations.\578\
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\575\ See, e.g., SIFMA August 2018 Letter; Vanguard Letter;
Morningstar Letter; Edward Jones Letter.
\576\ See, e.g., SIFMA August 2018 Letter; Direxion Letter;
Chapman Letter.
\577\ See, e.g., Primerica Letter (stating ``. . . . the term
[prudence] raises numerous interpretative issues and compliance
risks. Regulatory and judicial interpretations of ERISA `prudence'
and its requirements abound, but these are exclusive to employee
benefit plan duties and do not address duties with respect to retail
accounts for individual customers.''); Transamerica August 2018
Letter (``The term `prudence' is one used primarily in the ERISA
context and is not generally used in the federal securities laws. We
believe inclusion of the term `prudence' in describing the care
obligation is unnecessary and could lead to confusion in
interpretation of the care obligation set forth in the Proposal'');
IPA Letter (`` `Prudence' is an ERISA term based on trust law that
is not generally used under the federal securities laws''). See also
Fein Letter (discussing that the ``duties of loyalty and care are
the core fiduciary standards that apply across all fiduciary fields,
including trust law, agency law, and employee benefits law;'' that
``[b]oth of these duties are reflected in the existing regulation of
broker-dealers and investment advisers when they give investment
advice to retail customers;'' and that the ``duty of care--also
called `prudence'--requires a fiduciary to act with care, skill and
diligence in fulfilling his designated functions.'') (internal
citations omitted).
\578\ See LPL August 2018 Letter (``We believe that each of the
four component obligations identified in Regulation BI generally
rests on a `prudence' standard that is the foundation of the common
law principles and the Federal law that have governed the activities
of financial services providers for decades. The obligation to
provide prudent recommendations that are appropriate for an
investor's circumstances is a principal component of the suitability
obligations that apply to investment advisers under the [Advisers
Act]'' (internal citations omitted); FPC Letter (stating that ``the
duty of care, as described by both Reg BI and CFP Board Standards,
echoes elements found in the common law `prudent person rule' which
can serve to measure the reasonableness of a prudent professional's
actions. . . .''); see also CFA August 2018 Letter; NAIFA Letter.
---------------------------------------------------------------------------
After careful consideration of comments, we are revising the Care
Obligation to remove the term
[[Page 33375]]
``prudence.'' Accordingly, the Care Obligation will require broker-
dealers to ``exercise reasonable diligence, care, and skill'' to meet
the three components of the Care Obligation. We are persuaded by
commenters that its inclusion in the proposed rule text to satisfy the
components of the Care Obligation is superfluous and unnecessarily
presents the possibility for confusion and legal uncertainty.\579\ We
believe requiring broker-dealers ``to exercise reasonable diligence,
care, and skill'' conveys ``the fundamental importance of conducting a
proper evaluation of any securities recommendation in accordance with
an objective standard of care'' \580\ that was intended by the
inclusion of ``prudence.'' Removing ``prudence'' does not lessen nor
otherwise change the requirements or our expectations under the Care
Obligation, or Regulation Best Interest more broadly as it was
duplicative of the phrase ``diligence, care, and skill.'' \581\ The
revised obligation, in requiring the broker-dealer to ``exercise[ ]
reasonable diligence, care and skill'' and to have a ``reasonable basis
to believe that the recommendation is in the best interest . . . and
does not place'' the interest of the broker-dealer ahead of the
interest of the retail customer, will continue to require an analysis
that is comparable to the notion of ``prudence'' as described in other
regulatory frameworks,\582\ but does so using the terms ``diligence,
skill, and care''--terminology with which broker-dealers are familiar
and that is well understood under the federal securities laws.\583\ As
such, we believe that the revised language will minimize the potential
confusion and legal uncertainty created by using a term that is
predominantly interpreted in other legal regimes,\584\ and will aid
broker-dealers in achieving compliance with Regulation Best Interest as
well as permit broker-dealers to utilize existing compliance and
supervisory systems that already rely on this language.
---------------------------------------------------------------------------
\579\ See supra footnote 577.
\580\ Proposing Release at 21609.
\581\ See, e.g., LPL August 2018 Letter (noting that the
component obligations of Regulation Best Interest generally rest on
``prudence'' concepts); Fein Letter.
\582\ See Fein Letter (stating that the ``duty of care--also
called `prudence'--requires a fiduciary to act with care, skill and
diligence in fulfilling his designated functions'') (citing
Restatement 3d of Agency, Sec. 8.08 Duties of Care, Competence, and
Diligence (``[s]ubject to any agreement with the principal, an agent
has a duty to the principal to act with care, competence, and
diligence normally exercised by agents in similar circumstances. . .
.'')). The DOL interpreted ``prudence'' to represent ``an objective
standard of care that requires investment advice fiduciaries to
investigate and evaluate investments, make recommendations, and
exercise sound judgment in the same way that knowledgeable and
impartial professionals would.'' BIC Exemption Release, 81 FR 21208
at 21028-21029.
\583\ See, e.g., Proposing Release at 21595, 21609-21613. The
discussion that follows addresses what it means to ``exercise
reasonable diligence, care, and skill'' in the context of each
aspect of the Care Obligation.
\584\ See supra footnote 577.
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Moreover, we note that certain commenters' support for the term
``prudence'' was based on our interpretation of the Care Obligation in
the Proposing Release.\585\ As noted above, the removal of the term
``prudence'' does not change the obligations or our interpretation of
the Care Obligation, which we believe are addressed by the ``diligence,
care, and skill'' language and through Regulation Best Interest more
broadly. In light of concerns regarding legal uncertainty associated
with the term ``prudence,'' and our view that its inclusion or removal
would not change the requirements or expectations of Regulation Best
Interest, we have determined to remove it from the rule text.
---------------------------------------------------------------------------
\585\ See, e.g., NAIFA Letter.
---------------------------------------------------------------------------
Finally, in response to comments, we are retaining the facts-and-
circumstances determination for the reasons set forth in the Proposing
Release,\586\ and providing additional guidance on the application of
the components of the Care Obligation with respect to certain
securities and under certain scenarios. As we noted in the Proposing
Release, such an approach is consistent with how broker-dealers are
currently regulated with respect to the suitability of their
recommendations and would allow broker-dealers to utilize and
incorporate pre-existing compliance systems. In addition, this approach
is generally consistent with the principles-based approach applicable
to the duty of care of investment advisers.\587\
---------------------------------------------------------------------------
\586\ Proposing Release at 21587 (``[W]e preliminarily believe
that whether a broker-dealer acted in the best interest of the
retail customer when making a recommendation will turn on the facts
and circumstances of the particular recommendation and the
particular retail customer, along with the facts and circumstances
of how the four specific components of Regulation Best Interest are
satisfied.'').
\587\ See Fiduciary Interpretation.
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b. Understand Potential Risks, Rewards, and Costs Associated With
Recommendation, and Have a Reasonable Basis To Believe That the
Recommendation Could Be in the Best Interest of at Least Some Retail
Customers
Under the proposed ``reasonable basis'' component of the Care
Obligation, broker-dealers would be required to understand the
potential risks and rewards of the recommendation and have a reasonable
basis to believe that the recommendation could be in the best interest
of at least some retail customers. Although potential costs were not
specifically included in the proposed rule text as a factor to be
considered as part of a recommendation, the Proposing Release
identified potential costs associated with a recommendation as an
important factor to understand and consider as part of making a
recommendation, and likewise as a key factor to consider when
evaluating whether or not a broker-dealer had a reasonable basis to
believe it was acting in the best interest of the retail customer when
making the recommendation.\588\
---------------------------------------------------------------------------
\588\ See Proposing Release at 21609-21612. See also supra
footnote 572.
---------------------------------------------------------------------------
After careful consideration of comments, the Commission is
adopting, for the reasons set forth in the Proposing Release, Paragraph
(a)(2)(ii)(A) of the Care Obligation substantially as proposed.
However, as discussed above, in addition to requiring broker-dealers to
understand the potential risks and rewards associated with the
recommendation, we are also expressly requiring them to understand and
consider the potential costs associated with a recommendation.
Elevating costs to the rule text is consistent with a number of
commenters' recommendations and, importantly, stresses that cost will
always be a salient factor to be considered when making a
recommendation.\589\ Additionally, this requirement that the broker-
dealer understands and considers costs is a distinct enhancement over
existing reasonable basis suitability obligations, which do not
expressly require this consideration.\590\ Nevertheless, we recognize--
and emphasize--that cost is one important factor among many factors,
and thus provide additional guidance below regarding the importance of
weighing and considering costs in light of other relevant factors and
the retail customer's investment profile.
---------------------------------------------------------------------------
\589\ See, e.g., AFL-CIO April 2019 Letter; NASAA August 2018
Letter; U. of Miami Letter.
\590\ See supra footnote 572.
---------------------------------------------------------------------------
Paragraph (a)(2)(ii)(A) of Regulation Best Interest is intended to
incorporate and build upon broker-dealer's existing ``reasonable-basis
suitability'' obligations and would relate to the broker-dealer's
understanding of the particular security or investment strategy
recommended, rather than to any particular retail customer. Without
establishing such a threshold understanding of its particular
[[Page 33376]]
recommended security or investment strategy involving securities, we do
not believe that a broker-dealer could, as required by Regulation Best
Interest, have a reasonable basis to believe that it is acting in the
best interest of a retail customer when making a recommendation.\591\
---------------------------------------------------------------------------
\591\ See Proposing Release at 21609-21610 (for further
discussion regarding this requirement).
---------------------------------------------------------------------------
In order to meet the requirement under Paragraph (a)(2)(ii)(A), a
broker-dealer would need to undertake reasonable diligence, care, and
skill to understand the nature of the recommended security or
investment strategy involving a security or securities, as well as the
potential risks, rewards--and now costs--of the recommended security or
investment strategy, and have a reasonable basis to believe that the
recommendation could be in the best interest of at least some retail
customers based on that understanding. A broker-dealer must adhere to
both components of Paragraph (a)(2)(ii)(A). For example, a broker-
dealer could violate the obligation by not understanding the potential
risks, rewards, or costs of the recommended security or investment
strategy, even if the security or investment strategy could have been
in the best interest of at least some retail customers. Conversely,
even if a broker-dealer understands the recommended security or
investment strategy, the broker-dealer must still have a reasonable
basis to believe that the security or investment strategy could be in
the best interest of at least some retail customers.
What would constitute reasonable diligence, care, and skill under
Paragraph (a)(2)(ii)(A) will vary depending on, among other things, the
complexity of and risks associated with the recommended security or
investment strategy and the broker-dealer's familiarity with the
recommended security or investment strategy.\592\ While every inquiry
will be specific to the particular broker-dealer and the recommended
security or investment strategy, broker-dealers generally should
consider important factors such as the security's or investment
strategy's investment objectives, characteristics (including any
special or unusual features), liquidity, volatility, and likely
performance in a variety of market and economic conditions; the
expected return of the security or investment strategy; as well as any
financial incentives to recommend the security or investment strategy.
Together, this inquiry should allow the broker-dealer to develop a
sufficient understanding of the security or investment strategy and to
be able to reasonably believe that it could be in the best interest of
at least some retail customers.
---------------------------------------------------------------------------
\592\ See FINRA Rule 2111.05(a).
---------------------------------------------------------------------------
This ``reasonable-basis'' component of the Care Obligation is
especially important when broker-dealers recommend securities and
investment strategies that are complex or risky.\593\ For example, in
recent years, the Commission staff and FINRA have addressed broker-
dealer sales practice obligations under existing law relating to
complex products, such as inverse or leveraged exchange-traded
products.\594\ These products, which may be useful for some
sophisticated trading strategies, are highly complex financial
instruments and are typically designed to achieve their stated
objectives on a daily basis.\595\ However, because of the effects of
compounding, the performance of these products over longer periods of
time can differ significantly from their stated daily objectives. Thus,
broker-dealers recommending such products should understand that
inverse and leveraged exchange-traded products that are reset daily may
not be suitable for, and as a consequence also not in the best interest
of, retail customers who plan to hold them for longer than one trading
session, particularly in volatile markets.\596\ Without understanding
the terms, features, and risks of inverse and leveraged exchange-traded
products--as with the potential risks, rewards, and costs of any
security or investment strategy--a broker-dealer could not establish a
reasonable basis to recommend these products to retail customers.\597\
Further, these products may not be in the best interest of a retail
customer absent an identified, short-term, customer-specific trading
objective. Similarly, when a broker-dealer recommends a potentially
high risk product to a retail customer--such as penny stocks or other
thinly-traded securities--the broker-dealer should generally apply
heightened scrutiny to whether such investments are in a retail
customer's best interest.\598\
---------------------------------------------------------------------------
\593\ See FINRA Rule 2111 (Suitability) FAQ at Q5.1 (``The
reasonable-basis obligation is critically important because, in
recent years, securities and investment strategies that brokers
recommend to customers, including retail investors, have become
increasingly complex and, in some cases, risky.). See also SEC v.
Hallas, No. 17-cv-02999 (S.D.N.Y. filed Apr. 25, 2017).
\594\ See FINRA Regulatory Notice 09-31, Non-Traditional ETFs--
FINRA Reminds Firms of Sales Practice Obligations Relating to
Leveraged and Inverse Exchange-Traded Funds (June 2009); SEC staff
and FINRA, Investor Alert, Leveraged and Inverse ETFs: Specialized
Products with Extra Risks for Buy-and-Hold Investors (Aug. 1, 2009);
SEC Office of Investor Education and Advocacy, Investor Bulletin:
Exchange-Traded Funds (ETFs) (Aug. 2012).
\595\ See id. See also Exchange-Traded Funds, Securities Act
Release No. 10515 (Jun. 28, 2018); Use of Derivatives by Registered
Investment Companies and Business Development Companies, Investment
Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28,
2015)] (``Derivatives Proposing Release''); Direxion Letter
(recognizing that leveraged ETFs are not appropriate for all
customers, and thus the importance for broker-dealers to perform
sufficient diligence to adequately ``understand the terms and
features of such funds, including how they are designed to perform,
how they achieve that objective, and the impact that market
volatility, the ETF's use of leverage, and the customer's intended
holding period will have on their performance'').
\596\ See supra footnotes 593-595.
\597\ See id.
\598\ See, e.g., FINRA Regulatory Notice 17-32, Volatility-
Linked Exchange Traded Products--FINRA Reminds Firms of Sales
Practice Obligations for Volatility-Linked Exchange-Traded Products
(Oct. 2017) (explaining that ``The level of reasonable diligence
that is required will rise with the complexity and risks associated
with the security or strategy. With regard to a complex product such
as a volatility-linked ETP, an associated person should be capable
of explaining, at a minimum, the product's main features and
associated risks.''); FINRA Regulatory Notice 12-03, Complex
Products--Heightened Supervision of Complex Products (Jan. 2012)
(stating that ``Reasonable diligence must provide the firm or
registered representative `with an understanding of the potential
risks and rewards associated with the recommended security or
strategy.' This understanding should be informed by an analysis of
likely product performance in a wide range of normal and extreme
market actions. The lack of such an understanding when making the
recommendation could violate the suitability rule.'') (internal
citations omitted).
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Finally, several commenters expressed concern about the
applicability of Regulation Best Interest to variable annuities and
variable life insurance products.\599\ Variable annuities and variable
life insurance products have generated special attention from
regulators and their staff, such as statements regarding sales practice
obligations and specific FINRA rules relating to the recommendation of
variable annuities.\600\ These variable insurance products are often
unique and have different features depending on the company providing
the product, as well as depending on the chosen investment options,
benefits, fees and expenses, liquidity restrictions, and other
considerations.\601\ Consistent with
[[Page 33377]]
existing FINRA rules and existing suitability obligations under the
federal securities laws and SRO rules, regulators and their staffs have
stated that recommendations of these products would require careful
attention and a specific understanding of certain factors, such as
whether the product provides tax-deferred growth, or a death or living
benefit, before a broker-dealer could establish an understanding of the
product, and apply that understanding to a retail customer's investment
profile in making a recommendation.
---------------------------------------------------------------------------
\599\ See related discussion in Section II.C.2.c, Retail
Customer Investment Profile.
\600\ See, e.g., FINRA Rule 2330, Members Responsibilities
Regarding Deferred Variable Annuities; FINRA Rule 2320, Variable
Contracts of Insurance Companies; FINRA Regulatory Notice 10-05,
Deferred Variable Annuities--FINRA Reminds Firms of Their
Responsibilities Under FINRA Rule 2330 for Recommended Purchases or
Exchange of Deferred Variable Annuities (Jan. 2010); SEC Updated
Investor Bulletin: Variable Annuities (Oct. 30, 2018); SEC Investor
Bulletin: Variable Life Insurance (Oct. 30, 2018).
\601\ See id. See also Updated Disclosure Requirements and
Summary Prospectus for Variable Annuity and Variable Life Insurance
Contracts, Investment Advisers Act Release No. 10569 (Oct. 30, 2018)
[83 FR 61730 (Nov. 30, 2018)] (``VA Summary Prospectus Proposal'').
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While we stress the importance of understanding the potential
risks, rewards, and costs associated with a recommended security or
investment strategy, as well as other factors depending on the facts
and circumstances of each recommendation, we do not intend to limit or
foreclose broker-dealers from recommending complex or more costly
products or investment strategies where the broker-dealer has a
reasonable basis to believe that a recommendation could be in the best
interest of at least some retail customers and the broker-dealer has
developed a proper understanding of the recommended product or
investment strategy. As discussed below, once a broker-dealer develops
an appropriate understanding of a securities product or investment
strategy, including its potential costs, and believes it could be in
the best interest of at least some retail customers, the broker-dealer
will then need to apply that understanding to reasonably determine that
the recommended product or investment strategy is in the particular
retail customer's best interest at the time of the recommendation.
c. Have a Reasonable Basis To Believe the Recommendation Is in the Best
Interest of a Particular Retail Customer Based on That Retail
Customer's Investment Profile and the Potential Risks, Rewards, and
Costs Associated With the Recommendation and Does Not Place the
Interest of the Broker-Dealer Ahead of the Interest of the Retail
Customer
In the Proposing Release, we stated that beyond establishing an
understanding of the recommended securities transaction or investment
strategy, in order to act in the best interest of the retail customer,
a broker-dealer would be required to have a reasonable basis to believe
that a specific recommendation is in the best interest of the
particular retail customer based on its understanding of the investment
or investment strategy under Paragraph (a)(2)(ii)(A), and in light of
the retail customer's investment objectives, financial situation, and
needs. Accordingly, under proposed paragraph (a)(2)(ii)(A), the second
sub-component of the Care Obligation would require a broker-dealer to
``exercise reasonable diligence, care, skill, and prudence to . . .
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.'' In the Proposing Release, the
Commission further articulated that under this standard, a broker-
dealer could not have a reasonable basis to believe that the
recommendation is in the ``best interest'' of the retail customer, if
the broker-dealer put its interest ahead of the retail customer's
interest. This was intended to incorporate a broker-dealer's existing
well-established obligations under ``customer-specific suitability,''
but also to enhance these obligations by requiring that the broker-
dealer have a reasonable basis to believe that the recommendation is in
the ``best interest'' of (rather than ``suitable for'') the retail
customer.
Commenters largely supported the Commission's proposed approach,
but several commenters requested clarifying guidance regarding the
importance of costs and other specific factors in a ``best interest''
evaluation, as well as more broadly how ``best interest'' was to be
determined.\602\ For example, several commenters requested additional
guidance on the role of costs and other ``relevant factors,'' including
subjective and qualitative factors such as shareholder support
services, redemption procedures, or qualifications of the investment
adviser.\603\ Similarly, several commenters asked for clarification
that ``best interest'' does not necessarily mean the lowest cost option
or require the broker-dealer to look at every single possible
security.\604\ Commenters also requested further direction regarding
guidance in the Proposing Release related to the consideration of
``reasonably available alternatives'' and ``otherwise identical
securities,'' and requested certain modifications to the definition of
``Retail Customer Investment Profile.'' \605\
---------------------------------------------------------------------------
\602\ See, e.g., Wells Fargo Letter; Primerica Letter; Great-
West Letter; NASAA August 2018 Letter; Cambridge Letter; BlackRock
Letter.
\603\ See Chapman Letter; BlackRock Letter; Vanguard Letter; ICI
Letter; Morgan Stanley Letter.
\604\ See Great-West Letter; SIFMA August 2018 Letter.
\605\ See, e.g., Committee of Annuity Insurers Letter; Guardian
August 2018 Letter; IPA Letter; Morgan Stanley Letter; Invesco
Letter; CFA August 2018 Letter.
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After careful consideration of these comments, for the reasons set
forth in the Proposing Release, the Commission is adopting the
``customer specific'' component of the Care Obligation substantially as
set forth in the Proposing Release. However, as included under the
reasonable basis component of the Care Obligation and for the reasons
discussed above, the Commission is expressly incorporating ``costs''
into the rule text to emphasize that broker-dealers must consider the
potential costs associated with a recommendation to a particular retail
customer.
As noted above, the Commission is also incorporating into the rule
text that broker-dealers must have a reasonable basis to believe that
the recommendation ``does not place the financial or other interest of
the broker-dealer ahead of the interest of the retail customer.'' \606\
This addition is intended to make clear that while a broker-dealer
typically will have some interest in a recommendation, the broker-
dealer cannot put that interest ahead of the retail customer's interest
when making the recommendation.
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\606\ See related discussion in Section II.A.2; see also
Fiduciary Interpretation.
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To address feedback from commenters, the Commission is also
providing further interpretations and guidance regarding the
application of the Care Obligation, and in particular, what it means to
make a recommendation in a retail customer's best interest and not
place the broker-dealer's interest ahead of the retail customer's
interest. Specifically, recognizing that a facts and circumstances
evaluation of a recommendation makes it difficult to draw bright lines
around whether a particular recommendation would meet the Care
Obligation, the Commission is providing further interpretations and
guidance on how a broker-dealer could have a ``reasonable basis to
believe'' that a recommendation is in the best interest of its retail
customer and does not place the broker-dealer's interest ahead of the
retail customer's interest, as well as circumstances when we believe
that a broker-dealer could not have such a reasonable belief.
[[Page 33378]]
Factors To Consider Regarding a Recommendation to a Particular Retail
Customer and Relevance of Cost
Consistent with paragraph (a)(2)(ii)(A) of the Care Obligation, we
are incorporating ``costs'' in the rule text of paragraph (a)(2)(ii)(B)
of Regulation Best Interest as a relevant factor that, in addition to
risks and rewards, must always be understood and considered by the
broker-dealer prior to recommending a particular securities transaction
or investment strategy involving securities to a particular retail
customer. As discussed above, under paragraph (a)(2)(ii)(A) of the Care
Obligation, a broker-dealer will be required to exercise reasonable
diligence, care, and skill to understand the potential risks, rewards,
and costs of a recommended security or investment strategy and have a
reasonable basis to believe that it could be in the best interest of at
least some retail customers.\607\ Paragraph (a)(2)(ii)(B) of the Care
Obligation builds on this obligation and will require a broker-dealer
to have a reasonable basis to believe, based on its understanding of
the potential risks, rewards, and costs of the recommendation, and in
light of the retail customer's investment profile, that the
recommendation is in the best interest of a particular retail customer
and does not place the broker-dealer's interest ahead of the retail
customer's interest. Accordingly, when making a recommendation to a
particular retail customer, broker-dealers must weigh the potential
risks, rewards, and costs of a particular security or investment
strategy, in light of the particular retail customer's investment
profile. As discussed above,\608\ a broker-dealer's diligence, care,
and skill to understand the potential risks, rewards, and costs of a
security or investment strategy should generally involve a
consideration of factors, depending on the facts and circumstances of
the particular recommendation and the particular retail customer's
investment profile, as discussed below.
---------------------------------------------------------------------------
\607\ See Proposing Release at 21610-21611.
\608\ See related discussion in Section II.C.2.a and Section
II.C.2.b.
---------------------------------------------------------------------------
While the factors noted above are examples of important factors to
consider based on the particular security or investment strategy, this
list is not exhaustive and additional factors, including those raised
by commenters, could be relevant depending on the particular security
or investment strategy being recommended and depending on the
particular retail customer's investment profile. For example, prior to
recommending a variable annuity to a particular retail customer,
broker-dealers should generally develop a reasonable basis to believe
that the retail customer will benefit from certain features of deferred
variable annuities, such as tax-deferred growth, annuitization, or a
death or living benefit.\609\
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\609\ Cf. also FINRA Rule 2330, Members' Responsibilities
Regarding Deferred Variable Annuities. See Transamerica November
2018 Letter.
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As stated in the Proposing Release, the importance of each factor
in determining the customer-specific component of the Care Obligation
will depend on the facts and circumstances of each recommendation.
Thus, one or more factors may have more or less relevance--or may not
be obtained or analyzed at all--if the broker-dealer has a reasonable
basis for determining that the factors are not relevant. Regardless of
which factors are evaluated--and equally important, which factors are
not evaluated--a broker-dealer must have a reasonable basis to believe
that the particular recommendation is in the best interest of the
particular retail customer and does not place the broker-dealer's
interest ahead of the retail customer's interest, consistent with the
interpretations and guidance provided. For example, recommendations of
the ``lowest cost'' security or investment strategy, without
consideration of other factors, could violate Regulation Best Interest.
In the same vein, it is important to consider that a recommendation may
be considered to be in a retail customer's best interest when viewed in
the context of the retail customer's portfolio even if seemingly not in
a retail customer's best interest when viewed in isolation (e.g.,
inclusion of what otherwise might be seen as a risky investment in the
portfolio of a risk-adverse customer, such as including hedging
instruments in a conservative portfolio).
The customer-specific component of the Care Obligation will rest on
whether a broker-dealer had a reasonable basis to believe that the
recommendation was in the best interest of the particular retail
customer at the time of the recommendation, based on that retail
customer's investment profile and the potential risks, rewards, and
costs associated with the recommendation, and did not place the
financial or other interest of the broker, dealer, or such natural
person ahead of the interest of the retail customer. Thus, as discussed
further below, the importance of each factor, and which factors to
consider, will depend on the facts and circumstances of each
recommendation, as well as the specific security or investment
strategy.
While the Care Obligation does not require broker-dealers to
document the basis for a recommendation, broker-dealers may choose to
take a risk based approach when deciding whether or not to document
certain recommendations. For example, broker-dealers may wish to
document an evaluation of a recommendation and the basis for the
particular recommendation in certain contexts, such as the
recommendation of a complex product, or where a recommendation may seem
inconsistent with a retail customer's investment objectives on its
face.\610\ Similarly, broker-dealers may consider using existing
compliance measures, such as generating and reviewing exception reports
that identify transactions that fall outside of firm-specified
parameters to help evaluate and review for compliance with the Care
Obligation. These measures are not meant to be exhaustive, but rather
are examples of the sorts of compliance tools and methods broker-
dealers should generally consider using in evaluating whether
recommendations are consistent with a retail customer's best interests.
---------------------------------------------------------------------------
\610\ See FINRA Regulatory Notice 11-25 at FAQ 2 (explaining
that FINRA Rule 2111 (Suitability) permits firms to take a risk-
based approach with respect to documenting suitability
determinations). Regulation Best Interest similarly does not require
documentation; however, as noted above, we encourage broker-dealers
to take a risk-based approach when deciding whether or not to
document certain recommendations.
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Retail Customer Investment Profile
The Proposing Release would have required a ``Retail Customer
Investment Profile'' to include, but not be limited to, ``the retail
customer's age, other investments, financial situation and needs, tax
status, investment objectives, investment experience, investment time
horizon, liquidity needs, risk tolerance, and any other information the
retail customer may disclose to the broker, dealer, or a natural person
who is an associated person of a broker or dealer in connection with a
recommendation.'' \611\ The Proposing Release also explained that
broker-dealers would be required to exercise ``reasonable diligence''
to ascertain the
[[Page 33379]]
retail customer's investment profile as part of satisfying proposed
paragraph (a)(2)(i)(B), and that when retail customer information is
unavailable despite a broker-dealer's reasonable diligence to obtain
such information, a broker-dealer should consider whether it has
sufficient understanding of the retail customer to properly evaluate
whether the recommendation is in the retail customer's best
interest.\612\ Furthermore, under the proposed rule, a broker-dealer
would not meet its Care Obligation if it made a recommendation to a
retail customer for whom it lacks sufficient information to have a
reasonable basis to believe that the recommendation is in the best
interest of that retail customer based on such customer's investment
profile.
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\611\ Proposing Release at 21611 (noting the proposed definition
of Retail Customer Investment Profile was consistent with FINRA Rule
2111(a) (Suitability), which provides that ``A customer's investment
profile includes, but is not limited to, the customer's age, other
investments, financial situation and needs, tax status, investment
objectives, investment experience, investment time horizon,
liquidity needs, risk tolerance, and any other information the
customer may disclose to the member or associated person in
connection with such recommendation'').
\612\ Id. This is similar to the approach articulated below, as
well as in FINRA Regulatory Notice 12-25, which outlines what
constitutes ``reasonable diligence'' under FINRA's suitability rule
in attempting to obtain customer-specific information and that the
reasonableness of the effort also will depend on the facts and
circumstances. See FINRA Regulatory Notice 12-25 at Q16. Moreover,
under Regulation Best Interest, as with the approach under FINRA's
suitability rule, broker-dealers may generally rely on a retail
customer's responses absent ``red flags'' indicating that the
information is inaccurate. Id.
---------------------------------------------------------------------------
In response to this definition and the related discussion,
commenters identified several additional factors that they believed
should be included or discussed as part of a retail customer's
investment profile. For example, several commenters suggested adding
``longevity risk,'' ``retirement income needs,'' or ``lifetime income
needs'' as factors that should be included as part of an investor's
investment profile.\613\ Other commenters suggested additional factors,
such as, for trust accounts, considering the profile of trust
beneficiaries and not the trustee, or adding a retail customer's
``income profile.'' \614\
---------------------------------------------------------------------------
\613\ See, e.g., IRI Letter, The Committee of Annuity Insurers
Letter, CCMC Letters, Jackson National Letter, Pacific Life August
2018 Letter, Lincoln Financial Letter, AXA Letter, Principal Letter;
Transamerica November 2018 Letter; Letter from Mark F. Halloran, VP
Managing Director, Business Development, Transamerica (Dec. 14,
2018) (``Transamerica December 2018 Letter'').
\614\ See, e.g., Jackson National Letter, Lincoln Financial
Letter; Transamerica December 2018 Letter.
---------------------------------------------------------------------------
While we agree that many of these factors will likely be relevant
to a broker-dealer's recommendation of various securities or investment
strategies involving securities, we are adopting the definition of
``retail customer investment profile'' as proposed. We believe that the
list of factors under ``retail customer investment profile'' is widely
understood and importantly, offers broker-dealers the flexibility to
consider additional factors as deemed necessary.\615\ Although many of
the additional factors cited by commenters may be relevant to
securities or investment strategy recommendations under certain facts
and circumstances, we are not persuaded that we should add any specific
factor or factors to the existing list of profile factors, particularly
given that the list of factors is non-exhaustive and broker-dealers can
consider additional factors as appropriate under the unique facts and
circumstances of each recommendation. Thus, for example, where a
broker-dealer making a variable annuity recommendation believes that
longevity risk is an important factor for a particular retail customer
and that such factor is necessary to develop a reasonable basis to
believe that the product is in the best interest of that retail
customer, that broker-dealer should consider and utilize that
factor.\616\ We believe that this approach appropriately provides
broker-dealers with a well-understood starting framework, but also
gives broker-dealers the ability to consider additional factors based
on the unique nature of its particular securities products, investment
strategies, and retail customers.
---------------------------------------------------------------------------
\615\ See, e.g., CCMC Letters; Jackson National Letter; Pacific
Life August 2018 Letter; Committee of Annuity Insurers Letter; AXA
Letter.
\616\ See, e.g., AXA Letter; Committee of Annuity Insurers
Letter; Pacific Life August 2018 Letter.
---------------------------------------------------------------------------
Broker-dealers must obtain and analyze enough customer information
to have a reasonable basis to believe that the recommendation is in the
best interest of the particular retail customer. The significance of
specific types of customer information generally will depend on the
facts and circumstances of the particular case, including the nature
and characteristics of the product or strategy at issue. Where retail
customer information is unavailable despite a broker-dealer's
reasonable diligence, the broker-dealer should carefully consider
whether it has a sufficient understanding of the retail customer to
properly evaluate whether the recommendation is in the best interest of
that retail customer.\617\ In addition, a broker-dealer generally
should make a reasonable effort to ascertain information regarding an
existing customer's investment profile prior to the making of a
recommendation on an ``as needed'' basis--that is, where a broker-
dealer knows or has reason to believe that the customer's investment
profile has changed.\618\ The reasonableness of a broker-dealer's
efforts to collect information regarding a customer's investment
profile information depends on the facts and circumstances of a given
situation, and the importance of each factor may vary depending on the
facts and circumstances of the particular case.\619\ Under Regulation
Best Interest, as with the approach under FINRA's suitability rule,
broker-dealers may generally rely on a retail customer's responses
absent ``red flags'' indicating that the information is
inaccurate.\620\
---------------------------------------------------------------------------
\617\ See supra footnotes 611-612 and accompanying text.
\618\ See id.; see also Proposing Release at 21611-21612.
\619\ See id.; see also FINRA Regulatory Notice 12-25 at Q16.
\620\ See supra footnote 612.
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Moreover, as noted in the Proposing Release, one or more factors
may have more or less relevance, or may not be obtained or analyzed at
all if the broker-dealer has a reasonable basis for determining that
the factor is irrelevant to that particular best interest
determination. However, consistent with existing obligations, where a
broker-dealer determines not to obtain or analyze one or more of the
factors specifically identified in the definition of ``Retail Customer
Investment Profile,'' the broker-dealer should document its
determination that the factor(s) are not relevant components of a
retail customer's investment profile in light of the facts and
circumstances of the particular recommendation.\621\
---------------------------------------------------------------------------
\621\ FINRA Rule 2111.04.
---------------------------------------------------------------------------
Regulation Best Interest, as noted above, does not require
documentation of the basis for believing a particular recommendation
was in a particular retail customer's best interest.\622\ Nevertheless,
broker-dealers may wish to consider documenting the basis for
determining that the recommendation is in the best interest of the
retail customer when it is not evident from the recommendation
itself.\623\ Documentation by itself will not cure a recommendation in
circumstances in which a broker-dealer could not have reasonably
believed the recommendation was in the best interest of the retail
customer at the time the recommendation was made.\624\
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\622\ As discussed in Section II.C.1, we believe that the basis
for and risks associated with a broker-dealer's recommendations in
standardized terms (as opposed to individualized disclosure of the
basis for each recommendation made) is a material fact relating to
the scope and terms of the relationship that is required to be
disclosed under the Disclosure Obligation.
\623\ See supra footnote 610 and accompanying text.
\624\ See FINRA Rule 2111 (Suitability) FAQ.
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[[Page 33380]]
Application of the Care Obligation--Reasonably Available Alternatives
and Otherwise Identical Securities
In the Proposing Release, we provided guidance on what types of
recommendations would or would not be in the best interest of a
particular retail customer. In particular, the Proposing Release stated
that where a broker-dealer is choosing among identical securities
available to the broker-dealer, it would be inconsistent with the Care
Obligation to recommend the more expensive alternative for the
customer.\625\ Similarly, in the Proposing Release, we noted our belief
that it would be inconsistent with the Care Obligation if the broker-
dealer made a recommendation to a retail customer in order to: Maximize
the broker-dealer's compensation, further the broker-dealer's business
relationships, satisfy firm sales quotas or other targets, or win a
firm-sponsored sales contest.\626\
---------------------------------------------------------------------------
\625\ Proposing Release at 21612.
\626\ Id.
---------------------------------------------------------------------------
We also stated that under the Care Obligation a broker-dealer
generally should consider reasonable alternatives, if any, offered by
the broker-dealer in determining whether it has a reasonable basis for
making the recommendation.\627\ The Proposing Release explained that
this approach would not require a broker-dealer to analyze all possible
securities, all other products, or all investment strategies to
recommend the single ``best'' security or investment strategy for the
retail customer, nor necessarily require a broker-dealer to recommend
the least expensive or least remunerative security or investment
strategy. Further, the Proposing Release indicated that under the Care
Obligation, when a broker-dealer recommends a more expensive security
or investment strategy over another reasonably available alternative
offered by the broker-dealer, the broker dealer would need to have a
reasonable basis to believe that the higher cost is justified (and thus
nevertheless is in the retail customer's best interest) based on other
factors (e.g., the product's or strategy's investment objectives,
characteristics (including any special or unusual features), liquidity,
risks and potential benefits, volatility and likely performance in a
variety of market and economic conditions), in light of the retail
customer's investment profile.\628\ Relatedly, we stated that a broker-
dealer could not meet the Care Obligation through disclosure
alone.\629\
---------------------------------------------------------------------------
\627\ Proposing Release at 21608-21610.
\628\ Proposing Release at 21612 (emphasis in original). We
similarly noted that ``when a broker-dealer recommends a more
remunerative security or investment strategy over another reasonably
available alternative offered by the broker-dealer, the broker-
dealer would need to have a reasonable basis to believe that--
putting aside the broker-dealer's financial incentives--the
recommendation was in the best interest of the retail customer based
on the factors noted [therein], in light of the retail customer's
investment profile. Nevertheless, this does not mean that a broker-
dealer could not recommend the more remunerative of two reasonably
available alternatives, if the broker-dealer determines the products
are otherwise both in the best interest of--and there is no material
difference between them from the perspective of--the retail
customer, in light of the retail customer's investment profile.''
Id. (emphasis in original).
\629\ Id. at 21612-21613 (further explaining that ``where a
broker-dealer is choosing among identical securities with different
cost structures, we believe it would be inconsistent with the best
interest obligation for the broker-dealer to recommend the more
expensive alternative for the customer, even if the broker-dealer
had disclosed that the product was higher cost and had policies and
procedures reasonably designed to mitigate the conflict under the
Conflict of Interest Obligation, as the broker-dealer would not have
complied with the Care Obligation. Such a recommendation, disclosure
aside, would still need to be in the best interest of a retail
customer, and we do not believe it would be in the best interest of
a retail customer to recommend a higher-cost product if all other
factors are equal.'') (internal citations omitted).
---------------------------------------------------------------------------
The Commission received numerous comments relating to the Proposing
Release's discussion of ``reasonably available alternatives'' and
regarding recommendations of ``otherwise identical securities.'' \630\
For example, commenters sought clarification regarding what factors
need to be considered in the evaluation, and also how the evaluation
could be performed in certain contexts, such as where a broker-dealer
operates with an open architecture framework, recommends only a limited
menu of products, or recommends only proprietary products.\631\ A
majority of the IAC recommended that Regulation Best Interest should be
clarified to require recommendations of ``the investments, investment
strategies, accounts, or services, from among those that [the broker-
dealers, investment advisers, and their associated persons] have
reasonably available to recommend, that they reasonably believe
represent the best available options for the investor'' and that a
``determination regarding the best reasonably available options should
be based on a careful review of the investor's needs and goals, as well
as the full range of the reasonably available products', strategies',
accounts', or services' features, including, but by no means limited to
cost.'' \632\ Several other commenters recommended that the Commission
confirm that Regulation Best Interest will not require broker-dealers
to offer an unlimited number of securities or investment
strategies.\633\ Commenters also expressed concern over whether the
consideration of ``reasonably available alternatives'' would
effectively require a broker-dealer to document the basis of any
recommendation, as well as concerns about disclosure's role in
satisfying the Care Obligation.\634\ Finally, a majority of the IAC and
other commenters sought clarification on whether broker-dealers were
required to recommend only the single ``best'' product.\635\
---------------------------------------------------------------------------
\630\ See, e.g., Fidelity Letter; Vanguard Letter; MMI Letter;
BlackRock Letter.
\631\ See, e.g., CFA August 2018 Letter; Wells Fargo Letter;
Fidelity Letter; Morgan Stanley Letter. See also LPL August 2018
Letter (suggesting that its representatives could not conduct a
meaningful comparison across ``all similar available securities''
and that, such recommendations would be subject to legal challenges
in hindsight).
\632\ IAC 2018 Recommendation (emphasis in original).
\633\ See LPL August 2018 Letter (recommending that the
Commission clarify that a financial professional can satisfy his or
her obligations under Regulation Best Interest, even if he or she
limits recommendations to a smaller number of product sponsors
because financial professionals participating on large platforms
may, in practice, be discouraged from conducting focused analysis of
product offerings, instead opting for a more cursory review of a few
high-level cost, risk, and performance metrics across all available
products). See also Fidelity Letter; Cetera August 2018 Letter;
SIFMA August 2018 Letter; Guardian August 2018 Letter; Prudential
Letter.
\634\ See, e.g., Fidelity Letter; Wells Fargo Letter.
\635\ See 2018 IAC Recommendation (``The Commission should
recognize that there will often not be a single best option and that
more than one of the available options may satisfy this standard,''
and that ``compliance should be measured based on whether the broker
or adviser had a reasonable basis for the recommendation at the time
it was made, and not on how the recommendation ultimately performed
for the investor. . . .''); see also SIFMA August 2018 Letter.
---------------------------------------------------------------------------
The Care Obligation will require a broker-dealer to have a
reasonable basis to believe, based on its understanding of the
potential risks, rewards, and costs of the recommended security or
investment strategy involving securities, and in light of the retail
customer's investment profile, that the recommendation is in the best
interest of a particular retail customer and does not place the broker-
dealer's interest ahead of the retail customer's interest. As noted
above, determining what is in a retail customer's best interest is an
objective evaluation turning on the facts and circumstances of the
particular recommendation and the particular retail customer at the
time the recommendation is made.\636\
---------------------------------------------------------------------------
\636\ As noted and further reiterated below, a broker-dealer
will not be required to recommend the single ``best'' of all
possible alternatives that might exist, in part because many
different options may in fact be in the retail customer's best
interest. See infra footnote 640 and accompanying text.
---------------------------------------------------------------------------
Accordingly, as noted above, a broker-dealer would not satisfy the
Care Obligation by simply recommending the least expensive or least
remunerative
[[Page 33381]]
security without any further analysis of these other factors and the
retail customer's investment profile. A broker-dealer could recommend a
more expensive security or investment strategy if there are other
factors about the product that reasonably allow the broker-dealer to
believe it is in the best interest of the retail customer, based on
that retail customer's investment profile. Similarly, a broker-dealer
could recommend a more remunerative security or investment strategy if
the broker-dealer has a reasonable basis to believe that there are
other factors about the security or investment strategy that make it in
the best interest of the retail customer, in light of the retail
customer's investment profile.
We also continue to have the view that, as part of determining
whether a broker-dealer has a reasonable basis to believe that a
recommendation is in the best interest of the retail customer, a
broker-dealer generally should consider reasonably available
alternatives offered by the broker-dealer. It is our view that such a
consideration is an inherent aspect of making a ``best interest''
recommendation, and is a key enhancement over existing broker-dealer
suitability obligations, which do not necessarily require a comparative
assessment among such alternatives.\637\ Similarly, this concept has
been applied in the context of guidance regarding suitability and
heightened supervision of complex products, stating that when broker-
dealers are recommending complex or costly products, they should first
consider whether less complex or costly products could achieve the same
objectives for their retail customers.\638\
---------------------------------------------------------------------------
\637\ While enforcement actions and related guidance may be
construed as interpreting the suitability obligation to include a
consideration of available alternatives, it is generally limited to
certain circumstances, such as recommendations of mutual funds with
different share classes or recommendations of complex or costly
products. See In re Application of Raghavan Sathianathan, Exchange
Act Release No. 54722 at 21 (Nov. 8, 2006); In the Matter of Wendell
D. Belden, 56 S.E.C. 496 (2003); FINRA Regulatory Notice 12-03. See
also FINRA 2018 Letter; MSRB Rule G-42 (requiring a municipal
advisor to inform its municipal entity or obligated person client
whether it has investigated or considered other reasonably feasible
alternatives to the recommended municipal securities transaction).
Thus, although certain enforcement actions and guidance
contemplate a consideration of available alternatives under certain
situations, it is not a general expectation. Nevertheless, such
statements serve as an example and evidence that the concept is not
unfamiliar to broker-dealers.
\638\ See FINRA Regulatory Notice 12-03 (``For example,
registered representatives should compare a structured product with
embedded options to the same strategy through multiple financial
instruments on the open market, even with any possible advantages of
purchasing a single product.''). See also supra footnote 635.
---------------------------------------------------------------------------
In terms of conducting such an evaluation, a broker-dealer does not
have to conduct an evaluation of every possible alternative, either
offered outside of the firm (such as where the firm offers only
proprietary or other limited range of products) or available on the
firm's platform. We appreciate commenter concerns about the
impracticality and potential impossibility of such a comparative
evaluation, particularly where the firm offers numerous different
products, many of which may have similar strategies but with other
varying characteristics, including cost structures, that may apply
differently based on the particular retail customer.\639\ We also
recognize that different products are rarely perfectly equal, and that
differences will be both quantitative and qualitative in nature. A
broker-dealer will not be required to recommend the single ``best'' of
all possible alternatives that might exist, in part because many
different options may in fact be in the retail customer's best
interest.\640\ We are sensitive to commenters' concern that this
determination, to the extent it can be made at all, may be judged in
hindsight even though Regulation Best Interest applies at the time of
the recommendation.\641\
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\639\ See, e.g., Morgan Stanley Letter (``Large firms with an
open architecture like Morgan Stanley offer an enormous range of
products to their clients. To take but one example, Morgan Stanley
offers approximately 300 large capitalization equity mutual funds to
its retail customers.''); see also Morningstar Letter; Primerica
Letter; ICI Letter; Chapman Letter (stating that ``identical'' is
too stringent because they believe all securities have
distinctions).
\640\ Commenters suggesting different approaches acknowledged
this concern. See, e.g., IAC 2018 Recommendation (``[T]he Commission
should recognize there will often not be a single best option and
that more than one of the available options may satisfy this
standard.'').
\641\ See LPL August 2018 Letter.
---------------------------------------------------------------------------
In particular, we are not requiring a natural person who is an
associated person of the broker-dealer to be familiar with every
product on a broker-dealer's platform, particularly where a broker-
dealer operates in an open architecture framework or otherwise operates
a platform with a large number of products or options.\642\ Such a
requirement might not allow an associated person of a broker-dealer to
develop a proper understanding of every security or investment
strategy's potential risks, rewards, or costs, and thus it might not be
possible to fulfill the obligation set forth in paragraph
(a)(2)(ii)(A). Furthermore, such a requirement could encourage broker-
dealers to limit their product menus or otherwise restrict access to
products and services currently available to retail customers, which is
contrary to the purpose and goals of Regulation Best Interest.\643\
---------------------------------------------------------------------------
\642\ Conversely, where a broker-dealer only has a few products,
an associated person of the broker-dealer may be expected to
understand and consider all of these options when recommending a
security or investment strategy. We recognize that this facts-and-
circumstances approach does not provide a clear bright-line rule;
however, we are providing further guidance below on a broker-
dealer's process for evaluating reasonably available alternatives
and the scope herein. Furthermore, nothing in this discussion
excuses a broker-dealer from satisfying the Care Obligation. An
associated person of the broker-dealer cannot use a large platform
as an excuse for not developing a proper understanding of a
recommended security or investment strategy's potential risks,
rewards, or costs.
\643\ See LPL August 2018 Letter.
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As discussed above, the determination of whether a recommendation
is in the ``best interest'' of the retail customer and does not place
the interests of the broker-dealer ahead of the retail customer's
interest must be based on information reasonably known to the
associated person (based on her reasonable diligence, care, and skill)
at the time the recommendation is made. Accordingly, in fulfilling the
Care Obligation, the associated person should exercise reasonable
diligence, care, and skill to consider reasonably available
alternatives offered by the broker-dealer. This exercise would require
the associated person to conduct a review of such reasonably available
alternatives that is reasonable under the circumstances. Consistent
with the Compliance Obligation discussed below, a broker-dealer should
have a reasonable process for establishing and understanding the scope
of such ``reasonably available alternatives'' that would be considered
by particular associated persons or groups of associated persons (e.g.,
groups that specialize in particular product lines) in fulfilling the
reasonable diligence, care, and skill requirements under the Care
Obligation.
What will be a reasonable determination of the scope of
alternatives considered will depend on the facts and circumstances, at
the time of the recommendation, including both the nature of the retail
customer and the retail customer's investment profile, and the
particular associated persons or groups of associated persons that are
providing the recommendations. With respect to broker-dealers that
materially limit the range of products or services that they recommend
to retail customers (e.g., limits its product offerings to only
proprietary or other limited menus of products), the Conflict of
Interest
[[Page 33382]]
Obligation provision requires broker-dealers to have reasonably
designed policies and procedures to identify and disclose the material
limitations and any conflicts of interest associated with such
limitations, and to prevent such limitations and associated conflicts
of interest from causing the broker-dealer or associated person to make
recommendations that place the interest of the broker-dealer or
associated person ahead of the interest of the retail customer.\644\
Similarly, where a broker-dealer offers numerous products on its
platform, a broker-dealer or an associated person could reasonably
limit the universe of ``reasonably available alternatives'' if there is
a reasonable process or methodology for limiting the scope of
alternatives or the universe considered for a particular retail
customer, particular category of retail customers, or the retail
customer base more generally.\645\
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\644\ See Section II.C.3. Broker-dealers would be required to
disclose the conflict of interest, as well as the material facts
associated with such a conflict pursuant to the Disclosure
Obligation provision as described in Section II.C.1.
\645\ We note that where a broker-dealer (or an associated
person) limits the securities or investment strategies that are
considered as ``reasonably available alternatives'' from the
universe of securities or investment strategies involving securities
offered by the broker-dealer, this limitation may constitute a
material limitation placed on the securities or investment
strategies involving securities that may be recommended, which the
broker-dealer (or an associated person) would need to disclose and
address as provided in the Disclosure and Conflict of Interest
Obligations.
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In addition to the particular retail customer's investment profile,
we believe the scope of reasonably available alternatives considered
could depend upon a variety of factors, including but not limited to,
the associated person's customer base (including the general investment
objectives and needs of the customer base), the investments and
services available to the associated person to recommend (including
limitations due to licensing of the associated person), and other
factors such as specific limitations on the available investments and
services with respect to certain retail customers (e.g., product or
service income thresholds; product geographic limitations; or product
limitations based on account type, such as those only eligible for IRA
accounts). A reasonable process would not need to consider every
alternative that may exist (either outside the broker-dealer or on the
broker-dealer's platform) or to consider a greater number of
alternatives than is necessary in order for the associated person to
exercise reasonable diligence, care, and skill in providing a
recommendation that complies with the Care Obligation.
Importantly, where all reasonably available alternatives considered
would be inconsistent with a retail customer's investment profile, a
broker-dealer would not be able to form a reasonable belief that the
best of these options is in the best interest of that retail customer.
All recommendations to retail customers of securities or investment
strategies are required to satisfy the Care Obligation, and broker-
dealers cannot use a limited product menu or a process to determine the
scope of reasonably available alternatives considered to justify a
recommendation that is not in the best interest of the retail customer.
We recognize that the process by which a broker-dealer and its
associated persons develop and make recommendations to retail
customers, including the scope of reasonably available alternatives
considered, will depend upon a variety factors, including the nature of
the broker-dealer's business.\646\ The disclosure of this process
pursuant to the Disclosure Obligation will provide critical information
to retail customers and underscores our acknowledgment that we do not
expect every broker-dealer or associated person to follow the same
process. Instead, consistent with the Compliance Obligation, broker-
dealers and their associated persons must have a reasonable process for
developing and making recommendations to retail customers in compliance
with the Care Obligation, including the consideration of reasonably
available alternatives, which will depend on the facts and
circumstances.
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\646\ Accordingly, we believe that disclosure of this process is
of fundamental importance to a retail customer's understanding of
what services are being provided, and in deciding whether those
services are appropriate to the retail customer's needs and goals,
and have thus clarified that the basis for a broker-dealer's or an
associated person's recommendations as a general matter (i.e., what
might commonly be described as the firm's or associated person's
investment approach, philosophy or strategy) is a material fact
relating to the scope and terms of the relationship that must be
disclosed pursuant to the Disclosure Obligation. See Section II.C.1.
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We emphasize that what is in the ``best interest'' of a retail
customer depends on the facts and circumstances of a recommendation at
the time it is made, including matching the recommended security or
investment strategy to the retail customer's investment profile at the
time of the recommendation, and the process for coming to that
conclusion. Whether a broker-dealer has complied with the Care
Obligation will be evaluated based on the facts and circumstances at
the time of the recommendation (and not in hindsight) and will focus on
whether the broker-dealer had a reasonable basis to believe that the
recommendation is in best interest of the retail customer.
Finally, broker-dealers or their associated persons are not
required to prepare and maintain documentation regarding the basis for
each specific recommendation, including an evaluation of a recommended
securities transaction or investment strategy against similar available
alternatives. In circumstances where the ``match'' between the retail
customer profile and the recommendation appears less reasonable on its
face (for example, where a retail customer's account objective is
preservation of income and the recommendation involves higher risk, or
where there are more significant conflicts of interest present), the
more important the process will likely be for a broker-dealer to
establish that it had a reasonable belief that the recommendation was
in the best interest of the retail customer and did not place the
broker-dealer's interest ahead of the retail customer. This could
include reasonably designed policies and procedures to establish
compliance with the Care Obligation, as required by the new Compliance
Obligation, and could include maintaining supporting documentation for
certain recommendations.\647\
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\647\ See supra footnote 610 and accompanying text.
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Application of Care Obligation to Account Type Recommendations
As discussed above, Regulation Best Interest will apply to
recommendations by a broker-dealer of a securities account type. Thus,
the Care Obligation will require a broker-dealer to have a reasonable
basis to believe that a recommendation of a securities account type
(e.g., brokerage or advisory, or among the types of accounts offered by
the firm) is in the retail customer's best interest at the time of the
recommendation and does not place the financial or other interest of
the broker-dealer ahead of the interest of the retail customer.\648\
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\648\ As discussed in Section II.B.2, whether and how Regulation
Best Interest applies will depend on whether the financial
professional making the recommendation is dually registered.
In the section that follows we discuss how the Care Obligation
will apply to recommendations to open an IRA or to roll over assets
into an IRA.
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We believe broker-dealers would need to consider various factors in
determining whether a particular account is in a particular retail
customer's best interest. For example, broker-dealers generally should
consider: (1) The services and products provided in the account
(ancillary
[[Page 33383]]
services provided in conjunction with an account type, account
monitoring services, etc.); (2) the projected cost to the retail
customer of the account; (3) alternative account types available; (4)
the services requested by the retail customer; and (5) the retail
customer's investment profile. Moreover, retail customer-specific
factors, such as those identified in the definition of ``Retail
Customer Investment Profile,'' may not be applicable or available in
every context, and would depend on the facts and circumstances at the
time of account type recommendation. For example, one or more factors
may have more or less relevance, or information about those factors may
not be obtained or analyzed at all where the broker-dealer has a
reasonable basis for believing that a particular factor is or is not
relevant.\649\ In addition, as discussed above, we recognize that
factors other than cost may properly be considered when determining
whether an account is in a retail customer's best interest.\650\
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\649\ As discussed above, where a broker-dealer determines not
to obtain or analyze one or more of the factors specifically
identified in the definition of ``Retail Customer Investment
Profile,'' the broker-dealer generally should document its
determination that the factor(s) are not relevant components of a
retail customer's investment profile in light of the facts and
circumstances of the particular recommendation.
\650\ See id.
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Where the financial professional making the recommendation is
dually registered (i.e., an associated person of a broker-dealer and a
supervised person of an investment adviser (regardless of whether the
professional works for a dual-registrant, affiliated firms, or
unaffiliated firms)) the financial professional would need to make this
evaluation taking into consideration the spectrum of accounts offered
by the financial professional (i.e., both brokerage and advisory taking
into account any eligibility requirements such as account minimums),
and not just brokerage accounts. For example, all other things being
equal, it may be in the retail customer's best interest to recommend a
brokerage account to the retail customer who intends to buy and hold a
long-term investment (e.g., maintain an account primarily composed of
bonds or mutual funds and has a stated buy-and-hold strategy), as
opposed to an advisory account (i.e., it may not be in the retail
customer's best interest in this context to pay an ongoing fee for a
security that he or she plans to hold to maturity).\651\ On the other
hand, it may not be in the retail customer's best interest to recommend
a brokerage account where the retail customer plans to engage in at
least a moderate level of trading and prefers to pay for advice in
connection with such trading on the basis of a consistent recurring
monthly or annual charge.\652\ Furthermore, where a retail customer
holds a variety of investments, or prefers differing levels of services
(e.g., both episodic recommendations from a broker-dealer and
continuous advisory services including discretionary asset management
from an investment adviser), it may be in the retail customer's best
interest to recommend both a brokerage and an advisory account.
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\651\ See id.
\652\ See id. We reiterate that this is a facts and
circumstances determination, and that these examples are not meant
to provide a bright line rule, but rather to illustrate certain
considerations that a broker-dealer could consider when determining
whether a recommended account type is in the best interest of the
retail customer.
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Similarly, where the financial professional is only registered as
an associated person of a broker-dealer (regardless of whether that
broker-dealer entity is a dual-registrant or affiliated with an
investment adviser), he or she would need to take into consideration
only the brokerage accounts available.\653\ However, even if a broker-
dealer only offered brokerage accounts, the associated person would
nevertheless need to have a reasonable basis to believe that the
recommended account was in the best interest of the retail customer.
For example, if the retail customer were seeking a relationship where
the financial professional would have unlimited investment discretion
(i.e., having responsibility for a customer's trading decisions),\654\
the associated person would not have a reasonable basis to believe that
a brokerage account was in the best interest of the retail customer.
Thus, as with limited product menus, a limited selection of account
types would not excuse a broker-dealer from making a recommendation not
in the best interest of the retail customer.
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\653\ For example, if the natural person that is an associated
person of the broker-dealer is not registered as an investment
adviser representative, but is associated with a broker-dealer that
is a dual-registrant, that associated person would only need to
consider the brokerage accounts offered by the firm, and not the
firm's advisory accounts in making the recommendation.
\654\ See Solely Incidental Interpretation.
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Application of Care Obligation to IRA Rollovers and Related
Recommendations
Regulation Best Interest also applies to recommendations to open an
IRA or to roll over assets into an IRA. Thus, the Care Obligation will
require a broker-dealer to have a reasonable basis to believe that the
IRA or IRA rollover is in the best interest of the retail customer at
the time of the recommendation and does not place the financial or
other interest of the broker-dealer ahead of the interest of the retail
customer, taking into consideration the retail customer's investment
profile and other relevant factors, as well as the potential risks,
rewards, and costs of the IRA or IRA rollover compared to the
investor's existing 401(k) account or other circumstances.\655\
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\655\ See infra Section II.C.2; see also FINRA Regulatory Notice
13-45 (outlining several considerations regarding IRA rollovers).
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When making a recommendation to open an IRA, or to roll over
workplace retirement plan assets into an IRA rather than keeping assets
in a previous employer's workplace retirement plan (or rolling over
assets to a new employer's workplace retirement plan), broker-dealers
should consider a variety of factors, the importance of which will
depend on the particular retail customer's needs and circumstances. In
addition to the Factors to Consider Regarding a Recommendation to a
Particular Retail Customer discussed above, as well as the Retail
Customer's Investment Profile, broker-dealers should consider a variety
of additional factors specifically salient to IRAs and workplace
retirement plans, in order to compare the retail customer's existing
account to the IRA offered by the broker-dealer. These factors should
generally include, among other relevant factors: Fees and expenses;
level of service available; available investment options; ability to
take penalty-free withdrawals; application of required minimum
distributions; protection from creditors and legal judgments; holdings
of employer stock; and any special features of the existing
account.\656\ With respect to available investment options, we caution
broker-dealers not to rely on, for example, an IRA having ``more
investment options'' as the basis for recommending a rollover. Rather,
as with other factors, broker-dealers should consider available
investment options in an IRA, among other relevant factors, in light of
the retail customer's current situation and needs in order to develop a
reasonable basis to believe that the rollover is in the retail
customer's best interest.
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\656\ See id.
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While these examples may be relevant to an analysis of available
options, this list is not meant to be exhaustive. Furthermore, each
factor generally should be analyzed with respect to a particular retail
customer in order for a broker-dealer to form a reasonable belief that
the recommendation is in the best
[[Page 33384]]
interest of that retail customer and does not place the financial or
other interest of the broker-dealer ahead of the interest of the retail
customer. Finally, as described above, certain factors may have more or
less relevance, or not be relevant at all, depending on the particular
facts and circumstances of each recommendation.
d. Have a Reasonable Basis To Believe That a Series of Recommended
Transactions, Even if in the Retail Customer's Best Interest When
Viewed in Isolation, Is Not Excessive and Is the Retail Customer's Best
Interest When Taken Together in Light of the Retail Customer's
Investment Profile and Does Not Place the Interest of the Broker-Dealer
Ahead of the Interest of the Retail Customer
As proposed, the third component of the Care Obligation would
require a broker-dealer to exercise reasonable diligence, care, skill,
and prudence to have a reasonable basis to believe that a series of
recommended transactions, even if in the retail customer's best
interest when viewed in isolation, is not excessive and is in the
retail customer's best interest when taken together in light of the
retail customer's investment profile.\657\ The Proposing Release noted
that this requirement is intended to incorporate and enhance a broker-
dealer's existing ``quantitative suitability'' obligation by applying
the requirement irrespective of whether a broker-dealer exercises
actual or de facto control over a customer's account, thereby making
the obligation consistent with the current requirements for
``reasonable basis suitability'' and ``customer specific suitability.''
\658\
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\657\ Proposing Release at 21613.
\658\ Proposing Release at 21613-21614.
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We received a few comments suggesting modifications to this
component of the obligation. For example, one commenter recommended the
Commission clarify the meaning of ``series of transactions,'' while a
second commenter requested a carve-out for ``active traders'' who are
``interested in trading individual stocks . . . with a great degree of
regularity.'' \659\ Another commenter maintained that the quantitative
suitability obligations should only apply to those accounts over which
the member firm has ``control,'' and that if the Commission does not
include the control element of FINRA Rule 2111 as part of the Care
Obligation, that the Commission ``should at a minimum confirm that this
requirement applies only to recommendations by a single associated
person, not across multiple associated persons at the firm who act
independently.'' \660\
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\659\ See Letter from Keith Lampi, President, Alternative and
Direct Investment Securities Association (``ADISA'') (Aug. 7, 2018)
(``ADISA Letter'') (recommending the Commission clarify the meaning
of ``series of transactions''); Letter from Joseph C. Cascarelli,
Corporate Counsel, Network 1 Financial Securities (Aug. 7, 2018)
(``Network 1 Letter'') (suggesting a ``carve-out exemption formula''
from Regulation Best Interest to accommodate investors and their
stockbrokers who specialize in ``active trading'').
\660\ SIFMA August 2018 Letter.
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After considering these comments, the Commission is adopting the
proposed ``quantitative care'' component of the Care Obligation as
proposed. As noted in the Proposing Release, we believe that imposing
the quantitative care obligation without a ``control'' element would
provide consistency in the investor protections provided to retail
customers by requiring a broker-dealer to always form a reasonable
basis as to the recommended frequency of trading in a retail customer's
account--irrespective of whether the broker-dealer ``controls'' or
exercises ``de facto control'' over the retail customer's account.\661\
This would also be consistent with the other components of the Care
Obligation, which apply regardless of whether a broker-dealer
``controls'' or exercises ``de facto control'' over the retail
customers' account.
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\661\ See Proposing Release at 21613-21614.
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While the Commission appreciates the concern raised about ``active
traders'' and the concern relating to a retail customer that could
maintain several accounts at the same firm, we nevertheless believe
that retail customers could, and should, benefit from the protections
of this requirement, namely the protection from a broker-dealer
recommending a level of trading that is so excessive that the resulting
cost-to-equity ratio or turnover rate makes a positive return virtually
impossible.\662\ As we indicated in the Proposing Release, the fact
that a customer may have some knowledge of financial markets or some
``control'' should not absolve the broker-dealer of the ultimate
responsibility to have a reasonable basis to believe that any
recommendations it makes are in the best interest of the retail
customer.\663\ Where a retail customer expresses a desire for ``active
trading,'' \664\ a broker-dealer may take this factor into
consideration when evaluating a recommendation; however, the broker-
dealer will nevertheless need to reasonably believe that a series of
recommended transactions is in the best interest of the retail
customer. We further note that Regulation Best Interest does not
require a broker-dealer to refuse to accept a customer's order that is
contrary to the broker-dealer's recommendation. Nor does Regulation
Best Interest apply to self-directed or otherwise unsolicited
transactions by a retail customer, whether or not he or she also
receives separate recommendations from the broker-dealer.
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\662\ See id.
\663\ See id.
\664\ See Network 1 Letter.
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With respect to the concern about applying the requirement ``only
to recommendations by a single associated person, not across multiple
associated persons at the firm who act independently,'' \665\ we note
that both the firm and their associated persons have to comply with the
Care Obligation. If we took this commenter's suggestion, we are
concerned we would potentially create a loophole and a perverse outcome
that would allow for avoidance of the Care Obligation, and permit
potentially excessive trading, by encouraging recommendations across a
number of associated persons. We reiterate our position that,
consistent with the other components of the Care Obligation under the
Care Obligation, when a series of transactions is recommended to a
retail customer, a broker-dealer must evaluate whether the series of
recommended transactions places the broker-dealer's interest ahead of
the retail customer's--this is true for both the associated person
making the recommendation, as well as for the firm.\666\ This will
necessarily depend on the facts and circumstances of each particular
recommendation, and of each particular series of transactions; however,
we note that, as part of developing a retail customer's investment
profile, a broker-dealer is required to exercise reasonable diligence
to ascertain the retail customer's investment profile, which would
include seeking to obtain and analyze a retail customer's other
investments.\667\
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\665\ See SIFMA 2018 Letter.
\666\ See Proposing Release at 21613-21614.
\667\ See supra Section II.C.2.c.
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Finally, with respect to the meaning of series of recommended
transactions, what would constitute a ``series'' of recommended
transactions would depend on the facts and circumstances, and would
need to be evaluated with respect to a particular retail customer. In
other words, a broker-dealer would need to reasonably believe that the
level of trading (series of recommended transactions) is appropriate
for a particular retail customer, and thus a bright line definition
across all retail
[[Page 33385]]
customers would be unworkable. Moreover, providing a bright line
definition could encourage firms to focus on a particular number of
transactions rather than focusing on ensuring that a series of
recommendations, taken together, are in the best interest of the retail
customer. Finally, a ``series'' of recommended transactions is an
established term under the federal securities laws and SRO rules that
is evaluated in concert with existing guideposts, such as turnover
rate,\668\ cost-to-equity ratio,\669\ and use of in-and-out
trading,\670\ which have been developed over time and which serve as
indicators of excessive trading.
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\668\ See, e.g., Carras v. Burns, 516 F.2d 251, 258 (4th Cir.
1975); Shearson Lehman Hutton Inc., 49 S.E.C. 1119, 1122 at footnote
10 (1989); Laurie Jones Canady, 54 S.E.C. 65, 74 (1999), Exchange
Act Release No. 41250 (Apr. 5, 1999) (using the turnover rate for
relevant period), petition denied, 230 F.3d 362 (D.C. Cir. 2000).
\669\ See, e.g., Shearson Lehman, 49 S.E.C. at 1121 (stating
that ``[o]ne test for excessive trading is the relationship between
the account opening balance and the amounts of markups, commissions,
and margin charges''); Michael E. Tennenbaum, 47 S.E.C. 703 (Jan.19,
1982).
\670\ See, e.g., Hecht v. Harris, Upham & Co., 283 F. Supp. 417,
435-36 (N.D. Cal. 1968), modified in part and aff'd, 430 F.2d 1202
(9th Cir. 1970); R.H. Johnson & Co., 36 S.E.C. 467 (1955); Behel,
Johnson & Co., 26 S.E.C. 163 (1947). Cody v. S.E.C., 693 F.3d 251,
260 (1st Cir. 2012).
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3. Conflict of Interest Obligation
We proposed the Conflict of Interest Obligation to require a
broker-dealer entity \671\ to: (1) Establish, maintain, and enforce
written policies and procedures reasonably designed to identify, and
disclose, or eliminate all material conflicts of interest associated
with recommendations covered by Regulation Best Interest; and (2)
establish, maintain and enforce written policies and procedures
reasonably designed to identify and disclose and mitigate, or
eliminate, material conflicts of interest arising from financial
incentives associated with such recommendations. This proposed approach
reflected our view that establishing reasonably designed policies and
procedures is critical to identifying and addressing conflicts of
interest. In addition, the proposed approach would serve the
Commission's goal of addressing conflicts of interest that may harm
investors while providing flexibility to establish systems tailored to
broker-dealers' business models.
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\671\ Unlike the Disclosure and Care Obligations, which apply to
a broker or dealer and to natural persons who are associated persons
of a broker or dealer, the Conflict of Interest Obligation (and the
Compliance Obligation discussed in Section II.C.4 below) applies
solely to the broker or dealer entity, and not to the natural
persons who are associated persons of a broker or dealer. For
purposes of discussing the Conflict of Interest Obligation and the
Compliance Obligation, the term ``broker-dealer'' refers only to the
broker-dealer entity, and not to such individuals. While the
Conflict of Interest Obligation applies only to the broker-dealer
entity, the conflicts of interest that the broker-dealer entity must
analyze are conflicts (as defined in paragraph (c)(3) of the rule)
between: (i) The broker-dealer entity and the retail customer, (ii)
the natural persons who are associated persons and the retail
customer, and (iii) the broker-dealer entity and the natural persons
who are associated persons.
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The Commission solicited comment on the Conflict of Interest
Obligation, including the specific requirements to create policies and
procedures with respect to disclosure, mitigation, and elimination of
conflicts of interest. Commenters requested changes to several aspects
of the Conflict of Interest Obligation, including providing more
clarity and guidance surrounding when specific conflicts need to be
disclosed, mitigated or eliminated.\672\
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\672\ See, e.g., SIFMA August 2018 Letter; Primerica Letter;
BISA Letter; CCMC Letters; Wells Fargo Letter.
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In consideration of these comments, we are adopting the Conflict of
Interest Obligation with revisions to: (1) Create an overarching
obligation to establish written policies and procedures to identify and
at a minimum disclose, pursuant to the Disclosure Obligation, or
eliminate all conflicts of interest associated with the recommendation;
and (2) require broker-dealers to establish policies and procedures to
be reasonably designed to mitigate or eliminate certain identified
conflicts of interest.
In addition to the overarching obligation, we specifically require
broker-dealers to establish, maintain, and enforce written policies and
procedures reasonably designed to: (i) Identify and mitigate any
conflicts of interest associated with recommendations that create an
incentive for a natural person who is an associated person of a broker
or dealer to place the interest of the broker or dealer, or such
natural person making the recommendation, ahead of the interest of the
retail customer; (ii)(A) identify and disclose any material limitations
placed on the securities or investment strategies involving securities
that may be recommended (i.e., only make recommendations of proprietary
or other limited range of products) to a retail customer and any
conflicts of interest associated with such limitations, in accordance
with the Disclosure Obligation, and (B) prevent such limitations and
associated conflicts of interest from causing the broker, dealer, or a
natural person who is an associated person of the broker or dealer to
make recommendations that place the interest of the broker, dealer, or
such natural person ahead of the interest of the retail customer; and
(iii) identify and eliminate any conflicts of interest associated with
sales contests, bonuses, and non-cash compensation that are based on
the sales of specific securities or specific types of securities within
a limited period of time.\673\
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\673\ Rule 15l-1 under the Exchange Act.
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Each of these changes and the requirements pursuant to the Conflict
of Interest Obligation is discussed in more detail below.
a. Reasonably Designed Policies and Procedures
We proposed to require broker-dealers to establish reasonably
designed policies and procedures as we believe they are critical to
identifying and addressing conflicts of interest \674\ and helping
ensure compliance with the requirements to disclose conflicts of
interest pursuant to the Disclosure Obligation.\675\ In addition,
policies and procedures may minimize compliance costs that may be
passed on to retail customers.\676\ As discussed in the Proposing
Release, it would be reasonable for broker-dealers to use a risk-based
compliance and supervisory system rather than requiring a detailed
review of each recommendation and to have flexibility to tailor
policies and procedures to their specific business models. The
Commission also provided guidance on components a broker-dealer should
consider including in its program with regard to the Conflict of
Interest Obligation.\677\
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\674\ See FSI August 2018 Letter (``Experience shows that
investors already ignore much of the enormous volume of regulatory
disclosures they are being provided. Instead, a more realistic
approach is to require broker-dealers to adopt written supervisory
procedures to detect and manage conflicts of interest, to avoid
those they can and take steps to mitigate the impact of those
conflicts that can't be avoided.'').
\675\ See Proposing Release at Section II.D.3.b. See also CCMC
Letters (policies and procedures requirement should assist broker-
dealers in managing the potential impact of conflicts of interest);
FPC Letter (acknowledging the importance of firms' policies and
procedures when providing financial planning to act in the client's
best interest).
\676\ See Proposing Release at Section II.D.3.b. See also
Cambridge Letter (``Cambridge believes the SEC's goals of
facilitating disclosure and mitigating material conflicts of
interest, while minimizing additional compliance costs that may be
passed on to the retail customers can best be accomplished by
requiring broker-dealers to adopt written supervisory procedures to
detect and manage conflicts of interest, to avoid those they can and
take steps to mitigate the impact of those conflicts that can't be
avoided.'').
\677\ Proposing Release at Section II.D.3.b.
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In response to the proposed policies and procedures requirement,
some
[[Page 33386]]
commenters asserted that it was an effective means of addressing
conflicts \678\ while others were concerned that the Commission was
providing too much flexibility in addressing conflicts of
interest.\679\ A few commenters expressed agreement with allowing a
flexible risk-based approach tailored to a broker-dealer's business
model as opposed to a detailed review of each recommendation.\680\ A
few commenters expressed concern with the Commission's assertion that
policies and procedures may minimize compliance costs that may be
passed on to retail customers, noting the uncertainty surrounding how
conflicts of interest should be addressed by policies and
procedures.\681\ One commenter suggested that the Commission should
adopt a safe harbor for the Conflicts of Interest Obligation by
demonstrating compliance with certain existing FINRA rules.\682\ As
discussed below under the new Compliance Obligation, some commenters
suggested that the policies and procedures requirement should apply to
aspects of the entire rule.\683\
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\678\ See Fidelity Letter; SIFMA August 2018 Letter; Morgan
Stanley Letter.
\679\ See, e.g., NASAA August 2018 Letter; CFA Institute Letter;
Galvin Letter; Better Markets August 2018 Letter (policies and
procedures should be ``actually designed'' to achieve those ends,
not just ``reasonably designed'' to do so). But see IRI Letter
(``The Conflict of Interest Obligation should be simplified and
streamlined to give BDs the flexibility to determine appropriate
steps to manage material conflicts.'').
\680\ See Cambridge Letter; CCMC Letters. But see NASAA August
2018 Letter (suggesting the Commission reconsider the risk-based
approach to comply with its duties).
\681\ See, e.g., Better Markets August 2018 Letter; CFA
Institute Letter.
\682\ See AXA Letter.
\683\ See, e.g., NASAA August 2018 Letter (suggesting that, at a
minimum, a firm's policies and procedures should require an analysis
of the costs and risks of a product as well as the client's
financial goals).
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In consideration of the comments received, we are adopting the
approach with respect to reasonably designed policies and procedures to
identify and address conflicts of interest set forth in the proposal
substantially as proposed. As stated in the Proposing Release, we
believe that broker-dealers should have flexibility to tailor their
policies and procedures to their particular business model, focusing on
specific areas of their business that pose the greatest risk of
noncompliance and greatest risk of potential harm to retail customers
as opposed to a detailed review of each recommendation.\684\
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\684\ See Proposing Release at II.D.3.b.
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While we recognize a commenter's statement \685\ that policies and
procedures should be ``actually designed'' to address conflicts of
interest, we do not believe that the design of policies and procedures
should be measured against a standard of strict liability, but should
instead be measured against a standard of reasonableness. In addition,
we believe that policies and procedures are an effective tool to
identify and address conflicts of interest, and would allow the
Commission to identify and address potential compliance deficiencies or
failures (such as inadequate or inaccurate policies and procedures, or
failure to follow the policies and procedures) early on, reducing the
chance of retail customer harm.\686\ We also believe that there is no
one-size-fits all framework, and, as such, broker-dealers should have
flexibility to reasonably design their policies and procedures to
tailor them to account for their business model, given the structure
and characteristics of their relationships with retail customers,
including the varying levels and frequency of recommendations provided
and the types of conflicts that may be presented. This requirement of
``reasonably designed'' policies and procedures is also consistent with
Commission rules and regulations in other contexts, including under the
Advisers Act.\687\ Further, the Commission continues to believe that
while not required components, as an effective practice, broker-dealers
should consider including in their supervisory and compliance programs
the components listed in the Proposing Release, which may be relevant
in considering whether policies and procedures are reasonably
designed.\688\
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\685\ See Better Markets August 2018 Letter.
\686\ See infra footnote 809.
\687\ See Rule 206(4)-7 under the Advisers Act. See also Section
15(g) of the Exchange Act; 15E(g) of the Exchange Act.
\688\ These components could include, among other things:
policies and procedures outlining how the firm identifies conflicts,
identifying such conflicts and specifying how the broker-dealer
intends to address each conflict; robust compliance and monitoring
systems; processes to escalate identified instances of noncompliance
for remediation; procedures that designate responsibility to
business line personnel for supervision of functions and persons,
including determination of compensation; processes for escalating
conflicts of interest; processes for periodic review and testing of
the adequacy and effectiveness of policies and procedures; and
training on policies and procedures. Proposing Release at Section
II.D.3.b.
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The Commission is not providing a safe harbor to Regulation Best
Interest for broker-dealers who demonstrate compliance with FINRA rules
\689\ because, while FINRA rules may address specific conflicts of
interest, Regulation Best Interest establishes a broader obligation to
address conflicts both at the firm level and at the associated person
level.\690\ As to commenters' concerns that the policies and procedures
requirement provides too much flexibility and as discussed in more
detail below, the Commission has changed the specific requirements to
be addressed by the policies and procedures pursuant to the Conflict of
Interest Obligation to provide more certainty to firms on which
conflicts of interest should be addressed through disclosure,
mitigation or elimination. While the Commission also understands
concerns related to compliance costs, we believe that the revisions to
the Conflict of Interest Obligation, including the greater specificity
in the rule text, as well as the guidance provided below, will ease the
adjustment of broker-dealers' existing supervisory and compliance
systems and streamline compliance with Regulation Best Interest.
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\689\ See supra footnote 682.
\690\ ``While FINRA has repeatedly emphasized the importance of
identifying and managing conflicts and has a number of rules that
address discrete conflicts of interest, there is currently no
similarly broad conflicts provision in FINRA rules, including the
suitability rule.'' See FINRA 2018 Letter.
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b. Conflicts of Interest
The Proposing Release distinguished between material conflicts of
interest in general and material conflicts of interest arising from
financial incentives. Under the Proposing Release, broker-dealers would
be required to establish, maintain, and enforce policies and procedures
to identify and, in the case of material conflicts of interest,
disclose or eliminate, and in the case of financial incentives,
disclose and mitigate, or eliminate material conflicts of interest
arising from financial incentives.\691\
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\691\ See Proposing Release at Section II.D.3.
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The Commission proposed to interpret a material conflict of
interest as a conflict of interest that a reasonable person would
expect might incline a broker--consciously or unconsciously--to make a
recommendation that is not disinterested.\692\ For material conflicts
of interest arising from financial incentives associated with a
recommendation, the Proposing Release discussed compensation practices
established by the broker-dealer, including fees and other charges for
the services provided and products sold; employee compensation or
employment incentives (e.g., quotas, bonuses, sales contests, special
awards, differential or variable compensation, incentives tied to
appraisals or performance reviews); compensation practices involving
third-parties, including both sales
[[Page 33387]]
compensation and compensation that does not result from sales activity,
such as compensation for services provided to third-parties (e.g., sub-
accounting or administrative services provided to a mutual fund);
receipt of commissions or sales charges, or other fees or financial
incentives, or differential or variable compensation, whether paid by
the retail customer or a third-party; sales of proprietary products or
services, or products of affiliates; and transactions that would be
effected by the broker-dealer (or an affiliate thereof) in a principal
capacity.\693\
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\692\ Proposing Release at 21602.
\693\ Id.
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In addition, the Commission proposed to limit conflicts of interest
to those associated with recommendations as broker-dealers may provide
a range of services not involving a recommendation, and such services
are subject to general antifraud liability and specific requirements to
address associated conflicts of interest.\694\
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\694\ See Proposing Release at 21617. In including this
limitation, the Commission explained that it was not intending to
change the disclosure obligations associated with these services
under the general antifraud provisions of the federal securities
laws.
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Recognizing the phrase ``financial incentives'' could be
interpreted broadly, the Commission solicited comment on the proposed
requirement and the distinction between the different requirements
under the Conflict of Interest Obligation. In response, many commenters
suggested that the scope of the description of financial incentives be
narrowed as it was too broad and requested guidance or examples of
material conflicts of interest that would not fall within the
description of financial incentives.\695\ Specifically, a number of
commenters suggested that the mitigation obligation should focus on
financial incentives at the registered representative level as opposed
to the firm level.\696\ A number of commenters suggested that the
distinction between material conflicts and financial incentives should
be removed altogether.\697\ Commenters also stated that the mitigation
requirement is a higher standard of conduct than the investment adviser
fiduciary duty which allows for conflicts to be addressed through
disclosure sufficient for informed consent.\698\
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\695\ See, e.g., SIFMA August 2018 Letter; Primerica Letter;
BISA Letter; Committee of Annuity Insurers Letter; IPA Letter; CFA
Institute Letter.
\696\ See, e.g., Primerica Letter; TIAA Letter; ICI Letter;
Invesco Letter; Money Management Institute Letter; Committee of
Annuity Insurers Letter.
\697\ See, e.g., CFA August 2018 Letter; CFA Institute Letter;
Morgan Stanley Letter; SIFMA August 2018 Letter; CCMC Letters.
\698\ See Franklin Templeton Letter (stating that by including
this heightened requirement for financial conflicts of interest,
Regulation Best Interest would impose a higher standard on broker-
dealers than is required of investment advisers with respect to such
conflicts); Primerica Letter (stating that by requiring broker-
dealers to disclose and mitigate or eliminate conflicts resulting
from financial incentives, the standard is actually higher than the
standard that applies under the Advisers Act); CCMC Letters (stating
that the requirement to mitigate or eliminate material conflicts of
interest arising from financial incentives effectively subjects
broker-dealers to a higher standard than investment advisers, who
are generally able to disclose conflicts of interest). See also UBS
Letter; ASA Letter. Some commenters also suggested that the
obligation to address conflicts of interest should be harmonized
between broker-dealers and investment advisers. See, e.g., Schwab
Letter.
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In consideration of comments and as discussed in more detail below,
the Commission has restructured the Conflict of Interest Obligation to:
(1) Create an overarching obligation to establish, maintain and enforce
written policies and procedures that are reasonably designed to
identify and at a minimum disclose (pursuant to the Disclosure
Obligation), or eliminate, all conflicts of interest associated with
the recommendation; and (2) adopt specific requirements with respect to
such policies and procedures for the mitigation and elimination of
identified conflicts of interest.
In particular, we have revised the proposed policies and procedures
requirement for mitigation to focus on conflicts of interest that
create an incentive for an associated person to place his or her
interests ahead of the interest of the retail customer as described
below, by eliminating the distinction between material conflicts of
interest and material conflicts of interest arising from financial
incentives, and removing the affirmative mitigation requirement at the
firm level. However, in light of this change, we are adding a new
provision requiring broker-dealers to establish, maintain, and enforce
written policies and procedures to specifically require broker-dealers
to identify and disclose material limitations, and any associated
conflicts of interest a broker-dealer places on the securities or
investment strategies involving securities that may be recommended to
the retail customer, such as recommendations being based on limited
product menus (i.e., only make recommendations of proprietary or other
limited range of products) and prevent such limitations and associated
conflicts of interest from causing the broker-dealer to make
recommendations that place its interest ahead of the retail customer.
We believe the policies and procedures need to address those certain
conflicts of interest inherent in the broker-dealer business model by
heightened measures in order to prevent recommendations that are not in
the best interest of the retail customer. Therefore, we are adding a
provision requiring broker-dealers to establish, maintain, and enforce
written policies and procedures reasonably designed to identify and to
eliminate any conflicts of interest associated with 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.
For purposes of Regulation Best Interest, and for the reasons
described in more detail in the context of the Disclosure Obligation,
we have also amended the rule text by eliminating ``material'' from
``conflict of interest'' and codified the definition of a conflict of
interest \699\ to mean an interest that might incline a broker-dealer--
consciously or unconsciously--to make a recommendation that is not
disinterested.\700\ While ``material'' has been eliminated, pursuant to
the Disclosure Obligation, broker-dealers are required to disclose all
material facts relating to conflicts of interest associated with
recommendations, consistent with the Proposing Release's intent of
facilitating disclosure to assist retail customers in making informed
investment decisions.\701\
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\699\ See Section II.D.1. To provide clarity that the
interpretation of ``conflict of interest'' is limited to Regulation
Best Interest, the Commission has revised the rule text to include a
definition of the term.
\700\ See id.
\701\ Id.
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Regarding the application of the Conflict of Interest Obligation
only to those conflicts of interest associated with recommendations,
one commenter stated that given the lack of detail in the Proposing
Release, broker-dealers may have difficulty determining whether
material conflicts are associated with a recommendation and how to
adequately address such conflicts, which could create inconsistent
application of Regulation Best Interest.\702\ We continue to believe
this approach is appropriate, for the reasons discussed in the
Proposing Release \703\ and also believe
[[Page 33388]]
that our revised Conflict of Interest Obligation provides more
specificity about how to address specific conflicts of interest, in
conjunction with our Disclosure Obligation, which should address
commenters' concerns.
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\702\ See State Attorneys General Letter. (``Given the lack of
detail in the Proposed Rule, broker-dealers may have difficulty
determining whether material conflicts are (1) ``associated with
recommendations'' and therefore subject to disclosure or
elimination; or (2) ``arising from financial incentives associated
with such recommendations'' and therefore subject to disclosure and
mitigation, or elimination. This ambiguity, while designed to give
maximum flexibility to broker-dealers, may in fact result in
inconsistent application of the Proposed Rule nationwide and further
add to the existing confusion.'')
\703\ See Proposing Release at 21618.
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c. Identifying Conflicts of Interest
In the Proposing Release, the Commission stated that having a
process to identify and appropriately categorize conflicts of interest
is a critical first step to ensure that broker-dealers have reasonably
designed policies and procedures to address conflicts of interest in
order to comply with the Conflict of Interest Obligation. As stated in
the Proposing Release, reasonably designed policies and procedures to
identify conflicts of interest generally should do the following: (i)
Define such conflicts in a manner that is relevant to a broker-dealer's
business (i.e., conflicts of both the broker-dealer entity and the
associated persons of the broker-dealer), and in a way that enables
employees to understand and identify conflicts of interest; (ii)
establish a structure for identifying the types of conflicts that the
broker-dealer (and associated persons of the broker-dealer) may face;
(iii) establish a structure to identify conflicts in the broker-
dealer's business as it evolves; (iv) provide for an ongoing (e.g.,
based on changes in the broker-dealer's business or organizational
structure, changes in compensation incentive structures, and
introduction of new products or services) and regular, periodic (e.g.,
annual) review for the identification of conflicts associated with the
broker-dealer's business; and (v) establish training procedures
regarding the broker-dealer's conflicts of interest, including
conflicts of natural persons who are associated persons of the broker-
dealer, how to identify such conflicts of interest, as well as defining
employees' roles and responsibilities with respect to identifying such
conflicts of interest.\704\ Most commenters did not express a view on
such guidance relating to the process of identifying conflicts of
interest. Therefore, for the reasons discussed in the Proposing
Release, we are reiterating this guidance here.
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\704\ Id.
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d. Overarching Obligation Related to Conflicts of Interest
As proposed, the first component of the Conflict of Interest
Obligation would have required a broker-dealer to establish, maintain,
and enforce written policies and procedures reasonably designed to
identify, and disclose, or eliminate, all material conflicts of
interest that are associated with recommendations covered by Regulation
Best Interest. In guidance, the Commission stated that reasonably
designed policies and procedures should establish a clearly defined and
articulated structure for: determining how to effectively address
material conflicts of interest identified (i.e., whether to eliminate
or disclose (and mitigate, as required) the material conflict); and
setting forth a process to help ensure that material conflicts are
effectively addressed as required by the policies and procedures.
As such, the requirement was intended to provide flexibility to
broker-dealers regarding how to address conflicts of interest, whether
through disclosure pursuant to the Disclosure Obligation, or
elimination. The Commission also indicated that there may be situations
in which disclosure alone is not sufficient, and broker-dealers may
need to establish policies and procedures designed to eliminate the
conflict or both disclose and mitigate it.\705\ The Commission also
provided examples of how a broker-dealer could eliminate a
conflict.\706\
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\705\ See Proposing Release at 21619-21620.
\706\ Id.
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As discussed above, we received many comments generally on the
Conflict of Interest Obligation, requesting clarification on which
conflicts needed to be disclosed, versus those that should be mitigated
or eliminated.\707\ Some commenters suggested that disclosure and
informed consent should be considered to effectively address conflicts,
similar to the approach taken under the Advisers Act.\708\ Some
commenters suggested that disclosure alone was sufficient to address
conflicts arising from financial incentives.\709\ For example, a few
commenters identified specific types of conflicts they believed could
be addressed by appropriate disclosure, such as third-party
payments.\710\ A few commenters requested that the examples of how to
eliminate conflicts of interest in the Proposing Release be
removed.\711\
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\707\ See supra footnote 672.
\708\ See IPA Letter; Morgan Stanley Letter; ASA Letter.
\709\ See, e.g., Committee of Annuity Insurers Letter; Stifel
Letter; Mass Mutual Letter; SIFMA August 2018 Letter; HD Vest
Letter; Primerica Letter.
\710\ See, e.g., Invesco Letter; Transamerica August 2018
Letter; Primerica Letter.
\711\ See, e.g., ICI Letter (``This example suggests a firm that
offers proprietary funds should consider relinquishing the advisory
fees the firm or its affiliate receives for managing those funds as
a means to address conflicts that selling such funds creates. This
example is inconsistent with the SEC's explicit statements elsewhere
in the Best Interest Proposal that Regulation Best Interest would
not preclude a firm from offering proprietary products. . . .The SEC
should clarify in any adopting release that firms selling
proprietary funds are not obligated to credit fund advisory fees
against other broker-dealer charges. The ability to charge fees to
manage proprietary funds is critical to preserve the ability of
firms to offer both proprietary and third-party funds.''); Committee
of Annuity Insurers Letter (``This suggested method for elimination
of material conflicts of interest relating to affiliated mutual
funds presents a number of problematic issues. . . .This example is
exacerbated in the context of variable annuities.'').
---------------------------------------------------------------------------
After carefully considering comments, we are adopting, similar to
the Proposing Release, an overarching requirement to establish,
maintain, and enforce reasonably designed policies and procedures to
identify and, at a minimum, disclose, in accordance with the Disclosure
Obligation, or eliminate all conflicts of interest associated with the
recommendation. However, as discussed in the following sections, we are
otherwise revising the Conflict of Interest Obligation in response to
these comments. Subparagraphs (a)(2)(iii)(B)-(D) of the rule text will
now require policies and procedures that are reasonably designed to
address specific conflicts of interest in areas that we believe create
greater incentives for, and increased risk that, the broker-dealer or
associated person may place its or his or her own interest ahead of the
retail customer's interest, specifically conflicts of interest that:
(1) Create certain incentives to associated persons; (2) conflicts of
interest associated with material limitations on the securities or
investment strategies involving securities, such as, limited product
menus; and (3) sales contests, sales quotas, bonuses, and non-cash
compensation based on the sales of specific securities or type of
security within a limited period of time.
In adopting this overarching requirement, we are reaffirming
guidance in the Proposing Release on establishing a process to identify
and determine how to address a conflict, as discussed above.\712\
Further, similar to the Proposing Release, while we are not requiring
broker-dealers to develop policies and procedures to disclose and
mitigate all conflicts of interest, we are requiring that broker-
dealers develop policies and procedures reasonably designed to ``at a
minimum disclose, or eliminate'' all conflicts.\713\ We continue to
believe that where a broker-dealer cannot fully and fairly disclose a
conflict of interest in accordance with the Disclosure Obligation, the
broker-dealer should eliminate the conflict or adequately mitigate
(i.e., reduce) the
[[Page 33389]]
conflict such that full and fair disclosure in accordance with the
Disclosure Obligation is possible. In some cases, conflicts of interest
may be of a nature and extent that it would be difficult to provide
disclosure that adequately conveys to a retail customer the material
facts or the nature, magnitude and potential effect of the conflict for
informed decision-making or where disclosure may not be sufficiently
specific or comprehensible for the retail customer to understand
whether and how the conflict will affect the recommendations he or she
receives.\714\ Also, in certain situations, a broker-dealer, even if
not required, may determine that in addition to addressing a conflict
through disclosure, to take additional steps beyond disclosure to also
mitigate the conflict of interest.
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\712\ See Section II.C.3.c.
\713\ Proposing Release at 21620.
\714\ See id.; see also Fiduciary Interpretation (stating that
where an investment adviser cannot fully and fairly disclose a
conflict such that the client can provide informed consent, the
adviser should eliminate the conflict or adequately mitigate (i.e.,
modify practices to reduce) the conflict such that full and fair
disclosure and informed consent are possible).
---------------------------------------------------------------------------
The Commission acknowledges commenters' concerns regarding the
examples of how to eliminate conflicts of interest that were provided
in the Proposing Release. The Commission's intent was not to prevent
firms from offering certain products to the extent that they are in a
retail customer's best interest. In order to avoid confusion and to
respond to commenters, we are not including these examples as final
guidance here as we have instead decided to focus the rule text on
specific conflicts of interest associated with certain sales practices
based on the sale of specific securities that we require to be
eliminated and thus such examples are not necessary. In discussing the
separate mitigation and elimination requirements below, we provide
guidance on the specific conflicts for which we are requiring these
heightened measures beyond disclosure. However, while we have removed
the examples of potential conflicts of interest that may be more
appropriately avoided, we emphasize that pursuant to the overarching
obligation, elimination of conflicts of interest is one method of
addressing the conflict, in lieu of disclosure, which broker-dealers
may find appropriate in certain circumstances even when not required by
Regulation Best Interest.
e. Mitigation of Certain Incentives to Associated Persons
We proposed to require firms to establish, maintain, and enforce
written policies and procedures reasonably designed to identify and
disclose and mitigate, or eliminate, material conflicts of interest
arising from financial incentives with such recommendations. In
proposing this requirement, we recognized the importance of the
brokerage model as a potentially cost-effective option for investors,
acknowledging that the compensation structures and arrangements within
the business model create inherent conflicts \715\ but that such
compensation may be appropriate in light of the time and experience
necessary to understand investments. As such, we aimed to promote
investor choice and access to products and instead of requiring broker-
dealers to establish policies and procedures to eliminate compensation
structures and arrangements,\716\ required policies and procedures to
mitigate those conflicts of interest.
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\715\ See Proposing Release at II.D.3.e. See also Tully Report.
\716\ While the Commission's goal is to promote access and
choice to investors, as discussed in more detail in Section
II.C.3.g, Elimination of Certain Conflicts of Interest, the
Commission believes it is in the public interest and will enhance
investor protection to require broker-dealers to reasonably design
policies and procedures to eliminate certain conflicts of interest
as we believe such conflicts create too strong of an incentive for a
broker-dealer to make a recommendation that places the broker-
dealer's interest ahead of the retail customer's interest.
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We proposed a principles-based approach to provide flexibility to
firms to develop and tailor policies and procedures that included
conflict mitigation measures based on each firm's circumstances, for
example, the size, retail customer base, nature and significance of the
conflict, and complexity of the product.\717\ We stated that, depending
on the conflict and the firm's assessment, more or less demanding
measures may be appropriate.\718\ We provided examples of situations in
which heightened mitigation measures may be appropriate and also
suggested that broker-dealers assess their policies and procedures as
they may be reasonably designed at the outset but may later cease to be
reasonably designed based on subsequent events or information.\719\
Finally, we provided a non-exhaustive list of potential practices that
we believe broker-dealers should consider including in their policies
and procedures, and as discussed above, suggested that some practices
may be more appropriately avoided as they may be difficult to
mitigate.\720\
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\717\ Proposing Release at II.D.3.e.
\718\ Id.
\719\ Id.
\720\ Id.
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As discussed above, many commenters expressed concern with the
breadth of the mitigation requirement and requested that mitigation be
limited to certain types of compensation \721\ or solely to financial
incentives to the individual registered representative.\722\ Many
commenters were also concerned about what they described as ambiguities
in the Proposing Release, including the lack of a definition of the
term ``mitigate'' \723\ and requested further guidance surrounding
conflicts that needed to be mitigated versus those that can be
disclosed.\724\ Some commenters suggested that supervision should be
adequate mitigation and requested clarification on whether their
existing supervisory practices, if compliant, were sufficient.\725\ As
discussed above under Section II.C.3.b, a number of commenters
expressed concern that the mitigation requirement is a higher standard
of conduct than the investment adviser fiduciary duty and requested
that it be aligned with the fiduciary duty.\726\
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\721\ See, e.g., Cetera August 2018 Letter; SIFMA August 2018
Letter. But see CFA August 2018 Letter (stating that the Commission
has proposed an appropriately broad definition of material conflicts
that arise out of financial incentives and that it should not be
narrowed but a cleaner approach would be to eliminate the artificial
distinction between those material conflicts of interest that arise
from financial incentives and those that do not, and to apply the
same obligation to disclose and mitigate all material conflicts,
whatever the source).
\722\ See, e.g., Primerica Letter; Committee of Annuity Insurers
Letter; Cetera August 2018 Letter. See also Wells Fargo Letter
(stating that receipt of fees and other revenue that does not
otherwise result in a direct financial incentive at the registered
representative level should be disclosed); ICI Letter (recommending
revisions to the proposed conflict of interest obligation to focus
the mitigation obligation on the fees, revenue, or other financial
incentives that may influence the recommendation of a broker-dealer
representative--the individual making the recommendation); Invesco
Letter.
\723\ See, e.g., UVA Letter.
\724\ See, e.g., CFA August 2018 Letter; Wells Fargo Letter;
Committee of Annuity Insurers Letter; NASAA August 2018 Letter;
Cetera August 2018 Letter; Morningstar Letter.
\725\ See, e.g., BISA Letter; AALU Letter; Primerica Letter;
Committee of Annuity Insurers Letter.
\726\ Supra footnote 698.
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Many commenters expressed concern over some of the examples, and in
particular neutral compensation factors, described as a potential
mitigation measure.\727\ Similarly, some
[[Page 33390]]
commenters suggested that the Commission should take more of a
principles-based approach as they viewed the Proposing Release as too
prescriptive because it incorporated examples from the DOL Fiduciary
Rule.\728\ One commenter expressed concern over the suggestion that
heightened mitigation may be appropriate if a retail customer has a
less sophisticated understanding, stating that it is unclear how
mitigation would be measured and could create heightened costs and
risks for firms.\729\ Finally, some commenters requested confirmation
that certain practices are permissible such as use of compensation
grids,\730\ receipt of revenue sharing,\731\ differential
compensation,\732\ recommendations based on a limited range of products
and proprietary products,\733\ and use of employment benefits.\734\
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\727\ See, e.g., SIFMA August 2018 Letter; ICI Letter; Edward
Jones Letter; Morgan Stanley Letter; Transamerica August 2018
Letter; Ameriprise Letter; Capital Group Letter; Cetera August 2018
Letter; CCMC Letters; Letter from Michelle Bryan Oroschakoff, Chief
Legal Officer, LPL Financial (Dec. 18, 2018) (``LPL December 2018
Letter'') (requesting confirmation that the non-exhaustive list of
potential practices was intended merely as a list of examples and
are not required mitigation practices); Mass Mutual February 2019
Letter. But see NASAA August 2018 Letter (stating that neutral
compensation across products could constitute appropriate
mitigation), State Attorneys General Letter (suggesting differential
compensation be permitted based solely on neutral factors).
\728\ See, e.g., LPL August 2018 Letter; Cetera August 2018
Letter; Davis Harman Letter.
\729\ See Primerica Letter.
\730\ See, e.g., SIFMA August 2018 Letter; Committee of Annuity
Insurers Letter; Primerica Letter.
\731\ See, e.g., SIFMA August 2018 Letter; Cetera August 2018
Letter.
\732\ See, e.g., Cetera August 2018 Letter; Transamerica August
2018 Letter; Ameriprise Letter.
\733\ See, e.g., NY Life Letter; Fidelity Letter; ICI Letter;
T.Rowe Letter. These commenters suggested that disclosure would be
an appropriate way to address conflicts of interest associated with
limited product menus and proprietary products.
\734\ See, e.g., AALU Letter.
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In response to commenters, we have revised the Proposing Release's
requirement with respect to mitigation to require broker-dealers to
establish policies and procedures reasonably designed to identify and
mitigate any conflicts of interest associated with such recommendations
that create an incentive for a natural person who is an associated
person of a broker- dealer to place the interest of the broker-dealer,
or such natural person ahead of the interest of the retail customer.
We agree with commenters that it is appropriate to focus on the
incentives that directly affect the associated person making a
recommendation, because we believe those conflicts are most likely to
undermine the associated person's ability to make a recommendation that
is in the best interest of the retail customer, and thus present
heightened risk of recommendations that are not in a retail customer's
best interest and that place the associated person's or firm's
interests ahead of the retail customer's interest.
While disclosure can be an effective tool for retail customers to
increase awareness of a conflict of interest,\735\ in certain cases, we
do not believe that disclosure alone sufficiently reduces the potential
effect that these conflicts of interest may have on recommendations
made to retail customers.\736\ Instead, we believe that broker-dealers
are most capable of identifying and addressing the conflicts that may
affect the obligations of their associated persons with respect to the
recommendations they make, and therefore are in the best position, to
affirmatively reduce the potential effect of these conflicts of
interest such that they do not taint the recommendation.
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\735\ See Section II.C.1, Disclosure Obligation; Relationship
Summary Adopting Release.
\736\ See, e.g., Tully Report; CFA August 2018 Letter; AARP
August 2018 Letter; Warren Letter (``the [Commission] should not
rely on disclosure alone to protect consumers.''). See also DOL
Fiduciary Rule Release at 20950. ``Disclosure alone has proven
ineffective to mitigate conflicts in advice.''
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We are persuaded by commenters \737\ that expressed concern that
requiring broker-dealers to establish policies and procedures
reasonably designed to mitigate all financial incentives, including any
compensation, may result in broker-dealers narrowing their product
shelf and compensation practices which would be inconsistent with the
Commission's stated goal.\738\ As stated in the Proposing Release,
while the Commission's goal in adopting Regulation Best Interest is to
enhance investor protection by reducing the potential harm to retail
customers from conflicts of interest that may affect broker-dealer
recommendations, we want to do so while preserving, to the extent
possible, access and choice for investors who prefer to pay for
investment recommendations on a transaction-by-transaction basis, which
is the ``pay as you go'' model that broker-dealers generally provide,
as well as preserving retail customer choice of the level and types of
advice provided and the products available.\739\ As such, transaction
based-compensation need not be eliminated pursuant to Regulation Best
Interest.
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\737\ See, e.g., Primerica Letter (``The SEC's current
formulation of the conflicts obligation thus inappropriately, and we
believe unintentionally, preferences advisory models over brokerage
models.''); Transamerica August 2018 Letter (expressing concern that
the proposed interpretation of financial incentives is overbroad and
may result in broker-dealers narrowing their product shelf, which
seems inconsistent with the SEC's stated goal of preserving the
broker-dealer model to protect an investor's right to choose between
brokerage and advisory accounts).
\738\ The Commission recognizes that a broker-dealer's financial
or other interest can and will inevitably exist.
\739\ We are persuaded by commenters regarding the competitive
issues for broker-dealers that could arise if we require mitigation
of firm-level financial incentives, which is not required by an
investment adviser's fiduciary duty, and could further encourage
migration from the broker-dealer to investment adviser model and
result in a loss of choice for retail customers. See Section I; CCMC
Letters (``Imposing a standard on broker-dealers with respect to
managing conflicts of interest that is greater than that imposed on
investment advisers, on top of the additional regulatory obligations
to which broker-dealers are subject that are not imposed on
investment advisers, threatens to undermine the SEC's objective of
preserving retail customer choice and access to the brokerage advice
model and may introduce a new source of confusion when it comes to
investors' understanding of the duties they are owed.''); AALU
Letter (``Overly-rigid mitigation requirements could limit consumer
choice of products and access to professional financial advice'').
See also 913 Study; Proposing Release at 21575.
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Accordingly, rather than requiring mitigation of all firm-level
financial incentives, we have determined to refine our approach by
generally allowing firm-level conflicts to be generally addressed
through disclosure.\740\ At the same time, we are persuaded by
commenters \741\ that there are some conflicts that should be addressed
through mitigation at the firm level due to the potential impact that
we believe certain conflicts of interest (either at the associated
person or firm level) may have on recommendations to retail customers;
therefore we are requiring policies and procedures for mitigation or
elimination of those conflicts (as identified in the rule text) and are
not leaving it to the broker-dealer to determine whether disclosure
alone is sufficient.\742\ We believe that this approach appropriately
balances our goal of reducing the potential harm conflicts of interest
may have on broker-dealers' recommendations to retail customers and
preserving retail access (in terms of choice and cost) to brokerage
products and services.
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\740\ As discussed above in the section about the Disclosure
Obligation, the Commission believes that compliance with the
Disclosure Obligation, including disclosure of the material facts
relating to the scope and terms of the relationship with the retail
customer and all conflicts of interest, should give sufficient
information to enable a retail customer to make an informed decision
with regard to the recommendation. See II.D.1.
Nevertheless, as noted, there may be situations in which
disclosure alone may not be sufficient to provide ``full and fair''
disclosure in accordance with the Disclosure Obligation discussed
above, and the broker-dealer may need to take additional steps to
mitigate or eliminate the conflict, consistent with an investment
adviser's fiduciary duty. See Section II.C.3.d.
\741\ See, e.g., CFA August 2018 Letter.
\742\ See Section II.C.3.f and g.
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i. Guidance on Covered Incentives
The Commission interprets this requirement to establish, maintain,
and enforce reasonably designed policies and procedures to identify and
mitigate
[[Page 33391]]
any conflicts of interest that create an incentive for the associated
person to place the interest of the broker-dealer or such associated
person ahead of the interest of the retail customer, to only apply to
incentives provided to the associated person, whether by the firm or
third-parties that are within the control of or associated with the
broker-dealer's business.\743\ It would not cover external interests of
the associated person not within the control of or associated with the
broker-dealer's business.\744\ In the case of a dually registered
individual, this requirement would generally only apply to incentives
provided to the associated person when making a recommendation in a
brokerage capacity and not when making a recommendation in an
investment advisory capacity as the investment adviser fiduciary duty
would apply to the advice given in that instance.\745\
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\743\ The ability to control the compensation of associated
person, including incentives, is an important mechanism by which
broker-dealers exercise supervisory control over sales practices.
\744\ For example, if an associated person of a broker-dealer
participates in a securities transaction outside of the broker-
dealer and receives compensation, although the broker-dealer would
need to approve the transactions and record it in its books and
records under FINRA Rule 3280 (Private Securities Transaction of an
Associated Person), as described in more detail above, this
requirement to mitigate certain incentives to an associated person
would not apply to compensation that is not an incentive provided by
or in the control of the broker-dealer.
Nevertheless, additional registration, disclosure or other
obligations, and antifraud liabilities may apply to any other firm
through which an associated person may have such external interests
under federal or state law (for example, as a state-registered
adviser). We also note that an associated person of a broker-dealer
who receives transaction-based compensation and participates in a
private securities transactions that is not in accordance with FINRA
Rule 3280 should be mindful of the broker-dealer registration
requirements under Section 15 of the Exchange Act.
\745\ See Fiduciary Interpretation; Section II.B.3.
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The Commission generally considers the following as examples of
incentives to an associated person that would need to be addressed
under this revised provision: (i) Compensation from the broker-dealer
or from third-parties, including fees and other charges for the
services provided and products sold; (ii) employee compensation or
employment incentives (e.g., incentives tied to asset accumulation and
not prohibited under (a)(2)(iii)(D), as discussed below, special
awards, differential or variable compensation, incentives tied to
appraisals or performance reviews); and (iii) commissions or sales
charges, or other fees or financial incentives, or differential or
variable compensation, whether paid by the retail customer, the broker-
dealer or a third-party. These examples focus on compensation that
varies based on the advice given, such as commissions, markups/
markdowns, loads, revenue sharing, and Rule 12b-1 fees.
ii. Guidance on Mitigation Methods
By requiring that a broker-dealer establish policies and procedures
reasonably designed to ``mitigate'' these conflicts of interest, we
mean the policies and procedures must be reasonably designed to reduce
the potential effect such conflicts may have on a recommendation given
to a retail customer. Thus, whether or not a broker-dealer's policies
and procedures are reasonably designed to mitigate such conflicts will
be based on whether they are reasonably designed to reduce the
incentive for the associated person to make a recommendation that
places the associated person's or firm's interests ahead of the retail
customer's interest.
As noted in the Proposing Release, in lieu of mandating specific
mitigation measures or a ``one-size fits all'' approach, we are
providing broker-dealers with flexibility to develop and tailor
reasonably designed policies and procedures that include conflict
mitigation measures, based on each firm's circumstances.\746\
Reasonably designed policies and procedures should include mitigation
measures that depend on the nature and significance of the incentives
provided to the associated person and a variety of factors related to a
broker-dealer's business model (such as the size of the broker-dealer,
retail customer base (e.g., diversity of investment experience and
financial needs), and the complexity of the security or investment
strategy involving securities that is being recommended), some of which
may be weighed more heavily than others. For example, more stringent
mitigation measures may be appropriate in situations where the
characteristics of the retail customer base in general displays less
understanding of the incentives associated with particular securities
or investment strategies; \747\ where the compensation is less
transparent (for example, an incentive from a third-party or charge
built into the price of the product or a transaction versus a straight
commission); or in a situation involving a complex security or
investment strategy.\748\ A broker-dealer could reasonably determine
through its policies and procedures that the same mitigation measures
could apply to a particular type of retail customer, type of security
or investment strategy, or type of incentive across the board; or in
some instances a broker-dealer may reasonably determine that some
conflicts create incentives that may be more difficult to mitigate, and
are more appropriately avoided in their entirety or for certain
categories of retail customers.\749\
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\746\ See Proposing Release at 21618. See also Letter from
Steven W. Stone, Morgan, Lewis & Bockius LLP (May 3, 2019) (``Morgan
Lewis Letter'') (``The Commission should recognize that firms may
appropriately employ only some--or various combinations--of these
approaches depending on their businesses and business models,
compensation structures, and related conflicts of interest, and
should not prescribe a one-size-fits-all approach to mitigating
compensation-related conflicts.'').
\747\ FINRA's heightened suitability requirements for options
trading accounts require that a registered representative have ``a
reasonable basis for believing, at the time of making the
recommendation, that the customer has such knowledge and experience
in financial matters that he may reasonably be expected to be
capable of evaluating the risks of the recommended transaction, and
is financially able to bear the risks of the recommended position in
the complex product.'' FINRA Rule 2360(b)(19).
\748\ See Proposing Release at 21620-21621.
\749\ Id.
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As noted in the Proposing Release, policies and procedures may be
reasonably designed at the outset, but may later cease to be reasonably
designed based on subsequent events or information obtained (for
example, such as through supervision (e.g., exception testing) of
associated person recommendations), and the actual experience of a
broker-dealer should be used to revise the broker-dealer's measures as
appropriate.\750\ Further, what are considered reasonable mitigation
measures may vary based on the size of the firm.\751\ While many
broker-dealers have programs currently in place to manage conflicts of
interest, each broker-dealer will need to carefully consider whether
its existing framework complies with this provision.\752\
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\750\ Id.
\751\ In the FINRA Conflicts Report, FINRA identified certain
mitigation measures firms implemented that we believe highlight
differences in conflict management frameworks, based on the size of
the firm. For example, large firms may address conflicts of interest
through enterprise management or operational risk frameworks, and
components of such programs, for example, risk and control self-
assessments, may provide an opportunity to identify and evaluate
possible impacts. By contrast, small firms selling basic products
may have a conflicts management framework that relies largely on the
tone set by the firm owner coupled with required supervisory
controls, particularly related to suitability, and the firm's
compensation structure. See FINRA Conflicts Report. An effective
practice FINRA observed at a number of firms is implementation of a
comprehensive framework to identify and manage conflicts of interest
across and within firms' business lines that is scaled to the size
and complexity of their business. See FINRA Conflicts Report at 5.
\752\ See Proposing Release at 21621.
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In response to commenters' concerns regarding the potential
mitigation
[[Page 33392]]
methods described in the Proposing Release, and, in particular, the
references to neutral factors,\753\ we would like to emphasize that
this non-exhaustive list of factors is purely illustrative and the
factors are not required elements.\754\ In providing these examples, we
did not intend to take a prescriptive approach, as suggested by some
commenters, but a principles-based approach designed to provide
flexibility to broker-dealers, depending on their business model, level
of conflicts, and the retail customers they serve.\755\
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\753\ See, e.g., Mass Mutual February 2019 Letter; Edward Jones
Letter; IRI Letter; Capital Group Letter; SIFMA August 2018 Letter;
Committee of Annuity Insurers Letter.
\754\ See Proposing Release at 21621.
\755\ See Proposing Release at 21622.
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Among other things, firms may adopt a range of reasonable
alternatives to meet the mitigation requirement of the Conflict of
Interest Obligation. As noted above, we recognize that there are a
number of different kinds of incentives and that, depending on the
specific characteristics of an incentive, different levels and types of
mitigation measures may be necessary. For example, incentives tied to
asset accumulation generally would present a different risk and require
a different level or kind of mitigation, than variable compensation for
similar securities, which in turn may present a different level or kind
of risk and may require different mitigation methods than differential
or variable compensation or financial incentives tied to firm revenues.
In certain instances, we believe that compliance with existing
supervisory requirements and disclosure may be sufficient, for example,
where a firm may develop a surveillance program to monitor sales
activity near compensation thresholds.\756\
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\756\ FINRA Conflicts Report at 30-31.
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As discussed above, while not required elements, the Commission
believes the following non-exhaustive list of practices could be used
as potential mitigation methods for firms to comply with (a)(2)(iii)(B)
of Regulation Best Interest:
Avoiding compensation thresholds that disproportionately
increase compensation through incremental increases in sales;
minimizing compensation incentives for employees to favor
one type of account over another; or to favor one type of product over
another, proprietary or preferred provider products, or comparable
products sold on a principal basis, for example, by establishing
differential compensation based on neutral factors; \757\
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\757\ As noted above, we are not requiring firms to establish
differential compensation based on neutral factors but do believe
firms could choose to do so as potential practice to promote
compliance with the requirement to establish, maintain, and enforce
written policies and procedures reasonably designed to identify and
mitigate any conflicts of interest that create an incentive for an
associated person to place its interest ahead of the interest of the
retail customer.
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eliminating compensation incentives within comparable
product lines by, for example, capping the credit that an associated
person may receive across mutual funds or other comparable products
across providers;
implementing supervisory procedures to monitor
recommendations that are: Near compensation thresholds; near thresholds
for firm recognition; involve higher compensating products,\758\
proprietary products or transactions in a principal capacity; or,
involve the roll over or transfer of assets from one type of account to
another (such as recommendations to roll over or transfer assets in an
ERISA account to an IRA) or from one product class to another; \759\
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\758\ See Morgan Lewis Letter (suggesting, among other things,
that firms can conduct surveillance (whether transactions, periodic,
or forensic) to identify activity that appears to be driven by
compensation considerations--whether at the representative, team, or
business level--rather than a customer's interest).
\759\ See FINRA Exam Report 2017. FINRA observed a variety of
effective practices in recommending the purchase and sale of UITs,
including tailoring supervisory systems to products' features and
sources of risk to customers.
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adjusting compensation for associated persons who fail to
adequately manage conflicts of interest; and
limiting the types of retail customer to whom a product,
transaction or strategy may be recommended.\760\
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\760\ See, e.g., supra footnote 747; FINRA Regulatory Notice 12-
03, Heightened Supervision of Complex Products (Jan. 2012).
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While the Commission is providing flexibility so that broker-
dealers can determine the nature and extent of mitigation, whether a
broker-dealer has developed policies and procedures reasonably designed
to mitigate a conflict is not measured against industry practice
(although such practice could be a useful point of reference). Each
firm must look at the facts and circumstances surrounding the
mitigation methods, the particular broker-dealer's business model, and
whether or not the policies and procedures were reasonably designed for
the particular firm to reduce the impact of the incentive in a manner
to prevent the incentive from causing the associated person to place
the broker-dealer's or the associated person's interest ahead of the
retail customer's interest.
In response to a commenter's concern that we suggested in the
Proposing Release that some compensation conflicts may be more
appropriately avoided for certain categories of retail customers,\761\
we would like to clarify that such a suggestion is an example and not a
requirement. Nevertheless, we are adopting a requirement to establish,
maintain, and enforce written policies and procedures reasonably
designed to eliminate the incentives that we believe create the most
problematic conflicts, namely incentives to associated persons that are
tied to recommendations of specific securities or specific types of
securities within a limited period of time as we believe these
incentives cannot be adequately mitigated, and are likely to result in
recommendations that place the interest of the broker-dealer or
associated person ahead of the interests of the retail customer.
Furthermore, in accordance with the Care Obligation, a broker-dealer,
when making a recommendation, is required to, among other things, have
a reasonable basis to believe that the recommendation is in the best
interest of the particular retail customer.\762\ In particular, and
consistent with existing suitability obligations, a broker-dealer is
required to exercise ``reasonable diligence'' to ascertain (and
consider) the retail customer's investment profile which, among other
things, includes the retail customer's investment experience and risk
tolerance.\763\ A broker-dealer that has established reasonably
designed policies and procedures to mitigate the conflicts associated
with the incentives provided to the associated person would
nevertheless violate Regulation Best Interest if the recommendation
does not comply with the Care Obligation.
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\761\ See Primerica Letter (``The SEC's statements in the
Proposals regarding the additional protections broker-dealers should
afford `less sophisticated' retail customers could create a sub-
class of retail customers that broker-dealers would have to identify
based on subjective and poorly defined criteria, and potentially
further restrict access to help with saving and investing for
customers who need it most.'').
\762\ See Section II.C.2.
\763\ Id.
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Finally, in response to commenters' questions regarding the
permissibility of specific practices, the Commission believes the
revised, explicit requirements related to: Mitigation of incentives to
associated persons as discussed herein; mitigation of any material
limitations placed on the securities or investment strategies that may
be recommended to retail customers; and elimination of certain
[[Page 33393]]
practices, as discussed below, sufficiently address these comments. To
the extent the Commission has not identified a practice that needs to
be eliminated, it would be permitted, subject to compliance with the
requirements of Regulation Best Interest.
f. Mitigation of Material Limitations on Recommendations to Retail
Customers
As part of the proposed requirement to manage conflicts of interest
arising from financial incentives through mitigation, firms would have
been required to establish policies and procedures reasonably designed
to mitigate the conflicts of interest associated with offering a
limited range of products and proprietary products.
We also solicited comment on information related to the magnitude
of conflicts of interest when broker-dealers recommend, among other
things, proprietary products and a limited range of products. In
response, several commenters requested that the Commission confirm that
a product menu limited to appropriate alternative investments offered
by the broker-dealer would not violate Regulation Best Interest.\764\
Some commenters requested we clarify that, for certain customers, a
firm can limit its offerings to proprietary products or products for
which the firm receives revenue sharing payments if the limitation is
properly disclosed and appropriate to meet the retail customer's
needs.\765\
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\764\ See, e.g., SIFMA August 2018 Letter (requesting
clarification on how a broker-dealer could satisfy the Conflict of
Interest Obligation if the platform is limited to certain bond
offerings); Fidelity Letter (stating that given the vast array of
readily available investment options and the breadth of securities
typically available to customers through broker-dealers, some
limitation of the universe of investment options must be undertaken
in order for a broker-dealer to adequately understand, compare and
formulate a recommendation); Prudential Letter (``It is unclear what
`significantly limits' means for firms that offer predominantly, but
not exclusively, proprietary products. It is also unclear what
constitutes a `small choice of investments.' Additional examples or
more prescriptive instructions regarding when firms must disclose
such limitations would be helpful.''). See also Guardian August 2018
Letter; LPL August 2018 Letter; LPL December 2018 Letter.
\765\ See, e.g., SIFMA August 2018 letter; CFA Institute Letter;
Letter from Emanuel Alves, Senior Vice President and General
Counsel, John Hancock Life Insurance Company (Aug. 3, 2018) (``John
Hancock Letter''); Ameriprise Letter. See also NY Life Letter
(recommending the Commission require disclosure of the limits on the
universe of available products, while allowing further context so
that firms describe the full scope and impact of those limits);
SPARK Letter (recognizing that the SEC did not want to mandate
specific mitigation procedures or a ``one-size-fits'' all'' approach
but requesting further guidance in the case of, among other things,
broker-dealers who only offer proprietary products or only offer
limited investment menus). But see CFA August 2018 Letter
(suggesting that simply stating that a firm offers a limited
selection of investments may not be enough for an investor to
understand the limitations).
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In consideration of these comments, and our revisions to remove
firm-level conflicts from the proposed mitigation provision discussed
above, we are adopting a new requirement to specifically address the
conflicts of interest presented when broker-dealers place any material
limitations on the securities or investment strategies that may be
recommended to a retail customer (i.e., only make recommendations of
proprietary or other limited ranges of products). While we generally
believe that most firm-level conflicts of interest can be addressed
through appropriate disclosure, this new provision focuses on the
specific firm-level conflicts--namely, the conflicts associated with
the establishment of a product menu--which we believe are most likely
to affect recommendations made to retail customers and have the
greatest potential to result in recommendations that place the interest
of the broker-dealer or associated person ahead of the interest of the
retail customer.\766\ Given the potential impact on recommendations to
retail customer, we believe these conflicts should not be left to the
broker-dealer to determine whether disclosure alone is sufficient, and
are requiring broker-dealers to establish, maintain, and enforce
written policies and procedures reasonably designed to (1) identify and
disclose any material limitations broker-dealers place on their
securities offerings or investment strategies involving securities and
any associated conflicts of interest and (2) prevent such limitations
and associated conflicts of interest from causing the broker-dealer to
make recommendations that place the broker-dealer's interest ahead of
the interest of the retail customer.
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\766\ See CFA August 2018 Letter (``[M]any broker-dealers
currently restrict choice by only recommending from a limited menu
of proprietary funds or by only recommending products from companies
that make revenue sharing payments. If limits on investor choice are
of concern to the Commission, surely such limits deserve equal
scrutiny. After all, evidence suggests that the limited menus
offered by some firms consist entirely of low quality products that
impose excessive costs, deliver inferior returns, and expose
investors to excessive risk.'')
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While we believe broker-dealers should be permitted to limit their
product offerings from which they make recommendations to retail
customers, provided that they comply with Regulation Best
Interest,\767\ we are also concerned that without requiring a broker-
dealer to have a process in place to disclose and address negative
effects of such limitations, retail customers may be unaware that a
broker-dealer offers only a limited set of products and therefore would
be unable to make an informed investment decision.\768\ We are also
concerned that retail customers may be harmed by such limitations if
they are more likely to result in recommendations that are not in the
best interest of the retail customer.\769\
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\767\ See Section II.C.2 for a related discussion of the
application of the Care Obligation to such limitations. See also
AFL-CIO April 2019 Letter (recommending that the Commission make
clear that it will hold firms accountable for developing a product
menu that complies with the first prong of the proposed best
interest standard and that under such approach, firms would
periodically assess their product offerings against other products
available in the marketplace in order to ensure that their offerings
are competitive).
\768\ See Disclosure Obligation at Section II.C.1.
\769\ We believe that by including this requirement to address
material limitations to product menus, which does not rely on
disclosure alone, coupled with the requirements under the Care
Obligation, we are addressing a commenter's concern that product
limitations can limit investor choice which in turn harms investors.
See CFA August 2018 Letter.
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Broker-dealers will be required to establish, maintain and enforce
written policies and procedures reasonably designed to: (i) Identify
and disclose any material limitations placed on the securities or
investment strategies involving securities that may be recommended to a
retail customer and any conflicts of interest associated with such
limitations, in accordance with the Disclosure Obligation, and (ii)
prevent such limitations and associated conflicts of interest from
causing the broker, dealer, or a natural person who is an associated
person of the broker or dealer to make recommendations that place the
interest of the broker, dealer, or such natural person ahead of the
interest of the retail customer.
As discussed in the context of the Disclosure Obligation and the
Relationship Summary, for purposes of this requirement, a ``material
limitation'' \770\ placed on the securities or investment strategies
involving securities would include, for example, recommending only
proprietary products (i.e., any product that is managed, issued, or
sponsored by the financial institution or any of its affiliates), a
specific asset class, or products with third-party arrangements (i.e.,
revenue sharing).\771\ In addition, the fact that the broker-dealer
recommends only products from a select
[[Page 33394]]
group of issuers could also be a material limitation.
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\770\ As discussed in Section II.C.1, Disclosure Obligation, a
limitation is ``material'' if there is ``a substantial likelihood
that a reasonable shareholder would consider it important.'' Basic,
Inc. v. Levinson, 485 U.S. 224, 224 (1988). In the context of this
Regulation Best Interest, this standard would apply in the context
of retail customers, as defined.
\771\ See II.C.1.; Relationship Summary Adopting Release.
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We recognize, however, that, as a practical matter, almost all
broker-dealers limit their offerings of securities and investment
strategies to some degree. We do not believe that disclosing the fact
that a broker-dealer does not offer the entire possible range of
securities and investment strategies would convey useful information to
a retail customer, and therefore we would not consider this fact,
standing alone, to constitute a material limitation.\772\ Rather,
consistent with the examples of a ``material limitation'' provided
above, whether the limitation is material will depend on the facts and
circumstances of the extent of the limitation.
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\772\ See Basic, Inc. v. Levinson, 485 U.S. 224, 224 (1988).
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Adopting this revised requirement is critical to ensuring that
retail customers are aware of any material limitations associated with
a broker-dealer's recommendation and associated conflicts of interest
and that broker-dealers, through their policies and procedures,
establish processes to evaluate whether or not such a limited range of
products is consistent with making recommendations that are in the
retail customer's best interest and that do not place the interests of
the broker-dealer or associated person ahead of the retail customer's
interest, consistent with Care Obligation.\773\ Broker-dealers would be
able to satisfy paragraph (a)(2)(iii)(C)(1) by identifying any material
limitations and complying with the Disclosure Obligation which, as
discussed above, requires disclosure of ``the type and scope of
services provided to the retail customer, including any material
limitations on the securities or investment strategies involving
securities that may be recommended to the retail customer.'' \774\
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\773\ See Section II.C.2 and infra footnote 779.
\774\ Section II.C.1.
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Similar to the requirement to establish, maintain, and enforce
written policies and procedures reasonably designed to mitigate certain
incentives to associated persons, firms will have flexibility to
develop and tailor reasonably designed policies and procedures to
prevent such limitations and the associated conflicts from causing the
broker-dealer or associated person from placing their interest ahead of
the retail customer's interest. In developing such policies and
procedures, the Commission believes that firms should, for example,
consider establishing product review processes for products that may be
recommended, including establishing procedures for identifying and
mitigating the conflicts of interests associated with the product, or
declining to recommend a product where the firm cannot effectively
mitigate the conflict, and identifying which retail customers would
qualify for recommendations from this product menu.\775\ As part of
this process, firms may consider evaluating the use of ``preferred
lists,'' \776\ restricting the retail customers to whom a product may
be sold, prescribing minimum knowledge requirements for associated
persons who may recommend certain products,\777\ and conducting
periodic product reviews to identify potential conflicts of interest,
whether the measures addressing conflicts are working as intended, and
to modify the mitigation measures or product selection
accordingly.\778\ The Commission's intent is not to prevent firms from
offering proprietary products or other limited range of products so
long as firms comply with the Disclosure, Care,\779\ and Conflict of
Interest Obligations. In fact, we believe that these limitations can be
beneficial, such as by helping ensure that a broker-dealer and its
associated persons understand the securities they are recommending, as
required by the Care Obligation.\780\ This requirement is designed to
allow firms to determine whether and how to restrict their menu of
investment options based, among other things, on their retail customer
base and area of expertise, while protecting the interests of retail
customers when recommendations are made from such limited menus by
requiring firms have a reasonably designed process to identify,
disclose, and prevent the conflicts of interest associated with such
limitations from resulting in recommendations that place the broker-
dealer's interests ahead of the retail customer's interest.
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\775\ For example, in its Conflicts Report, FINRA identified the
following as effective practices to identify and manage conflicts of
interest for new products: (i) A product review process to identify
and mitigate conflicts of interest that may be associated with a
product; (ii) evaluation of whether to decline to offer products to
customers when the conflicts associated are too significant to be
mitigated effectively; (iii) differentiation of product eligibility
between institutional and retail clients; (iv) post-launch reviews
of products to identify potential problems; (v) evaluation of
registered representatives' ability to understand a product, provide
training where necessary, and limit access to products for which
they cannot demonstrate sufficient understanding to perform a
suitability analysis and effectively explain a product and its risks
to customers; and (vi) disclosure of product conflicts and risks.
See FINRA Conflicts Report at 3, 18-25.
\776\ See FINRA Conflicts Report at 24.
\777\ Cf. FINRA Conflicts Report at 19 (stating that as an
effective practice in evaluating new products, a product review
committee may engage in these activities to address conflicts of
interest).
\778\ Cf., e.g., NASD Notice to Members 03-71, Non-Conventional
Investments--NASD Reminds Members of Obligations When Selling Non-
Conventional Investments (Nov. 2003). Similarly, under the
Compliance Obligation, we suggest that compliance policies and
procedures' adequacy and effectiveness should be reviewed as
frequently as necessary in connection with changes in business
activities, affiliations, or regulatory and legislative
developments. See Section II.D.4, Compliance Obligation.
\779\ In particular, consistent with the Care Obligation and as
discussed further in Section II.C.2, Care Obligation, as part of
determining whether a broker-dealer has a reasonable basis to
believe that a recommendation is in the best interest of the retail
customer, broker-dealers generally need to evaluate reasonably
available alternatives offered by the broker-dealer. When a broker-
dealer materially limits is product offerings or offers only a
limited menu of products, it must still comply with the Care
Obligation, and could not use its limited menu to justify
recommending a product that does not satisfy this obligation. See
Section II.C.2.
\780\ See also supra footnote 775.
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We also note that the risk that limited product menus result in
recommendations that are not in the retail customer's best interest is
also addressed through the Care Obligation \781\ and required
disclosure pursuant to the Disclosure Obligation.\782\
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\781\ See id.
\782\ Material limitations are material facts that need to be
disclosed pursuant to the Disclosure Obligation. The Commission is
concerned about the potential effect that such limitations have on
the securities or investment strategies involving securities
recommended to a retail customer, and any associated conflicts of
interest, could have on the ability of a broker-dealer to make a
recommendation in the best interest of the retail customer. See
Disclosure Obligation at Section II.C.1.
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g. Elimination of Certain Conflicts of Interest
Under Section 15(l)(2) of the Exchange Act, the Commission may
examine and, where appropriate, promulgate rules prohibiting or
restricting certain sales practices, conflicts of interest, and
compensation schemes for brokers, dealers, and investment advisers that
the Commission deems contrary to the public interest and protection of
investors. As discussed below, the Commission finds that it is in the
public interest and consistent with the protection of investors to
require that broker-dealers establish, maintain, and enforce written
policies and procedures reasonably designed to identify and eliminate
any sales contests, sales quotas, bonuses, and non-cash compensation
that are based on the sales of specific securities or specific types of
securities within a limited period of time.
[[Page 33395]]
In the Proposing Release, the Conflict of Interest Obligation would
have required the establishment of policies and procedures reasonably
designed to at a minimum disclose or eliminate all material conflicts
of interest related to the recommendation (or to disclose and mitigate
or eliminate those material conflicts of interest arising from
financial incentives). We did not mandate the absolute elimination of,
or policies and procedures reasonably designed to eliminate any
particular conflicts.\783\ We were concerned that the absolute
elimination of specified particular conflicts could mean a broker-
dealer may not receive compensation for its services.\784\ Our intent,
rather, was to identify certain practices that may be more
appropriately avoided for certain categories of retail customers,
including, for example, sales contests, trips, prizes, and other
similar bonuses based on sales of certain securities or accumulation of
AUM.\785\
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\783\ See Proposing Release at 21619.
\784\ Id.
\785\ See id. FINRA rules also establish restrictions on the use
of non-cash compensation in connection with the sale and
distribution of certain types of products. See FINRA Rules 2310,
2320, 3221, and 5110.
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We also provided examples of how a broker-dealer could eliminate
conflicts of interest.\786\ We requested comment on elimination,
including suggestions of whether certain conflicts should be required
to be eliminated and how broker-dealers could eliminate conflicts of
interest. Specifically, we requested comment on whether the Commission
should explicitly prohibit receipt of certain non-cash compensation
(e.g., sales contests, trips, prizes, and other bonuses based on sales
of certain securities, accumulation of AUM or any other factor).\787\
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\786\ Proposing Release at 21621-21622.
\787\ Id.
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In response, several commenters requested greater certainty as to
whether certain conflicts of interest should be eliminated and if so,
which ones.\788\ Some commenters generally requested that certain sales
contests and financial incentives be prohibited.\789\ Of these
commenters, many expressed concern that product-based incentives could
lead to recommendations that are not in a customer's best interest,
with some commenters stating that firms could find ways to mitigate
these conflicts \790\ and others advocating that they should be
prohibited in their entirety.\791\ Other commenters requested
clarification that incentives not tied to a particular investment
product would be permitted and would not need to be eliminated.\792\ A
number of commenters requested clarification that incentives based on
asset growth would be permitted as they do not raise the same types of
conflicts present with product-based sales.\793\ A number of commenters
expressed concern that provisions requiring elimination of certain
conflicts could be in conflict with current treatment under the
Internal Revenue Code governing certain employee benefits.\794\
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\788\ See TIAA Letter (``If the SEC were to provide more
specific direction as to which conflicts are significant enough to
warrant complete elimination, broker-dealers would be better able to
effectively address material conflicts of interest in a manner
consistent with the SEC's goals and preferred approach.''); Wells
Fargo Letter (``Rather than leaving broker-dealers vulnerable to
second-guessing, the SEC should either provide more guidance on how
such conflicts may be mitigated or simply identify a set of
financial incentives that are prohibited.''); AXA Letter (``In the
absence of clear guidance from the Commission as to which financial
incentives must be eliminated, and not just mitigated and disclosed,
broker-dealers may be forced to curtail otherwise legitimate
practices and the sale of certain products and services out of an
abundance of caution--thereby depriving investors of choice of
offerings for which they might otherwise be suited. . . It would
also be helpful if the Commission could provide additional examples
of the types of conflicts (besides ``sales contests, trips, prizes .
. . based on sales of certain securities'') that likely require
elimination.''); see also Money Management Institute Letter;
Northwestern Mutual Letter; AALU Letter.
\789\ See, e.g., PIABA Letter (favoring a prohibition on
compensation structures that would incentivize a broker to:
Recommend a proprietary product or recommend one type of product
line over another; and/or which would reward the sale of certain
products within a product line''), Americans for Financial Reform
(recommending prohibiting brokers from adopting practices, such as
sales quotas and contests, that clearly incentivize their
representatives to base their recommendations on their own financial
interests rather than the customer's best interests); NASAA August
2018 Letter (``[W]e encourage the Commission to proceed further by
declaring these two practices--sales contests and preferential
treatment of allocations--per se impermissible under Regulation Best
Interest.''); Galvin Letter (identifying the following practices as
per se violations of the standard as they are contrary to the
requirement to provide advice that is in the true best interest of
customers: Sales contests; sales quotas (especially for in-house
products); and incentives to sell high-cost and high-risk products);
See also Warren Letter; Better Markets August 2018 Letter; CFA
August 2018 Letter. But see Primerica Letter (``The SEC should
recognize that sales contests, trips, prizes, awards, and similar
bonuses can be used to incentivize positive behavior and clarify
there is no per se requirement to eliminate such incentives.'').
\790\ See, e.g., SIFMA August 2018 Letter (``With respect to
product-based sales contests, we agree that instances where a firm
cannot adequately mitigate incentives that are misaligned with the
customer's best interest, the firm should eliminate such sales
contests. A firm, however, may be able to mitigate such conflicts
through several methods. . .under a principles-based regime, we ask
that the SEC allow firms to decide whether to mitigate or eliminate
such conflicts.''); Cetera August 2018 Letter (``A commonly-cited
example is sales contests or incentives that are focused on sales of
a single product. While we agree that such arrangements may be per
se inappropriate and Cetera does not permit them, this judgment is
largely subjective. We suggest that reaching consensus on what other
practices fall into this category would be well-nigh impossible. So
long as a broker-dealer can demonstrate that it has made a good
faith determination regarding identification and management of
conflicts, it should not be subject to either regulatory action or
private litigation based on those determinations.''); CFA Institute
Letter (``Our view is that recommendations aimed at winning sales
contests and meeting internal quotas are irreconcilable with the
concept of a best interest standard and should not be allowed.'').
\791\ See, e.g., PIABA Letter; CFA August 2018 Letter. See also
Fidelity Letter (``The SEC has properly pointed out that certain
conflicts of interest can be so problematic that it simply may not
be possible to mitigate them effectively. For example, we agree that
sales contests improperly favoring certain investment products over
others involve uniquely troubling conflicts and should generally be
impermissible.''); NY Life Letter (In this context, the proposal
notes that single product sales contests create conflicts that may
best be eliminated. We agree that it is inappropriate to use a
contest or other non-cash compensation to incentivize the sale of a
specific investment or variable insurance product over other
available alternatives, irrespective of a consumer's situation and
needs.'') But see AALU Letter (finding that the Commission should
not prohibit currently-compliant compensation arrangements and
business models, including non-cash compensation).
\792\ See, e.g., SIFMA August 2018 Letter; Edward Jones Letter;
NY Life Letter; Prudential Letter; LPL August 2018 Letter;
Transamerica August 2018 Letter; Northwestern Mutual Letter; Letter
from Eric R. Dinallo, Executive Vice President, General Counsel,
Guardian Life (Feb. 6, 2019) (``Guardian February 2019 Letter'');
Primerica Letter; Cambridge Letter. Some of these commenters stated
that FINRA's rules and supervisory practices appropriately cover
these incentives. See Transamerica August 2018 Letter; NY Life
Letter; Northwestern Mutual Letter; Guardian August 2018 Letter;
Primerica Letter.
\793\ Generally these commenters believed that programs tied to
assets under management, total production or revenue growth do not
give associated persons an incentive to recommend specific
securities that may be inconsistent with a customer's best interest.
See, e.g., SIFMA August 2018 Letter; Bank of America Letter; Edward
Jones Letter; Transamerica August 2018 Letter; ASA Letter; UBS
Letter; Fidelity Letter; NY Life Letter; Money Management Institute
Letter; IPA Letter.
\794\ See AALU Letter; NY Life Letter; Guardian February 2019
Letter; Northwestern Mutual Letter.
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After considering comments, we are modifying the rule text of the
Conflict of Interest Obligation to include new paragraph
(a)(2)(iii)(D), which requires the broker or dealer to establish,
maintain, and enforce written policies and procedures reasonably
designed to identify and eliminate any sales contests, sales quotas,
bonuses, and non-cash compensation that are based on the sales of
specific securities or specific types of securities within a limited
period of time. In adopting this new requirement, the Commission
believes it will provide certainty to broker-dealers regarding the
types of practices where conflicts of interest are so pervasive such
that they cannot be reasonably mitigated and must be
[[Page 33396]]
eliminated in their entirety, as we believe they create too strong of
an incentive for the associated persons to make a recommendation that
places their financial or other interest ahead of the interest of
retail customers' interests and therefore would be inconsistent with
Regulation Best Interest.\795\
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\795\ See Section I. See also AFL-CIO April 2019 Letter (``The
Commission must provide greater clarity regarding how the obligation
to eliminate or mitigate conflicts would apply to different types of
conflicts. In particular, it must make clear that conflicts cannot
be addressed through disclosure alone and that firms would be
prohibited from artificially creating harmful incentives that
undermine compliance with the best interest standard.'').
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The requirement is designed to eliminate sales contests, sales
quotas, bonuses and non-cash compensation that are based on the sales
of specific securities and specific types of securities within a
limited period of time. We believe that these practices, particularly
when coupled with a time limitation, create high-pressure situations
for associated persons to engage in sales conduct contrary to the best
interest of retail customers. For purposes of this requirement, we
interpret non-cash compensation to mean any form of compensation
received in connection with the sale and distribution of specific
securities or specific types of securities that is not cash
compensation, including but not limited to merchandise, gifts and
prizes, travel expenses, meals and lodging except we do not intend it
to cover certain employee benefits, including healthcare and retirement
benefits.\796\ We recognize that some associated persons may focus
their business on certain general categories of securities (e.g.,
mutual funds, variable annuities, bonds, or equities) and that broker-
dealers may provide compensation or other incentives related to such
sales. As discussed further herein, this requirement is not designed to
prohibit broker-dealers from providing such incentives, provided that
they do not create high-pressure situations to sell a specifically
identified type of security (e.g., stocks of a particular sector or
bonds with a specific credit rating) within a limited period of time,
such that the associated person cannot make a recommendation in the
retail customer's best interest.
---------------------------------------------------------------------------
\796\ Infra footnote 803 and accompanying text.
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We believe the conflicts created by these practices are in direct
opposition to our goal of reducing the effect of conflicts of interest
on broker-dealer recommendations to retail customers.\797\ We agree
with many commenters that broker-dealers cannot reasonably be expected
to make recommendations in a particular retail customer's best interest
consistent with the requirements of the Care Obligation, if they are
motivated to ``push'' certain securities or types of securities in
order to win a contest or reach a target in order to receive a bonus or
other non-cash compensation. We are also persuaded that it would be
difficult, if not impossible, for a firm to establish reasonably
designed policies and procedures to sufficiently mitigate the incentive
created to put the broker-dealer's interest ahead of the retail
customer's interest, as discussed above, as the point of these
practices is simply to increase the sale a particular security or type
of security, for example, in the context where a broker-dealer is
attempting to reduce its inventory of or exposure to that security.
Accordingly, we believe that these practices should be eliminated in
order to enhance investor protection \798\ and achieve the goals of
Regulation Best Interest.
---------------------------------------------------------------------------
\797\ See Section I.
\798\ See Chairman Jay Clayton, Statement on Investor
Roundtables Regarding Standards of Conduct for Investment
Professionals Rulemaking (Aug. 22, 2018), available at https://www.sec.gov/news/public-statement/statement-clayton-082218. See also
CFA Institute; CFA.
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By explicitly requiring broker-dealers to establish, maintain, and
enforce written policies and procedures reasonably designed to
eliminate certain practices, we believe we are responding to commenters
who requested certainty as to which specific incentives are
prohibited.\799\ Also in response to commenters requesting
clarification as to what practices would be permitted, the requirement
to have reasonably designed written policies and procedures to
eliminate sales contests, sales quotas, bonuses, and non-cash
compensation applies only to those that are based on the sales of
specific securities or types of securities, and does not apply to
compensation practices based on, for example, total products sold, or
asset growth or accumulation,\800\ and customer satisfaction. In
addition, this elimination requirement would not prevent firms from
offering only proprietary products, placing material limitations on the
menu of products, or incentivizing the sale of such products through
its compensation practices, so long as the incentive is not based on
the sale of specific securities or types of securities within a limited
period of time.\801\ While conflicts of interest are also associated
with sales contests, sales quotas, bonuses and non-cash compensation
that apply to, among other things, total products sold, or asset
accumulation and growth, we agree with commenters \802\ these conflicts
present less risk that the incentive would compromise compliance with
the Care Obligation and Conflict of Interest Obligation such that a
recommendation could be made that is in a retail customer's best
interest and that does not place the place the interest of the broker-
dealer or associated person ahead of the interest of the retail
customer.
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\799\ See supra footnote 788 and accompanying text.
\800\ See CCMC Letters (asserting that increasing assets under
management is a natural outgrowth of serving clients well and is
fundamentally different from sales contests based on a particular
product); UBS Letter (stating that compensation and other rewards
based on the growth of overall revenues or assets under management
should continue to be permitted as they do not incent sales of one
product over another but instead simply reward overall business
growth).
\801\ Although we are not defining what would constitute a
``limited period of time,'' as noted above, we are concerned about
time limitations that create high-pressure situations for associated
persons to increase the sales of specific securities or specific
types of securities which compromise the best interests of their
customers.
\802\ See, e.g., Ameriprise Letter (``We believe such concerns
around incentives do not exist with respect to programs that reward
asset growth or asset flows, or recruitment bonuses tied to assets
under management or revenue growth because these programs do not
give associated persons an incentive to recommend specific
securities that may not be consistent with a customer's best
interest.''); Empower Letter (``We also believe asset-gathering or
account-retention incentives should not be subject to the same level
of scrutiny as incentives aimed at increasing sales of particular
securities. The potential for a conflict of interest to result in a
bad outcome for a retail investor is much higher when a
recommendation is related to individual securities rather than the
type of account in which such securities should be held.'')
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We also recognize that certain production requirements may exist
for other reasons, specifically to maintain a contract of
employment.\803\ As discussed above, we do not intend to prohibit the
receipt of certain employee benefits by statutory employees, and do not
believe this provision would apply, as we do not consider these
benefits to be non-cash compensation for purposes of Regulation Best
Interest. In addition, we do not intend to prohibit training or
education meetings, including attendance at company-sponsored meetings
such as annual conferences,\804\ provided that these meetings are not
based on the sale of specific securities
[[Page 33397]]
or type of securities within a limited time period.
---------------------------------------------------------------------------
\803\ See Prudential Letter; NY Life Letter; Guardian February
2019 Letter; AALU Letter. Under the Internal Revenue Code, statutory
employees are eligible for certain employee benefits such as 401(k)
and health insurance. In order to qualify under this definition,
full time life insurance sales agents must devote their principal
business to the solicitation of life insurance or annuities
primarily for one company. See Department of Treasury, Internal
Revenue Service, Employer's Supplemental Tax Guide, Publication 15-A
(2018), available at https://www.irs.gov/pub/irs-pdf/p15a.pdf.
\804\ See Guardian August 2018 Letter; NY Life Letter.
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We emphasize that prohibiting certain incentives does not mean that
all other incentives are presumptively compliant with Regulation Best
Interest. As discussed above, such other incentives and practices that
are not explicitly prohibited are permitted provided that the broker-
dealer establishes reasonably designed policies and procedures to
disclose and mitigate the incentive created, and the broker-dealer and
its associated persons comply with the Care Obligation. Nevertheless,
if the firm determines that the conflicts associated with these
practice are too difficult to disclose and mitigate, the firm should
consider carefully assessing whether it is able to satisfy its best
interest obligation in light of the identified conflict and in certain
circumstances, may wish to avoid such practice entirely.
4. Compliance Obligation
As proposed, under the Conflict of Interest Obligation, a broker-
dealer entity \805\ would be required to: (1) Establish, maintain, and
enforce written policies and procedures reasonably designed to
identify, and disclose, or eliminate all material conflicts of interest
associated with recommendations covered by Regulation Best Interest;
and (2) establish, maintain and enforce written policies and procedures
reasonably designed to identify and disclose and mitigate, or
eliminate, material conflicts of interest arising from financial
incentives associated with such recommendations. As discussed above, in
response to commenters, we have made modifications to the Conflict of
Interest Obligation to more appropriately focus on the conflicts of
interest that create an incentive for broker-dealers and their
associated persons to place the interest of the broker-dealer or the
associated person ahead of the interest of the retail customer.
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\805\ See supra footnote 671.
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We solicited comment on the proposed requirement to establish,
maintain, and enforce certain policies and procedures as part of the
Conflict of Interest Obligation, including whether we should require
policies and procedures specifically to assist compliance with
Regulation Best Interest. While commenters generally viewed the
requirement to adopt policies and procedures as an effective means of
addressing conflicts of interest,\806\ some commenters suggested
broadening this requirement to a general policies and procedures
obligation that would be reasonably designed to ensure that
recommendations are made in the customer's best interest or reasonably
designed to ensure compliance with Regulation Best Interest as a
whole.\807\
---------------------------------------------------------------------------
\806\ See CFA August 2018 Letter; Fidelity Letter; Vanguard
Letter; FPC Letter.
\807\ See CFA August 2018 Letter; UBS Letter.
---------------------------------------------------------------------------
After considering the comments received, we are adopting the
Compliance Obligation, which requires, in addition to the policies and
procedures required by the Conflict of Interest Obligation, that
broker-dealer entities \808\ establish, maintain and enforce written
policies procedures reasonably designed to achieve compliance with
Regulation Best Interest. The Compliance Obligation creates an
affirmative obligation under the Exchange Act with respect to the rule
as a whole,\809\ while providing sufficient flexibility to allow
broker-dealers to establish compliance policies and procedures that
accommodate a broad range of business models.\810\ The Commission
believes that the Compliance Obligation is important to help ensure
that broker-dealers have strong systems of controls in place to prevent
violations of Regulation Best Interest, including the component
Disclosure and Care Obligations, in addition to the policies and
procedures required pursuant to the Conflict of Interest Obligation,
and to protect the interests of retail customers.\811\
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\808\ Similar to the Conflict of Interest Obligation, the
Compliance Obligation applies solely to the broker or dealer entity,
and not to the natural persons who are associated persons of a
broker or dealer. For purposes of discussing the Compliance
Obligation, the term ``broker-dealer'' refers only to the broker-
dealer entity, and not to such individuals. See footnote 671 and
accompanying text.
\809\ As noted in the Proposing Release, broker-dealers are
currently subject to supervisory obligations under Section
15(b)(4)(E) of the Exchange Act and SRO rules, including the
establishment of policies and procedures reasonably designed to
prevent and detect violations of, and to achieve compliance with,
the federal securities laws and regulations, as well as applicable
SRO rules. See Proposing Release at 21622. Specifically, the
Exchange Act authorizes the Commission to sanction a broker-dealer
or any associated person that fails to reasonably supervise another
person subject to the firm's or the person's supervision that
commits a violation of the federal securities laws. Exchange Act
Sections 15(b)(4)(E) and (b)(6)(A). The Exchange Act provides an
affirmative defense against a charge of failure to supervise where
reasonable procedures and systems for applying the procedures have
been established and effectively implemented without reason to
believe those procedures and systems are not being complied with.
Id. While the Compliance Obligation creates an explicit requirement,
we believe that broker-dealers would likely establish policies and
procedures to comply with Regulation Best Interest pursuant to
Section 15(b)(4)(E). In order to comply, broker-dealers could adjust
their current systems of supervision and compliance, as opposed to
creating new systems.
\810\ This approach is similar to the one taken under rule
206(4)-7 under the Advisers Act which requires policies and
procedures reasonably designed to prevent violations of the Advisers
Act, which should be tailored to address compliance considerations
relevant to the operations of each adviser. See Compliance Programs
of Investment Companies and Investment Advisers, Advisers Act
Release No. 2204 (Dec. 17, 2003) (``Advisers Act Release 2204'').
See also Questions Advisers Should Ask While Establishing or
Reviewing Their Compliance Programs (May 2006), available at https://www.sec.gov/info/cco/adviser_compliance_questions.htm (``No one
standard set of policies and procedures will address the
requirements established by the Compliance Rule for all advisers
because each adviser is different, has different business
relationships and affiliations, and therefore, has different
conflicts of interest.'').
\811\ Similar to the discussion included under Section II.C.3.a,
we believe that policies and procedures to comply with Regulation
Best Interest would allow the Commission to identify and address
potential compliance deficiencies or failures (such as inadequate or
inaccurate policies and procedures, or failure to follow the
policies and procedures) early on, reducing the chance of retail
customer harm.
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As with the policies and procedures requirement included in the
Conflict of Interest Obligation, whether policies and procedures are
reasonably designed to comply with Regulation Best Interest will depend
on the facts and circumstances of a given situation.\812\ As such, the
Compliance Obligation does not enumerate specific requirements that
broker-dealers must include in their policies and procedures as broker-
dealers are too varied in their operations for rules to impose a single
set of universally applicable specific required elements. Each broker-
dealer when adopting policies and procedures should consider the nature
of that firm's operations and how to design such policies and
procedures to prevent violations from occurring, detect violations that
have occurred, and to correct promptly any violations that have
occurred.\813\
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\812\ See Section II.C.3.
\813\ See Advisers Act Release 2204.
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A firm's compliance policies and procedures should be reasonably
designed to address and be proportionate to the scope, size, and risks
associated with the operations of the firm and the types of business in
which the firm engages.\814\ As such, the Commission is not mandating
specific requirements pursuant to the Compliance Obligation. In
addition to the required policies and procedures, depending on the size
and complexity of the firm, we believe a reasonably designed compliance
program generally
[[Page 33398]]
would also include: \815\ Controls; remediation of non-compliance;
\816\ training; \817\ and periodic review and testing.\818\
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\814\ See Section II.C.3.a.
\815\ Cf. FINRA Conflicts Report at 6 (identifying supporting
structures, policies, processes, controls and training as critical
to protect customers and the firm).
\816\ Id. at 10 (``Most firms' policies describe an escalation
process for handling those conflicts of interest that cannot be
handled through other firm policies. . . .'').
\817\ ``For firms, training is an important vehicle to
communicate firm culture, specific requirements of a firm's code of
conduct and its conflicts management framework.'' Id. at 15.
\818\ Cf. Questions Advisers Should Ask While Establishing or
Reviewing Their Compliance Programs (May 2006), available at https://www.sec.gov/info/cco/adviser_compliance_questions.htm; FINRA
Conflicts Report.
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D. Record-Making and Recordkeeping
In connection with proposed Regulation Best Interest, we proposed
new record-making and recordkeeping requirements for broker-dealers
with respect to certain information collected from or provided to
retail customers. Specifically, we proposed amendments to Exchange Act
Rules 17a-3 and 17a-4, which specify minimum requirements with respect
to the records that broker-dealers must make, and how long those
records and other documents must be kept, respectively. We received
several comments on the proposed new requirements and are adopting them
substantially as proposed with additional clarifications and guidance
to address commenters' concerns.
We proposed amending Rule 17a-3 \819\ to add a new paragraph
(a)(25), which would require, for each retail customer to whom a
recommendation of any securities transaction or investment strategy
involving securities is or will be provided, a record of all
information collected from and provided to the retail customer pursuant
to Regulation Best Interest, as well as the identity of each natural
person who is an associated person of a broker or dealer, if any,
responsible for the account. The new paragraph would specify that the
neglect, refusal, or inability of a retail customer to provide or
update any such information would excuse the broker-dealer from
obtaining that information.
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\819\ See Exchange Act Rule 17a-3.
---------------------------------------------------------------------------
We are adopting the provision substantially as proposed but
redesignating it as new paragraph (a)(35) of Rule 17a-3.\820\ We are
also amending the text of paragraph (ii) of the amendment as adopted to
refer to ``any information described in paragraph (a)(35)(i) of this
section'' rather than the proposed ``any information required under
paragraph (a)(25)(i) of this section.'' This is a non-substantive
change reflecting the fact that paragraph (i) of the new provision
requires a record of the information collected from a retail customer
by the broker-dealer pursuant to Regulation Best Interest; it does not
require the information itself directly as implied by the original
wording of paragraph (i) of the proposed amendment. It is therefore
more accurate to refer in paragraph (ii) to the information ``described
in,'' rather than ``required under,'' paragraph (i), as well as to
update the reference in paragraph (ii) to ``paragraph (a)(35)(i) of
this section.''
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\820\ The Commission is also reserving paragraphs (a)(24)
through (a)(34) of Rule 17a-3 for use in connection with future
rulemakings.
---------------------------------------------------------------------------
Several commenters expressed concern that the proposed rule
amendment would significantly expand recordkeeping requirements.\821\
One commenter expressed concern that the record retention requirements
of the proposed new paragraph to Rule 17a-3 would apply to each
recommendation made by the broker-dealer rather than to each account
(as required by existing paragraph (a)(17) of Rule 17a-3, which
operates on a per-account basis). Another commenter requested
clarification that ``the current books and records requirement is
sufficient to meet record-keeping requirements to satisfy Reg BI,''
adding that the Commission should ``affirm that Reg BI does not create
new record-keeping requirements to prove that an advisor acted in a
client's best interest.'' \822\
---------------------------------------------------------------------------
\821\ See SIFMA August 2018 Letter; Edward Jones Letter;
Primerica Letter.
\822\ See Raymond James Letter.
---------------------------------------------------------------------------
The Commission notes that the proposed new requirements of Rule
17a-3 are not designed to create additional, standalone burdens for
broker-dealers but instead to provide a means by which they can
demonstrate, and Commission examiners can confirm, their compliance
with the new substantive requirements of Regulation Best Interest. In
response to commenter concerns that the proposed requirements would
significantly expand their recordkeeping obligations, we reiterate
that, as stated in the Proposing Release, broker-dealers should already
be attempting to collect much of the information that would be required
under Regulation Best Interest pursuant to the FINRA suitability rule
and existing Exchange Act books and records rules. For example, we note
that under existing Rule 17a-3(a)(17), broker-dealers that make
recommendations for accounts with a natural person as customer or owner
are already required to create and periodically update customer account
information, although as part of developing a ``retail customer's
investment profile,'' Regulation Best Interest may require broker-
dealers to seek to obtain certain retail customer information that is
currently not required by Rule 17a-3(a)(17).\823\ In addition,
Regulation Best Interest would require broker-dealers to disclose in
writing the material facts relating to the scope and terms of their
relationship with the retail customer and the material facts relating
to conflicts of interest that are associated with the investment
recommendations provided to the retail customer. As such, it would not
be accurate to state, as suggested by the commenter, that the
Commission's current books and records requirements for broker-dealers
are sufficient to meet recordkeeping requirements to satisfy Regulation
Best Interest. The additional books and records requirements the
Commission is adopting today are designed to allow firms to demonstrate
compliance with the substantive requirements of Regulation Best
Interest.
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\823\ See Exchange Act Rule 17a-3(a)(17). As explained in the
Proposing Release, Rule 17a-3(a)(17) applies to each account with a
natural person as a customer or owner, while proposed Regulation
Best Interest would apply to each recommendation of any securities
transaction or investment strategy involving securities to a retail
customer. Because of this difference, the Commission believes it
would be appropriate to locate the record-making requirements
related to Regulation Best Interest in a new paragraph of Rule 17a-3
rather than in an amendment to paragraph (a)(17).
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We further note that the new record-making requirements would not
require the duplication of existing records. Rather, if a broker-dealer
relied upon previously existing records to demonstrate its compliance
with Regulation Best Interest for a given recommendation, it would not
be required to create and preserve duplicate copies but instead could
create a new record noting which pre-existing documents were provided
to the customer, or what customer information already being preserved
by the broker-dealer was relied upon, to meet the obligations of
Regulation Best Interest. However, reliance upon previously existing
records would only be permissible so long as such records are
preserved--a record noting that a document was relied upon would no
longer meet the recordkeeping obligations of Regulation Best Interest
if such document was no longer preserved by the broker-dealer.
Commenters also requested that the Commission limit new
recordkeeping requirements to customer profile information itself, not
the ``related and
[[Page 33399]]
underlying communications.'' \824\ In response to these concerns, the
Commission clarifies that new paragraph (a)(35) of Rule 17a-3 as
adopted requires a record of all information collected from and
provided to the retail customer pursuant to Regulation Best Interest.
Regulation Best Interest does not reference, and the Commission does
not intend that it require, ``related and underlying communications''--
rather, it applies only to the information that is actually provided to
or obtained from the customer pursuant to Regulation Best Interest.
Once again, the purpose of the new record-making provision is to allow
broker-dealers to demonstrate their compliance with the substantive
requirements of Regulation Best Interest. Complying with those
substantive requirements will require broker-dealers to obtain from and
provide to customers certain information, and new paragraph (a)(35) of
Rule 17a-3 requires a record of such information. In response to
comments received requesting clarification as to whether information
provided to or obtained from a customer orally would be covered by the
new record-making requirements,\825\ the Commission clarifies that the
requirements of new paragraph (a)(35) of Rule 17a-3 apply to all
information collected from or provided to a retail customer pursuant to
Regulation Best Interest, whether provided orally or in writing
(electronically or otherwise).\826\
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\824\ See SIFMA August 2018 Letter; Morgan Stanley Letter.
\825\ See SIFMA August 2018 Letter; Primerica Letter.
\826\ In the case of information provided orally under the
circumstances outlined in Section II.C.1, Disclosure Obligation,
Oral Disclosure or Disclosure After a Recommendation, the broker-
dealer must maintain a record of the fact that oral disclosure was
provided to the retail customer.
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Several commenters requested clarification that, except with
respect to the specific recordkeeping requirements in the rule text,
Regulation Best Interest does not require additional records (e.g.,
records to evidence best interest determinations on a recommendation-
by-recommendation basis).\827\ One commenter also stated that, as
drafted, there are significant obstacles and costs, including increased
privacy and cybersecurity risks, that would result from implementing
the proposed new rule, in particular with respect to the ``all
information collected from . . . . the retail customer''
requirement.\828\
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\827\ See SIFMA August 2018 Letter; Edward Jones Letter; Morgan
Stanley Letter; CCMC Letters.
\828\ See Primerica Letter.
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In response, the Commission clarifies that while the substantive
requirements of Regulation Best Interest apply on a recommendation-by-
recommendation basis, consistent with our approach elsewhere, we are
not requiring that broker-dealers create and maintain records to
evidence best interest determinations on a recommendation-by-
recommendation basis. Nor have we determined to require broker-dealers
to provide information to retail customers relating to the basis for
each particular recommendation (i.e., disclose such information), and
thus did not envision this information to come within the scope of Rule
17(a)(35).
Rather, in order to demonstrate compliance with Regulation Best
Interest, a broker-dealer must be able to demonstrate that it had a
reasonable basis to believe that each particular recommendation made to
a retail customer was in the best interest of the customer at the time
of the recommendation based on the customer's investment profile and
the potential risks, rewards, and costs associated with the
recommendation. As noted above, the Commission does not intend this to
require, in practice, the creation of extensive new and potentially
duplicative records for each and every recommendation to a retail
customer. Instead, broker-dealers should be able to explain in broad
terms the process by which the firm determines what recommendations are
in its customers' best interests, and similarly to explain how that
process was applied to any particular recommendation to a retail
customer. However, we are not mandating that broker-dealers create and
maintain a record of each such determination. Nonetheless, as noted
above we are providing guidance suggesting that firms may wish to
adequately document an evaluation of a recommendation and the basis for
that recommendation in particular contexts, such as the recommendation
of a complex product, or where a recommendation may seem inconsistent
with a retail customer's investment objectives on its face.\829\
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\829\ See supra footnote 610 and accompanying text.
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In addition, in response to requests from commenters for
confirmation that the proposed record-making requirements do not
contemplate broker-dealers needing to create and maintain records of
why certain products were recommended over others on a recommendation-
by-recommendation basis,\830\ we confirm that broker-dealers are not
expected to maintain records comparing potential investments to one
another so long as they are able to demonstrate that each individual
recommendation actually made to a customer meets the requirements of
Regulation Best Interest on its own. Regulation Best Interest applies
to recommendations made to a retail customer, rather than to potential
recommendations considered by the broker-dealer but not actually made
to the customer.
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\830\ See SIFMA August 2018 Letter; CCMC Letters.
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In response to the commenter's privacy and cybersecurity concerns
with respect to the proposed requirement to make a record of all
information collected from the customer pursuant to Regulation Best
Interest, as noted in the Proposing Release \831\ and Section II.C
above, although a broker-dealer's customer obligations under Regulation
Best Interest (e.g., the Care Obligation) go beyond those set forth in
the FINRA's suitability rule, the concept of the ``customer's
investment profile'' that a broker-dealer would be required to
compile--that is, the customer information it would be required to
obtain--pursuant to Regulation Best Interest is consistent with that
under FINRA's suitability rule. As such, we believe that since broker-
dealers are already required to seek to obtain identical types of
retail customer information pursuant to the FINRA suitability rule,
broker-dealers should already have in place policies and procedures,
including training programs, to address such privacy and cybersecurity
concerns.
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\831\ Proposing Release at 21611 (noting that Retail Customer
Investment Profile is consistent with FINRA Rule 2111(a)
(Suitability)).
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We also proposed an amendment to paragraph (e)(5) of Rule 17a-4,
which currently requires broker-dealers to maintain and preserve in an
easily accessible place all account information required by paragraph
(a)(17) of Rule 17a-3 for at least six years after the earlier of the
date the account was closed or the date on which the information was
replaced or updated.\832\ The proposed amendment would require broker-
dealers to retain any information that the retail customer provides to
the broker-dealer or the broker-dealer provides to the retail customer
pursuant to the proposed amendment to Rule 17a-3 being adopted today as
Rule 17a-3(a)(35), in addition to the existing requirement to retain
information obtained pursuant to Rule 17a-3(a)(17). As a result,
broker-dealers would be required to retain all records of the
information collected from or provided to each retail customer pursuant
to Regulation Best Interest for at least six years after the earlier of
the date the account was closed or the date
[[Page 33400]]
on which the information was replaced or updated. The Commission is
adopting this amendment to Rule 17a-4(e)(5) substantially as proposed,
with the proposed reference to paragraph (a)(25) of Rule 17a-3 replaced
with a reference to paragraph (a)(35) to reflect the redesignation of
the latter new rule provision as discussed above.
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\832\ See Exchange Act Rule 17a-4(e)(5).
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The Commission received several comments regarding the proposed
amendment to Rule 17a-4 requesting clarification as to what
communications would be required to be retained pursuant to the
proposed rule amendment beyond those already required to be retained by
existing paragraph (b)(4) of Rule 17a-4.\833\ Rule 17a-4(b)(4) requires
broker-dealers to retain originals of all communications received and
copies of all communications sent by the broker-dealer relating to its
business as such for a period of not less than three years, the first
two in an easily accessible place.
---------------------------------------------------------------------------
\833\ See Exchange Act Rule 17a-4(b)(4); SIFMA August 2018
Letter; Edward Jones Letter; Prudential Letter.
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In response, the Commission notes that while the records that a
broker-dealer would be required to make in connection with Regulation
Best Interest under new paragraph (a)(35) of Rule 17a-3 may be
``business as such'' records, the Commission believes it is important,
including for examination purposes, that broker-dealers separately
retain records that specifically demonstrate compliance with Regulation
Best Interest and new paragraph (a)(35) of Rule 17a-3 rather than
simply including them in the much broader ``business as such'' category
required to be retained under Rule 17a-4(b)(4). Rule 17a-3(e)(5)
currently serves the purpose of allowing broker-dealers to demonstrate
compliance with the customer information records required to be made
pursuant to Rule 17a-3(a)(17), and the amendment to Rule 17a-3(e)(5)
being adopted today will serve the same purpose with respect to records
required to be retained by broker-dealers to demonstrate compliance
with Regulation Best Interest and new paragraph (a)(35) of Rule 17a-3.
Finally, as noted in the Proposing Release, the written policies
and procedures that broker-dealers will be required to create pursuant
to Regulation Best Interest are already currently required to be
retained pursuant to Exchange Act Rule 17a-4(e)(7),\834\ which requires
broker-dealers to retain compliance, supervisory, and procedures
manuals (and any updates, modifications, and revisions thereto)
describing the policies and practices of the broker-dealer with respect
to compliance with applicable laws and rules, and supervision of the
activities of each natural person associated with the broker-dealer,
for a specified period of time. As such, we did not propose, and are
not adopting, any additional recordkeeping requirements with respect to
the written policies and procedures that broker-dealers will be
required to create pursuant to Regulation Best Interest.
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\834\ See Exchange Act Rule 17a-4(e)(7).
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E. Compliance Date
We are providing a compliance date of June 30, 2020, consistent
with the transition provisions described in the Relationship Summary
Adopting Release.\835\ In light of the importance of the protections
provided by Regulation Best Interest, we believe that this compliance
date will provide adequate notice and opportunity for broker-dealers to
comply with Regulation Best Interest, including by creating or updating
the necessary disclosures and to developing, updating or establishing
their policies and procedures and systems, as appropriate, to achieve
compliance with Regulation Best Interest. On and after the Compliance
Date, broker-dealers that provide recommendations of securities
transactions or investment strategies that register with the Commission
would be required to comply with Regulation Best Interest as of the
date of registration.
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\835\ See Relationship Summary Adopting Release.
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While most commenters requested an implementation period of 18-24
months,\836\ one commenter requested an implementation period of 12-18
months.\837\ We believe the operational capability needed to develop
processes to comply with Regulation Best Interest is sufficiently
established by firms of all sizes and resources. While we understand
commenters' requests for periods longer than 12 months after
effectiveness, the Commission has determined, in light of the
importance of the protections afforded by Regulation Best Interest to
retail customers, that a Compliance Date of one year after
effectiveness is an appropriate timeframe for firms to conduct the
requisite operational changes to their systems to establish internal
processes to comply with Regulation Best Interest.\838\
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\836\ See Cetera August 2018 Letter; SIFMA August 2018 Letter;
HD Vest Letter (recommending that the Commission adopt a 24-month
implementation period); Northwestern Mutual Letter; IRI Letter
(recommending that the Commission adopt an 18-to-24-month
implementation period); CCMC Letters; AXA Letter (recommending that
the Commission adopt at least an 18-month implementation period);
ACLI Letter; TIAA Letter (recommending that the Commission adopt an
18-month implementation period).
\837\ See Raymond James Letter (recommending that the Commission
adopt a 12-18-month implementation period).
\838\ See footnote 809 and accompanying text.
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The Commission also believes that it is important to coordinate the
transition dates of the Relationship Summary requirements with those of
Regulation Best Interest to ensure that all retail investors receive
the full suite of protections and benefits afforded by the amended and
new rules. Finally, the Commission staff intends to offer firms
significant assistance and support during the transition period and
thereafter with the aim of helping to ensure that the investor
protections and other benefits of the final rule are implemented in an
efficient and effective manner.
III. Economic Analysis
A. Introduction and Primary Goals of the Regulation, Comments on Market
Failure and Quantification, and Broad Economic Considerations
1. Introduction and Primary Goals of the Regulation
Regulation Best Interest enhances the broker-dealer standard of
conduct beyond existing suitability obligations and aligns the standard
of conduct with retail customers' reasonable expectations.
Under Regulation Best Interest, broker-dealers and their associated
persons will be required to act in the best interest of the retail
customer at the time the recommendation is made, without placing the
financial or other interest of the broker-dealer or an associated
person making the recommendation ahead of the interests of the retail
customer. They also will be required 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 instances where the
Commission has determined that disclosure is insufficient to reasonably
address the conflict, to mitigate or, in certain instances, eliminate
the conflict. As a result, Regulation Best Interest should enhance the
efficiency \839\ of recommendations that broker-dealers provide to
retail customers, allow retail customers to better evaluate the
recommendations received, improve retail customer protection when
[[Page 33401]]
receiving recommendations from broker-dealers, and, ultimately, reduce
agency costs \840\ and other costs. Importantly, Regulation Best
Interest is designed to preserve, to the extent possible, (1) access
and choice for investors who may prefer the transaction-based model
that broker-dealers generally provide, or the fee-based model that
investment advisers generally provide, or a combination of both types
of arrangements, and (2) retail customer choice of the level and types
of services provided and the securities available. For example, retail
customers who intend to buy and hold a long-term investment on a non-
discretionary basis may find that paying a one-time commission to a
broker-dealer who recommends such an investment is more cost effective
than paying an ongoing advisory fee to an investment adviser merely to
hold the same investment.\841\ Retail customers who would prefer
advisory accounts but have not yet accumulated sufficient assets to
qualify for investment advisory accounts, which may require customers
to have a minimum amount of assets, may similarly benefit from
recommendations from broker-dealers. Other retail customers who hold a
variety of investments, or prefer different levels of services from
financial professionals, may benefit from having access to both
brokerage and advisory accounts.
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\839\ See infra footnote 846 and accompanying text.
\840\ See infra footnote 855 and accompanying text.
\841\ See infra footnote 1353 and accompanying text.
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The Commission is mindful of the costs imposed by, and the benefits
obtained from our rules. Whenever the Commission engages in rulemaking
under the Exchange Act and is required to consider or determine whether
an action is necessary or appropriate in the public interest. Section
3(f) of the Exchange Act also requires the Commission to consider, in
addition to the protection of investors, whether the action would
promote efficiency, competition, and capital formation.\842\ Also, when
making rules pursuant to the Exchange Act, S the Commission is required
under Section 23(a)(2) to consider, among other matters, the impact any
rule would have on competition and is prohibited from adopting any rule
that would impose a burden on competition not necessary or appropriate
in furtherance of the purposes of the Exchange Act.\843\ The following
analysis considers, in detail, the economic effects that the Commission
believes are likely to or may result from Regulation Best Interest. The
analysis includes consideration of the benefits and costs to retail
investors and broker-dealers, and also takes into account the broader
implications of Regulation Best Interest for efficiency, competition,
and capital formation.
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\842\ See 15 U.S.C. 77b(b) and 15 U.S.C. 78c(f).
\843\ See 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
Where possible, the Commission has sought to quantify the likely
economic effects of Regulation Best Interest. The Commission is
providing both a qualitative assessment and quantified estimates of the
potential effects of Regulation Best Interest, where feasible. The
Commission has incorporated data and other information provided by
commenters to assist it in the analysis of the economic effects of
Regulation Best Interest.\844\ However, as explained below in more
detail, because the Commission does not have, has not received, and, in
certain cases, does not believe it can reasonably obtain data that may
inform on certain economic effects, the Commission is unable to
quantify certain economic effects. The Commission further notes that
even in cases where it has some data or it has received some data
regarding certain economic effects, the quantification of these effects
is particularly challenging due to the number of assumptions that it
would need to make to forecast how broker-dealers will respond to
Regulation Best Interest, and how those responses will, in turn, affect
the broader market for investment advice and the retail customers'
participation in financial markets.
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\844\ See infra Section III.A.3.
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2. Broad Economic Considerations
Investors generally derive utility from consuming goods and
services over their lifetime and from bequeathing wealth to
others.\845\ The amount of goods and services that an investor can
consume or the amount of wealth the investor can bequeath is limited by
the value of the resources available to the investor over his or her
lifetime. These resources generally vary across market and economic
conditions and over time. An investor generally seeks to allocate his
or her resources across market and economic conditions and over time to
achieve the highest expected utility possible over his or her lifetime.
For example, an investor may decide to save, and therefore allocate, a
proportion of his or her wages to maximize his or her expected utility
from bequeathing wealth toward his or her children's future education.
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\845\ See, e.g., Irving Fisher, Theory of Interest, as
Determined by Impatience to Spend Income and Opportunity to Invest
it (1930).
---------------------------------------------------------------------------
Capital markets facilitate this allocation and reallocation of
resources. An investor can allocate available resources across
financial assets available to them in the capital markets, such that
these resources become available to the investor at the times, and in
the market and economic conditions, when he or she needs them. There
may be many combinations of financial assets or investment strategies
that achieve an investor's allocation goals, but each of these
strategies may not necessarily provide the investor with the same
benefits or cause the investor to bear the same costs. The expected
benefit of allocating resources to an investment strategy depends on
the expected utility to the investor from the expected payoff of the
strategy and from whether this strategy pays off in the market and
economic conditions and at the times that the investor cares about.
Importantly, the various costs of allocating resources to any strategy
reduce the resources available for consumption and saving.
A rational investor seeks out investment strategies that are
efficient in the sense that they provide the investor with the highest
possible expected net benefit, in light of the investor's investment
objective that maximizes expected utility.\846\ From the discussion
above, an efficient investment strategy may depend on the investor's
utility from consumption, including: (1) His or her risk tolerance; (2)
time available for the funds to be invested, and not consumed; (3) the
resources that the investor has currently available (e.g., current
wealth) or anticipates to become available at some point in the future
(e.g., future income); and (4) the cost to the investor of implementing
the strategy. An investor's efficient investment strategy may change
over time because the investor's preferences, as well as market
conditions and investment performance, may change over time.
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\846\ See, e.g., Andreu Mas-Colell, Michael D. Whinston, & Jerry
R. Green, Microeconomic Theory (1995), specifically Chapter 10:
Competitive Markets for a discussion of efficient allocations of
resources.
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In general, a typical investor may not have the knowledge or the
time to identify efficient strategies on his or her own. In addition,
investors may be limited in their access to information and their human
computational capacity when evaluating choices.\847\ As
[[Page 33402]]
an alternative to attempting to identify efficient strategies on his or
her own, an investor may solicit advice from financial professionals.
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\847\ See, e.g., Herbert A. Simon, A Behavioral Model of
Rational Choice, 69 Q. J. Econ. 99 (1955) for one of the first works
on bounded rationality. See also Richard H. Thaler, Behavioral
Economics: Past, Present, and Future, 106 Am. Econ. Rev. 1577 (2016)
for a discussion of the evolution of bounded rationality in
economics.
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While there are many types of financial professionals \848\ that
can provide advice related to a retail customer's finances, we focus
here (and in Regulation Best Interest) on a type of professional that
retail customers commonly access, namely broker-dealers and their
associated persons.
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\848\ The list of financial professionals that can provide
advice related to a retail customer's finances includes broker-
dealers and their associated persons, investment advisers, banks,
and insurance agents.
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A broker is any person engaged in the business of effecting
transactions in securities for the account of others.\849\ A dealer is
any person engaged in the business of buying and selling securities for
its own account, through a broker or otherwise.\850\ Within the scope
of these definitions, a ``broker-dealer'' (or, a firm that fits both
definitions) may offer a wide variety of services to retail customers.
These services include buying and selling securities for the retail
customer as well as providing limited personalized investment advice in
the form of recommendations of whether or not to engage in securities
transactions or investment strategies involving securities.\851\
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\849\ See Section 3(a)(4)(A) of the Securities Exchange Act.
\850\ See Section 3(a)(5)(A) of the Securities Exchange Act.
\851\ We focus our discussion on recommendations that are the
focus of Regulation Best Interest but note that broker-dealers and
their representatives provide a wide variety of ``agency services''
as described in footnote 1 of the Proposing Release. See, e.g., 913
Study. See also infra Section III.B.1.a.
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Federal securities laws and SRO rules govern broker-dealers'
conduct of business. Among other things, they require that a broker-
dealer or associated person ``have a reasonable basis to believe that a
recommended transaction or investment strategy involving a security or
securities is suitable for the customer, based on the information
obtained through the reasonable diligence of the [firm] or associated
person to ascertain the customer's investment profile.'' \852\ While a
suitable recommendation must take into account the elements of a retail
customer's investment profile that make securities transactions or an
investment strategy efficient for that particular retail customer, this
requirement for suitability may not lead to an efficient result for the
retail customer.
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\852\ See FINRA Rule 2111 (Suitability); see also infra Section
III.B.2.b.
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The efficiency of a recommendation to a retail customer may depend
on: (1) The menu of securities transactions and investment strategies
the broker-dealer or its associated persons considers and makes
available to the retail customer; (2) the return distribution and the
costs of these securities transactions and strategies; (3) the
associated person's understanding of these investment options and the
retail customer's objectives, such as the retail customer's risk
tolerance and time preference; and (4) the retail customer's resource
constraints.
A recommendation provided by an associated person of the broker-
dealer may be influenced by the conflicts of interest that the
associated person may have or the conflicts of interest that the
broker-dealer may have at the time of the recommendation. These
conflicts can arise as a result of how broker-dealers generate revenue
from various securities or investment strategies that they make
available to retail customers and how broker-dealers compensate their
associated persons for providing recommendations to retail customers.
In the United States, broker-dealers may earn transaction-based
compensation that is commonly paid either directly by the retail
customer (e.g., commissions and markups or markdowns) or indirectly
through the investment sponsor (e.g., 12b-1 fees or revenue sharing).
Broker-dealers may compensate their associated persons that provide
recommendations to retail customers with a portion of the commissions
and markups or markdowns these persons generate through their
recommendations. Such financial incentives can vary depending on the
investment product line, account type, or other factors (e.g., amount
of customer assets brought into the broker-dealer or revenue generated
from customer accounts).
A retail customer generally chooses to accept or reject a
recommendation supplied by the associated person of the broker-
dealer.\853\ Some retail customers may base their decisions on an
assessment of whether the recommendations they receive would result in
securities transactions or investment strategies that are efficient for
them. These customers' assessment may depend on factors such as their
perception of the associated person's ability to properly understand
and account for the customer's objectives, any information they have
about the associated person's or firm's conflicts of interest with
respect to that recommendation, and the extent to which these conflicts
are expected to result in less than efficient recommendations for the
retail customer. However, other retail customers may rely in full or in
part on factors less directly related to the recommendation at hand.
Instead, they might rely on factors such as their level of trust with
the associated person or firm, and in certain circumstances might be
inclined to simply accept all of the associated person's
recommendations without evaluating for themselves whether the
recommendations are efficient.\854\
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\853\ Note, however, that a retail customer may receive
automated advice without involvement of an associated person of the
broker-dealer. For example, a broker-dealer may generate
recommendations through an asset allocation model. FINRA Regulatory
Notice 12-25; See also FINRA Report on Digital Investment Advice
(Mar. 2016).
\854\ See, e.g., the discussion on investor trust in the markets
for financial advice in Section III.B.4.a, infra. See also Gross
Letter. See also Roman Inderst & Marco Ottaviani, How (not) to pay
for advice: A framework for consumer financial protection, 105 the
J. Fin. Econ 393 (2012) for a discussion of the economic surplus
extracted by broker-dealers that provide recommendations to retail
customers, and how this surplus relates to the factors that
determine a retail customer's decision to accept or reject a
recommendation.
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As noted above, broker-dealers or their associated persons may have
conflicts of interest that could influence their recommendations to
retail customers at the time when they are provided.
A retail customer's choice to accept a particular recommendation
often directly affects the compensation that an associated person or
broker-dealer itself receives. For example, an associated person may
receive greater compensation from selling certain securities or
strategies relative to other securities or strategies. Differences in
compensation across the securities or strategies offered by a broker-
dealer may add complexity to an associated person's incentives and may
create conflict between the interests of the associated person, who
desires to maximize his or her compensation, and the interests of the
retail customer, who expects the recommended transaction to be
efficient for him or her.
In general, this conflict of interest may result in a broker-dealer
recommending securities or investment strategies that are less
efficient for the retail customer. For instance, the recommended
securities or strategies may be enhancing the associated person's
compensation at the expense of the retail customer. Put another way,
because of the financial incentives, broker-dealers and their
associated
[[Page 33403]]
persons may be motivated to recommend certain types or quantities of
securities or strategies, and those recommendations may place the
interests of the broker-dealer or its associated persons ahead of the
interests of the retail customer, which may not result in the retail
customer maximizing his or her expected net benefit. An inefficient
recommendation may lead to various results for the retail customer,
including inferior investment outcomes, such as risk-adjusted expected
returns that are lower relative to other similar investments or
investment strategies.
A retail customer may accept a recommendation that is less
efficient if he or she is unable to assess correctly the efficiency of
the recommendation.
The difference between the net benefit to the retail customer from
accepting a less than efficient recommendation about a securities
transaction or investment strategy, where the associated person or
broker-dealer puts its interests ahead of the interests of the retail
customer, and the net benefit the retail customer might expect from a
similar securities transaction or investment strategy that is efficient
for him or her, as defined above, is an agency cost.\855\ As discussed
in the Proposing Release and above, this agency cost arises because of
the conflicts of interest of the broker-dealer and its associated
persons, and the differences between the information sets available to
the broker-dealer and the retail customer at the time of the
recommendation.
---------------------------------------------------------------------------
\855\ See, e.g., Michael C. Jensen, and William. H. Meckling,
Theory of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure, 3 J. Fin. Econ. 305 (1976) for a more general discussion
of agency costs.
---------------------------------------------------------------------------
In certain principal-agent relationships, the principal may be able
to reduce the agency costs that he or she is facing in various ways,
including by structuring the agent's compensation in a way that better
aligns the interest of the agent with that of the principal.\856\ A
feature of the agency relationship between a retail customer (the
principal) and a broker-dealer (the agent) that is common in many
principal-agent relationships (including the investment adviser-client
relationship) is that the retail customer generally does not have full
transparency about the agent's compensation for providing advice and
the sources of the agent's compensation. Thus, the retail customer,
through the decision to accept or reject a recommendation received, has
generally limited understanding of and control over the compensation
that the broker-dealer and its associated person obtains from providing
the recommendation. These limitations restrict the retail customer's
ability to reduce the agency costs that he or she is facing.
---------------------------------------------------------------------------
\856\ See, e.g., Stephen A. Ross, The Economic Theory of Agency:
The Principal's Problem, 63 Am. Econ. Rev. ( Papers & Proc.) 134
(1973).
---------------------------------------------------------------------------
We also recognize that even if the retail customer were to have
full transparency about the broker-dealer's and its associated person's
compensation from providing advice, the retail customer's ability to
reduce the agency costs may be constrained in other ways. For example,
if the menu of securities from which the associated person of the
broker-dealer offers recommendations is limited, the retail customer's
and the associated person's ability to identify and select a more
efficient investment may be constrained.
Different retail customers may face different agency costs
depending on whether they base their decision to act on a
recommendation on an assessment of the efficiency of the
recommendation. Specifically, as noted above, a retail customer that
evaluates and uses a recommendation received based on an assessment
about the efficiency of that recommendation may be more successful in
identifying and controlling, albeit in a limited fashion, the
compensation that the broker-dealer and its associated person receive
from the recommendation--such as by being more likely to reject a less
than efficient recommendation--compared to a retail customer that makes
this decision without forming an assessment of the efficiency of the
recommendation. Thus, the agency costs may be higher for those retail
customers that make their decision of whether to act on a
recommendation received without an assessment of the efficiency of the
recommendation.
While the discussion above focuses on the actions that the
principal (i.e., the retail customer) can take to reduce the agency
costs that he or she is facing, the agent can also take actions to
reduce the agency costs to the principal. For example, in the agency
paradigm, when the principal may forgo sharing a potentially large
surplus with the agent because of the high agency costs, the agent may
have an incentive to structure the terms of the relationship in a way
that reduces the agency costs to the principal.\857\ In the agency
relationship between a retail customer and a broker-dealer, given the
features of the compensation that the broker-dealer and its associated
persons receive for providing recommendations (e.g., this compensation
does not depend on the value of the assets in a principal's account),
the broker-dealer and its associated persons may not have sufficient
incentive to take actions voluntarily that would reduce agency costs to
the retail customer, such as voluntarily increasing transparency with
respect to compensation.\858\
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\857\ See, e.g., Sanford J. Grossman & Oliver D. Hart, The Costs
and Benefits of Ownership: A Theory of Vertical and Lateral
Integration, 94 J. Pol. Econ. 691 (1986) for a discussion of the
actions that agents can take to reduce the agency costs to the
principal in the context of the relationship between an owner (the
principal) and a manager (the agent) when the agent that has a
valuable investment opportunity that can only be financed by the
principal.
\858\ Limited transparency with respect to how broker-dealers
and their associated persons are compensated from recommending a
security and what constrains their menus of securities may make it
difficult for retail customers to grasp the size of the agency costs
that they are facing at the time when they receive the
recommendation. As a result, this limited transparency may allow
broker-dealers and their associated persons to extract informational
rents (i.e., in the context of a transaction, compensation in excess
of what is competitively feasible that stems solely from the
informational advantage of one party over another) from the retail
customers when providing recommendations. The adviser business model
also has its own set of conflicted incentives to gather assets
(based on AUM fees) or maximize the time that it takes to complete a
job (if paid an hourly fee). Dual-registrants also have an incentive
to recommend the type of account that is most profitable to the
firm. See AFL-CIO April 2019 Letter. See also Morgan Lewis Letter
(describing investment adviser compensation and conflicts disclosure
in Form ADV); Bruce Ian Carlin & Gustavo Manso, Obfuscation,
Learning, and the Evolution of Investor Sophistication, 24 Rev. Fin.
Stud. 754 (2011) for a discussion about the relationship between
informational rents and the opacity of recommended investments
(e.g., securities with complex payoff structures).
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Although the dynamics of the agency relationship between a retail
customer and a broker-dealer may not cause the broker-dealer to take
steps to increase transparency, competitive factors in the broker-
dealer industry such as steps toward transparency taken by other
broker-dealers may cause increased transparency in that relationship.
Competitive dynamics are more effective in areas where comparisons can
be more easily made. For example, in the market for mutual funds --
particularly index funds--comparability and competition, among other
factors, have driven down fees significantly.\859\
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\859\ Comparability among index funds that follow the same
market index is facilitated in part by their passive style of
investing. Actively managed funds that follow the same investment
strategy can show different performance due to, among other things,
the ``skill'' of the manager of outperforming the market (or any
other benchmark). This skill is unobservable and generally hard to
measure, which makes comparisons across actively managed funds
difficult. In contrast, comparisons across index funds that follow
the same market index and that have passive investment styles are
based more on observable variables, such as fees, rather than
unobservable variables, such as managerial skill. In this context,
disclosure that is more salient with respect to these observable
variables may facilitate comparisons across index funds.
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[[Page 33404]]
While we do not have evidence to establish the degree to which
broker-dealers can extract large informational rents from retail
customers under the current legal and regulatory regime that governs
the broker-dealers' standard of conduct, the existing agency costs of
the relationship between the retail customer and the broker-dealer
would likely be larger, absent the current legal and regulatory
regime.\860\ In general, standards and regulation are effective means
of reducing agency costs when principals (e.g., retail customers) and
agents (e.g., broker-dealers) cannot reduce the agency costs on their
own by negotiating to address the market frictions in their
relationship through mechanisms available to them, such as bilateral
contracting \861\ or ``side payments.'' \862\
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\860\ See, e.g., Matthew L. Kozora, Security Recommendations and
the Liabilities of Broker-Dealers (U.S. Sec. & Exch. Comm'n, Working
Paper, May 1, 2016), available at https://www.sec.gov/files/Kozora_BD-Liability_05-2016.pdf, which provides evidence from
investor awards in FINRA arbitrations that the author interprets as
indicative of informational rents being nonzero. See also our more
comprehensive discussion in Section III.B.3.c, infra, about
potential investor harm associated with investment advice, including
from potential informational rents.
\861\ See Proposing Release at 21643.
\862\ Another way principals and agents negotiate around market
frictions is through ``side payments.'' In a transaction between two
parties, a side payment is a monetary exchange from one party to
another that is not part of the transaction. This mechanism is
discussed in the literature on bilateral externalities, which
focuses on how the actions of one party can affect the well-being of
the other party. This mechanism also applies to the relationship
between a broker-dealer and a retail customer because the action
taken by a broker-dealer, namely providing a recommendation, may
affect the well-being of the retail customer receiving that
recommendation. In the literature on bilateral externalities, if the
party taking these externality actions is unconstrained, the
allocation of resources across the two parties may be inefficient.
However, in certain circumstances, the parties can avoid this
inefficient outcome through side payments that neutralize the effect
of the externality on the allocations. See, e.g., Mas-Colell et al.
(1995), supra footnote 846, specifically Part 3: Market Equilibrium
and Market Failure for a discussion of bilateral externalities.
---------------------------------------------------------------------------
Regulation Best Interest enhances the current standard of conduct
for broker-dealers and codifies it in an Exchange Act rule. Regulation
Best Interest is designed to: (1) Enhance the current standard of
conduct applicable to broker-dealers and associated persons when they
make a recommendation to a retail customer of any securities
transaction or investment strategy involving securities; (2) reduce
conflicts of interest that currently exist between retail customers and
broker-dealers and their associated persons; and (3) reduce information
asymmetries that currently limit the ability of retail customers to
evaluate the efficiency of recommendations they receive from broker-
dealers and their associated persons. In each of these three ways,
Regulation Best Interest is designed to reduce the agency costs in the
relationship between broker-dealers and their retail customers,
including in situations where the existing legal and regulatory regime
that governs broker-dealers' standard of conduct has had limited
effectiveness.
3. Comments on Market Failure of the Principal-Agent Relationship and
Quantification; Comments That the Broker-Dealer, Commission-Based Model
Should Be Severely Restricted or Eliminated
The economic analysis in the Proposing Release characterized the
relationship between a retail customer and a broker-dealer as one
between a principal (the retail customer) and an agent (the broker-
dealer).\863\ The analysis noted that the potential conflict between
interests and the differences between the information sets available to
the agent and the principal may result in agency costs. It further
noted that the inability of the broker-dealers and retail customers to
overcome the market frictions underlying these agency costs may result
in inefficient allocations of resources. An inability of the principal
and the agent to efficiently negotiate around the frictions that
produce agency costs and take actions that would increase the
efficiency of their allocations is what economists refer to as a
``market failure'' of the principal-agent relationship,\864\ generally,
and of the agency relationship between the retail customer and the
broker-dealer, specifically.\865\
---------------------------------------------------------------------------
\863\ See Proposing Release at 21629-21631.
\864\ See, e.g., Mas-Colell et al. (1995), supra footnote 846.
\865\ In general, because frictions such as asymmetric
information are ever present, all markets and agency relationships
have some degree of market failure.
---------------------------------------------------------------------------
The analysis in the Proposing Release recognized that while the
Commission cannot provide a quantified estimate of the magnitude of
this agency cost, the existence of these costs and their persistence
justifies regulatory intervention.\866\
---------------------------------------------------------------------------
\866\ See Proposing Release at 21631.
---------------------------------------------------------------------------
A number of commenters questioned this approach. Certain of these
commenters stated that the Commission needs to more fully identify the
market failure that needs to be addressed, and certain commenters
stated that the Commission did not provide a quantitative assessment of
the severity of the market failure that would prompt the need for
regulatory intervention.\867\ We address these concerns below.
---------------------------------------------------------------------------
\867\ See, e.g., CFA August 2018 Letter at 105, noting that
``[c]orrectly diagnosing the problem requires identifying and
analyzing the market failure that has occurred in investment advice
securities markets, as well as assessing the significance of that
problem''; See also, e.g., Letter from Charles Cox, Former SEC Chief
Economist, et al. (Feb. 6, 2019) (``Former SEC Senior Economists
Letter'') at 2, noting that ``the Commission confronts important
questions about advisers balancing their own compensation against
the effect of that compensation on the customer's expected returns.
We wonder if the extreme asymmetry of information and financial
sophistication between advisers and many of their clients
constitutes a market failure that the April proposals are intended
to ameliorate.'' In addition, the Former SEC Senior Economists
Letter raised three main concerns with the economic analysis in the
Proposing Release: (1) The discussion of the potential problems in
the customer-adviser relationship was incomplete and identified
other features of the market for ongoing retail investment advice
that might be problematic; (2) there was inadequate discussion and
analysis of the existing economic literature on financial advice;
and (3) there were questions of whether the disclosure requirements
in the Proposing Release would provide meaningful information for
customers. The economic analysis addresses these concerns. For
instance, with respect to (1), Section III.A.2 provides a more in
depth discussion of the potential problems that may arise when a
broker-dealer provides recommendations to a retail customer. With
respect to (2), Section III.B.3 engages more fully with the economic
literature on financial advice. Finally, with respect to (3),
Sections III.B.4, III.C.2, and III.C.4 provide discussions on the
effectiveness of the disclosure requirements of Regulation Best
Interest.
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With respect to the issue of appropriately identifying the market
failure, one commenter questioned whether the relationship between the
retail customer and the broker-dealer is a principal-agent
relationship.\868\ This commenter stated that in many instances, a
broker-dealer's provision of recommendations to a retail customer
resembles an arm's length transaction (e.g., purchasing a car) that
benefits the more informed broker-dealer at the expense of the less
informed retail customer. This commenter disagreed with the
Commission's broader view that the market failure stems from the agency
costs of the relationship between
[[Page 33405]]
a broker-dealer and a retail customer,\869\ and instead stated that the
market failure is due to conflicts of interest caused by the way
broker-dealers and their associated persons are generally compensated
for providing recommendations to retail customers.\870\ Similarly,
another commenter stated that the Commission failed to discuss how the
current compensation practices associated with providing
recommendations to retail customers creates incentives for the broker-
dealer and its associated persons to favor one securities transaction
or investment strategy over another when making recommendations to
retail customers.\871\ This commenter further questioned whether the
information asymmetry and the discrepancy in the level of financial
sophistication between broker-dealers and their retail customers
constitute a market failure.\872\ One commenter noted that the poor
performance of actively managed funds that are being recommended by
broker-dealers to small retail customers reflects a principal-agent
problem that causes an ``enormous'' wealth transfer from retail
customers to the financial industry, including broker-dealers.\873\
This commenter stated that this problem arises because of the broker-
dealer's commission-based compensation for providing recommendations
and because of the information asymmetries between the broker-dealer
and the retail customer at the time of the recommendation.\874\ This
commenter also stated that recommendations subject to conflicts of
interest may have no value for retail customers.\875\
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\868\ See CFA August 2018 Letter at 107, noting that ``[t]he
Commission's economic analysis gets off to a faulty start by
mischaracterizing, or at least over-simplifying, the broker-customer
`advice' relationship, as a principal-agent relationship. While
there are certainly instances where a broker and its customer can
exhibit features of a bona fide principal-agent relationship--for
example when executing a customer's order--it's not clear that, in
the context of receiving investment recommendations, those same
characteristics are present. Certainly, the brokerage industry
expressly refutes this characterization, having argued successfully
in the Fifth Circuit that brokers engage in nothing more than an
arm's length commercial sales transaction, no different from a car
dealer soliciting interest in inventory.''
\869\ See CFA August 2018 Letter at 108, noting that
``[t]ypically, principal-agent relationships don't involve third
party payments to the agent, which can adversely affect the level of
loyalty the agent provides to the principal.''
\870\ See CFA August 2018 Letter at 107, noting that the
Commission ``fails to acknowledge that conflicts of interest are a
real problem that result in real harm to investors [. . .]'' and
``[. . .] the Release fails to make clear whether the Commission is
truly seeking to address the underlying problem of conflicts'
harmful impact on investors.''
\871\ See Former SEC Senior Economists Letter at 3, noting that
``[n]owhere does the EA emphasize that an adviser's compensation
provides numerous opportunities for her to favor one investment over
another on the basis of the compensation it pays to her or to her
firm.''
\872\ See Former SEC Senior Economists Letter at 2. See also
supra footnote 867 that describes in more detail the concerns raised
by this commenter.
\873\ See Letter from Monique Morrissey, Economist and Heidi
Shierholz, Senior Economist and Director of Policy, EPI (Aug. 7,
2018) (``EPI Letter'') at 6, noting that ``[i]n an equilibrium with
knowledgeable investors, we would expect returns from active and
passive strategies to be equal. The fact that actively-managed funds
marketed to small investors tend to perform poorly reflects a market
distortion--naivet[eacute]--or a `principal-agent problem' in
economics parlance, which results in enormous transfers from
investors to the financial industry.''
\874\ See EPI Letter at 2, noting that ``[c]onflicts of interest
between buyers and sellers are commonplace. Many salesmen, including
brokers and car dealers, are paid on commission. However, it has
long been recognized that markets for professional advice are
different from markets for automobiles because information
asymmetries are inherent in these transactions.''
\875\ See EPI Letter at 8, noting that ``the SEC never considers
that `advice' offered may not just be of lower quality than
expected, but worse than no advice at all'' and that ``much of the
`advice' provided by broker-dealers not only lacks value, but is
actually harmful, steering savers to higher-cost products and costly
services that will reduce their future standard of living compared
to how they would fare in the absence of this `advice.' This may be
true whether or not, in the absence of conflicted `advice,'
investors would have availed themselves of more paid or free advice
from more impartial sources.''
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As an initial matter, in response to comments regarding the need to
discuss fully the existing market failure, it is important to recognize
that the Commission has been studying and carefully considering the
issues related to the broker-dealer-client relationship and the related
standard of conduct for broker-dealers for many years, which led to the
development of the Proposing Release and the economic analysis
therein.\876\ In light of the comments on the Proposing Release, the
extensive outreach by the Commission and staff, as well as investor
testing, the Commission has more specifically and fully described the
relationship between the broker-dealer and the client, the related
market failure, and the resulting potential economic effects of
Regulation Best Interest in addressing the market failure.\877\
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\876\ See Proposing Release at 21579-21583.
\877\ See supra Section III.A.2.
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The Commission continues to believe that agency costs are at the
root of existing allocative inefficiencies in the market for broker-
dealer advice. Moreover, this economic analysis recognizes that a
proper understanding of the economic fundamentals of an investor's
decision to allocate resources across market and economic conditions
and over time is central to identifying the frictions that cause
inefficiencies in the agency relationship between a broker-dealer and a
retail customer.
In response to the commenter that stated that in a principal-agent
relationship agents do not receive compensation from third parties
(e.g., investment sponsors), the Commission notes that the compensation
that the investment sponsor provides to the agent is ultimately funded
by the principal (i.e., the retail customer).\878\ In addition, in
response to the commenter's concern that a broker-dealer's provision of
recommendations to retail customers resembles an arm's length
transaction that is ``no different from a car dealer soliciting
interest in inventory,'' \879\ the Commission notes that under the
current regulatory regime broker-dealers and their associated persons
are subject to a suitability standard of conduct that has been
interpreted to ``be consistent with [the] customer's best interests.''
\880\ In contrast, in an arm's length transaction, the parties involved
are generally not subject to a standard of conduct that would constrain
the more informed party from acting solely in its own interest.\881\
Finally, in response to the commenter's concern with respect to the
identification of the market failure,\882\ the Commission notes that
while conflicts of interest arise in many types of transactions, in
certain instances the parties involved can negotiate an arrangement
between themselves that would reduce the effect of conflicts of
interest on the allocation of resources across the parties and improve
the efficiency of this allocation. The Commission further notes that
agency costs may deter the parties from engaging in privately
negotiated arrangements that would improve the efficiency of the
allocation of resources between the parties. From this perspective, the
Commission believes that it is the agency costs rather than the
conflicts of interest themselves that should be viewed as the source of
the market failure.
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\878\ See supra footnote 869.
\879\ See supra footnote 868.
\880\ See infra footnote 979 and accompanying text.
\881\ However, in certain markets, there may be market
mechanisms in place that would prevent the more informed party to a
transaction from acting solely in its own interest.
\882\ See supra footnote 870.
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In response to the commenter that noted that the Commission did not
discuss how the compensation received by the broker-dealer and its
associated persons creates incentives to favor one security or
investment strategy over another when making recommendations to retail
customers,\883\ the Commission has incorporated into this economic
analysis a detailed discussion of the incentives created by the current
compensation practices associated with providing recommendations to
retail customers.\884\ In addition, in response to the commenter's
concerns about whether the information asymmetry and the discrepancy in
the level of financial sophistication between retail customers and a
broker-dealer and its associated persons are the source of market
failure, the Commission notes that this economic analysis establishes a
more
[[Page 33406]]
clear link between bounded rationality, including access to information
and financial literacy of retail customers, and agency costs, and
reflects our conclusion that the agency costs are at the root of the
market failure.
---------------------------------------------------------------------------
\883\ See supra footnote 871.
\884\ See infra Section III.C.4.
---------------------------------------------------------------------------
The Commission further notes that the so-called ``informational
rent'' that a broker-dealer may be incentivized to extract from a
retail customer to take advantage of the information asymmetry or the
discrepancy in the level of financial sophistication is one component
of the agency costs associated with the relationship between a retail
customer and a broker-dealer. In addition, the Commission notes that
the evidence on the size of the agency costs associated with such
informational rents is limited.\885\ This evidence is not generally
supportive of a commenter's assessment that the wealth transfer from
retail customers to broker-dealers is ``enormous.'' \886\ The
Commission agrees with this commenter, who stated that the way broker-
dealers are compensated for providing recommendations and the
information asymmetry between retail customers and broker-dealers are
important determinants of the agency costs. However, based on the
evidence discussed below, the Commission disagrees with this
commenter's assessment that the advice provided by the associated
persons of the broker-dealer has no value.\887\
---------------------------------------------------------------------------
\885\ See supra Section III.A.2 and infra Section III.B.3.
\886\ See supra footnote 873.
\887\ See infra Section III.B.3.b.
---------------------------------------------------------------------------
With respect to the issue of measuring the severity of the market
failure, some commenters stated that the Commission failed to take into
account existing academic literature that provides evidence of investor
harm caused by accepting advice from the associated persons of the
broker-dealer. A subset of these commenters believed that the evidence
provided in some of these academic studies is compelling and that the
Commission should use it to quantify the severity of the market
failure.\888\ One commenter also urged the Commission to supplement the
academic evidence on investor harm with evidence from data available to
the Commission from regulatory oversight.\889\
---------------------------------------------------------------------------
\888\ See, e.g., CFA August 2018 Letter; EPI Letter; AARP August
2018 Letter; Better Markets August 2018 Letter; Former SEC Senior
Economists Letter.
\889\ See CFA August 2018 Letter at 112. This commenter
suggested that we present additional information about the existence
and frequency of the potential harm to investors ``that results from
conflicted brokerage `advice','' which may collectively be seen as
misconduct by financial professionals.
---------------------------------------------------------------------------
In response to these comments, the Commission maintains that the
existence of misconduct that commenters requested the Commission to
document does not render the approach taken in Regulation Best Interest
irrational, inappropriate, or unreasonable, nor does it suggest that an
alternative approach would be more effective in fulfilling the
Commission's mission. The Commission is aware and understands the
concerns raised by the commenters with regards to the evidence on
investor harm and the extent to which such evidence can inform on our
understanding of the severity of the market failure in the market for
broker-dealer advice. As discussed in the Proposing Release and
reiterated in this economic analysis, the Commission believes that
retail investors can be harmed when they accept recommendations from a
broker-dealer that places the financial or other interest of the
broker-dealer or its associated persons ahead of the interests of the
retail customers. In addition, this economic analysis engages more
fully with the economic literature on financial advice and considers
these studies in analyzing the costs and benefits associated with
Regulation Best Interest.\890\
---------------------------------------------------------------------------
\890\ See infra Section III.B.3.c.
---------------------------------------------------------------------------
B. Economic Baseline
This section discusses, as it relates to this rulemaking, the
current state of the broker-dealer and investment adviser markets; the
current regulatory environment and market practices surrounding the
provision of recommendations by broker-dealers; evidence on the
potential value and harm of investment advice; and how issues related
to trust, financial literacy, and disclosure effectiveness affect
conflicts between investors and financial professionals. The economic
baseline has been revised and expanded relative to the Proposing
Release to address comments, discussed more fully below.
1. Providers of Financial Services \891\
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\891\ In addition to broker-dealers and Commission-registered
investment advisers discussed below in the baseline, there are a
number of other entities, such as state-registered investment
advisers, commercial banks and bank holding companies, and insurance
companies, which also provide financial advice services to retail
customers; however, because of unavailability of data, the
Commission is unable to estimate the number of some of those other
entities that are likely to provide financial advice to retail
customers as well as their size and the scope of services they
provide. A number of broker-dealers (see infra footnote 899) have
non-securities businesses, such as insurance or tax services. As of
December 2018, there were approximately 17,300 state-registered
investment advisers. The Department of Labor in its Regulatory
Impact Analysis identifies approximately 398 life insurance
companies that could provide advice to retirement investors. See
infra footnote 1002.
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a. Broker-Dealers
Regulation Best Interest will affect the market for broker-dealer
services, including firms that are dually registered as broker-dealers
and investment advisers \892\ and broker-dealers affiliated with an
investment adviser.\893\ The market for broker-dealer services
encompasses a small set of large and medium sized broker-dealers and
thousands of smaller broker-dealers competing for niche or regional
segments of the market.\894\ The market for broker-dealer services
includes many different markets for a variety of services, including
(1) managing orders for customers and routing them to various trading
venues; (2) providing advice to customers that is in connection with
and reasonably related to their primary business of effecting
securities transactions; \895\ (3) holding retail customers' funds and
securities; (4) handling clearance and settlement of trades; (5)
intermediating between retail customers and carrying/clearing brokers;
(6) dealing in corporate debt and equities, government bonds, and
municipal bonds, among other securities; (7) privately placing
securities; and (8) effecting transactions in mutual funds that involve
transferring funds directly to the issuer. Some broker-dealers may
specialize in just one narrowly defined service, while
[[Page 33407]]
others may provide a wide variety of services.
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\892\ Not all firms that are dually registered as an investment
adviser and a broker-dealer offer both brokerage and advisory
accounts to retail investors. For example, some dually registered
firms offer advisory accounts to retail investors but offer only
brokerage services, such as underwriting services, to institutional
clients. For purposes of the discussion of the baseline in this
economic analysis, a dually registered firm is any firm that is
dually registered with the Commission as an investment adviser and a
broker-dealer.
\893\ Some broker-dealers may be affiliated with investment
advisers and not dually registered. From Question 10 on Form BD,
2,098 (55.7%) broker-dealers report that, directly or indirectly,
they control, are controlled by, or are under common control with an
entity that is engaged in the securities or investment advisory
business. Comparatively, 2,421 (18.2%) SEC-registered investment
advisers report an affiliate that is a broker-dealer in Section 7A
of Schedule D of Form ADV, including 1,878 SEC-registered investment
advisers that report an affiliate that is a registered broker-
dealer. Approximately 77% of total regulatory AUM are managed by the
2,421 SEC-registered investment advisers.
\894\ See Risk Management Controls for Brokers or Dealers with
Market Access, Securities Exchange Act Release No. 63241 (Nov. 3,
2010) [75 FR 69791, 69822 (Nov. 15, 2010)]. For simplification, we
present our analysis as if the market for broker-dealer services
encompasses one broad market with multiple segments, even though, in
terms of competition, it could also be discussed in terms of
numerous interrelated markets.
\895\ See Solely Incidental Interpretation.
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As of December 2018, there were approximately 3,764 registered
broker-dealers with over 140 million customer accounts. In total, these
broker-dealers have over $4.3 trillion in total assets, which are total
broker-dealer assets as reported on Form X-17a-5.\896\ More than two-
thirds of all brokerage assets and close to one-third of all customer
accounts are held by the 17 largest broker-dealers, as shown in Table
1, Panel A.\897\ Of the broker-dealers registered with the Commission
as of December 2018, 563 broker-dealers were dually registered as
investment advisers.\898\ These firms hold over 90 million (63%)
customer accounts. Approximately 539 broker-dealers (14%) report at
least one type of non-securities business, including insurance,
retirement planning, mergers and acquisitions, and real estate, among
others.\899\ Approximately 73.5% of registered broker-dealers report
retail customer activity.\900\
---------------------------------------------------------------------------
\896\ Assets are estimated by Total Assets (allowable and non-
allowable) from Part II of the FOCUS filings (Form X-17A-5 Part II,
available at https://www.sec.gov/files/formx-17a-5_2.pdf) and
correspond to balance sheet total assets for the broker-dealer. The
Commission does not have an estimate of the total amount of customer
assets for broker-dealers. We estimate broker-dealer size from the
total balance sheet assets as described above.
\897\ Approximately $4.24 trillion of total assets of broker-
dealers (98%) are at broker-dealers with total assets in excess of
$1 billion. Of the 33 dual-registrants in the group of broker-
dealers with total assets in excess of $1 billion, total assets for
these dual-registrants are $2.32 trillion (54%) of aggregate broker-
dealer assets. Of the remaining 99 broker-dealers with total assets
in excess of $1 billion that are not dual-registrants, 91 have
affiliated investment advisers.
\898\ This number includes the number of broker-dealers who are
also registered as state investment advisers. For purposes of the
discussion of the baseline in this economic analysis, a dual-
registrant is any firm that is dually registered with either the
Commission or a state as an investment adviser and a broker-dealer.
Excluding state registered advisers, there are 359 entities that are
dually registered with the Commission as an investment adviser and a
broker-dealer.
\899\ We examined Form BD filings to identify broker-dealers
reporting non-securities business. For the 393 broker-dealers
reporting such business, staff analyzed the narrative descriptions
of these businesses on Form BD, and identified the most common types
of businesses: Insurance (202), management/financial/other
consulting (99), advisory/retirement planning (71), mergers and
acquisitions (70), foreign exchange/swaps/other derivatives (28),
real estate/property management (30), tax services (15), and other
(146). Note that a broker-dealer may have more than one line of non-
securities business.
\900\ The value of customer accounts is not available from FOCUS
data for broker-dealers. Therefore, to obtain estimates of firm size
for broker-dealers, we rely on the value of broker-dealers' total
assets as obtained from FOCUS reports. Retail sales activity is
identified from Form BR, which categorizes retail activity broadly
(by marking the ``sales'' box) or narrowly (by marking the
``retail'' or ``institutional'' boxes as types of sales activity).
We use the broad definition of sales as we preliminarily believe
that many firms will just mark ``sales'' if they have both retail
and institutional activity. However, we note that this may capture
some broker-dealers that do not have retail activity, although we
are unable to estimate that frequency.
---------------------------------------------------------------------------
Panel B of Table 1 is limited to the broker-dealers that report
some retail investor activity. As of December 2018, there were
approximately 2,766 broker-dealers that served retail investors, with
over $3.8 trillion in total assets (89% of total broker-dealer assets)
and almost 139 million (97%) customer accounts.\901\ Of those broker-
dealers serving retail investors, 452 were dually registered as
investment advisers.\902\ The number of broker-dealers that serve
retail customers (i.e., 2,766) likely overstates the number of broker-
dealers that will be subject to Regulation Best Interest, because not
all broker-dealers that serve retail investors provide recommendations
to retail investors. We do not have reliable data to determine the
precise number of broker-dealers that provide recommendations (and the
extent to which broker-dealers that provide recommendations do so, as
opposed to executing unsolicited trades), and as a result, we have
assumed, for purposes of this Section III and Sections IV (Paperwork
Reduction Act Analysis) and V (Final Regulatory Flexibility Act
Analysis) that 2,766 broker-dealers will be subject to Regulation Best
Interest.
---------------------------------------------------------------------------
\901\ Total assets and customer accounts for broker-dealers that
serve retail customers also include institutional accounts. Data
available from Form BD and FOCUS data is not sufficiently granular
to identify the percentage of retail and institutional accounts at
firms.
\902\ Excluding state registered advisers, there are 359
entities that are dually registered with the Commission as an
investment adviser and a broker-dealer. Of the 31 dual-registrants
in the group of retail broker-dealers with total assets in excess of
$500 million, total assets for these dual-registrants are nearly
$2.01 trillion (53%) of aggregate retail broker-dealer assets (Table
1, Panel B). Of the remaining 81 retail broker-dealers with total
assets in excess of $500 million that are not dual-registrants, 76
have affiliated investment advisers.
\903\ The data is obtained from FOCUS filings as of December
2018. Note that there may be a double-counting of customer accounts
among, in particular, the larger broker-dealers as they may report
introducing broker-dealer accounts as well in their role as clearing
broker-dealers.
\904\ In addition to the approximately 143 million individual
accounts at broker-dealers, there are approximately 302,000 omnibus
accounts (0.2% of total accounts at broker-dealers), with total
assets of $32.1 billion, across all 3,764 broker-dealers, of which
approximately 99% are held at broker-dealers with greater than $1
billion in total assets. See also supra footnote 897. Omnibus
accounts reported in FOCUS data are the accounts of non-carrying
broker-dealers with carrying broker-dealers. These accounts may have
securities of multiple customers (of the non-carrying firm), or
securities that are proprietary assets of the non-carrying broker-
dealer. We are unable to determine from the data available how many
customer accounts non-carrying broker-dealers may have. The data
does not allow the Commission to parse the total assets in those
accounts to determine to whom such assets belong. Therefore, our
estimate may be under inclusive of all customer accounts held at
broker-dealers.
\905\ Customer Accounts includes both broker-dealer and
investment adviser accounts for dual-registrants.
Table 1--Panel A: Registered Broker-Dealers as of December 2018 \903\
[Cumulative broker-dealer total assets and customer accounts] \904\
----------------------------------------------------------------------------------------------------------------
Cumulative
Total number of Number of Cumulative number of
Size of broker-dealer (total assets) BDs dually total assets customer
registered BDs (billion) accounts \905\
----------------------------------------------------------------------------------------------------------------
>$50 billion................................ 17 10 $2,879 40,550,200
$1 billion to $50 billion................... 114 23 1,363 96,037,591
$500 million to $1 billion.................. 35 7 23 397,814
$100 million to $500 million................ 105 20 23 1,603,818
$10 million to $100 million................. 490 115 17 4,277,432
$1 million to $10 million................... 1,021 182 3.6 460,748
<$1 million................................. 1,982 206 0.5 5,675
-------------------------------------------------------------------
Total................................... 3,764 563 4,309 143,333,278
----------------------------------------------------------------------------------------------------------------
[[Page 33408]]
Table 1--Panel B: Registered Retail Broker-Dealers as of December 2018
[Cumulative broker-dealer total assets and customer accounts]
----------------------------------------------------------------------------------------------------------------
Cumulative
Total number of Number of Cumulative number of
Size of broker-dealer (total assets) BDs dually total assets customer
registered BDs (billion) accounts
----------------------------------------------------------------------------------------------------------------
>$50 billion................................ 16 8 $2,806 40,545,792
$1 billion to $50 billion................... 75 18 990 91,991,118
$500 million to $1 billion.................. 21 5 13 365,632
$100 million to $500 million................ 84 17 18 1,603,818
$10 million to $100 million................. 378 96 14 3,762,620
$1 million to $10 million................... 783 153 2.8 450,132
<$1 million................................. 1,409 155 0.4 5,672
-------------------------------------------------------------------
Total BDs \906\......................... 2,766 452 3,844 138,724,784
----------------------------------------------------------------------------------------------------------------
Table 2 reports information on brokerage commissions,\907\ fees,
and selling concessions from the fourth quarter of 2018 for all broker-
dealers, including dual-registrants.\908\ We observe significant
variation in the sources of revenues for broker-dealers, with large
broker-dealers, on average, generating substantially higher levels of
aggregate commission and fee revenues (on a nominal basis) than smaller
broker-dealers. On average, broker-dealers, including those that are
dually registered as investment advisers, earn about $5.1 million per
quarter in revenue from commissions and nearly four times that amount
in fees,\909\ although the Commission notes that fees encompass various
types of fees, not just fees for advisory services.\910\ The level of
revenues earned by broker-dealers (including dually registered firms)
for commissions and fees increases with broker-dealer size, but also
tends to be more heavily weighted toward commissions for broker-dealers
with less than $10 million in assets and is weighted more heavily
toward fees for broker-dealers with assets in excess of $10 million.
For example, for the 114 broker-dealers with assets between $1 billion
and $50 billion, average revenues from commissions are approximately
$45 million, while average revenues from fees are approximately $225
million.\911\
---------------------------------------------------------------------------
\906\ Total BDs includes all retail-facing broker-dealers,
including those dual-registrants that have retail-facing broker-
dealers.
\907\ Mark-ups or mark-downs are not included as part of the
brokerage commission revenue in FOCUS data; instead, they are
included in Net Gains or Losses on Principal Trades, but are not
uniquely identified as a separate revenue category.
\908\ Source: FOCUS data.
\909\ Fees, as detailed in the FOCUS data, include fees for
account supervision, investment advisory services, and
administrative services. Beyond the broad classifications of fee
types included in fee revenue, we are unable to determine whether
fees such as Rule 12b-1 fees, sub-accounting, or other such service
fees (e.g., payments by an investment company for personal service
and/or maintenance of shareholder accounts) are included. The data
covers both broker-dealers and dually registered firms. FINRA's
Supplemental Statement of Income, Line 13975 (Account Supervision
and Investment Advisory Services) denotes that fees earned for
account supervision are those fees charged by the firm for providing
investment advisory services where there is no fee charged for trade
execution. Investment Advisory Services generally encompass
investment advisory work and execution of client transactions, such
as wrap arrangements. These fees also include fees charged by
broker-dealers that are also registered with the Commodity Futures
Trading Commission (``CFTC''), but do not include fees earned from
affiliated entities (Item A of question 9 under Revenue in the
Supplemental Statement of Income).
\910\ With respect to the FOCUS data, additional granularity of
what services comprise ``advisory services'' is not available. See
also Solely Incidental Interpretation.
\911\ An estimate of total fees in this size category would be
114 broker-dealers with assets between $1 billion and $50 billion
multiplied by the average fee revenue of $225 million, or $25.65
billion in total fees.
---------------------------------------------------------------------------
In addition to revenue generated from commissions and fees, broker-
dealers may also receive revenues from other sources, including margin
interest, underwriting, research services, and third-party selling
concessions, such as from sales of investment company (``IC'') shares.
As shown in Table 2, Panel A, these selling concessions are generally a
smaller fraction of broker-dealer revenues than either commissions or
fees, except for broker-dealers with total assets between $10 million
and $100 million. For these broker-dealers, revenue from third-party
selling concessions is the largest category of revenues and constitutes
approximately 42% of total revenues earned by these firms.
Table 2, Panel B below provides aggregate revenues by revenue type
(commissions, fees, or selling concessions from sales of IC shares) for
broker-dealers delineated by whether the broker-dealer is also a dual-
registrant. Broker-dealers dually registered as investment advisers
have a significantly larger fraction of their revenues from fees
compared to commissions or selling concessions, whereas broker-dealers
that are not dually registered generate approximately 42% of their
advice-related revenues as commissions and only 33% of their advice-
related revenues from fees, although we lack granularity to determine
whether advisory services, in addition to supervision and
administrative services, contribute to fees at standalone broker-
dealers.
---------------------------------------------------------------------------
\912\ The data is obtained from December 2018 FOCUS reports and
averaged across size groups.
\913\ Fees, as detailed in the FOCUS data, include fees for
account supervision, investment advisory services, and
administrative services. The data covers both broker-dealers and
dually registered firms.
Table 2--Panel A: Average Broker-Dealer Revenues From Revenue Generating Activities \912\
----------------------------------------------------------------------------------------------------------------
Sales of IC
Size of broker-dealer in total assets N Commissions Fees \913\ shares
----------------------------------------------------------------------------------------------------------------
>$50 billion................................ 17 $170,336,258 $414,300,268 $23,386,192
$1 billion-$50 billion...................... 114 45,203,225 225,063,257 53,671,602
500 million-1 billion....................... 35 8,768,547 30,141,270 5,481,248
100 million-500 million..................... 105 12,801,889 33,726,336 16,610,013
10 million-100 million...................... 490 3,428,843 8,950,892 9,092,971
[[Page 33409]]
1 million-10 million........................ 1,021 996,130 1,037,825 652,905
<1 million.................................. 1,982 197,907 269,459 85,219
-------------------------------------------------------------------
Average of All Broker-Dealers........... 3,764 5,092,808 21,948,551 4,368,823
----------------------------------------------------------------------------------------------------------------
Table 2--Panel B: Aggregate Total Revenues From Revenue Generating Activities for Broker-Dealers Based on Dual-
Registrant Status
----------------------------------------------------------------------------------------------------------------
Sales of IC
Broker-dealer type N Commissions Fees \914\ shares
(billion) (billion) (billion)
----------------------------------------------------------------------------------------------------------------
Dually Registered as IAs.................... 563 $4.62 $17.56 $2.65
Standalone Registered BDs................... 3,201 4.07 3.22 2.55
-------------------------------------------------------------------
All..................................... 3,764 8.69 20.78 5.20
----------------------------------------------------------------------------------------------------------------
As shown in Table 3, based on responses to Form BD, broker-dealers'
most commonly provided business lines include private placements of
securities (62.7% of broker-dealers); retail sales of mutual funds
(55.4%); acting as a broker or dealer retailing corporate equity
securities over the counter (52.0%); acting as a broker or dealer
retailing corporate debt securities (47.2%); acting as a broker or
dealer selling variable contracts, such as life insurance or annuities
(41.0%); acting as a broker of municipal debt/bonds or U.S. government
securities (39.8% and 37.4%, respectively); acting as an underwriter or
selling group participant of corporate securities (31.2%); and
investment advisory services (26.4%), among others.\915\
---------------------------------------------------------------------------
\914\ See id.
\915\ Form BD requires applicants to identify the types of
business engaged in (or to be engaged in) that accounts for 1% or
more of the applicant's annual revenue from the securities or
investment advisory business. Table 3 provides an overview of the
types of businesses listed on Form BD, as well as the frequency of
participation in those businesses by registered broker-dealers as of
December 2018.
Table 3--Lines of Business at Retail Broker-Dealers as of December 2018
----------------------------------------------------------------------------------------------------------------
Total
---------------------------------
Line of business Number of Percent of
broker-dealers broker-dealers
----------------------------------------------------------------------------------------------------------------
Private Placements of Securities.............................................. 1,735 62.70
Mutual Fund Retailer.......................................................... 1,533 55.40
Broker or Dealer Retailing:
Corporate Equity Securities OTC........................................... 1,438 51.97
Corporate Debt Securities................................................. 1,306 47.20
Variable Contracts........................................................ 1,132 40.91
Municipal Debt/Bonds Broker................................................... 1,101 39.79
U.S. Government Securities Broker............................................. 1,035 37.41
Put and Call Broker or Dealer or Options Writer............................... 993 35.89
Underwriter or Selling Group Participant--Corporate Securities................ 862 31.15
Non-Exchange Member Arranging For Transactions in Listed Securities by 785 28.37
Exchange Member..............................................................
Investment Advisory Services.................................................. 730 26.38
Broker or Dealer Selling Tax Shelters or Limited Partnerships--Primary Market. 619 22.37
Trading Securities for Own Account............................................ 614 22.19
Municipal Debt/Bonds Dealer................................................... 475 17.17
U.S. Government Securities Dealer............................................. 339 12.25
Solicitor of Time Deposits in a Financial Institution......................... 308 11.13
Underwriter--Mutual Funds..................................................... 237 8.57
Broker or Dealer Selling Interests in Mortgages or Other Receivables.......... 216 7.81
Broker or Dealer Selling Oil and Gas Interests................................ 207 7.48
Broker or Dealer Making Inter-Dealer Markets in Corporate Securities OTC...... 207 7.48
Broker or Dealer Involved in Networking, Kiosk, or Similar Arrangements 197 7.12
(Banks, Savings Banks, Credit Unions)........................................
Internet and Online Trading Accounts.......................................... 192 6.94
Exchange Member Engaged in Exchange Commission Business Other than Floor 171 6.18
Activities...................................................................
Broker or Dealer Selling Tax Shelters or Limited Partnerships--Secondary 164 5.93
Market.......................................................................
Commodities................................................................... 162 5.85
Executing Broker.............................................................. 107 3.87
Day Trading Accounts.......................................................... 89 3.22
Broker or Dealer Involved in Networking, Kiosk, or Similar Arrangements 88 3.18
(Insurance Company or Agency)................................................
Real Estate Syndicator........................................................ 94 3.40
Broker or Dealer Selling Securities of Non-Profit Organizations............... 71 2.57
[[Page 33410]]
Exchange Member Engaged in Floor Activities................................... 61 2.20
Broker or Dealer Selling Securities of Only One Issuer or Associate Issuers... 43 1.55
Prime Broker.................................................................. 21 0.76
Crowdfunding FINRA Rule 4518(a)............................................... 21 0.76
Clearing Broker in a Prime Broker............................................. 14 0.51
Funding Portal................................................................ 8 0.29
Crowdfunding FINRA Rule 4518(b)............................................... 5 0.18
Number of Retail-Facing Broker-Dealers........................................ 2,766 ...............
----------------------------------------------------------------------------------------------------------------
b. Investment Advisers
Other parties that could be affected by Regulation Best Interest
are SEC- or state-registered investment advisers, because Regulation
Best Interest could affect the competitive landscape in the market for
the provision of financial advice.\916\ This section first discusses
SEC-registered investment advisers, followed by a discussion of state-
registered investment advisers.
---------------------------------------------------------------------------
\916\ In addition to SEC-registered investment advisers, which
are the focus of this section, Regulation Best Interest could also
affect banks, trust companies, insurance companies, and other
providers of financial advice.
---------------------------------------------------------------------------
As of December 2018, there were approximately 13,300 investment
advisers registered with the Commission. The majority of SEC-registered
investment advisers report that they provide portfolio management
services for individuals and small businesses.\917\
---------------------------------------------------------------------------
\917\ Of the approximately 13,300 SEC-registered investment
advisers, 8,410 (63.24%) report in Item 5.G.(2) of Form ADV that
they provide portfolio management services for individuals and/or
small businesses. In addition, there are approximately 17,300 state-
registered investment advisers, of which 125 are also registered
with the Commission. Approximately 13,900 state-registered
investment advisers are retail facing (see Item 5.D of Form ADV).
---------------------------------------------------------------------------
Of all SEC-registered investment advisers, 359 identify themselves
as dually registered broker-dealers.\918\ Further, 2,421 investment
advisers (18%) report an affiliate that is a broker-dealer, including
1,878 investment advisers (14%) that report an SEC-registered broker-
dealer affiliate.\919\ As shown in Panel A of Table 4 below, in
aggregate, investment advisers have over $84 trillion in AUM. A
substantial percentage of AUM at investment advisers is held by
institutional clients, such as investment companies, pooled investment
vehicles, and pension or profit sharing plans; therefore, the total
number of accounts for investment advisers is only 29% of the number of
customer accounts for broker-dealers.
---------------------------------------------------------------------------
\918\ See supra footnote 892.
\919\ Item 7.A.1 of Form ADV.
---------------------------------------------------------------------------
Based on staff analysis of Form ADV data, approximately 62% of
registered investment advisers (8,235) have some portion of their
business dedicated to retail investors, including both high net worth
and non-high net worth individual clients,\920\ as shown in Panel B of
Table 4.\921\ In total, these firms have approximately $41.4 trillion
of AUM.\922\ Approximately 8,200 registered investment advisers (61%)
serve almost 32 million non-high net worth individual clients and have
approximately $4.8 trillion in AUM, while approximately 8,000
registered investment advisers (60%) serve approximately 4.8 million
high net worth individual clients with $6.15 trillion in AUM.\923\
---------------------------------------------------------------------------
\920\ We note that the data on individual clients obtained from
Form ADV may not be exactly the same as who would be a ``retail
customer'' as defined in Regulation Best Interest because the data
obtained from Form ADV regarding clients who are individuals does
not involve any test of use for personal, family, or household
purposes.
\921\ We use the responses to Items 5.D.(a)(1), 5.D.(a)(3),
5.D.(b)(1), and 5.D.(b)(3) of Part 1A of Form ADV. If at least one
of these responses was filled out as greater than 0, the firm is
considered as providing business to retail investors. Part 1A of
Form ADV.
\922\ The aggregate AUM reported for these investment advisers
that have retail investors includes both retail AUM as well as any
institutional AUM also held at these advisers.
\923\ Estimates are based on IARD system data as of December 31,
2018. The AUM reported here is specifically that of those non-high
net worth clients. Of the 8,235 investment advisers serving retail
investors, 318 are also dually registered as broker-dealers.
Table 4--Panel A: Registered Investment Advisers (RIAs) as of December 2018
[Cumulative RIA AUM and accounts]
----------------------------------------------------------------------------------------------------------------
Number of Cumulative
Size of investment adviser (AUM) Number of RIAs dually Cumulative AUM number of
registered RIAs (billion) accounts
----------------------------------------------------------------------------------------------------------------
>$50 billion................................ 270 15 $59,264 20,655,756
$1 billion to $50 billion................... 3,453 121 22,749 13,304,154
$500 million to $1 billion.................. 1,635 47 1,151 1,413,099
$100 million to $500 million................ 5,927 119 1,397 5,135,070
$10 million to $100 million................. 1,070 24 59 310,031
$1 million to $10 million................... 162 3 0.8 69,664
<$1 million................................. 782 30 0.02 13,976
-------------------------------------------------------------------
1Total.................................. 13,299 359 84,621 41,081,750
----------------------------------------------------------------------------------------------------------------
[[Page 33411]]
Table 4--Panel B: Retail Registered Investment Advisers (RIAs) as of December 2018
[Cumulative RIA AUM and accounts]
----------------------------------------------------------------------------------------------------------------
Number of Cumulative
Size of investment adviser (AUM) Number of RIAs dually Cumulative AUM number of
registered RIAs (billion) accounts
----------------------------------------------------------------------------------------------------------------
>$50 billion................................ 119 14 $30,291 20,592,326
$1 billion to $50 billion................... 1,614 111 9,570 13,224,188
$500 million to $1 billion.................. 1,007 44 700 1,392,842
$100 million to $500 million................ 4,548 113 1,026 5,287,584
$10 million to $100 million................. 706 23 40 308,285
$1 million to $10 million................... 102 3 0.5 69,534
<$1 million................................. 169 10 0.02 13,946
-------------------------------------------------------------------
Total IAs \924\......................... 8,235 318 41,434 40,887,325
----------------------------------------------------------------------------------------------------------------
In addition to SEC-registered investment advisers, other investment
advisers are registered with state regulators.\925\ As of December
2018, there are 17,268 state-registered investment advisers,\926\ of
which 125 are also registered with the Commission. Of the state-
registered investment advisers, 204 are dually registered as broker-
dealers, while approximately 4.6% (786) report a broker-dealer
affiliate. In aggregate, state-registered investment advisers have
approximately $334 billion in AUM. Eighty-two percent of state-
registered investment advisers report that they provide portfolio
management services for individuals and small businesses, compared to
63% for Commission-registered investment advisers.
---------------------------------------------------------------------------
\924\ Total IAs includes all retail-facing investment advisers,
including those dual-registrants that have retail-facing SEC-
registered broker-dealers and SEC-registered investment advisers.
\925\ Item 2.A. of Part 1A of Form ADV and Advisers Act rules
203A-1 and 203A-2 require an investment adviser to register with the
SEC if it (1) is a large adviser that has $100 million or more of
regulatory AUM (or $90 million or more if an adviser is filing its
most recent annual updating amendment and is already registered with
the SEC); (2) is a mid-sized adviser that does not meet the criteria
for state registration or is not subject to examination; (3) meets
the requirements for one or more of the revised exemptive rules
under section 203A; (4) is an adviser (or subadviser) to a
registered investment company; (5) is an adviser to a business
development company and has at least $25 million of regulatory AUM;
or (6) receives an order permitting the adviser to register with the
Commission. Although the statutory threshold is $100 million, the
SEC raised the threshold to $110 million to provide a buffer for
mid-sized advisers with AUM close to $100 million to determine
whether and when to switch between state and Commission
registration. Advisers Act rule 203A-1(a).
\926\ There are 70 investment advisers with latest reported
regulatory AUM in excess of $110 million but that are not listed as
registered with the SEC. None of these 70 investment advisers has
exempted status with the Commission. For the purposes of this
rulemaking, these are considered potentially erroneous submissions.
---------------------------------------------------------------------------
Approximately 81% of state-registered investment advisers (13,927)
have some portion of their business dedicated to retail investors,\927\
and in aggregate, these firms have approximately $324 billion in
AUM.\928\ Approximately 13,910 (81%) state-registered advisers serve 14
million non-high net worth retail clients and have approximately $137
billion in AUM, while over 11,497 (67%) state-registered advisers serve
approximately 170,000 high net worth retail clients with $169 billion
in AUM.\929\
---------------------------------------------------------------------------
\927\ We use the responses to Items 5.D.(a)(1), 5.D.(a)(3),
5.D.(b)(1), and 5.D.(b)(3) of Part 1A. If at least one of these
responses was filled out as greater than 0, the firm is considered
as providing business to retail investors. Form ADV Part 1A.
\928\ The aggregate AUM reported for these investment advisers
that have retail investors includes both retail AUM as well as any
institutional AUM also held at these advisers.
\929\ Estimates are based on IARD system data as of February 10,
2018. The AUM reported here is specifically that of those non-high
net worth investors. Of the 13,927 state-registered investment
advisers serving retail investors, 134 may also be dually registered
as broker-dealers.
---------------------------------------------------------------------------
c. Trends in the Relative Numbers of Providers of Financial Services
Over time, the relative number of broker-dealers and investment
advisers has changed. Figure 1 presented below shows the time series
trend of growth in broker-dealers and SEC-registered investment
advisers between 2005 and 2018. Over the last 14 years, the number of
broker-dealers has declined from over 6,000 in 2005 to less than 4,000
in 2018, while the number of investment advisers has increased from
approximately 9,000 in 2005 to over 13,000 in 2018. This change in the
relative numbers of broker-dealers and investment advisers over time
likely is a reflection of the market for investment advice, and
potentially of the choices available to retail investors regarding how
to receive or pay for such advice, the nature of the advice, and the
attendant conflicts of interest.
[[Page 33412]]
[GRAPHIC] [TIFF OMITTED] TR12JY19.000
Increases in the number of investment advisers and decreases in the
number of broker-dealers could have occurred for a number of reasons,
including changes in regulation and the enforcement of regulation,
anticipation of possible regulatory changes, technological innovation
(e.g., the increase in automated advisers, which are often colloquially
referred to as ``robo-advisors'' and online trading platforms), product
proliferation (e.g., index mutual funds and exchange-traded products),
and industry consolidation driven by economic and market conditions,
particularly among broker-dealers.\930\ Commission staff has observed
the transition by broker-dealers from traditional brokerage services to
also providing investment advisory services (often under an investment
adviser registration, whether federal or state), and many firms have
been more focused on offering fee-based accounts because they provide a
more steady source of revenue than accounts that charge commissions and
are dependent on transactions.\931\ Broker-dealers have indicated that
the following factors have contributed to this migration: Provision of
revenue stability or increase in profitability,\932\ perceived lower
regulatory burden, and provisions of more services to retail
customers.\933\ Some firms have reported record profits as a result of
moving clients into fee-based accounts, and cite that it provides
``stability and high returns.'' \934\
\930\ See Hester Peirce, Dwindling Numbers in the Financial
Industry, Brookings Center on Markets and Regulation Report (May 15,
2017), available at https://www.brookings.edu/research/dwindling-numbers-in-the-financial-industry/ (``Brookings Report''), which
notes that ``SEC restrictions have increased by almost thirty
percent [since 2000],'' and that regulations post-2010 were driven
in large part by the Dodd-Frank Act. Further, the Brookings Report
observation of increased regulatory restrictions on broker-dealers
only reflects CFTC or SEC regulatory actions, but does not include
regulation by FINRA, other SROs, National Futures Association
(``NFA''), or the Municipal Securities Rulemaking Board (``MSRB'').
\931\ Beyond Commission observations, the Brookings Report,
supra footnote 930, also discusses the shift from broker-dealer to
investment advisory business models for retail investors, in part
due to the DOL Fiduciary Rule. Declining transaction-based revenue
due to declining commission rates and competition from discount
brokerage firms has made fee-based securities and services more
attractive to providers of such securities and services. Although
discount brokerage firms generally provide execution-only services
and do not compete directly in the advice market with full service
broker-dealers and investment advisers, entry by discount brokers
has contributed to lower commission rates throughout the broker-
dealer industry. Further, fee-based activity generates a steady
stream of revenue regardless of the customer trading activity,
unlike commission-based accounts. See also Angela A. Hung, et al.,
Investor and Industry Perspectives on Investment Advisers and
Broker-Dealers, RAND Institute for Civil Justice Technical Report
(2008), available at https://www.rand.org/content/dam/rand/pubs/technical_reports/2008/RAND_TR556.pdf (``2008 RAND Study''), which
discusses a shift from transaction-based to fee-based brokerage
accounts prior to recent regulatory changes.
\932\ Commission staff examined a sample of recent Form 10-K or
Form 10-Q filings of large broker-dealers, many of which are dually
registered as investment advisers, that have a large fraction of
retail customer accounts to identify relevant broker-dealers. See,
e.g., Edward Jones 3/14/2019 Form 10-K available at https://www.sec.gov/Archives/edgar/data/815917/000156459019007788/ck0000815917-10k_20181231.htm; Raymond James 11/21/2018 Form 10-K
available at https://www.sec.gov/Archives/edgar/data/720005/000072000518000083/rjf-20180930x10k.htm; Stifel 2/20/2019 Form 10-K
available at https://www.sec.gov/Archives/edgar/data/720672/000156459019003474/sf-10k_20181231.htm; Wells Fargo 2/27/2019 10-K
available at https://www.sec.gov/Archives/edgar/data/72971/000007297119000227/wfc-12312018x10k.htm; and Ameriprise 2/23/2018
Form 10-K available at https://www.sec.gov/Archives/edgar/data/820027/000082002718000008/amp12312017.htm. We note that discussions
in Form 10-K and 10-Q filings of this sample of broker-dealers here
may not be representative of other large broker-dealers or of small
to mid-size broker-dealers.
\933\ See infra Section III.B.2.e.ii, which discusses industry
trends, particularly in response to the DOL Fiduciary Rule.
\934\ See Hugh Son, Morgan Stanley Wealth-Management Fees Climb
to All-Time High, Bloomberg, Jan. 18, 2018, https://www.bloomberg.com/news/articles/2018-01-18/morgan-stanley-wealth-management-fees-hit-record-on-stock-rally. Morgan Stanley increased
the percentage of client assets in fee-based accounts from 37% in
2013 to 44% in 2017, while decreasing the dependence on transaction-
based revenues from 30% to 19% over the same time period. See Morgan
Stanley Strategic Update (Jan. 18, 2018), available at https://www.morganstanley.com/about-us-ir/shareholder/4q2017-strategic-update.pdf. See also Lisa Beilfuss & Brian Hershberg, WSJ Wealth
Adviser Briefing: The Reinvention of Morgan and Merrill, Adviser
Profile, Wall St. J., Jan. 25, 2018, https://blogs.wsj.com/moneybeat/2018/01/25/wsj-wealth-adviser-briefing-the-reinvention-of-morgan-and-merrill-adviser-profile/.
---------------------------------------------------------------------------
[[Page 33413]]
Further, there has been a substantial increase in the number of
retail clients at investment advisers, both high net worth clients and
non-high net worth clients as shown in Figure 2. Although the number of
non-high net worth retail customers of investment advisers dipped
between 2010 and 2012, it increased by more than 12 million new non-
high net worth retail clients between 2012 and 2017, and has declined
since 2017. With respect to AUM, we observe a similar, albeit more
pronounced pattern for non-high net worth retail clients as shown in
Figure 3. For high net worth retail clients, there has been a
pronounced increase in AUM since 2012, although AUM has leveled off
since 2015 and there also has been leveling and subsequent reduction in
AUM for non-high net worth retail clients over a similar time period.
[GRAPHIC] [TIFF OMITTED] TR12JY19.001
[[Page 33414]]
[GRAPHIC] [TIFF OMITTED] TR12JY19.002
BILLING CODE 8011-01-Cd. Registered Representatives of Broker-Dealers,
Investment Advisers, and Dually Registered Firms
We estimate the number of associated natural persons of broker-
dealers through data obtained from Form U4, which generally is filed
for individuals who are engaged in the securities or investment banking
business of a broker-dealer that is a member of an SRO (``registered
representatives'').\935\ Similarly, we approximate the number of
supervised persons of registered investment advisers through the number
of registered investment adviser representatives (or ``registered
IARs''), who are supervised persons of investment advisers who meet the
definition of investment adviser representatives in Advisers Act rule
203A-3 and are registered with one or more state securities authorities
to solicit or communicate with clients.\936\
---------------------------------------------------------------------------
\935\ The number of associated natural persons of broker-dealers
may be different from the number of registered representatives of
broker-dealers because clerical/ministerial employees of broker-
dealers are associated persons but are not required to register with
FINRA. Therefore, the registered representative number does not
include such persons. However, we do not have data on the number of
associated natural persons and therefore are not able to provide an
estimate of the number of associated natural persons. We believe
that the number of registered representatives is an appropriate
approximation because they are the individuals at broker-dealers
that provide advice and services to customers.
\936\ See Advisers Act, [17 CFR 275.203A-3 (2019)]. However, we
note that the data on numbers of registered IARs may undercount the
number of supervised persons of investment advisers who provide
investment advice to retail investors because not all supervised
persons who provide investment advice to retail investors are
required to register as IARs. For example, Commission rules exempt
from IAR registration supervised persons who provide advice only to
non-individual clients or to individuals that meet the definition of
``qualified client.'' In addition, state securities authorities may
impose different criteria for requiring registration as an
investment adviser representative.
---------------------------------------------------------------------------
We estimate the number of registered representatives and registered
IARs, including dually-registered representatives, (together
``registered financial professionals'') at broker-dealers, investment
advisers, and dual-registrants by considering only the employees of
those firms that have Series 6 or Series 7 licenses or are registered
with a state as a registered representative or investment adviser
representative.\937\ We only consider employees at firms who have
retail-facing business, as defined previously.\938\ We observe in Table
5 that approximately 60% of registered financial professionals are
employed by dually registered entities. The percentage varies by the
size of the firm. For example, for firms with total assets between $1
billion and $50 billion, 67% of all registered financial professionals
in that size category are employed by dually registered firms. Focusing
on dually registered firms only, approximately 60.5% of total
registered financial professionals at these firms are dually registered
representatives; approximately 39.1% are only registered
representatives; and less than one percent are only registered
investment adviser representatives.
---------------------------------------------------------------------------
\937\ We calculate these numbers based on Form U4 filings.
Representatives of broker-dealers, investment advisers, and issuers
of securities must file this form when applying to become registered
in appropriate jurisdictions and with SROs. Firms and
representatives have an obligation to amend and update information
as changes occur. Using the examination information contained in the
form, we consider an employee a registered financial professional if
he or she has an approved, pending, or temporary registration status
for either Series 6 or 7 (registered representative) or is
registered as an investment adviser representative in any state or
U.S. territory (IAR). We limit the firms to only those that do
business with retail investors, and only to licenses specifically
required as a registered representative or IAR.
\938\ See supra footnotes 900 and 927.
[[Page 33415]]
Table 5--Total Registered Representatives at Broker-Dealers, Investment Advisers, and Dually Registered Firms With Retail Investors \939\
--------------------------------------------------------------------------------------------------------------------------------------------------------
% of reps. in % of reps. in % of reps. in % of reps. in % reps. in
Size of firm (total assets for standalone BDs and dually Total number dually standalone BD standalone BD standalone IA standalone IA
registered firms; AUM for standalone IAs) of reps. registered w/an IA w/o an IA w/a BD w/o a BD
firms affiliate affiliate affiliate affiliate
--------------------------------------------------------------------------------------------------------------------------------------------------------
>$50 billion............................................ 84,461 73 7 0 19 1
$1 billion to $50 billion............................... 170,256 67 11 0 15 7
$500 million to $1 billion.............................. 29,874 71 5 1 7 16
$100 million to $500 million............................ 66,924 51 27 0 4 18
$10 million to $100 million............................. 106,178 55 42 2 1 1
$1 million to $10 million............................... 33,790 35 54 11 0 0
<$1 million............................................. 12,522 8 52 36 3 1
-----------------------------------------------------------------------------------------------
Total Licensed Representatives...................... 504,005 60 23 2 9 6
--------------------------------------------------------------------------------------------------------------------------------------------------------
In Table 6 below, we estimate the number of employees who are
registered representatives, registered investment adviser
representatives, or dually registered representatives.\940\ Similar to
Table 5, we calculate these numbers using Form U4 filings. Here, we
also limit the sample to employees at firms that have retail-facing
businesses as discussed previously.\941\
---------------------------------------------------------------------------
\939\ The classification of firms as dually registered,
standalone broker-dealers, and standalone investment advisers comes
from Forms BD, FOCUS, and ADV as described earlier. The number of
representatives at each firm is obtained from Form U4 filings. Note
that all percentages in the table have been rounded to the nearest
whole percentage point.
\940\ We calculate these numbers based on Form U4 filings.
\941\ See supra footnotes 900 and 927.
---------------------------------------------------------------------------
In Table 6, approximately 25% of registered employees at registered
broker-dealers or investment advisers are dually registered
representatives. However, this proportion varies significantly across
size categories. For example, for firms with total assets between $1
billion and $50 billion,\942\ approximately 35% of all registered
employees are dually registered representatives. In contrast, for firms
with total assets below $1 million, 13% of all employees are dually
registered representatives.
---------------------------------------------------------------------------
\942\ Firm size is defined as total assets from the balance
sheet for broker-dealers and dual-registrants (source: FOCUS
reports) and as AUM for investment advisers (source: Form ADV). We
are unable to obtain customer assets for broker-dealers, and for
investment advisers, we can only obtain information from Form ADV as
to whether the firm assets exceed $1 billion. We recognize that our
approach of using firm assets for broker-dealers and customer assets
for investment advisers does not allow for direct comparison;
however, our objective is to provide measures of firm size and not
to make comparisons between broker-dealers and investment advisers
based on firm size. Across both broker-dealers and investment
advisers, larger firms, regardless of whether we stratify on firm
total assets or AUM, have more customer accounts, are more likely to
be dually registered, and have more representatives or employees per
firm than smaller broker-dealers or investment advisers.
Table 6--Number of Employees at Retail-Facing Firms Who Are Registered Representatives, Investment Adviser
Representatives, or Both \943\
----------------------------------------------------------------------------------------------------------------
Percentage of Percentage of
Size of firm (total assets for standalone Total number of dually registered Percentages of
BDs and dually registered firms; AUM for employees registered representatives IARs only
standalone IAs) representatives only
----------------------------------------------------------------------------------------------------------------
>$50 billion................................ 218,539 19 16 1
$1 billion to $50 billion................... 328,842 35 12 4
$500 million to $1 billion.................. 43,211 18 40 10
$100 million to $500 million................ 119,214 23 24 9
$10 million to $100 million................. 176,559 20 39 1
$1 million to $10 million................... 56,230 17 39 1
<$1 million................................. 18,334 13 46 3
-------------------------------------------------------------------
Total Employees at Retail-Facing Firms.. 960,929 25 23 4
----------------------------------------------------------------------------------------------------------------
Approximately 87% of investment adviser representatives are dually
registered representatives. This percentage is relatively unchanged
from 2010. According to information provided in a FINRA comment letter
in connection with the 913 Study, 87.6% of registered investment
adviser representatives were dually registered as registered
representatives as of mid-October 2010.\944\ In contrast, approximately
52% of registered representatives were dually registered as investment
adviser representatives at the end of 2018.\945\
---------------------------------------------------------------------------
\943\ See supra footnotes 899, 920, 940, and 942. Note that all
percentages in the table have been rounded to the nearest whole
percentage point.
\944\ See Letter from Angela C. Goelzer, FINRA, to Jennifer B.
McHugh, Senior Advisor to the Chairman, U.S. Securities and Exchange
Commission, re: File Number 4-606; Obligations of Brokers, Dealers
and Investment Advisers (Nov. 3, 2010), at 1, available at https://www.sec.gov/comments/4-606/4606-2836.pdf.
\945\ In order to obtain the percentage of IARs that are dually
registered as registered representatives of broker-dealers, we sum
the representatives at dually registered entities and those at
investment advisers across size categories to obtain the aggregate
number of representatives in each of the two categories. We then
divide the aggregate dually registered representatives by the sum of
the dually registered representatives and the IARs at investment
adviser-only firms. We perform a similar calculation to obtain the
percentage of registered representatives of broker-dealers that are
dually registered as IARs.
---------------------------------------------------------------------------
e. Investor Account Statistics
Investors seek financial advice and services to achieve a number of
different goals, such as saving for retirement or children's college
education. Approximately 73% of adults live in a
[[Page 33416]]
household that invests.\946\ The OIAD/RAND survey indicates that non-
investors are more likely to be female, to have lower family income and
educational attainment, and to be younger than investors.\947\
Approximately 35% of households that do invest do so through accounts
such as broker-dealer or advisory accounts.\948\
---------------------------------------------------------------------------
\946\ See OIAD/RAND, defining ``investors'' as persons ``owning
at least one type of investment account, (e.g., an employer-
sponsored retirement account, a non-employer sponsored retirement
account such as an IRA, a college savings investment account, or
some other type of investment account such as a brokerage or
advisory account), or owning at least one type of investment asset
(e.g., mutual funds, exchange-traded funds or other funds;
individual stocks; individual bonds; derivatives; and annuities).''
\947\ Id. at 36.
\948\ Id. at 39.
---------------------------------------------------------------------------
As shown above in Figures 2 and 3, the number of retail investors
and their AUM associated with investment advisers has increased
significantly, particularly since 2012. As of December 2016, nearly
$24.2 trillion is invested in retirement accounts, of which $7.5
trillion is in IRAs.\949\ A total of 43.3 million U.S. households have
either an IRA or a brokerage account; an estimated 20.2 million U.S.
households have a brokerage account, and 37.7 million households have
an IRA (including 72% of households that also hold a brokerage
account).\950\ With respect to IRA accounts, one commenter documents
that 43 million U.S. households own either traditional or Roth IRAs and
that approximately 70% are held with financial professionals, with the
remainder being direct market.\951\ Further, this commenter finds that
approximately 64% of households have aggregate IRA (traditional and
Roth) balances of less than $100,000, and approximately 36% of
investors have balances below $25,000. As noted in one study, the
growth of assets in traditional IRAs comes from rollovers from
workplace retirement plans; for example, 58% of traditional IRAs
consist of rollover assets, and contributions due to rollovers exceeded
$460 billion in 2015 (the most recently available data).\952\
---------------------------------------------------------------------------
\949\ See Sarah Holden & Daniel Schrass, The Role of IRAs in
U.S. Households' Saving for Retirement, 2016, ICI Res. Persp., Jan.
2017, available at https://www.ici.org/pdf/per17-08.pdf. See also
ICI Letter.
\950\ The data is obtained from the Federal Reserve System's
2016 Survey of Consumer Finances (``SCF Survey''), a triennial
survey of approximately 6,200 U.S. households, and imputes weights
to extrapolate the results to the entire U.S. population. As noted,
some survey respondent households have both a brokerage and an IRA.
See Board of Governors of the Federal Reserve System, Survey of
Consumer Finances (2016), available at https://www.federalreserve.gov/econres/scfindex.htm. The SCF Survey data
does not directly examine the incidence of households that could use
advisory accounts instead of brokerage accounts; however, some
fraction of IRA accounts reported in the survey could be those held
at investment advisers.
\951\ See Sarah Holden & Daniel Schrass, The Role of IRAs in US
Households' Saving for Retirement, 2018, ICI Res. Persp., Dec. 2018,
available at https://www.ici.org/pdf/per24-10.pdf. See also ICI
Letter.
\952\ See Holden & Schrass (2018), supra footnote 951.
---------------------------------------------------------------------------
While the number of retail investors obtaining services from
investment advisers and the aggregate value of associated AUM has
increased, the OIAD/RAND study also suggests that the general
willingness of investors to use planning or to take financial advice
regarding strategies, securities, or accounts is relatively fixed over
time.\953\ With respect to the account assets associated with retail
investors, the OIAD/RAND survey also estimates that approximately 10%
of investors who have brokerage or advisory accounts hold more than
$500,000 in assets, while approximately 47% hold $50,000 in assets or
less. Altogether, investors who have brokerage or advisory accounts
typically trade infrequently, with approximately 31% reporting no
annual transactions and an additional approximately 30% reporting three
or fewer transactions per year.\954\
---------------------------------------------------------------------------
\953\ See OIAD/RAND at 50 (noting that this conclusion was
limited by the methodology of comparing participants in a 2007
survey with those surveyed in 2018).
\954\ See OIAD/RAND.
---------------------------------------------------------------------------
With respect to particular securities, commenters have provided us
with additional information about ownership of mutual funds and IRA
account statistics. For example, one commenter stated that 56 million
U.S. households and nearly 100 million individual investors own mutual
funds, of which 80% are held through 401(k) and other work-based
retirement plans, while 63% of investors hold mutual funds outside of
those plans.\955\ Of those investors who own mutual funds outside of
workplace retirement plans, approximately 50% use financial
professionals, while nearly one-third purchase direct-sold funds either
directly from the fund company or through a discount broker.\956\
---------------------------------------------------------------------------
\955\ See ICI Letter; see also Sarah Holden, Daniel Schrass, &
Michael Bogdan, Ownership of Mutual Funds, Shareholder Sentiment,
and Use of the internet, 2018, ICI Res. Persp., Nov. 2018, available
at https://www.ici.org/pdf/per22-06.pdf.
\956\ See Holden et al. (2018), supra footnote 955. See also ICI
Letter.
---------------------------------------------------------------------------
Table 7 below provides an overview of account ownership segmented
by account type (e.g., IRA, brokerage, or both) and investor income
category based on the SCF Survey.\957\
---------------------------------------------------------------------------
\957\ See SCF Survey, supra footnote 950. To the extent that
investors have IRA accounts at banks that are not also registered as
broker-dealers, our data may overestimate the numbers of IRA
accounts held by retail investors that could be subject to
Regulation Best Interest.
Table 7--Ownership by Account Type in the U.S. by Income Group
[As reported by the 2016 SCF Survey]
----------------------------------------------------------------------------------------------------------------
% Both
Income category % Brokerage % IRA only brokerage and
only IRA
----------------------------------------------------------------------------------------------------------------
Bottom 25%...................................................... 1.2 7.6 2.4
25%-50%......................................................... 3.2 14.5 5.4
50%-75%......................................................... 4.1 21.4 11.4
75%-90%......................................................... 7.5 33.4 16.5
Top 10%......................................................... 12.0 24.7 43.9
Average......................................................... 4.4 18.3 11.6
----------------------------------------------------------------------------------------------------------------
With respect to the nature of the accounts held by investors and
whether they are managed by financial professionals, the OIAD/RAND
survey finds that 36% of its sample of participants report that they
currently use a financial professional and approximately 33% receive
some kind of recommendation service.\958\ Of the
[[Page 33417]]
subset of those investors who report holding a brokerage, advisory, or
similar account, approximately 33% self-direct their own account, 25%
have their account managed by a financial professional, and 10% have
their account advised by a financial professional.\959\ For those
investors who take financial advice, the OIAD/RAND study suggests that
they may differ in characteristics from other investors. The survey
further finds that investors who take financial advice are generally
older, retired, and have a higher income than other investors, but also
may have lower educational attainment (e.g., high school or less) than
other investors.\960\
---------------------------------------------------------------------------
\958\ See OIAD/RAND at 48. In a focus group preceding the
survey, focus group participants provided a number of reasons for
not using a financial professional in making investments, including
being unable or unwilling to pay the fees, doing their own financial
research, being unsure of how to work with a professional, and being
concerned about professionals selling securities without attending
to investors' plans and goals.
\959\ See OIAD/RAND at 46.
\960\ See OIAD/RAND at 48.
---------------------------------------------------------------------------
Similarly, one question in the SCF Survey asks what sources of
information households' financial decision-makers use when making
decisions about savings and investments. Respondents can list up to
fifteen possible sources from a preset list that includes ``Broker'' or
``Financial Planner'' as well as ``Banker,'' ``Lawyer,''
``Accountant,'' and a list of non-professional sources.\961\ Panel A of
Table 8 below presents the breakdown of where households who have
brokerage accounts seek advice about savings and investments. The table
shows that of those respondents with brokerage accounts, 23% (4.7
million households) use advice services of broker-dealers for savings
and investment decisions, while 49% (7.8 million households) take
advice from a ``financial planner.'' Approximately 36% (7.2 million
households) seek advice from other sources such as bankers,
accountants, and lawyers. Almost 25% (5.0 million households) do not
use advice from the above sources.
---------------------------------------------------------------------------
\961\ See SCF Survey, supra footnote 950, which specifically
asks participants ``Do you get advice from a friend, relative,
lawyer, accountant, banker, broker, or financial planner? Or do you
do something else?'' See Federal Reserve Codebook for 2016 Survey of
Consumer Finances (2016), available at https://www.federalreserve.gov/econres/files/codebk2016.txt. Other response
choices presented by the survey include ``Calling Around,''
``Magazines,'' ``Self,'' ``Past Experience,'' ``Telemarketer,'' and
``Insurance Agent,'' as well as other choices. Respondents could
also choose ``Do Not Save/Invest.'' The SCF Survey allows for
multiple responses, so these categories are not mutually exclusive.
However, we would note that the list of terms in the question does
not specifically include ``investment adviser.''
---------------------------------------------------------------------------
Panel B of Table 8 below presents the breakdown of advice received
by households who have an IRA. Approximately 15% (5.7 million
households) rely on advice services of their broker-dealers and 48%
(18.3 million households) obtain advice from financial planners.
Approximately 41% (15.5 million households) seek advice from bankers,
accountants, or lawyers, while the 25% (9.5 million households) use no
advice or seek advice from other sources.
Table 8--Panel A: Sources of Advice for Households Who Have a Brokerage Account in the U.S. by Income Group
\962\
----------------------------------------------------------------------------------------------------------------
% Taking advice
% Taking advice % Taking advice from lawyers, % Taking no
Income category from brokers from financial bankers, or advice or from
planners accountants other sources
----------------------------------------------------------------------------------------------------------------
Bottom 25%.................................. 20.55 53.89 35.64 24.30
25%-50%..................................... 22.98 38.03 43.92 32.36
50%-75%..................................... 20.75 52.00 31.42 23.61
75%-90%..................................... 22.56 48.94 32.25 28.10
Top 10%..................................... 25.29 50.53 38.47 21.06
Average..................................... 23.02 49.02 35.99 24.94
----------------------------------------------------------------------------------------------------------------
Table 8--Panel B: Sources of Advice for Households Who Have an IRA in the U.S. by Income Group \963\
----------------------------------------------------------------------------------------------------------------
% Taking advice
% Taking advice % Taking advice from lawyers, % Taking no
Income category from brokers from financial bankers, or advice or from
planners accountants other sources
----------------------------------------------------------------------------------------------------------------
Bottom 25%.................................. 12.14 38.30 43.69 31.85
25%-50%..................................... 9.79 43.82 40.67 32.74
50%-75%..................................... 14.93 45.20 41.23 25.23
75%-90%..................................... 14.68 52.14 41.65 24.26
Top 10%..................................... 21.40 55.40 40.03 18.56
Average..................................... 15.25 48.45 41.17 25.28
----------------------------------------------------------------------------------------------------------------
The OIAD/RAND survey notes that for survey participants who
reported working with a specific individual for investment advice, 70%
work with a dual-registrant, 5.4% with a broker-dealer, and 5.1% with
an investment adviser.\964\
---------------------------------------------------------------------------
\962\ See SCFR Survey, supra footnote 950.
\963\ Id.
\964\ See OIAD/RAND at 53. As documented by OIAD/RAND, retail
investors surveyed had difficulty in accurately identifying the type
of relationship that they have with their financial professional.
---------------------------------------------------------------------------
f. Financial Incentives of Firms and Financial Professionals
Commission experience indicates that there is a broad range of
financial incentives provided by standalone broker-dealers and dually
registered firms to their financial professionals.\965\ While some
firms provide base pay for their financial professionals ranging from
approximately $45,000 to $85,000 per year, many firms provide
compensation only through a percentage of commissions, plus
performance-
[[Page 33418]]
based awards, such as individual or team bonuses based on
production.\966\ Commission-based compensation to financial
professionals range from 30% to 95% of total commissions paid to the
firm on a particular transaction, although this compensation is
generally reduced by various costs and expenses attributable to the
financial professional (e.g., clearing costs associated with some
securities, charges related to an SRO or the Securities Investor
Protection Corporation (``SIPC''), and insurance, among others).
---------------------------------------------------------------------------
\965\ Information on compensation and financial incentives
generally relates to 2016 compensation arrangements for a sample of
approximately 20 firms, comprising both standalone broker-dealers
and dually registered firms. We acknowledge that the information
provided in this baseline may not be representative of the
compensation structures more generally because of the diversity and
complexity of services and securities offered by standalone broker-
dealers and dually registered firms.
\966\ Commission experience indicates that some firms award
production bonuses based on commissions generated, while other firms
provide awards based on AUM.
---------------------------------------------------------------------------
Several firms have varying commission-based compensation rates
depending on the investment type being sold. For example, compensation
ranges from 76.5% for stocks, bonds, options, and commodities to 90%
for open-ended mutual funds, private placements, and unit investment
trusts. Several firms charge varying commissions on securities
depending on the amount of security sold (e.g., rates on certain
proprietary mutual funds range from 0.75% to 5.75% depending on the
share class), but do not provide those rates to financial professionals
based on investment type. Some firms also provide incentives for their
financial professionals to recommend proprietary securities and
services over third-party or non-proprietary securities. Commission
rates for some firms, however, decline as the dollar amount sold
increases, and such rates vary across asset classes as well (e.g.,
within a given share class, rates range from 1.50% to 5.75% depending
on the dollar amount of the fund sold). With respect to compensation to
individual financial professionals, if compensation rates for mutual
funds are approximately 90% (as discussed above, for example),
financial professionals can earn between 0.68% and 5.18%, depending on
the type and amount of security sold.
For financial professionals who do not earn commission-based
compensation, some firms charge retail customers flat fees ranging from
$500 to $2,500, depending on the level of service required, such as
financial planning, while others charge hourly rates ranging from $150
to $350 per hour. For dually registered firms that charge clients based
on a percentage of AUM, the average percentage charge varies based on
the size of the account: The larger the AUM, the lower the percentage
fee charged. Percentage-based fees for the sample firms range from
approximately 1.5% for accounts below $250,000 to 0.5% for accounts in
excess of $1 million.\967\ If compensation rates range between 30% and
95%, a firm charging a customer $500 can provide compensation to the
financial professional between $150 and $475 for each financial plan
provided. For fee-based accounts, assuming that a retail customer has
an account worth $250,000, the firm will charge account-level fees of
$3,750 ($250,000 x 1.5%), and the financial professional can earn
between $1,170 and $3,560 annually for each account. However, accounts
may also be subject to additional fees beyond those described here and
the financial professionals also may receive additional compensation.
---------------------------------------------------------------------------
\967\ We note that some firms could have higher or lower
commission-based compensation rates or asset-based fee percentages
than those provided here. For example, based on a review of Form ADV
Part 2A (the brochure) of several large dual-registrants (not
included in the sample above), asset-based fees for low AUM accounts
could range as high as 2.0% to 3.0%, with the average fee for high
AUM accounts ranging between 0.5% to 1.5%. See also AdvisoryHQ,
Average Financial Advisor Fees in 2018-2019: Fees Charged by
Advisory & Wealth Management Firms, http://www.advisoryhq.com/articles/financial-advisor-fees-wealth-managers-planners-and-fee-only-advisors/. The AdvisoryHQ report shows that average asset-based
fees range from 1.18% for accounts less than $50,000 to less than
0.60% for accounts in excess of $30 million, while fixed-fees range
from $7,500 for accounts less than $500,000 to $55,000 for accounts
in excess of $7.5 million. Again, we note that these are charges to
clients and are not indicative of the total compensation earned by
the financial professional per account.
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In addition to ``base'' compensation, most firms also provide
bonuses (based on either individual or team performance) or variable
compensation, ranging from approximately 10% to 83% of base
compensation. These bonuses could be awarded based on either
commissions generated or AUM. While the majority of firms base at least
some portion of their bonuses on production, usually in the form of
total gross revenue, other forms of bonus compensation are derived from
customer retention, customer experience, and manager assessment of
performance. Moreover, some firms use a tiered system within their
compensation grids depending on firm experience and production levels.
Financial professionals' variable compensation can also increase when
they enroll retail customers in advisory accounts versus other types of
accounts, such as brokerage accounts. Some firms also provide
transition bonuses for financial professionals with prior work
experience based on historical trailing production levels and AUM.
Although many firms do not have any incentive-based contests or
programs, some firms award non-cash incentives for meeting certain
performance, best practices, or customer service goals, including
trophies, dinners with senior officers, and travel to annual meetings
with other award winners.\968\
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\968\ See FINRA Regulatory Notice 16-29, Gifts, Gratuities and
Non-Cash Compensation Rules--FINRA Requests Comment on Proposed
Amendments to Its Gifts, Gratuities and Non-Cash Compensation Rules
(Aug. 2016). At the time this notice was published, FINRA's
impression was that investment-specific internal sales contests for
non-cash compensation were not widely used.
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2. Regulatory Baseline and Current Market Practices
Broker-dealers' current standards of conduct are governed by
federal and state law and regulation as well as the rules and guidance
of SROs,\969\ particularly, for the purposes of this rulemaking, those
related to the suitability of recommendations and disclosure of
conflicts of interest. In response to comment letters that stated the
Proposing Release did not fully consider the current market practices,
we have provided an overview of these practices reported by commenters
and from industry studies.\970\ Together, these laws and regulations
comprise the regulatory baseline.
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\969\ Generally, all registered broker-dealers that deal with
the public must become members of FINRA, a registered national
securities association, and may choose to become exchange members.
See Exchange Act section 15(b)(8) and Exchange Act rule 15b9-1.
FINRA is the sole national securities association registered with
the SEC under section 15A of the Exchange Act. Accordingly, for
purposes of discussing a broker-dealer's regulatory requirements
when providing advice, we focus on FINRA's regulation, examination,
and enforcement with respect to member broker-dealers.
\970\ See, e.g., AALU Letter; Letter from John L. Thornton, Co-
Chair, Committee in Capital Markets Regulation (Jul. 18, 2018)
(``CCMR Letter''); CFA August 2018 Letter; Davis & Harman Letter;
EPI Letter; Lincoln Financial Letter; NASAA August 2018 Letter; UVA
Letter (which stated that the Proposing Release did not adequately
address current market practices and/or provide industry studies and
surveys of those practices).
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a. Federal and State Securities Laws
Under the antifraud provisions of the federal securities laws and
SRO rules, broker-dealers are required to deal fairly with their
customers.\971\ In addition, broker-dealers must comply with a wide
[[Page 33419]]
range of specific obligations specified in the Exchange Act and the
rules thereunder. Moreover, there is a body of case law holding that
broker-dealers that exercise discretion or control over customer
assets, or have a relationship of trust and confidence with their
customers, may owe customers a fiduciary duty, depending on the
circumstances.\972\ Additionally, some states provide through statute
or regulation, among other requirements such as minimum requirements
for sales practices, that broker-dealers have some form of state-
specific fiduciary duty to their customers in at least some
circumstances. Substantial variation exists among states' fiduciary
standards, ranging from states with express fiduciary standards that
apply to broker-dealers to those with limited or no such
standards.\973\
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\971\ See, e.g., FINRA Rule 2010 (Standards of Commercial Honor
and Principles of Trade); NASD Interpretive Material 2310-2, Fair
Dealing with Customers (``Implicit in all member and registered
representative relationships with customers and others is the
fundamental responsibility for fair dealing. Sales efforts must
therefore be undertaken only on a basis that can be judged as being
within the ethical standards of [FINRA's] Rules, with particular
emphasis on the requirement to deal fairly with the public.'');
Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), cert.
denied, 321 U.S. 786 (1944); Hanly v. SEC, 415 F.2d 589, 596 (2d
Cir. 1969); see also e.g., 913 Study at 51 and footnote 221.
\972\ See, e.g., U.S. v. Skelly, 442 F.3d 94, 98 (2d Cir. 2006)
(fiduciary duty found ``most commonly'' where ``a broker has
discretionary authority over the customer's account''); United
States v. Szur, 289 F.3d 200, 211 (2d Cir. 2002) (``Although it is
true that there `is no general fiduciary duty inherent in an
ordinary broker/customer relationship,' a relationship of trust and
confidence does exist between a broker and a customer with respect
to those matters that have been entrusted to the broker.'')
(citations omitted); Leib v. Merrill Lynch, Pierce, Fenner & Smith,
Inc., 461 F. Supp. 951, 953-954 (E.D. Mich. 1978), aff'd, 647 F.2d
165 (6th Cir. 1981) (recognizing that a broker who has de facto
control over non-discretionary account generally owes customer
duties of a fiduciary nature; looking to customer's sophistication,
and the degree of trust and confidence in the relationship, among
other things, to determine duties owed); Arleen W. Hughes, Exchange
Act Release No. 4048 (Feb. 18, 1948) (Commission Opinion), aff'd sub
nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949) (``Release 4048'')
(noting that fiduciary requirements generally are not imposed upon
broker-dealers who render investment advice as an incident to their
brokerage unless they have placed themselves in a position of trust
and confidence, and finding that Hughes was in a relationship of
trust and confidence with her clients). See also Gross Letter (which
discussed the obligations of broker-dealers with discretionary or de
facto control over customer accounts); Solely Incidental
Interpretation.
\973\ See AARP August 2018 Letter; PIABA Letter; U. of Miami
Letter. See also Michael S. Finke & Thomas Patrick Langdon, The
Impact of the Broker-Dealer Fiduciary Standard on Financial Advice
(Working Paper, Mar. 9, 2012) for a discussion of state fiduciary
standards. One comment letter also provided an extensive overview of
the fiduciary obligations of state-registered investment advisers,
``typified by an expectation of undivided loyalty where the adviser
acts primarily for the benefit of its clients.'' See NASAA February
2019 Letter at 22 and footnote 40. This comment letter also stated
that ``[s]ome states also extend these fiduciary obligations beyond
investment advisers to brokers, especially in dual-hatted
scenarios,'' and that these fiduciary obligations were extended even
when broker-dealers handled non-discretionary accounts. Id. at 23-24
and footnote 41.
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b. FINRA Rule 2111: Suitability
FINRA Rule 2111 (the ``Suitability Rule'') requires that a broker-
dealer or associated person have a reasonable basis to believe that a
recommended securities transaction or investment strategy involving
securities is suitable for the retail customer.\974\ A broker-dealer
cannot disclaim away its suitability obligation under the Suitability
Rule.\975\ We reviewed the Suitability Rule and drew upon it and
enhanced the suitability requirement in developing Regulation Best
Interest.\976\ FINRA also requires additional specific suitability
obligations with respect to certain types of securities or
transactions, such as variable insurance products and derivatives
securities, including options and securities-based futures.\977\
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\974\ See FINRA Rule 2111, supra footnote 161. As a ``General
Principle,'' the rule states that associated persons have a
``fundamental responsibility for fair dealing'' and that the rule is
intended to promote ethical sales practices and high standards of
commercial conduct. See FINRA Rule 2111.01. See also, In re
Application of Raghavan Sathianathan, Exchange Act Release No. 54722
at 10 (Nov. 8, 2006) (``Sathianathan's recommendations . . . were
unsuitable because they were designed to maximize his own
commissions rather than to establish a suitable portfolio.''). See
also 913 Study at 59 and footnote 187.
\975\ FINRA Rule 2111.02 (Disclaimers).
\976\ See supra footnote 161. The primary requirements for the
Suitability Rule are described in the Proposing Release at Section
IV.B.2.a.
\977\ See, e.g., FINRA Rule 2330 (Members' Responsibilities
Regarding Deferred Variable Annuities); FINRA Rule 2360 (Options);
FINRA Rule 2370 (Securities Futures); FINRA Rule 2821 (Sales
Practices for Deferred Variable Annuities including a Suitability
Obligation). See also 913 Study at 65-66.
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As discussed by several commenters,\978\ the regulatory baseline
also includes FINRA guidance on best practices, such as guidance
regarding suitability, which provides guidance on how broker-dealers
and associated persons should comply with suitability obligations when
making recommendations to customers. FINRA guidance regarding
suitability includes Regulatory Notice 12-25, which states that under
the Suitability Rule, ``a broker's recommendations must be consistent
with his customers' best interests,'' \979\ as well as other regulatory
notices that provide guidance on the suitability of specific securities
or investment strategies involving securities, including, but not
limited to, mutual funds, variable contracts including annuities,
structured and complex securities, leveraged and inverse exchange-
traded products, and IRA rollovers.\980\
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\978\ See CFA August 2018 Letter; Bank of America Letter;
Transamerica August 2018 Letter.
\979\ See FINRA Regulatory Notice 12-25; see also FINRA
Regulatory Notice 13-31, Suitability--FINRA Highlights Examination
Approaches, Common Findings and Effective Practices for Complying
With its Suitability Rules (Sep. 2013) (which provides ``. . .
effective practices . . . to help firms enhance compliance and
supervision under the suitability rule'').
\980\ See, e.g., NASD Notice to Members 94-16, NASD Reminds
Members Of Mutual Fund Sales Practice Obligations (Mar. 1994) and
NASD Notice to Members 95-80, NASD Further Explains Members
Obligations and Responsibilities Regarding Mutual Funds Sales
Practices (Sep. 1995) (mutual fund suitability and sales practices);
NASD Notice to Members 96-86, NASD Regulation Reminds Members and
Associated Persons that Sales of Variable Contracts are Subject to
NASD Suitability Requirements (Dec. 1996) and NASD 99-35, NASD
Reminds Members of Their Responsibilities Regarding Sales of
Variable Annuities (May 1999) (suitability and sales practices of
variable contracts and variable annuities); NASD Notice to Members
05-59, NASD Provides Guidance Concerning the Sale of Structure
Products; and FINRA Regulatory Notice 12-03, Complex Products--
Heightened Supervision of Complex Products (Jan. 2012); (suitability
and sales practices of structured and complex products); FINRA
Regulatory Notice 09-31, FINRA Reminds Firms of Sales Practice
Obligations Relating to Leveraged and Inverse Exchange-Traded Funds
(June 2009) (sales practices of leveraged and inverse ETFs); and
FINRA Regulatory Notice 13-45, Rollovers to Individual Retirement
Accounts--FINRA Reminds Firms of Their Responsibilities Concerning
IRA Rollovers (Dec. 2013) (obligations when recommending a rollover
or transfer of assets from a sponsored retirement plan to an IRA).
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c. FINRA Report on Conflicts of Interest
In 2013, FINRA published as guidance a Report on Conflicts of
Interest (``FINRA Conflicts Report'') to provide an overview of
effective practices that broker-dealers could employ to manage and
mitigate conflicts of interest.\981\ In the report, FINRA provides
suggestions for broker-dealers for addressing conflicts of interest
related to three broad areas: A firm-level approach to identify and
manage conflicts of interest; the production and distribution of new
securities; and compensation and other financial incentives of
associated persons.\982\ With respect to new securities, the FINRA
Conflicts Report recommends, among other things, new security review
committees and disclosure of conflicts related to recommendations of
new securities to customers.\983\ The FINRA Conflicts Report also
provides guidance to broker-dealers on managing conflicts of interest
that arise from compensation and financial incentives of broker-
dealers. For example, the FINRA Conflicts Report recommends increased
surveillance of recommendations near compensation thresholds and
capping compensation credits across similar
[[Page 33420]]
investment types to prevent representatives from preferentially
recommending securities that yield the largest compensation.\984\
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\981\ See FINRA Conflicts Report, supra footnote 459. See also
IRI Letter, which notes that the FINRA Conflicts Report ``. . .
provides valuable guidance as to the elements of an effective
practice framework for managing BDs' conflicts of interest. . .''
See also SIFMA August 2018 Letter; CFA August 2018 Letter; Raymond
James Letter; Ameriprise Letter; ACLI Letter; Fein Letter.
\982\ See FINRA Conflicts Report, supra footnote 459.
\983\ Id.
\984\ Id.
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d. Other Broker-Dealer Obligations: Disclosure, Supervision, and
Compensation
Broker-dealers are subject to other disclosure obligations under
the federal securities laws and SRO rules. For instance, under existing
antifraud provisions of the Exchange Act, a broker-dealer has a duty to
disclose material adverse information to its customers.\985\ Broker-
dealers found to be acting as fiduciaries also have a duty to disclose
material conflicts of interest.\986\ Broker-dealers are also prohibited
from making misleading statements.\987\ Courts have found that broker-
dealers, in making recommendations, should have disclosed that they
were: Acting as a market maker for the recommended security; trading as
a principal with respect to the recommended security; engaging in
revenue sharing with a recommended mutual fund; or ``scalping'' a
recommended security.\988\
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\985\ A broker-dealer may be liable if it does not disclose
``material adverse facts of which it is aware.'' See, e.g., Chasins
v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2nd Cir. 1970); SEC v.
Hasho, 784 F. Supp. 1059, 1110 (S.D.N.Y. 1992); In the Matter of
RichMark Capital Corp., Exchange Act Release No. 48758 (Nov. 7,
2003) (Commission Opinion) (``When a securities dealer recommends
stock to a customer, it is not only obligated to avoid affirmative
misstatements, but also must disclose material adverse facts of
which it is aware. That includes disclosure of `adverse interests'
such as `economic self-interest' that could have influenced its
recommendation.'') (citations omitted). See also Relationship
Summary Proposal.
\986\ See, e.g., United States v. Szur, 289 F.3d 200, 212 (2d
Cir. 2002) (broker's fiduciary relationship with customer gave rise
to a duty to disclose commissions to customer, which would have been
relevant to customer's decision to purchase stock); Arleen W.
Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948) (Commission
Opinion), aff'd sub nom. Hughes v. SEC, 174 F.2d 969, 976 (D.C. Cir.
1949) (broker-dealer acted in the capacity of a fiduciary and, as
such, broker-dealer was under a duty to make full disclosure of the
nature and extent of her adverse interest when engaging in principal
transactions, ``including her cost of the securities and the best
price at which the security might be purchased in the open
market'').
\987\ See Proposing Release at footnotes 175-177 and 205, and
accompanying text. See Exchange Act Sections 10(b) and 15(c).
\988\ See 913 Study at footnotes 251-54. See also id. at
footnotes 225-232 (which discuss existing SRO rules on disclosures).
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Broker-dealers are also currently subject to supervisory
obligations under Section 15(b)(4)(E) of the Exchange Act and SRO
rules, including the establishment of policies and procedures
reasonably designed to prevent and detect violations of, and to achieve
compliance with, the federal securities laws and regulations, as well
as applicable SRO rules.\989\ Specifically, the Exchange Act authorizes
the Commission to sanction a broker-dealer or any associated person
that fails to reasonably supervise another person subject to the firm's
or the person's supervision that commits a violation of the federal
securities laws.\990\ The Exchange Act provides an affirmative defense
against a charge of failure to supervise where reasonable procedures
and systems for applying the procedures have been established and
effectively implemented without reason to believe those procedures and
systems are not being complied with. Further, under the federal
securities laws and FINRA rules, prices for securities and broker-
dealer compensation are required to be fair and reasonable, taking into
consideration all relevant circumstances.\991\
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\989\ See supra footnote 809. See also Proposing Release at
21622.
\990\ Exchange Act Sections 15(b)(4)(E) and (b)(6)(A).
\991\ See, e.g., Exchange Act Sections 10(b) and 15(c); FINRA
Rules 2121 (Fair Prices and Commissions), 2122 (Charges for Services
Performed), and 2341 (Investment Company Securities). See also FINRA
Rule 3221 (Non-Cash Compensation). Several commenters stated that,
as part of their overall business practices, they use non-cash
compensation (e.g., firm-sponsored business conferences), which they
believe is in compliance with existing FINRA Rule 3221 on non-cash
compensation practices. See Guardian August 2018 Letter; NY Life
Letter.
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Broker-dealers also register with and report information, including
about their business and affiliates, to the Commission, the SROs, and
other jurisdictions through Form BD.\992\ Form BD requires information
about the background of the applicant, its principals, controlling
persons, and employees, as well as information about the type of
business in which the broker-dealer proposes to engage and all control
affiliates engaged in the securities or investment advisory
business.\993\ Once a broker-dealer is registered, it must keep its
Form BD current by amending it promptly when the information is or
becomes inaccurate for any reason.\994\ In addition, firms report
similar information and additional information--such as written
customer complaints and other disciplinary matters-- to FINRA pursuant
to FINRA Rule 4530 (Reporting Requirements).
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\992\ See Relationship Summary Proposal at 21472; see also
generally Form BD.
\993\ See generally Form BD.
\994\ See Exchange Act rule 15b3-1(a).
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e. DOL Fiduciary Rule as It Relates to Current Market Practice
This section discusses the recently vacated DOL Fiduciary
Rule,\995\ the implications for broker-dealers, and the industry
response to the DOL Fiduciary Rule. Although the DOL Fiduciary Rule was
vacated by the Fifth Circuit Court of Appeals in June, we discuss the
DOL Fiduciary Rule as part of the baseline because certain broker-
dealers and other industry participants may have adjusted their
practices in order to plan for the implementation of the requirements
of this rule. It is possible that some of these broker-dealers may
continue to operate their business using these adjusted practices,
while other may have reverted to the pre-DOL Fiduciary Rule practices.
Below, we discuss actual and potential costs, as well as changes in
services and securities offerings, in response to the DOL Fiduciary
Rule as reported by industry participants through surveys. We also
describe how, following the Fifth Circuit Court of Appeals decision
vacating the DOL Fiduciary Rule, certain of those costs have been
reduced and the trend toward reduction in retail investor access to
services and securities offerings that may have been caused in part by
the DOL Fiduciary Rule appears to have ended and may be reversing.
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\995\ See supra footnote 32.
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i. Department of Labor's Fiduciary Rule and Temporary Enforcement
Policy
As noted above, prior to the Fifth Circuit decision, many firms
took steps to come into compliance with the DOL Fiduciary Rule, and in
particular, the BIC Exemption and other PTEs, including changes to
business practices.\996\
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\996\ See supra footnotes 32-34 and accompanying text.
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Following the decision by the Fifth Circuit, the DOL acknowledged
that uncertainty about fiduciary obligations and the scope of exemptive
relief under the prohibited transaction provisions of ERISA and the
Internal Revenue Code following the court's decision could temporarily
disrupt existing investment advice arrangements during the transition
period, and also that financial institutions had devoted significant
resources to comply with PTEs issued in connection with the DOL
Fiduciary Rule, including the BIC Exemption.\997\ Based on these
concerns, the DOL issued a temporary enforcement policy stating that it
would not pursue claims against fiduciaries working in good faith to
comply with the BIC Exemption's Impartial Conduct Standards for
transactions that would have been exempted by the BIC Exemption or
treat such fiduciaries as violating applicable
[[Page 33421]]
prohibited transactions rules.\998\ Prior to the Fifth Circuit
decision, some broker-dealers that offered services to IRAs and other
retirement accounts may have implemented changes to services and
securities to comply with and meet the conditions of the BIC Exemption
and other PTEs, including the Impartial Conduct Standards.\999\
Although the Commission does not currently have data on the number of
firms that may have devoted resources to comply with the PTEs,\1000\
the Commission can broadly estimate the maximum number of broker-
dealers that could have undertaken changes in order to comply with
requirements of the PTEs from the number of broker-dealers that have
retail customer accounts. Approximately 73.5% (2,766) of registered
broker-dealers report sales to retail customers.\1001\ Similarly,
approximately 8,235 (62% of) investment advisers serve high net worth
and non-high net worth individual clients. The Commission understands
that these numbers are an upper bound and likely overestimate the
broker-dealers and investment advisers that provide retirement account
services and began compliance with the requirements of the PTEs.\1002\
---------------------------------------------------------------------------
\997\ See U.S. Department of Labor Field Assistance Bulletin
2018-02, available at https://www.dol.gov/agencies/ebsa/employers-and-advisers/guidance/field-assistance-bulletins/2018-02.
\998\ Id.
\999\ See, e.g., Michael Wursthorn, A Complete List of Brokers
and Their Approach to `The Fiduciary Rule', Wall St. J., Feb. 6,
2017, https://www.wsj.com/articles/a-complete-list-of-brokers-and-their-approach-to-the-fiduciary-rule-1486413491?mod=article_inline
for a discussion of how broker-dealers adjusted certain practices in
response to the DOL Fiduciary Rule.
\1000\ In order to perform this analysis, the Commission would
need to know which financial firms offer services to IRAs and other
retirement accounts. Under the current reporting regimes for both
broker-dealers and investment advisers, they are not required to
disclose whether (or what fraction of) their accounts are held by
retail investors in retirement accounts.
\1001\ As of December 2018, 3,764 broker-dealers have filed Form
BD. Retail sales by broker-dealers were obtained from Form BR. See
supra footnote 900.
\1002\ The Department of Labor Regulatory Impact Analysis (``DOL
RIA'') identifies approximately 4,000 broker-dealers (FINRA, 2016),
of which approximately 2,500 are estimated to have either ERISA
accounts or IRA accounts serviced by broker-dealers, similar to the
estimates that we provide above. In addition to broker-dealers, the
DOL RIA estimates that other providers of ERISA or IRA accounts
include: Approximately 10,600 federally registered investment
advisers and 17,000 state-registered investment advisers (NASAA
2012/2013 Report), of which approximately 17,000 of federal and
state investment advisers that are not dually registered,
approximately 6,000 ERISA plan sponsors (2013 Form 5500 Schedule C),
and approximately 400 life insurance companies (2014 SNL Financial
Data). See U.S. Department of Labor, Regulating Advice Markets:
Definition of the Term 'Fiduciary', Conflicts of Interest,
Retirement Investment Advice: Regulatory Impact Analysis for Final
Rule and Exemptions (Apr. 2016), available at https://www.dol.gov/sites/default/files/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2/ria.pdf.
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ii. Industry Response to DOL Fiduciary Rule
Although the DOL Fiduciary Rule became effective in June 2017, the
DOL provided transitional relief through July 2019,\1003\ which is now
indefinitely extended under the temporary enforcement policy put in
place in June 2018 following the Fifth Circuit decision. As described
above, a significant subset of broker-dealers have retail customers
with retirement accounts and would have been affected by the DOL
Fiduciary Rule, and at least some broker-dealers began taking steps to
effectuate compliance with the DOL Fiduciary Rule. A number of
commenters stated that we did not sufficiently consider the existing
regulatory environment and the current market practices of firms and
financial professionals in light of the DOL's Fiduciary Rule and other
existing rules and regulations.\1004\ Below, we discuss the industry
response to the DOL Fiduciary Rule and the effect of the Fifth Circuit
decision on broker-dealers.
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\1003\ See supra footnote 1002.
\1004\ See, e.g., AALU Letter; CCMC Letters; CCMR Letter; CFA
August 2018 Letter; Davis & Harman Letter; EPI Letter; Lincoln
Financial Letter; Morningstar Letter; NASAA August 2018 Letter;
Wells Fargo Letter.
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In the Proposing Release, we predominantly based our discussion of
the industry and customer effects of the DOL Fiduciary Rule on
information from a single industry study.\1005\ Commenters provided
additional citations to industry studies,\1006\ which describe changes
in market practices across a broader-sample of broker-dealers in
response to the DOL Fiduciary Rule.\1007\ In these studies, certain of
the survey participants reported that they responded to the DOL
Fiduciary Rule and the BIC Exemption by reducing certain services and
access to advice to small retirement accounts. Certain participants
further reported that they encouraged customers toward self-directed
accounts and/or advisory accounts, including robo-advisors. Certain
other participants reported that they reduced or eliminated certain
securities within certain types of retirement accounts that they
offered. Finally, certain participants reported that they increased
certain fees for some of their customers. However, as it is generally
the case with survey analysis, the surveys in the aforementioned
studies are subject to potential selection biases (i.e., the sample of
respondents is not necessarily random) and methodological limitations
(e.g., the design of the questionnaire may influence the choices made
by the respondents). Given these limitations, it is generally not clear
whether the results of these studies capture significant or marginal
changes in broker-dealer practices, and whether these changes are
indicative of broader trends in the market for advice in response to
the DOL Fiduciary Rule.
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\1005\ See SIFMA Study, supra footnote 33. The SIFMA Study
surveyed 21 SIFMA members and captured 43% of U.S. ``financial
advisors'' (132,000 out of 310,000), 35 million retail retirement
accounts, and 27% of qualified retirement savings assets ($4.6
trillion out of $16.9 trillion). The types of retirement accounts
serviced by the participants in the SIFMA Study were not defined.
\1006\ See, e.g., CCMC Letters; Davis & Harman Letter; EPI
Letter; Lincoln Financial Letter.
\1007\ See, e.g., Financial Services Roundtable & Harper
Polling, Department of Labor Fiduciary Rule: National Survey of
Financial Professionals (July 2017), available at https://www.sec.gov/comments/ia-bd-conduct-standards/cll4-2641320-161289.pdf
(see Appendix A) (``FSR Study''). The FSR Study surveyed 600
financial advisers in July 2017, including certified financial
planners, chartered financial analysts, broker-dealers, and dually
registered representatives. See also Center for Capital Markets
Competitiveness, Fiduciary Rule: Initial Impact Analysis, FTI
Consulting Report Presented to the U.S. Chamber of Commerce (Sept.
7, 2017), available at https://www.centerforcapitalmarkets.com/wp-content/uploads/2017/07/Fiduciary-Rule-Initial-Impact-Analysis.pdf
(``Chamber Study''). The Chamber Study surveyed 14 financial
advisory companies (insurance companies, securities manufacturers,
and broker-dealers) responsible for $10 trillion in AUM and nearly
26 million investment accounts. The types of accounts serviced by
the participants in the Chamber Study were not defined. See also
A.T. Kearney, The $20 Billion Impact of the New Fiduciary Rule on
the U.S. Wealth Management Industry, Perspective for Discussion
(Oct. 2016), available at https://www.atkearney.com/documents/10192/7041991/DOL+Perspective+-+August+2016.pdf/b2a2176b-c821-41d9-b12e-d3d2b0807d69 (``Kearney Study''). We note that the development of
business models and practices discussed herein reflect changes made
voluntarily by firms in response to the DOL Fiduciary Rule, but were
not necessarily required by the DOL Fiduciary Rule.
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Changes to Services and Securities
A number of studies indicated that, as a result of the DOL
Fiduciary Rule, certain industry participants had already or were
planning to alter their menu of services and securities that they made
available to retail customers. For example, of the 21 SIFMA members
that participated in the SIFMA Study, 53% eliminated or reduced access
to certain brokerage advice services and 67% migrated away from open
choice to fee-based or limited brokerage services.\1008\ Another study
also discussed a shift from commission-based accounts to fee-based
accounts but offered no details about the sample or the methodology
employed to arrive
[[Page 33422]]
at the estimates.\1009\ Finally, another study documented that at least
29% of their survey participants expected to move clients, particularly
those with low account balances, to robo-advisors.\1010\ In addition, a
number of media articles describe several cases of broker-dealers that
have adjusted their practices with respect to the range of accounts
offered as a result of the DOL Fiduciary Rule.\1011\
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\1008\ See SIFMA Study, supra footnote 33.
\1009\ See Kearney Study (provided by the Davis & Harman and
Lincoln Financial Letters).
\1010\ See FSR Study, which states that ``[a]dvisors who say the
average net worth of their clients is under $25,000 are more likely
to say they will definitely, probably, or have already directed more
clients to robo advisor services, both online and at call centers
(43% vs. 29% overall).''
\1011\ For example, in response to the DOL Fiduciary Rule, J.P.
Morgan and Merrill Lynch phased out commission-based retirement
plans and instead charged fees based on AUM. See Crystal Kim, BofA,
JPMorgan, and the Fiduciary Rule: Will They or Won't They, Barron's,
Mar. 15, 2017, https://www.barrons.com/articles/bofa-jpmorgan-and-the-fiduciary-rule-will-they-or-wont-they-1489588442. However, upon
the Fifth Circuit's ruling on the DOL Fiduciary Rule, J.P. Morgan
and Merrill Lynch reversed their earlier decision and began to offer
commission-based retirement plans again. See Jed Horowitz, JPMorgan
to Remove Some Fiduciary Rule Handcuffs, Others May Follow,
AdvisorHub, May 4, 2018, https://advisorhub.com/jpmorgan-to-remove-some-fiduciary-rule-handcuffs-others-may-follow/; Imani Moise,
Merrill Lynch Does about Face on Fiduciary-Era Policy, Reuters, Aug.
30, 2018, https://www.reuters.com/article/us-bank-of-america-fiducuary/merrill-lynch-does-about-face-on-fiduciary-era-policy-idUSKCN1LF1R9. See also Daisy Maxey, Winners and Losers in a Post-
Fiduciary World, Wall St. J., May 24, 2017, available at https://www.wsj.com/articles/winners-and-losers-in-a-post-fiduciary-world-1495638708; Nir Kaissir, Merrill Lynch Can't Restore the Bad Old
Days of Conflicts, Bloomberg, Sept. 4, 2018, available at https://www.bloomberg.com/opinion/articles/2018-09-04/merrill-lynch-can-t-restore-the-bad-old-days-of-conflicts.
---------------------------------------------------------------------------
Further, industry studies noted that certain of their respondents
changed their securities offerings as a result of the DOL Fiduciary
Rule.\1012\ For example, 95% of the SIFMA Study participants altered
their securities offerings by reducing or eliminating certain asset or
share classes; 86% of the respondents reduced the number or type of
mutual funds (e.g., 29% eliminated no-load funds, while 67% reduced the
number of mutual funds), and 48% reduced annuity securities
offerings.\1013\ Similarly, another study found that nearly 30% of
survey participants eliminated or reduced securities or services
available to retirement investors in response to the DOL Fiduciary
Rule,\1014\ while the Chamber Study noted that 13.4 million accounts of
the companies surveyed had limited access to certain securities,
including mutual funds, variable annuities, and exchange-traded
funds.\1015\ Finally, the SIFMA Study states that although the DOL
Fiduciary Rule applied only in connection with services for retirement
accounts, certain of the survey participants had implemented the
changes to both retirement and non-retirement accounts.\1016\ These
studies do not discuss the attributes of the securities that the
participants chose to no longer offer. In addition, as noted above,
survey analysis is subject to certain limitations that, generally,
complicate the interpretation of their results. For instance, it is not
generally clear whether the results of these studies capture
significant or marginal changes in broker-dealer practices, and whether
these changes are indicative of broader trends in the market for advice
in response to the DOL Fiduciary Rule.
---------------------------------------------------------------------------
\1012\ While the industry studies discussed in this section
examined shifts in services and securities provided to retail
investors, one limitation of these studies is that they did not
discuss whether the quality of advice provided to retail investors
also changed as a result.
\1013\ See SIFMA Study, supra footnote 33.
\1014\ See American Bankers Association, ABA Survey: Department
of Labor Fiduciary Rule (July 20, 2017), available at https://www.aba.com/Advocacy/Issues/Documents/dol-fiduciary-rule-survey-summary-report.pdf (``ABA Study''). The ABA Study conducted a survey
of 57 banks about their understanding of the DOL Fiduciary Rule on
securities and services available to retirement investors. See also
Kearney Study, which anticipated a shift from mutual funds to
exchange-traded funds, and that ``certain high-cost investment
products (such as variable annuities) will be phased out as the
business model is no longer viable under [the DOL Fiduciary Rule].''
See also FSR Study, which reported that 63% of its survey
participants anticipated fewer investment options and 56% had
already reduced or anticipated reducing the number of mutual funds
offered to retirement customers.
\1015\ See Chamber Study. See also Editorial Board, Tom Perez's
Fiduciary Flop, Wall St. J., Mar. 18, 2018, https://www.wsj.com/articles/tom-perezs-fiduciary-flop-1521412228, which noted that some
firms restricted sales of commission-based securities such as load
mutual funds and variable annuities in retirement accounts.
\1016\ See, e.g., SIFMA Study, supra footnote 33.
---------------------------------------------------------------------------
Besides the studies mentioned above, a number of media articles
provide anecdotal evidence of broker-dealers that chose to no longer
offer certain securities.\1017\ Some commenters also provided data
about historical trends in certain product markets.\1018\ For example,
one commenter provided data for the market of mutual funds and showed
that between 2007 and 2018, the percentage of assets in load mutual
funds declined from 27% to 12%, while no-load share classes increased
from 51% to 71% over the same time period.\1019\ Further, this
commenter stated that this shift has occurred because of the growth in
assets in 401(k) plans and other retirement accounts, as well as the
increase in the number of advisory accounts, both of which tend to
invest in no-load share classes.
---------------------------------------------------------------------------
\1017\ See Alex Steger, Exclusive: UBS to Cut over 800 Funds
from Platform, City Wire, Mar. 13, 2018, https://citywireusa.com/professional-buyer/news/exclusive-ubs-to-cut-over-800-funds-from-platform/a1100101; Michael Thrasher, Ameriprise Drops Hundreds of
Funds Offered to Brokerage Clients, WealthManagement.com, June 8,
2017, https://www.wealthmanagement.com/industry/ameriprise-drops-hundreds-funds-offered-brokerage-clients; Hugh Son, Morgan Stanley
to Reduce Wealth Fees Even with Rule Uncertainty, Bloomberg, Jan.
26, 2017, https://www.bloomberg.com/news/articles/2017-01-26/morgan-stanley-to-proceed-with-wealth-changes-ahead-of-new-rules; Margarida
Correia, LPL Puts Final Touches on Product Lineups in Preparation
for Fiduciary Rule, Financial Planning, Mar. 9, 2017, https://www.financial-planning.com/news/lpl-puts-final-touches-on-product-lineups-in-preparation-for-fiduciary-rule?tag=00000154-3e16-d45e-a175-7f9f48a20001; Bruce Kelly, Wells Fargo Advisors Restricting
Investments for Retirement Accounts, Investment News, May 24, 2017,
https://www.investmentnews.com/article/20170524/FREE/170529959/wells-fargo-advisors-restricting-investments-for-retirement-accounts.
\1018\ See, e.g., ICI Letter.
\1019\ See id.
---------------------------------------------------------------------------
However, the DOL Fiduciary Rule may have caused certain product
markets to adjust.\1020\ For example, innovations, including the
introduction of T and clean share classes of mutual funds, can be
regarded as a paradigm shift in terms of how product sponsors
compensate broker-dealers for distribution services. One commenter
noted that these products may reduce the expected fund underperformance
net of costs for retail investors relative to A shares by nearly 50
basis points annually.\1021\
---------------------------------------------------------------------------
\1020\ See, e.g., James Chen, Clean Shares, Investopedia,
available at https://www.investopedia.com/terms/c/clean-shares.asp,
stating that ``[t]he mutual fund industry introduced clean shares,
along with T shares, in response to the Department of Labor's
fiduciary rule.''
\1021\ See Letter from Aron Szapiro, Director of Policy
Research, Morningstar (Sept. 2017).
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The Effect of Costs and Fees
Some firms may have responded to the DOL Fiduciary Rule by either
presenting customers with the option to enter into different and
potentially more costly advice relationships compared to a brokerage
advice relationship or by passing some of the compliance costs to
customers.\1022\ However, one study observed that 63% of the responding
firms that limited or eliminated access to advised brokerage services
stated that they had at least some customers who chose to move to self-
directed accounts rather than fee-based accounts and cited the reasons
that customers provided as (1) ``did not want to move to a fee-based
account,'' (2) ``was not in the retirement investor's best interest to
move to a fee-
[[Page 33423]]
based account,'' (3) ``did not meet the account minimums,'' or (4)
``wished to maintain positions in certain asset classes which were not
eligible for a fee-based account.'' \1023\ Another study further
observed that nearly 40% of the responding firms believed that the
relationship with their customers had been altered as a result of the
DOL Fiduciary Rule and that customers with smaller account balances
were nearly ten times more likely to have been negatively affected by
the DOL Fiduciary Rule than customers with larger account
balances.\1024\ Further, another study observed that 68% of the
responding firms were less likely to provide services to smaller
accounts, and 46% anticipated that they may service fewer clients
overall.\1025\
---------------------------------------------------------------------------
\1022\ See supra footnote 1011 (which describes how certain
firms responded to the DOL Fiduciary Rule and later reversed changes
in response to the Fifth Circuit decision).
\1023\ See SIFMA Study, supra footnote 33.
\1024\ See ABA Study.
\1025\ See FSR Study. See also Chamber Study, which found that
some survey participants have added minimum account balances and
have migrated away from commission-based models toward fee-based
models.
---------------------------------------------------------------------------
One study observed that, generally, based on the numbers provided
by the respondents, a fee-based account can be more costly than a
brokerage account; however, such comparison is generally hard to make
without knowing the securities in the two types of accounts, and it is
not clear that the survey made this clear to respondents.\1026\ One
study \1027\ observed that approximately 52% of its survey participants
indicated that they may pass on the costs associated with complying
with the DOL Fiduciary Rule to clients in the form of higher fees,
while another study stated that more than 6 million client accounts of
the survey participants may be subject to higher costs and fees as a
result of the DOL Fiduciary Rule, although it is not clear whether this
estimate assumes full adoption of the DOL Fiduciary Rule.\1028\
---------------------------------------------------------------------------
\1026\ See SIFMA Study. We note that only a subset of the SIFMA
Study participants provided information on the costs associated with
brokerage and advisory accounts. See CFA August 2018 Letter. The
SIFMA Study did not provide any information on the set of firms
comprised in this subset that provided information on brokerage and
advisory costs. See also ICI Letter (which provided similar
estimates for fees and costs attributable to brokerage and advisory
accounts).
\1027\ See FSR Study.
\1028\ See Chamber Study.
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Estimated Costs of Compliance and Effects on Compensation Structures
One study observed that survey respondents were expecting to incur
compliance costs as a result of the DOL Fiduciary Rule that would vary
by the size of the respondent.\1029\ For instance, large firms with net
capital in excess of $1 billion were expected to have start-up and
ongoing compliance costs of $55 million and $6 million, respectively,
while firms between $50 million and $1 billion in net capital were
expected to have start-up and ongoing compliance costs of $16 million
and $3 million, respectively. The study further estimated that the
total start-up compliance costs for large and medium-size firms
combined would have been approximately $4.7 billion, while ongoing
costs would have been approximately $700 million per year.
---------------------------------------------------------------------------
\1029\ See SIFMA Study. As a general matter, we note that the
estimates reported by industry studies, including this study, are
based on a rulemaking with more extensive requirements for changes
to business models than those required by Regulation Best Interest.
---------------------------------------------------------------------------
Another study observed that the costs of complying with DOL
Fiduciary Rule would encompass technology, legal, process changes,
educational, and training costs for firms.\1030\ This study forecasted
that the DOL Fiduciary Rule may cause a $2 trillion redistribution in
assets from broker-dealers to investment advisers, robo-advisors, and
self-directed accounts, and a nearly $20 billion decrease in revenues
to the entire financial services industry, including broker-dealers.
---------------------------------------------------------------------------
\1030\ See Kearney Study.
---------------------------------------------------------------------------
The study further forecasted that as a result of the DOL Fiduciary
Rule product sponsors ``will be incentivized to streamline product
offerings, lower fees, and improve performance,'' and investor would
pay $7.5 billion less in mutual fund and ETF expenses by the end of
2010. However, as noted above, this study does not provide details
about how it obtained its estimates.
Several media articles provide some anecdotal evidence suggesting
that as a response to the DOL Fiduciary Rule some broker-dealers began
to alter the compensation structures of their registered
representatives.\1031\ For example, some broker-dealers have indicated
that they adjusted their compensation structures by equalizing
commissions and deferred sales charges across similar securities.\1032\
Other broker-dealers banned sales quotas, contests, special awards, and
bonuses,\1033\ including deferred bonuses as part of recruitment
efforts.\1034\ However, following the decision by the Fifth Circuit to
vacate the DOL Fiduciary Rule, some firms reinstated back-end
recruiting bonuses.\1035\
---------------------------------------------------------------------------
\1031\ See Son (2017), supra footnote 1017; Tara Siegel Bernard,
Do Financial Advisers Have to Act in Your Interest? Maybe, N.Y.
Times, Mar. 22, 2018, https://www.nytimes.com/2018/03/22/your-money/financial-advisers-customer-interest.html.
\1032\ See, e.g., Andrew Welsch, Facing Higher Costs, Raymond
James Cuts Adviser Pay in Rare Move, Financial Planning, July 11,
2017, https://onwallstreet.financial-planning.com/news/facing-higher-costs-raymond-james-cuts-adviser-pay-in-rare-move?tag=00000151-16d0-def7-a1db-97f024310000.
\1033\ See Bernard (2018).
\1034\ See Mason Braswell, Morgan Stanley Resumes Recruiting
Offers--Slimmer and DOL-Compliant, AdvisorHub, Nov. 3, 2016, https://advisorhub.com/morgan-stanley-resumes-recruiting-offers-slimmer-and-dol-compliant/; Deon Roberts, Wells Fargo Overhauling Bonuses to
Comply with New Rules on Financial Advisers, Charlotte Observer,
Dec. 14, 2016, https://www.charlotteobserver.com/news/business/banking/bank-watch-blog/article120961138.html.
\1035\ See Mason Braswell, Farewell Fiduciary Rule? Morgan
Stanley Sweetens Recruiting Bonuses, AdvisorHub, May 1, 2018,
https://advisorhub.com/farewell-fiduciary-rule-morgan-stanley-sweetens-recruiting-bonuses/. ``Back-end'' bonuses are expressly
contingent on the achievement of sales or asset targets. See U.S.
Department of Labor, Conflict of Interest FAQs (Part I--Exemptions)
(Oct. 27, 2016), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-rules-and-exemptions-part-1.pdf.
---------------------------------------------------------------------------
iii. Additional Evidence of Current Market Practices
In this section, we include information on Commission observations
on the broker-dealer industry. Commission experience indicates that
there have been a number of changes to the broker-dealer industry and
its business practices over time.\1036\ Consistent with the trend
baseline provided in Section III.B.1.c and industry studies and
anecdotal evidence described above, we have observed firms choosing to
do business with retail investors as investment advisers, not as
broker-dealers, by either migrating existing brokerage accounts to
advisory accounts or directing new retail customers to advisory
accounts.
---------------------------------------------------------------------------
\1036\ Information on the broker-dealer industry and business
practices comes from a variety of Commission resources and generally
relates to market trends and changes to business practices that have
emerged in recent years and is comprised of both standalone broker-
dealers and dually registered firms. With respect to industry
trends, Commission resources generally verify data cited above in
Section III.B.2.e.ii. We acknowledge that the information provided
in this baseline may not be representative of business practices
more generally because of the diversity and complexity of services
and securities offered by standalone broker-dealers and dually
registered firms.
---------------------------------------------------------------------------
Beyond broker-dealer trends in business practices, Commission
experience also indicates that some broker-dealers have responded to
the DOL Fiduciary Rule and the Fifth Circuit decision vacating the DOL
Fiduciary Rule by modifying their existing business practices. For
example, some firms, consistent with anecdotal evidence discussed
above, eliminated brokerage IRA accounts in response to the DOL
Fiduciary Rule; however, upon the Fifth Circuit decision, the firms
reinstituted
[[Page 33424]]
brokerage IRAs. Other examples of changes following the Fifth Circuit
decision include changes to incentive-based compensation in certain
types of accounts and principal trading restrictions.
3. Investment Advice and Evidence of Potential Investor Harm
A number of commenters expressed the view that the Proposing
Release did not fully document the problems attributed to potential
conflicts of interest stemming from the broker-dealer model and the
resulting harm to retail customers.\1037\ In order to address these
commenters' concerns, we analyze academic and industry studies to
present an overview of the market for advice for retail
customers.\1038\ Below, we discuss which types of investors seek
investment advice; the benefits attained through investment advice for
retail investors; limitations to the value of that advice that stem
from agency costs, particularly those related to conflicts of interest
arising from financial professional compensation; and evidence of
potential investor harm. Where appropriate, we note limitations to the
application of various academic studies that form the basis of other
economic analyses, which investigate potential investor harm attributed
to recommendations received from financial professionals.
---------------------------------------------------------------------------
\1037\ See, e.g., AARP August 2018 Letter; Better Markets August
2018 Letter; CFA August 2018 Letter; EPI Letter; U. of Miami Letter;
Morningstar Letter; PIABA Letter; Letter from Ron A. Rhoades,
Director, Personal Financial Planning Program and Assistant
Professor of Finance, Gordon Ford College of Business, Western
Kentucky University (Aug. 6, 2018) (``Rhoades August 2018 Letter'');
Former SEC Senior Economists Letter.
\1038\ Although the discussion here generally focuses on studies
provided by comment letters, at times we have included additional
references either to more fully articulate specific arguments or to
provide counterarguments to studies provided by comment letters in
an effort to present a complete overview of pertinent literature.
Because the studies we cite in this section generically discuss
investment advice or advice rather than recommendations, and use a
variety of terms to describe financial professionals or firms (e.g.,
brokers, advisers, or financial advisers) and investors (e.g.,
investors, customers, or clients), in the discussion that follows,
we use generic terms of advice or investment advice, financial
professional, firm, and retail investor or investor. Although we
believe that the studies generally discuss advice as it relates to
broker-dealers or investment advisers, because of generic terms
used, such as ``financial adviser,'' it is possible that other types
of advice providers (e.g., commercial banks, tax consultants, etc.)
could be included in some of the studies cited below. However,
because not all authors clearly define which financial professionals
are included in a given study, we are unable to provide an
exhaustive list of all types of financial professionals that make up
the market for advice.
---------------------------------------------------------------------------
a. Who Seeks Investment Advice \1039\
---------------------------------------------------------------------------
\1039\ One limitation of the majority of the studies examined is
that we are unable to distinguish whether the retail investor is
seeking and/or receiving investment advice from a broker-dealer or
an investment adviser (or some other type of financial
professional). The studies generally do not have sufficiently
granular data to distinguish broker-dealer customers from investment
adviser clients. Further, for studies where retail investors can be
distinguished by their investment choices (e.g., purchasing direct-
sold versus broker-sold funds), we are unable to determine whether
differences exist between broker-sold funds sold by broker-dealers
and broker-sold funds sold by investment advisers. As discussed
below, some commenters expressed the view that buy-and-hold retail
investors were more likely to prefer the services of brokerage
accounts over advisory accounts. See infra footnote 1055.
---------------------------------------------------------------------------
Approximately 37% of U.S. households currently engage with
financial professionals according to OIAD/RAND; however, households who
hire these professionals are not uniformly distributed among the U.S.
population.\1040\ In addition to OIAD/RAND, a number of academic
studies, provided with comment letters, examine characteristics of
investors and their propensity for seeking (and following) investment
advice. Older, wealthier, more educated, and financially more literate
retail investors are more likely to seek and act on advice obtained
from financial professionals, suggesting that investors who may benefit
most from advice (younger, less educated, and less financially
sophisticated) are least likely to obtain it.\1041\ Several studies
examine the choice by retail investors to select into broker-sold or
direct-sold mutual funds. These studies find less financially
sophisticated investors are more likely to purchase ``broker-sold''
funds and therefore more likely to receive advice from a financial
professional.\1042\
---------------------------------------------------------------------------
\1040\ According to OIAD/RAND, the use of financial
professionals varies by both income and education levels. For
example, 38% of retail investors with income greater than $100,000
engage with financial professionals, while only 13.7% of retail
investors with incomes below $25,000 did so. Another study, the
Survey of Consumer Finance, indicates that the use of financial
professionals by American households is closer to 60%, but also
includes financial planners, accountants, lawyers, and bankers, in
addition to broker-dealers and investment advisers. See SCF Survey,
supra footnote 950.
\1041\ See, e.g., Utpal Bhattacharya et al., Is Unbiased
Financial Advice to Retail Investors Sufficient? Answers from a
Large Field Study, 25 Rev. Fin. Stud. 975 (2012); Daniel Hoechle et
al., The Impact of Financial Advice on Trade Performance and
Behavioral Biases, 21 Rev. Fin. 871 (2017); Jeremy Burke & Angela A.
Hung, Do Financial Advisors Influence Savings Behavior?, RAND Labor
and Population Report Prepared for the Department of Labor (2015),
available at https://www.rand.org/content/dam/rand/pubs/research_reports/RR1200/RR1289/RAND_RR1289.pdf; Claude Montmarquette
& Nathalie Viennot-Briot, Econometric Models on the Value of Advice
of a Financial Advisor, CIRANO Project Report No. 2012RP-17 (July
2012), available at https://www.cirano.qc.ca/pdf/publication/2012RP-17.pdf; Andreas Hackethal, Michael Haliassos, & Tullio Jappelli,
Financial Advisors: A Case of Babysitters?, 36 J. Banking & Fin. 509
(2012). See also AARP August 2018 Letter; CFA August 2018 Letter;
FPC Letter; Primerica Letter; Wells Fargo Letter (which provided
several studies cited here; other studies (e.g., Hoechle et al.
(2017)) are included because they capture characteristics of the
investors most likely to seek and act on financial advice that are
not captured by the studies suggested by the commenters). Studies
also note that the characteristics of investors most likely to seek
advice are also likely to be those most attractive to financial
professionals as they have more assets to manage. See Michael S.
Finke, Financial Advice: Does it Make a Difference? (Working Paper,
May 5, 2012) (which describes the relationship between investors and
financial professionals).
\1042\ See, e.g., Christopher J. Malloy & Ning Zhu, Mutual Fund
Choices and Investor Demographics (Working Paper, Mar. 14, 2004),
available at https://pdfs.semanticscholar.org/16a1/8daed89c3c48a765ad3a265018b4d27bd0f4.pdf; John Sabelhaus, Daniel
Schrass, & Steven Bass, Characteristics of Mutual Fund Investors,
2008, ICI Res. Fundamentals, Feb. 2009, available at https://www.ici.org/pdf/fm-v18n2.pdf; John Chalmers & Jonathan Reuter, Is
Conflicted Advice Better than No Advice? (Working Paper, Sept. 14,
2015), available at https://www.semanticscholar.org/paper/Is-Conflicted-Investment-Advice-Better-than-No-Chalmers-Reuter/3337ce8c3a72bf55dac43f407fd104b93aec863b. See also AARP August 2018
Letter; CFA August 2018 Letter; EPI Letter (which provided the
Chalmers & Reuter (2015) citation; Malloy & Zhu (2004) and Sabelhaus
et al. (2009) are included because they capture aspects of the
mutual fund selection decision by retail investors that are not
captured by the studies suggested by the commenters). We provide a
more detailed discussion of these studies below in Section
III.B.3.c.
---------------------------------------------------------------------------
As we detail below, retail investors bear costs associated with
obtaining advice from financial professionals, which may deter some
investors, especially those with limited wealth or income, from seeking
investment advice. However, an investor's lack of sophistication may
also prevent the investor from obtaining or using investment advice
even when advice is provided at no cost. One paper examines the
outcomes from a large sample of active retail investors of a large
broker-dealer.\1043\ These retail investors received unsolicited and
unbiased advice from the broker-dealer at no cost. Although the advice
was designed to improve the efficiency of the investors' portfolios,
only 5% of investors accepted the offer to receive the free advice.
Moreover, those that did accept the advice rarely followed the advice.
Investors who participated in the study had only minimal improvements
to their portfolio efficiency. The authors cite lack of financial
sophistication and lack of familiarity or trust as reasons why the
unsolicited advice was not followed.\1044\
---------------------------------------------------------------------------
\1043\ See Bhattacharya et al. (2012), supra footnote 1041.
\1044\ See id.
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[[Page 33425]]
b. Benefits and Limitations of Investment Advice
A number of commenters provided academic studies of benefits that
investors may obtain from hiring financial professionals.\1045\ One
benefit of hiring a firm or financial professional is that professional
advice can help the average retail investor overcome common
``investment mistakes'' that he or she may make when investing.\1046\
Common ``investment mistakes'' made by retail investors include limited
allocation of assets to equities, under-diversification, excessive
trading, and home bias.\1047\ These studies also attempt to identify
reasons why retail investors persistently make inefficient investment
choices.
---------------------------------------------------------------------------
\1045\ See infra footnote 1048.
\1046\ See Bhattacharya et al. (2012), supra footnote 1041.
``Investment mistakes'' are investors' actions that would go against
what a rational investor would do when undertaking efficient
investment decisions (here and below, infra footnote 1047, we
provide studies that analyze common ``investment mistakes'' made by
retail investors). For example, evidence suggests that retail
investors tend to trade too frequently. See Brad M. Barber &
Terrance Odean, Trading is Hazardous to Your Wealth: The Common
Stock Performance of Individual Investors, 55 J. FIN. 773 (2000).
\1047\ As described in Bhattacharya et al. (2012), supra
footnote 1041, possible explanations for common ``investment
mistakes'' may arise from behavioral biases (e.g., cognitive
errors), the cost of information acquisition, or the selection of
the financial professional. See, e.g., Luigi Guiso, Paolo Sapienza,
& Luigi Zingales, People's Opium? Religion and Economic Attitudes,
50 J. Monetary Econ. 225 (2003); Laurent E. Calvet, John Y.
Campbell, & Paolo Sodini, Down or Out: Assessing the Welfare Costs
of Household Investment Mistakes, 115 J. Pol. Econ. 707 (2007);
Barber & Odean (2000), supra footnote 1046; Karen K. Lewis, Trying
to Explain Home Bias in Equities and Consumption, 37 J. Econ.
Literature 571 (1999).
---------------------------------------------------------------------------
Beyond correcting potential ``investment mistakes,'' academic
studies document a multitude of other benefits that accrue to retail
investors as a result of seeking investment advice, including, but not
limited to: Higher household savings rates, setting long-term goals and
calculating retirement needs, more efficient portfolio diversification
and asset allocation, increased confidence and peace of mind,
improvement in financial situations, and improved tax efficiency.\1048\
For example, one study notes that investors who engaged financial
professionals for at least 15 years had approximately 173% more assets
on average than investors who did not hire financial professionals,
driven by higher household savings rates and increased asset allocation
to non-cash instruments.\1049\ Further, financial professionals may be
able to help retail investors overcome information asymmetries that
exist between firms that supply securities and their customers that
retail investors would not be able to disentangle on their own.\1050\
---------------------------------------------------------------------------
\1048\ See, e.g., Mitchell Marsden, Catherine D. Zick, & Robert
N. Mayer, The Value of Seeking Financial Advice, 32 J. Fam. & Econ.
Issues 625 (2011); Jinhee Kim, Jasook Kwon, & Elaine A. Anderson,
Factors Related to Retirement Confidence: Retirement Preparation and
Workplace Financial Education, 16 J. Fin. Counseling & Plan. 77
(2005); Michael S. Finke, Sandra J. Huston, & Danielle D.
Winchester, Financial Advice: Who Pays, 22 J. Fin. Counseling &
Plan. 18 (2011); Daniel Bergstresser, John M.R. Chalmers, & Peter
Tufano, Assessing the Costs and Benefits of Brokers in the Mutual
Fund Industry, 22 Rev. Fin. Stud. 4129 (2009); Ralph Bluethgen,
Steffen Meyer, & Andreas Hackethal, High-Quality Financial Advice
Wanted! (Working Paper, Feb. 2008), available at http://citeseerx.ist.psu.edu/viewdoc/summary?doi=10.1.1.596.2310; Neal M.
Stoughton, Youchang Wu, & Josef Zechner, Intermediated Investment
Management, 66 J. Fin. 947 (2011). Marsden et al. (2011) documents
benefits attributable to hiring a financial professional, such as
better retirement account diversification and savings goals, but
does not find that hiring a financial professional measurably
increases the amount of overall wealth accumulation for those
investors. See also, Burke & Hung (2015), supra footnote 1041, for
additional studies on the causal relation between the use of a
financial professional and wealth accumulation. Francis M. Kinniry
et al., Putting a Value on Your Value: Quantifying Vanguard
Advisor's Alpha, Vanguard Research (Sept. 2016), available at
https://www.vanguard.com/pdf/ISGQVAA.pdf, estimates the value to
investors associated with obtaining financial advice of
approximately 3% in net returns to investors, associated with
suitable asset allocation, managing expense ratios, behavioral
coaching, alleviating home bias, among others. See also AARP August
2018 Letter; CCMC Letters; CFA August 2018 Letter; Edward Jones
Letter; Letter from Brian M. Nelson (Jul. 10, 2018) (``Nelson
Letter'') (which provided several of these studies; other studies
were included because they capture aspects of the benefits of advice
for retail investors that are not captured by the studies suggested
by the commenters (e.g., Marsden et al. (2011), Finke et al.
(2011)).
\1049\ See Montmarquette & Vionnet-Briot (2012), supra footnote
1041. While this study describes the benefits of hiring financial
professionals on asset accumulation, it also notes that termination
of relationships with financial professionals resulted in a
significant loss of overall investment asset value. See Primerica
Letter; Wells Fargo Letter (which provided references to this
academic study).
\1050\ See Roman Inderst & Marco Ottaviani, Financial Advice, 50
J. Econ. Literature 494 (2012). See also AARP August 2018 Letter.
---------------------------------------------------------------------------
Commenters also provided academic studies which discussed the
limitations of the advice received from financial professionals,
including how both direct and indirect costs of advice can reduce
returns earned by investors.\1051\ How financial professionals are
compensated can erode the value of advice in two primary ways: (1) The
direct costs associated with purchasing advice detract from returns
over time; \1052\ and (2) the indirect costs to retail investors that
arise from conflicts of interest between financial professionals and
investors. Financial professionals are generally compensated directly
by retail investors in three principal ways: Commission-based (e.g.,
broker-dealers), fee-based on AUM (e.g., investment advisers), and flat
or hourly fees (e.g., financial planners), although some financial
professionals may receive compensation in multiple ways for providing
advice to the same investor.\1053\
---------------------------------------------------------------------------
\1051\ See, e.g., AARP August 2018 Letter; CFA August 2018
Letter; EPI Letter; Letter from Ron A. Rhoades, Director, Personal
Financial Planning Program and Assistant Professor of Finance,
Gordon Ford College of Business, Western Kentucky University (Dec.
6, 2018) (``Rhoades December 2018 Letter'').
\1052\ As noted in one study, the direct costs (fees and
expenses) may not be transparent to retail investors. Coupled with
conflicts of interest that can bias any advice provided, information
asymmetry between financial professionals and retail investors may
be large. See Finke (2012), supra footnote 1041.
\1053\ For example, investment advisers and supervised persons
may receive account-level advisory fees, and may also receive
compensation for the sale of securities or other investment
products, including asset-based sales charges or service fees for
the sale of mutual funds to their advisory clients. See Items 5.C,
5.E, and 14.A of Form ADV Part 2A; Items 4.A.2, 4.B, and 5 of Form
ADV Part 2B. When we refer to advisers and supervised persons
receiving fees for the sale of securities or other investment
products, we generally mean advisers that are also registered
broker-dealers or advisers whose affiliated broker-dealers receive
these fees. Form ADV instructs advisers that if they receive
compensation in connection with the purchase or sale of securities,
they should carefully consider the applicability of broker-dealer
registration requirements of the Exchange Act and any applicable
state securities statutes. See Form ADV, Part 2A, Note to Item 5.E.
---------------------------------------------------------------------------
One study estimates that the average annual costs associated with
commission-based accounts are approximately 75 bps, while the average
fee-based account costs 130 bps.\1054\ We acknowledge that in addition
to the fees charged for particular types of services, other expenses
may be incurred that reduce returns earned by investors, some of which
may be earned by the financial professional or the firm and paid by the
firm's product or service providers (e.g., fund loads, 12b-1 fees, and
shareholder servicing fees).
---------------------------------------------------------------------------
\1054\ See John H. Robinson, Who's the Fairest of Them All? A
Comparative Analysis of Financial Advisor Compensation Models, 20 J.
Fin. Plan. 56 (2007). See also AARP August 2018 Letter. One study,
however, argues that when the direct costs associated with
commissions are combined with the estimated agency costs, there is
little difference in the costs between commission-based and fee-
based advice. See Quinn Curtis, The Fiduciary Rule Controversy and
the Future of Investment Advice (Univ. of Va. Sch. of Law, Law &
Econ. Research Paper Series No. 2018-04, Mar. 2018). See also UVA
Letter. We note that services provided may also vary between
brokerage and advisory accounts, which could also affect differences
in costs paid by retail investors.
---------------------------------------------------------------------------
Some commenters expressed the view that certain investors (e.g.,
buy-and-hold investors) may prefer to pay a single commission relative
to an ongoing fee-
[[Page 33426]]
based obligation that is tied to AUM in their account.\1055\ We note
that this choice may be dependent on the investor's holding period and
other ongoing expenses that affect an investor's net return over time.
For example, a buy-and-hold investor that chooses an account where fees
are based on AUM may pay more over time than a similar buy-and-hold
investor that pays a single commission. Further, some commission-based
securities, such as mutual funds, may have ongoing expenses, including
12b-1 fees, which could lead to an erosion of net returns over
time.\1056\ Such ongoing expenses, however, may not be adequately
accounted for by investors when making investment decisions about the
type of account to open and what type of security to purchase.\1057\
Several commenters provided analyses to show the expected effect of
one-time costs and ongoing expenses (e.g., operating costs or advisory
fees) to investors from both commission-based and fee-based
perspectives, conditional on the investor's holding period.\1058\
---------------------------------------------------------------------------
\1055\ See, e.g., Cetera August 2018 Letter; AALU Letter;
Pacific Life August 2018 Letter; NAIFA Letter; Empower Retirement
Letter; CCMR Letter; Primerica Letter.
\1056\ See CFA August 2018 Letter; EPI Letter. See also ICI
Letter (which described a shift from load to no load funds,
decreasing expense ratios, and a decline in the percentage of funds
that charge 12b-1 fees).
\1057\ See infra footnote 1084 and corresponding discussion.
\1058\ See, e.g., Cetera August 2018 Letter and November 2018
Letter; Pacific Life August 2018 Letter.
---------------------------------------------------------------------------
Separately, investors may face indirect costs that are a result of
agency problems that emerge when financial professionals seek to
maximize their own compensation and take actions that place their own
interests ahead of the investors that they are supposed to serve.\1059\
A number of commenters and academic studies have stated that
commission-based compensation is more likely to contribute to conflicts
of interest between financial professionals and retail investors than
fee-based compensation.\1060\ Other commenters, however, indicated that
commission-based compensation provides benefits to investors.\1061\ One
study finds that conflicts of interest are likely to be present in all
forms of compensation earned by financial professionals. For example,
fee-based compensation could result in so-called ``reverse churning''
and a disincentive to reduce AUM, even if that would be in the
investor's best interest, while flat-fee models can lead to shirking
and overbilling.\1062\ However, due to limitations on the data
available regarding fee-based advice, most of the academic studies to
date regarding conflicts of interest focus on commission-based
compensation models. As such, the potential conflicts associated with
the fee-based compensation models, including fee-based compensation
earned by broker-dealers, have not been subject to as much analysis.
Studies show that commission-based compensation potentially leads to
biased advice, including excessive trading in accounts and
recommendations to purchase high-commission securities, both of which
benefit the financial professional and may lead to lower net
returns.\1063\
---------------------------------------------------------------------------
\1059\ See Jeremy Burke et al., Impacts of Conflicts of Interest
in the Financial Services Industry (RAND Labor & Population, Working
Paper No. WR-1076, Feb. 2015), available at https://www.rand.org/pubs/working_papers/WR1076.html; Hamid Mehran & Rene M. Stulz, The
Economics of Conflicts of Interest in Financial Institutions, 85 J.
Fin. Econ. 267 (2007). See also Letter from D. Bruce Johnsen,
Professor of Law, Scalia Law School, George Mason University (Aug.
7, 2018) (``Johnsen Letter''); Robinson (2007), supra footnote 1054.
Broker-dealers may act in a brokerage (i.e., agency) capacity or a
dealer (i.e., principal) capacity. See Proposing Release at Section
I. While the discussion is framed in terms of agency problems, it is
applicable to both capacities.
\1060\ See IPA Letter; CFA August 2018 Letter.
\1061\ See AALU Letter; Invesco Letter; ACLI Letter; NAIFA
Letter. See Burke et al. (2015), supra footnote 1059 for a survey on
the academic literature on conflicts of interest.
\1062\ See Robinson (2007), supra footnote 1054.
\1063\ See, e.g., Stoughton et al. (2011), supra footnote 1048;
Roman Inderst & Marco Ottaviani, Misselling Through Agents, 99 Am.
Econ. Rev. 883 (2009); Max Beyer, David de Meza, & Diane Reyniers,
Do Financial Advisor Commissions Distort Client Choice?, 119 Econ.
Letters 117 (2013). See also AARP August 2018 Letter. Financially
unsophisticated investors, as discussed by Stoughton et al. (2011),
are those most likely to purchase inefficient assets.
---------------------------------------------------------------------------
Financial professionals also may benefit from other forms of
transaction-based payment from customers, such as mark-ups and mark-
downs; for instance, one study documents that the size of the mark-up
or mark-down is significantly positively related to whether the broker-
dealer solicits the transaction and whether the broker-dealer acts in a
principal capacity.\1064\ Because mark-ups and mark-downs are payments
from the customer to the broker-dealer, they give rise to conflicts of
interest between a broker-dealer and his or her customer at the time of
a recommendation, particularly if they are opaque to the customer, at
the time of the recommendation. Mechanisms, including regulation,\1065\
disclosure, and reputation,\1066\ may be able to mitigate the risk of
financial professionals acting on conflicts of interest to the
detriment of their customers.\1067\ In addition to direct payments of
commissions from retail investors, financial professionals may receive
payments from third parties, such as securities issuers, which can
increase costs to investors through higher management fees and reduced
net returns, and provide incentives to recommend these securities over
those that do not provide such incentives.\1068\
---------------------------------------------------------------------------
\1064\ See Allen Ferrell, The Law and Finance of Broker-Dealer
Mark-Ups (Harvard John M. Olin Ctr. for Law, Econ., and Bus.,
Discussion Paper, Apr. 6, 2011), available at https://www.finra.org/sites/default/files/NoticeAttachment/p123492.pdf. See AARP August
2018 Letter.
\1065\ See, e.g., antifraud provisions of the federal securities
laws, FINRA Rule 2121 (Fair Prices and Commissions); MSRB Rules G-15
and G-30, amended pursuant to Exchange Act Release No. 79347 (Nov.
17, 2016) [81 FR 84637] (Nov. 23, 2016); and FINRA Rules 2121 and
2232, amended pursuant to Exchange Act Release No. 79346 (Nov. 17,
2016) [81 FR 84659] (Nov. 23, 2016).
\1066\ See William P. Rogerson, Reputation and Product Quality,
14 Bell J. Econ. 508 (1983); Benjamin Klein & Keith B. Leffler, The
Role of Market Forces in Assuring Contractual Performance, 89 J.
Pol. Econ. 615 (1981); W. Bentley MacLeod, Reputations,
Relationships, and Contract Enforcement, 45 J. Econ. Literature 595
(2007) for theoretical models of the effect of reputation on
investment quality. See AARP August 2018 Letter. For example, FINRA
and MSRB introduced rules in May 2018 regarding mark-up disclosure
rules for same-day trades, allowing investors to be able to see what
they have paid for riskless principal transactions (FINRA Rule 2232
and MSRB Rule G-15). The Commission has also brought enforcement
cases for undisclosed excessive markups under Exchange Act Rule 10b-
5.
\1067\ See, e.g., Inderst & Ottaviani (2012), supra footnote
1050. See also Bolton et al. (2007), infra footnote 1073, which
posits that competition or consolidation affect reputation costs and
provide a disciplining mechanism for providers of financial advice.
Although various mechanisms exist to address agency problems in
general, such as monitoring, bonding, and contracting (see, e.g.,
Finke (2012), supra footnote 1041), the agency problem between
financial professionals and retail investors is not necessarily one
that can be solved cost-effectively through these approaches. See
infra Section III.A.2 for a discussion of limitations to these
approaches. See also Curtis (2018), supra footnote 1054. See also
AARP August 2018 Letter; CFA August 2018 Letter; UVA Letter.
\1068\ See Stoughton et al. (2011), supra footnote 1048. The
authors also state that ``[i]n addition to the advisory fees charged
to the clients, wrap account managers may receive rebates from fund
management companies as well,'' and that wrap accounts have
increased in popularity. See also Mark Egan, Brokers vs. Retail
Investors: Conflicting Interests and Dominated Products, J. Fin.
(forthcoming 2019). See also AARP August 2018 Letter; CFA August
2018 Letter.
---------------------------------------------------------------------------
While a number of studies suggest that conflicts of interest may
lead to investor harm, one study, which provides a survey of the
literature on conflicts of interest, states that ``although conflicts
of interest are omnipresent when contracting is costly and parties are
imperfectly informed, there are important factors that mitigate their
impact and, strikingly, it is possible for customers of financial
institutions to benefit from the existence of such conflicts . . . The
existence of a conflict of interest . . . does not mean that . . . the
customers of that
[[Page 33427]]
institution will be harmed . . . [A] variety of mechanisms help control
conflicts of interest and their impact [e.g., a financial institution's
reputation].'' \1069\ Another study of commission-based compensation in
the United Kingdom indicates that commission-based compensation leads
to significant bias in certain types of securities (e.g., with profit
bonds or distribution bonds) and financial professionals and when bias
exists, retail investors are harmed and the costs associated with such
harm are significant; however, the study also states that the advice
market in the United Kingdom is not overrun with bias (``adviser
recommendations are not dominated by self-interest'') and the market
for advice generally works well.\1070\
---------------------------------------------------------------------------
\1069\ See Mehran & Stulz (2007), supra footnote 1059. See also
Johnsen August 2018 Letter.
\1070\ See Robert Laslett, Tim Wilsdon, & Kyla Malcolm,
Polarisation: Research into the Effect of Commission Based
Remuneration on Advice, Charles River Associates Report Submitted to
the U.K. Financial Services Authority (Jan. 2002), available at
http://www.crai.com/sites/default/files/publications/polarisation-research-into-the-effect-of-commission-based-remuneration-on-advice.pdf. Laslett et al. (2002) estimate harm resulting from
biased advice of approximately [pound]140 million per year.
Following the ban on commission-based compensation in the U.K. in
2013, another study finds that while the quality of financial advice
increases, increased costs of providing advice lead some financial
professionals to turn away small retail investors. See Tracey
McDermott & Charles Roxbury, Financial Advice Market Review,
Financial Conduct Authority and HM Treasury Final Report (Mar.
2016), available at https://www.fca.org.uk/publication/corporate/famr-final-report.pdf (which provides an overview of the effects of
the Retail Distribution Review by the Financial Conduct Authority in
the United Kingdom). Further, McDermott & Roxbury (2016) report that
financial advice costs approximately [pound]150 per hour and that
giving retirement advice requires an average of nine hours on the
part of the financial professional.
---------------------------------------------------------------------------
Although financial professionals may aid retail investors in
correcting common investing mistakes and overcoming informational
hurdles associated with securities transactions or investment
strategies, the average retail investor may not be able to assess the
quality of advice received from financial professionals.\1071\ The
difficulty in assessment can arise from several sources, including a
large degree of heterogeneity in the quality of advice, insufficient
financial literacy on the part of investors, and information asymmetry
between the financial professional and investors.\1072\ Information
asymmetry arises when information necessary to assess the quality of
the advice received may not be available to the retail investor, even
when it is available to the financial professional. For example, a
financial professional may disclose conflicts of interest that could
affect the advice provided, but the information may not be sufficiently
precise to help a retail investor gauge how those conflicts affect the
advice provided.
---------------------------------------------------------------------------
\1071\ A number of studies consider advice to be a credence
good, which is a type of good with qualities that cannot be observed
by the consumer after purchase, making it difficult to assess its
utility. See, e.g., Roman Inderst, Consumer Protection and the Role
of Advice in the Market for Retail Financial Services, 167 J.
Institutional & Theoretical Econ. 4 (2011) (which provides a review
of investors' ability to assess the quality of investment advice).
\1072\ See, e.g., Bluethgen et al. (2008), supra footnote 1048.
Although this study documents reasons why investors may be unable to
assess the quality of advice, the focus is on using adviser
characteristics as screening mechanisms to alleviate the first
complication noted, the high degree of heterogeneity in the quality
of advice. The paper finds that good predictors of high quality
advice include the financial professional's cognitive ability (e.g.,
analytical skills, rationality, and financial knowledge), how
financial professionals are compensated (financial professionals
that have a high fraction of commission-based revenue are less
likely to recommend high quality investments, e.g., index funds),
and the firm's business model. See also Finke (2012), supra footnote
1041; AARP August 2018 Letter. See also Relationship Summary
Adopting Release.
---------------------------------------------------------------------------
Conflicts of interest, therefore, can erode the benefits of advice
provided to retail investors, particularly if investors are unaware
that the conflicts exist or if they do not understand the implications
of conflicts.\1073\ Financial professionals may use this information
asymmetry, particularly with unsophisticated investors, to capture
economic rents for themselves, and this could exacerbate biases that
investors sometimes exhibit, such as return chasing or under-
diversification.\1074\ One experimental study sent ``mystery shoppers''
to broker-dealers and investment advisers in several large cities in
the United States and found that financial professionals provided
recommendations that benefited themselves and exacerbated behavioral
biases on the part of investors, including return chasing or
recommendations of high-cost actively managed funds.\1075\
---------------------------------------------------------------------------
\1073\ See, e.g., Inderst & Ottaviani (2012), supra footnote
1050; Patrick Bolton, Xavier Freixas, & Joel Shapiro, Conflicts of
Interest, Information Provision, and Competition in the Financial
Services Industry, 85 J. Fin. Econ. 297 (2007). See also AARP August
2018 Letter.
\1074\ See, e.g., Marco Ottaviani, The Economics of Advice
(Working Paper, May 2000), available at http://faculty.london.edu/mottaviani/EOA.pdf (included because they capture aspects of the
information asymmetries between retail investors and financial
professionals that are not captured by the studies suggested by the
commenters); Miriam Krausz & Jacob Paroush, Financial Advising in
the Presence of Conflict of Interests, 54 J. Econ. & Bus. 55 (2002);
Inderst & Ottaviani (2012), supra footnote 1050; Stoughton et al.
(2011), supra footnote 1048. See also AARP August 2018 Letter.
\1075\ See Sendhil Mullainathan, Markus Noeth, & Antoinette
Schoar, The Market for Financial Advice: An Audit Study (Nat'l
Bureau of Econ. Research, Working Paper No. 17929, Mar. 2012),
available at https://www.nber.org/papers/w17929.pdf. See also AARP
August 2018 Letter; CFA August 2018 Letter; EPI Letter. Although the
Mullainathan et al. (2012) study included both broker-dealers and
investment advisers, the study notes that most professionals in
their sample focused on the lower end of the retail spectrum and
tended to be compensated through commissions rather than fees based
on AUM. See also Santosh Anagol, Shawn Cole, & Shayak Sarkar,
Understanding the Advice of Commissions Motivated Agents: Evidence
from the Indian Life Insurance Market (Harvard Bus. Sch., Working
Paper No. 12-055, Oct. 2015), available at https://www.hbs.edu/faculty/Publication%20Files/12-055_13c23c02-e57f-4aea-9630-316aa4b772ce.pdf, which used a similar audit approach to evaluate
the quality of advice provided by life insurance agents in India,
and found that agents recommended unsuitable products and strategies
that paid high commissions.
---------------------------------------------------------------------------
Although financial professionals may be hired to help overcome
``investment mistakes'' made by investors,\1076\ a number of studies
show that financial professionals themselves may be subject to the same
behavioral biases as unadvised retail investors, such as return chasing
and overconfidence.\1077\ One study, using data on Canadian investors
and their financial professionals, observes that financial
professionals appear to have the same ``misguided beliefs'' as their
investors, and therefore do not correct, and may even exacerbate common
investment mistakes.\1078\ In that study, financial professionals
invested in the same manner that they recommended to their
[[Page 33428]]
clients; they traded excessively, chased returns, bought expensive
actively managed funds, under-diversified their portfolios, and earned
similar net returns. Further, these financial professionals continued
to follow similar investment strategies as those they recommended to
their clients, even after they had left the industry, suggesting that
they believed their own investment advice.\1079\
---------------------------------------------------------------------------
\1076\ See supra footnote 1046.
\1077\ See, e.g., Mullinathan et al. (2012), supra footnote
1075; Terrance Odean, Are Investors Reluctant to Realize Their
Losses?, 53 J. Fin. 1775 (1998); Zur Shapira & Itzhak Venezia,
Patterns of Behavior of Professionally Managed and Independent
Investors, 25 J. Banking & Fin. 1573 (2001). See also AARP August
2018 Letter. See also Anagol et al. (2015), supra footnote 1075,
which documents that life insurance agents in India purchase the
same inefficient products that they recommend to their clients. One
study of Canadian financial professionals and their clients observed
a commonality among portfolios of a given financial professional,
and that the financial professional's own portfolio allocations
strongly predicted the asset allocations of his or her customers,
indicating limited customization, regardless of the customer's risk
tolerance, age, or financial sophistication. Although the results of
this paper indicate that conflicts of interest are unlikely to
motivate advice because financial professionals and their investors
hold similar portfolios, it does raise questions of the high cost of
financial advice when customization is limited. See Stephen Foerster
et al., Retail Financial Advice: Does One Size Fit All?, 72 J. Fin.
1441 (2017) (included because they capture insights into how
financial professionals may be subject to similar biases as retail
investors that are not captured by the studies suggested by the
commenters). See Robinson (2007), supra footnote 1054.
\1078\ See Juhani T. Linnainmaa, Brian T. Melzer, & Alessandro
Previtero, The Misguided Beliefs of Financial Advisors (Kelley Sch.
of Bus., Research Paper No. 18-9, May 2018), available at http://www.aleprevitero.com/wp-content/uploads/2018/06/SSRN-id3101426.pdf.
See also CFA August 2018 Letter.
\1079\ Linnainmaa et al. (2018), supra footnote 1078, also
suggest that conflicts of interest may not be driven by financial
professionals, but instead are between the firm and its clients, and
that firms deliberately hire financial professionals who believe
their misguided (and ultimately expensive) advice. In light of their
findings, the authors suggest that regulation designed to stem
conflicts of interest could be ineffective if aligning investors and
financial professionals does not alter the advice that they provide,
could raise barriers to entry that could reduce the amount of advice
available, and may limit investor choice.
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c. Evidence of Potential Investor Harm
A number of commenters provided citations to academic studies that
analyze the evidence of potential investor harm driven by conflicts of
interest of financial professionals.\1080\ A number of these studies,
including Bergstresser et al. (2009), Del Guercio and Reuter (2014),
and Christoffersen, Evans, and Musto (2013), underpinned the economic
analyses of the Council of Economic Advisors 2015 Study (``CEA Study'')
and the DOL RIA assessment of the aggregate harm borne by retail
investors in retirement plans due to conflicts of interest.\1081\ Below
we discuss evidence of potential investor harm attributable to
recommendations of certain investments by financial professionals,
including mutual funds, 401(k) plans, corporate bonds, and non-traded
REITs. We then discuss the aggregate measures of investor harm
estimated by the CEA Study and the DOL RIA and the limitations of those
estimates.
---------------------------------------------------------------------------
\1080\ See, e.g., AARP August 2018 Letter; Better Markets August
2018 Letter; CFA August 2018 Letter; EPI Letter; State Attorneys
General Letter.
\1081\ See Letter from Linda Agerbak (Jun. 21, 2018) (``Agerbak
Letter''); Better Markets August 2018 Letter; CFA August 2018
Letter; EPI Letter; Letter from Public Citizen (Aug. 7, 2018)
(``Public Citizen Letter''); State Attorneys General Letter; Former
SEC Senior Economists Letter. See also Bergstresser et al. (2009),
supra footnote 1048; Diane Del Guercio & Jonathan Reuter, Mutual
Fund Performance and the Incentive to Generate Alpha, 69 J. Fin.
1673 (2014); Susan E.K. Christoffersen, Richard Evans, & David K.
Musto, What Do Consumers' Fund Flows Maximize? Evidence from Their
Brokers' Incentives, 68 J. Fin. 201 (2013). See Office of the
President of the United States, Council of Economic Advisers, The
Effects of Conflicted Investment Advice on Retirement Savings (Feb.
2015), available at https://obamawhitehouse.archives.gov/sites/default/files/docs/cea_coi_report_final.pdf. See also DOL RIA, supra
footnote 1002. Both the CEA Study and the DOL RIA assumed that the
DOL Fiduciary Rule would eliminate all conflicts of interest and,
therefore, all of the harms to retirement investors resulting from
conflicts. See also Curtis (2018) and infra footnote 1103. By
contrast, Regulation Best Interest would not require elimination or
mitigation of firm-level conflicts, and will require written
policies and procedures reasonably designed to eliminate or mitigate
of some representative-level conflicts, which means that some
conflicts and their attendant harms may remain, especially at the
firm level. The disclosure requirements of Regulation Best Interest,
however, may empower some customers to push back on broker-dealer
conflicts of interest and more generally may have a deterrent
effect.
---------------------------------------------------------------------------
Directly addressing the question of whether and how brokerage
customers or advisory clients are affected by conflicts of interest
(e.g., through quantification) requires measurement of the effect of
advice, subject to different levels of conflict, received from broker-
dealers or investment advisers. Most data currently available to
researchers does not make distinctions between types of firms or
financial professionals, and generally aggregates all firms or
financial professionals into a single category of financial
professionals (e.g., ``adviser'' or ``financial adviser''). Further, an
investor's propensity to choose a particular type of relationship may
be correlated with the investor's skill or choice of investment and,
therefore, may introduce bias into studies that are able to
differentiate between types of advice relationships. Despite these
limitations, by examining the existing academic literature, discussed
below, we are able to gain qualitative insight into, and address
commenter concerns, about conflicts of interest in the market for
financial advice and the potential harm to investors.
The majority of studies to date that investigate the potential harm
to investors arising from potential conflicts of interest have
generally centered on findings based on analysis of investments in
mutual funds. Due to the readily available data for mutual funds, the
literature is rich with studies exploring various aspects of those
securities, including the performance of funds, relationships between
flows and performance or expenses, and differences in performance of
funds depending on the distribution channel. These studies have further
been used by commenters and other providers of economic analyses to
estimate the magnitude of investor harm potentially stemming from
conflicts of interest as it relates to mutual fund investments.\1082\
---------------------------------------------------------------------------
\1082\ See CEA Study, supra footnote 1081, and DOL RIA, supra
footnote 1002. See also EPI Letter; Better Markets August 2018
Letter; St. John's U. Letter; Letter from Royce A. Charney,
President, Trust Administrators (Aug. 7, 2018) (``Charney Letter'');
Agerbak Letter; CFA August 2018 Letter.
---------------------------------------------------------------------------
Evidence suggests that there is a strong relationship between past
performance and subsequent fund flows, even when funds do not
persistently outperform, suggesting that investors and/or their
financial professionals may engage in return-chasing behavior.\1083\
Several studies also examine the effect of mutual fund costs, and find
that (1) fund flows are negatively related to front-end loads, but are
relatively insensitive to fund-level operating expenses (e.g., 12b-1
fees), indicating that investors may be aware of upfront costs when
selecting funds, but may be less attuned to the effect on net returns
of ongoing operating expenses; \1084\ and (2) unsophisticated investors
are more likely to pay higher fees than sophisticated investors and are
less likely to expend search costs to look for lower-fee funds.\1085\
Retail investors, however, can benefit when funds commence operation of
an institutional ``twin'' fund as overall expenses decrease and
managerial effort increases, suggesting that retail investors may not
be able to monitor fund managers as effectively as institutional
investors.\1086\
---------------------------------------------------------------------------
\1083\ See Judith Chevalier & Glenn Ellison, Risk Taking by
Mutual Funds as a Response to Incentives, 105 J. Pol. Econ. 1167
(1997); Jonathan B. Berk & Richard C. Green, Mutual Fund Flows and
Performance in Rational Markets, 112 J. Pol. Econ. 1269 (2004); Brad
M. Barber, Terrance Odean, & Lu Zheng, Out of Sight, Out of Mind:
The Effects of Expenses on Mutual Fund Flow, 78 J. Bus. 2095 (2005);
Erik R. Sirri & Peter Tufano, Costly Search and Mutual Fund Flows,
53 J. Fin. 1589 (1998). In the theoretical model provided by Berk
and Green (2004), active funds do not outperform passive funds
because investors compete to invest in strong past performers (i.e.,
they chase returns), driving these funds' returns to the competitive
level. See also AARP August 2018 Letter; CFA August 2018 Letter.
\1084\ See Barber et al. (2005), supra footnote 1083.
\1085\ See Todd Houge & Jay Wellman, The Use and Abuse of Mutual
Fund Expenses, 70 J. Bus. Ethics 23 (2007). See AARP August 2018
Letter.
\1086\ See Richard B. Evans & Rudiger Fahlenbrach, Institutional
Investors and Mutual Fund Governance: Evidence from Retail-
Institutional Fund Twins, 25 Rev. Fin. Stud. 3530 (2012). See AARP
August 2018 Letter. The authors identify funds as ``twins'' if they
share the same manager, investment objectives, fund families, and
have a gross return correlation of 0.95 or greater.
---------------------------------------------------------------------------
Analyses in the CEA Study and the DOL RIA focus on the
underperformance of certain broker-sold funds, potentially driven by
conflicts of interest and a misalignment of incentives between
financial professionals and investors.\1087\ A number of studies
document that actively managed load mutual funds purchased by investors
through a financial professional underperform
[[Page 33429]]
other types of mutual funds.\1088\ For example, several studies find
that actively managed load funds underperform a buy-and-hold strategy
by between 1.56% and 2.28% annually, while other studies show that
actively managed load funds underperform no-load funds by between 1%
and 1.5% per year.\1089\ This underperformance could be driven by poor
market timing of investors (e.g., return chasing),\1090\ or because
increased expenditures by the funds on marketing and advertising
successfully attract retail flows, and such expenses decrease net
returns to investors over time.\1091\ Fees and expenses, as documented
by several studies, are two of the most reliable predictors of future
returns, and fees should reflect performance (e.g., funds with high
fees hypothetically should have better ex post performance in order to
justify the fees), as at least some portion of the fees are dedicated
to portfolio management; however, these studies consistently find a
negative relationship between fees and performance--lower cost funds on
average are more likely to generate higher performance net of fees than
high cost funds.\1092\
---------------------------------------------------------------------------
\1087\ See CEA Study, supra footnote 1081, and DOL RIA, supra
footnote 1002.
\1088\ See Bergstresser et al. (2009), supra footnote 1048; Del
Guercio & Reuter (2014), supra footnote 1081.
\1089\ See, e.g., Mercer Bullard, Geoffrey Friesen, & Travis
Sapp, Investor Timing and Fund Distribution Channels (Working Paper,
2008); Geoffrey C. Friesen & Travis R.A. Sapp, Mutual Fund Flows and
Investor Returns: An Empirical Examination of Fund Investor Timing
Ability, 31 J. Banking & Fin. 2796 (2007); Matthew R. Morey, Should
You Carry the Load? A Comprehensive Analysis of Load and No-Load
Mutual Fund Out-of-Sample Performance, 27 J. Banking & Fin. 1245
(2003). See also Eugene F. Fama & Kenneth R. French, Luck Versus
Skill in the Cross-Section of Mutual Fund Returns, 65 J. Fin. 1915
(2010), which notes that although some active managers may
outperform passive benchmarks while others underperform, on average,
the alpha attributable to active management will net to zero;
therefore, net of fees, on average, and the alpha earned by actively
managed funds will be reduced by the aggregate amount of fees and
expenses of active management. See also William F. Sharpe, The
Arithmetic of Active Management, 47 Fin. Analysts J. 7 (1991). See
AARP August 2018 Letter; CFA August 2018 Letter.
\1090\ See, e.g., Bullard et al. (2008), supra footnote 1089;
Friesen & Sapp (2007), supra footnote 1089.
\1091\ One study documents that heavily advertised funds
outperform their benchmarks prior to the marketing efforts, but do
not outperform their benchmarks in the post-advertising period.
These funds, however, attract significantly more inflows, relative
to a control group. See Prem C. Jain & Joanna Shuang Wu, Truth in
Mutual Fund Advertising: Evidence on Future Performance and Fund
Flows, 55 J. Fin. 937 (2000). See also Nikolai Roussanov, Hongxun
Ruan, & Yanhao Wei, Marketing Mutual Funds (Nat'l Bureau of Econ.
Research, Working Paper No. 25056, Sept. 2018), available at https://www.nber.org/papers/w25056.pdf. See AARP August 2018 Letter; CFA
August 2018 Letter; EPI Letter.
\1092\ See Javier Gil-Bazo & Pablo Ruiz-Verdu, The Relation
Between Price and Performance in the Mutual Fund Industry, 64 J.
Fin. 2153 (2009); Russel Kinnel, Predictive Power of Fees: Why
Mutual Fund Fees Are So Important, Morningstar Manager Research (May
2016); William F. Sharpe, The Arithmetic of Investment Expenses, 69
Fin. Analysts J. 34 (2013). Gil-Bazo & Ruiz-Verdu (2009) find that
actively managed funds with the worst performance charge, on
average, the highest fees. See AARP August 2018 Letter; CFA August
2018 Letter.
---------------------------------------------------------------------------
A number of studies, also cited by the DOL RIA and the CEA Study,
explore the distinction between broker-sold funds and direct-sold
funds, and the effect of the distribution channel on fund flows and
performance. When examining a sample of only broker-sold funds, one
study shows that funds that pay higher fees to financial professionals
or charge higher excess loads generate greater fund inflows.\1093\
Moreover, broker-sold funds, on average, underperform direct-sold funds
by between 23 bps and 255 bps per annum, with most studies observing
average underperformance of approximately 100 bps (1%) per year.\1094\
---------------------------------------------------------------------------
\1093\ See Christoffersen et al. (2013), supra footnote 1081;
Chalmers & Reuter (2015), supra footnote 1042; Jasmin Sethi, Jake
Spiegel, & Aron Szapiro, Conflicts of Interest in Mutual Fund Sales:
What Do the Data Tell Us?, 6 J. Retirement 46 (2019). Christoffersen
et al. (2013) and Sethi et al. (2019) measure excess loads by first
estimating the baseline (average) load paid with regressions of
loads on a number of explanatory variables, then using the residuals
from these regressions (excess loads) to explain fund flows and
performance. See also Morningstar Letter; Letter from Aron Szapiro,
Director of Policy Research, Morningstar, Inc., et al. (Aug. 24,
2018) (``Morningstar Letter Supplement''). Sethi et al. (2019) find,
however, that the relation between excess loads and fund flows
tapered off after the DOL Fiduciary Rule was adopted, suggesting
that the DOL Fiduciary Rule may have discouraged financial
professionals from directing flows to funds with high excess loads.
\1094\ See, e.g., Bergstresser et al. (2009), supra footnote
1048; Chalmers & Reuter (2015), supra footnote 1042; Xuanjuan Chen,
Tong Yao, & Tong Yu, Prudent Man or Agency Problem? On the
Performance of Insurance Mutual Funds, 16 J. Fin. Intermediation 175
(2007). See AARP August 2018 Letter.
---------------------------------------------------------------------------
Further, conflicts of interest appear to depend upon the choice of
investment (e.g., broker-sold versus direct-sold funds) as well as the
magnitude of the costs (e.g., mutual fund loads). One study suggests
that the market for funds is segmented: More financially sophisticated
investors select direct-sold funds, which unbundle portfolio management
from advice of financial professionals, while less financially
sophisticated investors purchase broker-sold funds, which combine
portfolio management and advice.\1095\ Another study focuses
exclusively on broker-sold funds, but segments those funds into groups
that depend on the size of excess loads and whether the funds are sold
by affiliated or unaffiliated brokers.\1096\ That study observes that
funds with a one-standard deviation increase in excess loads are
related to a reduction in future performance of between 34 bps and 49
bps in the following year. As detailed in Bergstresser et al. (2009),
the broker-sold channel is likely to include funds sold through both
broker-dealers and investment advisers; however, the data provided to
the authors is not granular enough to be able to distinguish the
performance characteristics of the two distinct channels.\1097\
---------------------------------------------------------------------------
\1095\ See Del Guercio & Reuter (2014), supra footnote 1081.
Moreover, this study finds that broker-sold actively managed funds
underperform broker-sold index funds by between 1.1% and 1.3% per
year, which the authors suggest may reflect an agency conflict. See
also Diane Del Guercio, Jonathan Reuter, & Paula A. Tkac, Broker
Incentives and Mutual Fund Market Segmentation (Nat'l Bureau of
Econ. Research, Working Paper No. 16312, Aug. 2010), available at
https://www.nber.org/papers/w16312.pdf. See AARP August 2018 Letter;
CFA August 2018 Letter. Although some of the growth in direct-sold
funds comes from passive investing (e.g., index funds), greater than
75% of the number of direct-sold funds are actively managed (as of
2012). See Jonathan Reuter, Revisiting the Performance of Broker-
Sold Mutual Funds (Working Paper, Nov. 2, 2015), available at
https://www2.bc.edu/jonathan-reuter/research/brokers_revisited_201511.pdf.
\1096\ See Christoffersen et al. (2013), supra footnote 1081.
\1097\ See Bergstresser et al. (2009), supra footnote 1048. The
Bergstresser et al. study also notes that many funds in the direct-
sold channel may be recommended by fee-based advisers, whose
services ``are typically paid for with an advisory fee that is
outside of the fund expenses or distribution costs. As a practical
matter, the `direct' channel may not be as direct as one might
imagine.''
---------------------------------------------------------------------------
A number of commenters stated that the Proposing Release did not
appropriately account for existing economic analyses produced by the
CEA Study and the DOL RIA to measure the potential harm to investors
from conflicts of interest.\1098\ The CEA Study and the DOL RIA use the
literature on underperformance of broker-sold mutual funds as the
foundation for their analyses on the potential harm of retail
investors, focusing on harm specifically directed at retirement
savings. Applying an estimate of approximately 1% underperformance to
broker-sold funds, which is consistent with estimates of
underperformance provided by several studies,\1099\ the CEA Study and
the DOL
[[Page 33430]]
RIA apply different methods and approaches to calculate the aggregate
dollar harm for retail investors in their retirement accounts.\1100\
Based on $1.7 trillion invested in potentially conflicted funds, the
CEA Study estimates annual harm to retirement investors of
approximately $17 billion.\1101\ Similarly, the DOL RIA, which
estimates potential loss due to conflicts of interest of between 50 bps
and 100 bps per year, produces ten-year aggregate estimates of investor
harm of between $95 billion and $189 billion stemming from the
underperformance of broker-sold mutual funds.
---------------------------------------------------------------------------
\1098\ See also ARA August 2018 Letter; EPI Letter; Better
Markets August 2018 Letter; St. John's U. Letter; Charney Letter;
Agerbak Letter; CFA August 2018 Letter.
\1099\ See Bergstresser et al. (2009), supra footnote 1048; Del
Guercio & Reuter (2014), supra footnote 1081; Christoffersen et al.
(2013), supra footnote 1081. A number of commenters, regarding the
DOL RIA, indicated that both the CEA Study, supra footnote 1081, and
the DOL RIA, supra footnote 1002, misinterpreted estimated effects
described in the Christoffersen et al. (2013) paper, and overstated
the potential harm associated with funds with high excess loads by
more than double the actual estimate had the interpretation been
correct. See Craig M. Lewis, The Flawed Cost-Benefit Analysis
Underlying the Department of Labor's Fiduciary Rule (White Paper,
Aug. 2017), available at https://www.sec.gov/comments/ia-bd-conduct-standards/cll4-2268185-160965.pdf; Public Interest Comment from Mark
Warshawsky & Hester Peirce, George Mason University Mercatus Center
(Apr. 17, 2017), available at https://www.mercatus.org/system/files/warshawsky-dol-fiduciary-rule-pic-v1.pdf. See also Curtis (2018),
supra footnote 1054.
\1100\ See CEA Study, supra footnote 1081, and DOL RIA, supra
footnote 1002.
\1101\ See CEA Study, supra footnote 1081.
---------------------------------------------------------------------------
The level of underperformance due to fund selection is highly
sensitive to the data sample, including the sample period, as well as
the methodology employed to calculate performance. Many of the studies
used to support the analyses underlying the CEA Study and the DOL RIA
rely on data obtained prior to 2011. However, since 2011 there have
been a number of advances in the market for mutual funds (e.g., shifts
from load to no-load funds and increase in no-load funds without 12b-1
fees), likely leading some of the inferences drawn from those studies
to be dated and not reflective of the current market environment.\1102\
A number of commenters indicated potential flaws associated with the
approach and interpretation of the analyses used by the CEA Study and
the DOL RIA.\1103\ One study updates the Del Guercio and Reuter (2014)
sample using data from between 2003 and 2012 and tests the robustness
of the methodology by examining the underperformance of broker-sold
funds relative to direct-sold funds.\1104\ While underperformance of
broker-sold funds still existed, depending on the methodology and
empirical approach used, the underperformance of these funds was
reduced to between 20 bps and 70 bps, with the majority of the
estimation approaches falling to between 20 bps and 50 bps, indicating
a reduction in the underperformance of broker-sold funds relative to
earlier studies.\1105\ Another study replicates the Christoffersen et
al. (2013) analysis of excess loads on underperformance using data from
between 2010 and 2017, and finds that after 2010, funds with high
excess loads did not underperform funds with low excess loads, which
the authors interpret as evidence that financial professionals have
improved their recommendations over time.\1106\ Taken together, these
recent studies on fund selection suggest that the magnitude of
potential investor harm likely is not as large as that estimated by the
CEA Study and the DOL RIA when more recent data is used to compute the
underperformance of broker-sold mutual funds.
---------------------------------------------------------------------------
\1102\ See ICI Letter and Section III.B.2.e.ii, supra.
\1103\ See Lewis (2017), supra footnote 1099; Warshawsky &
Peirce (2017), supra footnote 1099. See also Curtis (2018), supra
footnote 1054. To date, only one academic study of which we are
aware (Curtis (2018)) has analyzed the DOL Fiduciary Rule and the
DOL RIA, and discusses issues with the approach taken by the DOL RIA
in estimating the benefits and costs of the DOL Fiduciary Rule,
noting that the DOL RIA likely underestimates the potential costs of
the rule. This study also indicates that the net benefits of the DOL
Fiduciary Rule are expected to be close to zero because the DOL
Fiduciary Rule may not completely eliminate conflicts of interest
and the actual cost of investment advice at the intermediary-level
was excluded from the DOL RIA computation of benefit. Once the
calculation accounted for costs of advice, Curtis (2018) estimates
that the total costs attributed to conflicts of interest, including
underperformance of some securities, is only slightly higher than
the costs associated with advice that is free of conflicts.
\1104\ See Reuter (2015), supra footnote 1095.
\1105\ Reuter (2015), supra footnote 1095, states that ``[t]hese
changes suggest that the average broker-sold fund has become more
competitive with the average direct-sold fund''; however additional
research would be required to determine if these changes are driven
by existing fund families, new fund families, or some combination of
factors. When performance is value-weighted, Reuter (2015) discusses
that brokers appear to direct clients toward funds that pay
``higher-than-average distribution costs.''
\1106\ See Sethi et al. (2019), supra footnote 1093. The authors
note that the underperformance of high excess load funds becomes
statistically insignificant in the analysis only with the inclusion
of prior-year performance of the fund (which Christoffersen et al.
(2013), supra footnote 1081, include in one of their models). The
authors suggest that the reduction in flows to funds with excess
loads could be due in part to the DOL Fiduciary Rule; however, they
also note that their analysis does not reveal a clear association
between the DOL Fiduciary Rule and returns. The authors further cite
to Holden et al. (2018), supra footnote 955, which discusses the
shift away from load mutual funds to no-load funds over time. See
also ICI Letter; Morningstar Letter; Morningstar Letter Supplement.
---------------------------------------------------------------------------
Another recent study replicates and extends the Friesen and Sapp
(2007) and Bullard et al. (2008) analyses of market timing ability by
investors in mutual fund sales and purchases to newer data (2007
through 2016).\1107\ The study shows that the difference between dollar
returns and buy-and-hold returns (``performance gap'') declined from
1.56% between 1991 and 2004 to 1.01% between 2007 and 2016 for a
combined sample of load and no-load funds, suggesting a moderation in
market timing errors in the most recent period. However, the excess
performance gap (the difference between the performance gap on load
funds and no load funds) has slightly increased between 2007 and 2016,
from approximately 1% to 1.12%, indicating that, to the extent that
load funds are sold by financial professionals and that all inflows and
outflows are due solely to market timing motivations, investors who
hold load funds are more prone to market timing errors than investors
in no-load funds, and these errors are not being corrected by financial
professionals. The studies discussed above acknowledge that
interpretation of the empirical result that broker-sold funds
underperform direct-sold funds is subject to another caveat because
there is likely to be a selection bias in the type of investor that
utilizes the direct-sold fund channel relative to those investors who
rely on financial professionals for advice and recommendations about
which funds to purchase. A similar selection bias is likely to exist
for investors who purchase no-load funds versus those that purchase
load funds from financial professionals. For example, although numerous
studies discussed above suggest that financial advice is more likely to
be obtained by older, more financially sophisticated, and wealthier
investors,\1108\ Chalmers and Reuter (2015) observe that younger, less
financially experienced, and less wealthy investors are more likely to
buy broker-sold funds.\1109\
---------------------------------------------------------------------------
\1107\ See Karthik Padmanabhan, Constantijn Panis, & Timothy
Tardiff, The Ability of Investors to Time Purchases and Sales of
Mutual Funds (Working Paper, Nov. 1, 2017) (see also Department of
Labor April 2019 memo). See, e.g., Bullard et al. (2008), supra
footnote 1089; Friesen & Sapp (2007), supra footnote 1089.
\1108\ See supra Section III.B.3.a.
\1109\ See supra footnote 1042.
---------------------------------------------------------------------------
Beyond mutual funds, a nascent literature is emerging on other
securities that may be prone to conflicts of interest by financial
professionals.\1110\ Recent
[[Page 33431]]
studies have examined potential conflicts of interest in markets for
more complex investments, including reverse convertible corporate bonds
and non-traded REITs. One study uses a sample of reverse convertible
corporate bonds that differ only in the financial incentives provided
to financial professionals and the coupon rate, and finds that
investors are more likely to purchase--based on the advice given--the
inferior bond (lower coupon, all else equal) with the higher ``kick-
back'' to the broker-dealer, which appears to be driven by conflicts of
interest between the financial professional and the investors.\1111\ In
an examination of non-traded REITs, one study documents that retail
investors in non-traded REITs underperformed by over $45 billion
relative to a portfolio of traded REITs, and that nearly one-third of
that underperformance was driven by upfront fees used to compensate
broker-dealers.\1112\
---------------------------------------------------------------------------
\1110\ Some commenters (see, e.g., CFA August 2018 Letter; AARP
August 2018 Letter; EPI Letter) also provided studies about
conflicts of interest in 401(k) plans which have shown that (i) plan
sponsors tilt securities toward high-cost securities (see Ian Ayres
& Quinn Curtis, Beyond Diversification: The Pervasive Problem of
Excessive Fees and ``Dominated Funds'' in 401(k) Plans, 124 Yale
L.J. 1476 (2015)); (ii) plans have inadequate or excessive
investment choices (see Edwin J. Elton, Martin J. Gruber, &
Christopher R. Blake, The Adequacy of Investment Choices Offered by
401(K) Plans, 90 J. Pub. Econ. 1299 (2006); Sheena Sethi-Iyengar,
Gur Huberman, & Wei Jiang, How Much Choice is Too Much?
Contributions to 401(k) Retirement Plans, in Pension Design and
Structure: New Lessons from Behavioral Finance (Olivia S. Mitchell &
Stephen P. Utkuss eds., 2004)); (iii) plans may include proprietary
funds even when other funds perform better (see Veronika K. Pool,
Clemens Sialm, & Irina Stefanescu, It Pays to Set the Menu: Mutual
Fund Investment Options in 401(K) Plans, 71 J. Fin. 1779 (2016));
and (iv) funds included in 401(k) plans underperform passive
benchmarks by approximately 31 bps annually (see Edwin J. Elton,
Martin J. Gruber, & Christopher T. Blake, How do Employer's 401(K)
Mutual Fund Selections Affect Performance?, Ctr. for Retirement
Research at Bos. Coll., Issue in Brief No. 13-1 (Jan. 2013),
available at https://crr.bc.edu/wp-content/uploads/2013/01/IB_13-1-508.pdf).
\1111\ See Egan (2019), supra footnote 1068.
\1112\ See Craig McCann, Fiduciary Duty and Non-Traded REITs,
Investments & Wealth Monitor, July/Aug. 2015, at 39, available at
https://www.slcg.com/pdf/workingpapers/Fiduciary%20duty%20and%20Non-traded%20REITs.pdf. See CFA August 2018 Letter.
---------------------------------------------------------------------------
Finally, although a significant amount of empirical evidence
suggests that there may be investor harm due to conflicts of interest
between financial professionals and investors, because of changes to
the mutual fund industry (e.g., shifts from load to no-load funds and
the introduction of new share classes),\1113\ increased
competition,\1114\ and the anticipation of regulation designed to
ameliorate potential conflicts of interest, several new studies
indicate that potential harm to investors arising from conflicts of
interest may be declining.\1115\ One survey paper concludes that
although the empirical evidence is consistent with financial
professionals having conflicts of interest that may harm consumers,
``none of the articles concludes that clients would have been better
off by foregoing advice. Even if people receive lower returns . . .
consulting with an advisor may provide intangible benefits that
consumers value,'' and ``it is important to bear in mind that these
studies may have data limitations and in general cannot account for
selection issues and the intangible benefits that investors receive
from financial advisors.'' \1116\
---------------------------------------------------------------------------
\1113\ See ICI Letter and Holden et al. (2018), supra footnote
951. See also Capital Group Letter; Money Management Institute
Letter; FPC Letter at footnote 73. As noted above, innovations,
including the introduction of T and clean share classes of funds may
reduce the expected fund underperformance net of costs for retail
investors relative to A shares by nearly 50 basis points annually.
See supra footnote 1021 and accompanying text. See also supra
footnote 1020 and accompanying text.
\1114\ See LPL December 2018 Letter; Morgan Stanley Letter
(which discuss the migration to open architecture platforms).
\1115\ See Reuter (2015), supra footnote 1042; Sethi et al.
(2019), supra footnote 1093. See also CFA August 2018 Letter; EPI
Letter; Morningstar Letter; Morningstar Letter Supplement. We
include recent studies provided by commenters to present the current
baseline of empirical findings on potential investor harm stemming
from conflicts of interest.
\1116\ See Burke et al. (2015), supra footnote 1059. The DOL
RIA, supra footnote 1002, and some commenters, however, have stated
that no advice is a better alternative to advice subject to
conflicts of interest. See also EPI Letter; Betterment Letter; PIABA
Letter; CFA August 2018 Letter. The DOL RIA suggests that investors
who obtain advice subject to conflicts of interest are worse off due
to the costs associated with obtaining such advice (e.g.,
underperformance) than had they not sought or received advice at
all.
---------------------------------------------------------------------------
4. Trust, Financial Literacy, and the Effectiveness of Disclosure
A number of commenters stated that the Proposing Release did not
sufficiently address how issues related to trust in financial
professionals, investors' level of financial literacy or
sophistication, and limitations on the effectiveness of disclosure
likely exacerbate the problems of information asymmetry and potential
conflicts of interest between retail investors and financial
professionals.\1117\ In order to address commenters' concerns, we
examined and discuss below both academic and industry research on how
trust and financial literacy could affect the recommendations provided
by financial professionals to retail investors, as well as the
effectiveness and limitations of disclosure in ameliorating potential
conflicts of interest.
---------------------------------------------------------------------------
\1117\ See AARP August 2018 Letter; CFA August 2018 Letter; FPC
Letter; Rhoades December 2018 Letter; EPI Letter.
---------------------------------------------------------------------------
a. Trust in Investment Advice
In seeking financial advice, a retail investor places not only
money but also trust in a financial professional. Commenters stated
that retail investors will follow the advice of their ``trusted
advisors,'' because they believe ``financial professional[s] will place
the investor's financial interest before his or her own.'' \1118\
Moreover, one industry study of over 800 investors notes that ``96% of
U.S. investors report that they trust their financial professional and
97% believe their financial professional has their best interest in
mind.'' \1119\ Academic studies have explored the issue of trust and
how it affects financial decisions of investors. Studies in this strand
of academic literature find that higher levels of trust increase
investors' propensity to seek investment advice and hire financial
professionals,\1120\ increase levels of stock market
participation,\1121\ and increase willingness to take on higher-risk
investments.\1122\ Regarding the importance of trust in established
advice relationships, some studies find that trust in financial
professionals is greater when investors have lower financial literacy
or when purchasing complex products, such as insurance products.\1123\
Further, as trust in
[[Page 33432]]
financial professionals grows, investors may be more likely to delegate
all investment decisions to the financial professional, irrespective of
their level of financial education.\1124\
---------------------------------------------------------------------------
\1118\ See Letter from Christine Lazaro, President, PIABA (Dec.
7, 2018) (``PIABA December 2018 Letter''). See also, e.g., Rhoades
December 2018 Letter; Gross Letter; Letter from William W. McGinnis,
W. McGinnis Advisors (Aug. 7, 2018) (``McGinnis Letter''); EPI
Letter; Betterment Letter; State Attorneys General Letter; Better
Markets August 2018 Letter; OIAD/RAND (providing a survey on
academic literature on trust). One survey notes, however, that
approximately 15% of survey participants do not consult with
financial professionals because they ``don't trust them.'' See
Cetera November 2018 Letter.
\1119\ See CCMC Letters. See also Center for Capital Markets
Competitiveness, Working with Financial Professionals: Opinions of
American Investors (2018), available at https://www.centerforcapitalmarkets.com/wp-content/uploads/2018/04/CCMC_InvestorPolling_v5-1.pdf.
\1120\ See Jeremy Burke & Angela A. Hung, Trust and Financial
Advice (RAND Labor & Population, Working Paper No. WR-1075, Jan.
2015), available at https://www.dol.gov/sites/default/files/ebsa/laws-and-regulations/rules-and-regulations/proposed-regulations/1210-AB32-2/trust-and-financial-advice.pdf. This study indicates
that increased financial trust is associated with higher levels of
both seeking and following investment advice. See also AARP August
2018 Letter; FPC Letter; CFA August 2018 Letter.
\1121\ See Luigi Guiso, Paola Sapienza, & Luigi Zingales,
Trusting in the Stock Market, 63 J. Fin. 2557 (2008). Guiso et al.
(2008) find that higher levels of trust in financial professionals
by investors is associated with a 50% increase in the probability of
buying stocks and a 3.4% increase in the proportion of equity
investments in the aggregate portfolio. See Rhoades December 2018
Letter.
\1122\ See Nicola Gennaioli, Andrei Shleifer, & Robert Vishny,
Money Doctors, 70 J. Fin. 91 (2015). This study suggests that
increased trust in financial professionals by investors alleviates
anxiety in undertaking higher-risk investments (e.g., equities)
(included because they capture aspects of the benefits of higher
levels of trust in financial professionals by retail investors that
are not captured by the studies suggested by the commenters).
\1123\ See Thomas Pauls, Oscar Stolper, & Adreas Walter, Broad-
Scope Trust and Financial Advice (Working Paper, Nov. 17, 2016),
available at https://www.researchgate.net/publication/314235638_Broad-scope_trust_and_financial_advice; David de Meza,
Bernd Irlenbusch, & Diane Reyniers, Disclosure, Trust and Persuasion
in Insurance Markets (IZA Discussion Paper Series, No. 5060, July
2010), available at http://repec.iza.org/dp5060.pdf. See also OIAD/
RAND, which shows that investors most likely in need of investor
protection (e.g., financially unsophisticated) are most likely to
place their trust in financial professionals. See also Letter from
AFL-CIO et al. (Dec. 7, 2018) (``AFL-CIO December 2018 Letter'').
\1124\ See Riccardo Calcagno, Maela Giofre, & Maria Cesira Urzi-
Brancati, To Trust is Good, but to Control is Better: How Investors
Discipline Financial Advisors' Activity, 140 J. Econ. Behav. & Org.
287 (2017). See OIAD/RAND.
---------------------------------------------------------------------------
Several commenters stated that some financial professionals respond
to the trust that retail investors place in them by acting on their
conflicts of interest, which could benefit the financial professional
at the expense of the investor.\1125\ In addition, some studies have
shown that higher levels of trust by retail investors can provide
incentives for financial professionals to provide conflicted investment
advice or undertake actions that benefit themselves at the expense of
their customers. For example, one study found that because investors
trust their financial professionals to provide higher ex ante expected
returns on their risky investments, firms employing those professionals
increased fees above levels that, in the author's view, were consistent
with a competitive equilibrium, resulting in lower ex post net returns
to investors.\1126\ Further, this study documents that, although a
relationship with a trusted professional can encourage investors to
invest in financial markets when it is efficient for them to do so, in
some cases financial professionals may instead provide more conflicted
investment advice or inefficient advice in order to satisfy the desires
of investors who trust them (e.g., undertaking lottery-like behavior by
investing in the riskiest securities).\1127\ Although trust in
financial professionals can help alleviate certain behavioral biases
and encourage participation in the securities markets, one commenter
stated that ``[r]etail customers who place their trust in salespeople
that market services as acting in their best interest can end up paying
excessively high costs for higher risk or underperforming investments
that only satisfy a suitability standard, not a fiduciary standard.''
\1128\
---------------------------------------------------------------------------
\1125\ See, e.g., Rhoades December 2018 Letter; EPI Letter;
Better Markets August 2018 Letter.
\1126\ See Calcagno et al. (2017), supra footnote 1124.
\1127\ See id.
\1128\ See AARP August 2018 Letter. See also PIABA Letter; St.
John's U. Letter. See also Joseph C. Peiffer & Christine Lazaro,
Major Investor Losses Due to Conflicted Advice: Brokerage Industry
Advertising Creates the Illusion of a Fiduciary Duty, PIABA Report
(Mar. 25, 2015), available at https://piaba.org/sites/default/files/newsroom/2015-03/PIABA%20Conflicted%20Advice%20Report.pdf.
---------------------------------------------------------------------------
b. Financial Literacy and Investment Advice
As discussed above, financial literacy affects those who seek
investment advice from financial professionals. One commenter noted
that ``[a]s consumers move closer to retirement, they may be more
vulnerable to the negative impact of advice that is not in their best
interest for three reasons: (1) The assets they have to invest are
larger; (2) they may lack strong financial literacy skills; and (3)
reduced cognition may affect financial decision making.'' \1129\ A
number of studies have shown that financial literacy is significantly
related to retirement planning and wealth accumulation by retail
investors.\1130\ Generally, studies find that investors who are more
financially literate or sophisticated are more likely to seek
investment advice and are more likely to follow that advice than less
financially sophisticated investors.\1131\ Further, one study shows
that investors with lower financial literacy who do not seek investment
advice underperform investors with higher financial literacy who seek
investment advice by more than 50 bps on average, and these losses are
predominantly driven by under-diversification of their
portfolios.\1132\
---------------------------------------------------------------------------
\1129\ See AARP August 2018 Letter.
\1130\ See, e.g., Jere R. Behrman et al., Financial Literacy,
Schooling, and Wealth Accumulation (Nat'l Bureau of Econ. Research,
Working Paper No. 16452, Oct. 2010), available at https://www.nber.org/papers/w16452.pdf; Hans-Martin von Gaudecker, How Does
Household Portfolio Diversification Vary with Financial Literacy and
Financial Advice?, 70 J. Fin. 489 (2015) (included in response to
comment letters that expressed views about limited financial
literacy by some retail investors).
\1131\ See supra Section III.B.3. See also Riccardo Calcagno &
Chiara Monticone, Financial Literacy and the Demand for Financial
Advice, 50 J. Banking & Fin. 363 (2015), who observe that investors
with lower levels of financial literacy are less likely to consult
advisers and avoid risky assets; however, when they do seek advice,
they generally delegate investment decisions to their financial
professionals. Lusardi & Mitchell (2011) indicate that investors who
are more financially sophisticated are more likely to plan for
wealth accumulation and be successful in their planning. See
Annamaria Lusardi & Olivia S. Mitchell, Financial Literacy and
Planning: Implications for Retirement Wellbeing (Nat'l Bureau of
Econ. Research, Working Paper No. 17078, May 2011), available at
https://www.nber.org/papers/w17078.pdf. See AARP August 2018 Letter.
\1132\ See von Gaudecker (2015), supra footnote 1130. This study
finds that losses borne by investors with lower financial literacy
are predominantly driven by under-diversification of their
portfolios.
---------------------------------------------------------------------------
A number of studies link retail investor demographic
characteristics to financial literacy and document that financial
illiteracy, although widespread, is most significant among investors
with lower levels of educational attainment, women, and
minorities.\1133\ Moreover, many studies have examined the relationship
between age, cognition, and financial literacy, and have shown that
older investors, on average, are the least likely to be financially
literate, and that financial literacy degrades as investors age.\1134\
A number of these studies show, however, that investors with low levels
of financial literacy are likely to be over-confident in their
financial abilities. For example, several studies that explore the
relationship between age and financial literacy show that confidence in
financial decision making does not decline with age, and potentially
leads to poor decisions (e.g., paying higher mortgage rates).\1135\
Although over-confident investors with low levels of financial literacy
could potentially benefit most from seeking and following investment
advice, one study shows that over-confident investors are less likely
to seek advice and perceive it as less valuable.\1136\
---------------------------------------------------------------------------
\1133\ See Lusardi & Mitchell (NBER 2011), supra footnote 1131.
See also Annamaria Lusardi & Olivia S. Mitchell, Financial Literacy
and Retirement Planning in the United States, 10 J. Pension Econ. &
Fin. 509 (2011). See AARP August 2018 Letter.
\1134\ See Michael S. Finke, John Howe & Sandra J. Huston, Old
Age and Decline in Financial Literacy (Working Paper, Aug. 24,
2011), who document that financial literacy scores decline by
approximately 1% each year over the age of 60. See also Annamaria
Lusardi, Olivia S. Mitchell, & Vilsa Curto, Financial Literacy and
Financial Sophistication Among Older Americans (Nat'l Bureau of
Econ. Research, Working Paper No. 15469, Nov. 2009), available at
https://www.nber.org/papers/w15469.pdf; Keith Gamble et al., Aging
and Financial Decision Making, 61 Mgmt. Sci. 2603 (2015). See AARP
August 2018 Letter.
\1135\ See Finke et al. (2011) and Gamble et al. (2015), supra
footnote 1134.
\1136\ See Marc M. Kramer, Financial Literacy, Overconfidence
and Financial Advice Seeking (Working Paper, Dec. 19, 2014),
available at https://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2015-Amsterdam/papers/EFMA2015_0067_fullpaper.pdf.
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One potential problem, however, for investors with lower financial
literacy is that they may not be able to distinguish the quality of
their financial professional or the advice that they receive.\1137\ One
study documents that small traders, relative to large institutional
investors, are unable to recognize biases in recommendations
[[Page 33433]]
provided by securities analysts, and therefore follow analyst
recommendations to buy and sell securities without considering other
information produced by the analyst.\1138\ Additionally, financial
literacy may influence the quality of advice that financial
professionals are willing to provide their clients. Some financial
professionals appear to be more likely to provide superior information
to more financially literate investors, who may be able to discern the
quality of the advice, and more likely to provide inferior and
potentially more conflicted information to investors who are less
financially literate.\1139\
---------------------------------------------------------------------------
\1137\ See Lauren E. Willis, Against Financial-Literacy
Education, 94 Iowa L. Rev. 197 (2008). See AARP August 2018 Letter.
\1138\ See Ulrike Malmendier & Devin Shanthikumar, Are Small
Investors Naive About Incentives?, 85 J. Fin. Econ. 457 (2007). See
AARP August 2018 Letter.
\1139\ See Willis (2008), supra footnote 1137, and Calcagno &
Monticone (2015), supra footnote 1131. See also John A. Turner,
Bruce W. Klein, & Norman P. Stein, Financial Illiteracy Meets
Conflicted Advice: The Case of Thrift Savings Plan Rollovers
(Working Paper, Apr. 2015), available at https://gflec.org/wp-content/uploads/2015/04/Turner-0408Assessing-the-Standard-for-Financial-Advice.pdf, which documents that financial professionals
often suggest rolling over from thrift savings plans to more
expensive plans (e.g., IRAs), and that such behavior is pervasive
among both broker-dealers and investment advisers. See AARP August
2018 Letter.
---------------------------------------------------------------------------
c. Evidence on the Effectiveness and Limitations of Disclosure
Regulation Best Interest relies in part on disclosure of certain
material facts to retail customers.\1140\ A number of commenters,
however, stated that we failed to sufficiently account for limitations
of disclosure in the Proposing Release of Regulation Best
Interest.\1141\ One commenter stated that ``studies show that
regulation by disclosure alone can actually undermine investor
protection by emboldening advisers to ignore the client's best interest
once they have `checked the disclosure box,' and by rendering investors
even more vulnerable to conflicted advice once they receive
disclosures.'' \1142\ Another commenter asserted that the
ineffectiveness of disclosure arises because of investors' failure to
understand the disclosure, inadequate time to read and process the
information, cognitive dissonance, and trust in financial
professionals' oral representations over written disclosures, among
others.\1143\ Below, we discuss studies that have identified
characteristics that make disclosure effective as well as limitations
to the effectiveness of disclosure to investors, in particular focusing
on issues related to disclosure of conflicts of interest and how
disclosure could inflate potential conflicts between financial
professionals and investors.
---------------------------------------------------------------------------
\1140\ See supra Section II.C.1.
\1141\ See AARP August 2018 Letter; Better Markets August 2018
Letter; State Attorneys General Letter; EPI Letter; Morningstar
Letter; Warren Letter; UVA Letter.
\1142\ See Better Markets August 2018 Letter. See infra footnote
1148 for studies submitted by this commenter.
\1143\ See State Attorneys General Letter. See also EPI Letter.
---------------------------------------------------------------------------
Characteristics of effective disclosures include saliency of
information, clear and concise information delivered in a transparent
manner, and increased use of visual and interactive design, among
others.\1144\ One study, examining the effect of disclosure of fees and
costs for mutual funds, observes that disclosures that prominently
feature fees are more effective than others, but do not appear to
reduce the importance that investors place on other fund
characteristics, such as performance or risk.\1145\ Other studies,
however, have found that disclosures may be ineffective, particularly
if the intended audience does not read the disclosure documents or does
not understand the material presented to them. One study, for example,
notes that as the length and complexity of the disclosure document
increases, so does the time that it takes for investors to read and
understand the material contained within; therefore, investors are more
likely to prefer shorter, simpler, and more straightforward language in
disclosures.\1146\
---------------------------------------------------------------------------
\1144\ See Relationship Summary Adopting Release at Section IV,
which also discusses the benefits and limitation of disclosure. See
also Margaret Hagan, Designing 21st Century Disclosure Methods for
Financial Decision Making, Stanford Law School Policy Lab (2016),
available at https://law.stanford.edu/publications/designing-21st-century-disclosures-for-financial-decision-making/. One study finds
that when fund expenses are bundled with brokerage commissions,
reducing the transparency of various fees and costs, investors
experience larger degrees of underperformance than when the fees are
more transparent. See Roger M. Edelen, Richard B. Evans, & Gregory
B. Kadlec, Disclosure and Agency Conflict: Evidence from Mutual Fund
Commission Bundling, 103 J. Fin. Econ. 308 (2012). See AARP August
2018 Letter.
\1145\ See Lucy Hayes, William Lee, & Anish Thakrar, Now You See
It: Drawing Attention to Charges in the Asset Management Industry
(Fin. Conduct Auth., Occasional Paper No. 32, Apr. 2018), available
at https://www.fca.org.uk/publication/occasional-papers/occasional-paper-32.pdf. See Morningstar Letter. See also Anagol et al. (2015),
supra footnote 1075.
\1146\ See Tamar Frankel, The Failure of Investor Protection by
Disclosure, 81 U. Cin. L. Rev. 421 (2013). See FPC. See also Omri
Ben-Shahar & Carl E. Schneider, The Failure of Mandated Disclosure,
159 U. Pa. L. Rev. 647 (2011), which also questions the
effectiveness of disclosures and finds mandated disclosures
ineffective substitutes for more direct regulation. See AARP August
2018 Letter; Better Markets August 2018 Letter; State Attorneys
General Letter.
---------------------------------------------------------------------------
Many studies have explored the effect of revealing conflicts of
interest to consumers and note that disclosure of conflicts may produce
undesirable behavior by the disclosing party, or that receivers of the
information provided by disclosures may fail to appropriately account
for the implications.\1147\ A series of studies documents that
consumers do not account for conflicts of interest revealed through
disclosures, and that such disclosures of conflicts can have the
perverse effect of increasing bias and moral licensing in the provision
of advice.\1148\ Moral licensing arises when the discloser of
information ``take[s] an ethical action that validates [her] self-image
as a good person'' so she feels as though she ``may well give [herself]
permission to play fast and loose with the rules for a while.'' \1149\
Disclosure may also lead to a decrease in trust of biased advice
because consumers feel pressured to satisfy the discloser's self-
interest (``panhandler effect''); \1150\ however, the panhandler effect
can be mitigated if the disclosure is provided from an external source,
the disclosure is not common knowledge between the discloser and the
receiver of the information, the receiver can change his or her mind at
a later date, and the receiver can change his or her mind in
private.\1151\ One
[[Page 33434]]
study notes that, beyond conflicts disclosures, disclosures of actual
bias lead to an improvement in performance of portfolios relative to
investors who only receive conflict disclosures.\1152\
---------------------------------------------------------------------------
\1147\ See also Relationship Summary Adopting Release.
\1148\ See Daylian M. Cain, George Loewenstein, & Don A. Moore,
When Sunlight Fails to Disinfect: Understanding the Perverse Effects
of Disclosing Conflicts of Interest, 37 J. Consumer Res. 836 (2011);
Daylian M. Cain, George Loewenstein, & Don A. Moore, The Dirt on
Coming Clean: Perverse Effects of Disclosing Conflicts of Interest,
34 J. Legal Stud. 1 (2005); George Loewenstein, Daylian M. Cain &
Sunita Sah, The Limits of Transparency: Pitfalls and Potential of
Disclosing Conflicts of Interest, 101 Am. Econ. Rev. (Papers &
Proc.) 423 (2011). These studies also note that, although disclosure
is intended to help financially unsophisticated consumers,
disclosure is most likely to be beneficial to sophisticated users of
the information. One study, however, notes that disclosure can
reduce biased advice if the disclosure acts as a deterrent against
entering into conflicts, and may improve trust in advisers. See
Sunita Sah & George Loewenstein, Nothing to Declare: Mandatory and
Voluntary Disclosure Leads Advisors to Avoid Conflicts of Interest,
25 PSYCH. SCI. 575 (2014). See also Morningstar Letter; EPI Letter;
Better Markets August 2018 Letter; Warren Letter; UVA Letter; AARP
August 2018 Letter; Johnsen Letter.
\1149\ See Robert A. Prentice, Moral Equilibrium: Stock Brokers
and the Limits of Disclosure, 2011 Wis. L. Rev. 1059 (2011). See
AARP August 2018 Letter; Better Markets August 2018 Letter; State
Attorneys General Letter.
\1150\ See Cain et al. (2011), supra footnote 1148; Sunita Sah,
Prashant Malaviya, & Debora Thompson, Conflict of Interest
Disclosure as an Expertise Cue: Differential Effects of Automatic
and Deliberative Processing, 147 Organizational Behav. & Hum.
Decision Processes 127 (2018), whereby disclosures of conflicts of
interest act ``as a heuristic cue to infer greater trust in
advisors' expertise.''
\1151\ See Sunita Sah, George Loewenstein, & Daylian M. Cain,
The Burden of Disclosure: Increased Compliance With Distrusted
Advice, 104 J. Personality & Soc. Psychol. 289 (2013). See
Morningstar Letter; Better Markets August 2018 Letter; EPI Letter.
\1152\ See Christopher Tarver Robertson, Biased Advice, 60 Emory
L.J. 653 (2011). This study also suggests that obtaining an opinion
from an unbiased adviser ``is a much better remedy for biased advice
than disclosure.'' See AARP August 2018 Letter.
---------------------------------------------------------------------------
From the perspective of the investor, conflicts disclosures may
lead to under- or over-reaction by investors. According to one study,
investors may not know how to appropriately respond to information
about conflicts (e.g., estimating the effects on the quality of advice
or knowing how to search for an unbiased second opinion) and therefore
may fail to adequately adjust their behaviors when conflicts are
disclosed.\1153\ Alternatively, some investors may overreact to
disclosures of conflicts of interest, and may instead forgo valuable
investment advice.\1154\
---------------------------------------------------------------------------
\1153\ See Angela A. Hung, Min Gong, & Jeremy Burke, Effective
Disclosures in Financial Decisionmaking, RAND Labor and Population
Report Prepared for the Department of Labor (2015), available at
https://www.rand.org/content/dam/rand/pubs/research_reports/RR1200/RR1270/RAND_RR1270.pdf. See also AARP August 2018 Letter; Better
Markets August 2018 Letter; Warren Letter. See also James M. Lacko &
Janis K. Pappalardo, The Effect of Mortgage Broker Compensation
Disclosures on Consumers and Competition: A Controlled Experiment,
Federal Trade Commission, Bureau of Economics Staff Report (Feb.
2004), available at https://www.ftc.gov/sites/default/files/documents/reports/effect-mortgage-broker-compensation-disclosures-consumers-and-competition-controlled-experiment/030123mortgagefullrpt.pdf, which documents that when mortgage
customers receive information about mortgage broker compensation
through disclosures, such disclosures lead to an increase in more
expensive loans and create a bias against broker-sold loans, even
when the broker-sold loans are the more cost effective option. See
EPI Letter.
\1154\ See George Loewenstein, Cass R. Sunstein, & Russell
Golman, Disclosure: Psychology Changes Everything, 6 Ann. Rev. Econ.
391 (2014). See IRI Letter.
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C. Benefits and Costs
1. General
In formulating Regulation Best Interest, the Commission has
considered the potential benefits of establishing a best interest
standard of conduct for broker-dealers, as well as the potential costs.
Regulation Best Interest enhances the broker-dealer standard of
conduct beyond existing suitability obligations, and aligns the
standard of conduct with retail customers' reasonable expectations.
Under Regulation Best Interest, broker-dealers and their associated
persons will be required, among other things, to: (1) Act in the best
interest of the retail customer at the time the recommendation is made,
without placing the financial or other interest of the broker-dealer
ahead of the interests of the retail customer; and (2) 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
instances where we have determined that disclosure is insufficient to
reasonably address the conflict, to mitigate or, in certain instances,
eliminate the conflict. As a result, Regulation Best Interest should
enhance the efficiency of recommendations that broker-dealers provide
to retail customers, help retail customers evaluate the recommendations
received, and improve retail customer protection when receiving
recommendations from broker-dealers. The four component obligations of
Regulation Best Interest's work together to enhance the current
standard of conduct for broker-dealers and improve disclosure of
material facts relating to the scope and terms of the relationship and
conflicts of interest. Both on its own and together with the other new
rules and forms we are adopting,\1155\ we anticipate that Regulation
Best Interest will reduce the agency costs of the relationship between
the associated persons of the broker-dealer and their retail customers,
while preserving access to financial advice and choice in the scope of
services and how to pay for them.
---------------------------------------------------------------------------
\1155\ See, e.g., Relationship Summary Adopting Release.
---------------------------------------------------------------------------
In this section, we discuss broader themes associated with the
costs and benefits of Regulation Best Interest, including general
comments we received on our analysis of the costs and benefits in the
Proposing Release. Following this more general discussion, we discuss
the specific costs and benefits associated with Regulation Best
Interest's four component obligations.
While the Commission has considered the potential benefits and
costs of Regulation Best Interest, the Commission notes that generally
it is difficult to quantify such benefits and costs with meaningful
precision.\1156\ Where possible, the Commission has provided an
estimate of specific costs; however, several factors make the
quantification of many of the effects of Regulation Best Interest
difficult. With respect to costs to broker-dealers, there is a lack of
data on the extent to which broker-dealers with different business
practices engage in disclosure and conflict mitigation activities to
comply with existing requirements, and therefore how costly it would be
to comply with the proposed requirements. Also, the final rule will
provide broker-dealers flexibility in complying with Regulation Best
Interest, and, as a result, there could be multiple ways in which
broker-dealers will satisfy this obligation, although broker-dealers
must comply with each of the elements of the obligation. In addition,
Regulation Best Interest may affect broker-dealers differently
depending on their business model (e.g., full service broker-dealer,
broker-dealer that uses independent contractors, insurance-affiliated
broker-dealer) and size. More generally, estimates of the magnitude of
such benefits and costs depend on assumptions about (1) the extent to
which broker-dealers currently engage in disclosure and conflict
mitigation activities, (2) how broker-dealers currently develop
recommendations for their customers, (3) how broker-dealers choose to
comply with Regulation Best Interest, (4) whether and how broker-
dealers change investments and share classes offered as a result of
Regulation Best Interest, (5) whether and how product manufacturers
change their investment offerings as a result of Regulation Best
Interest, (6) whether broker-dealers restrict access to brokerage
accounts by raising minimum account sizes or adding additional
qualification requirements, (7) whether broker-dealers try to shift
customers to advisory accounts as a result of Regulation Best Interest,
(8) how retail customers perceive the risk and return of their
portfolios, (9) how likely retail investors are to act on a
recommendation that complies with Regulation Best Interest, (10) how
the risk and return of retail customer portfolios change as a result of
how they act on the recommendation, and (11) how investment advisers,
including dually registered advisers, react to the adoption of
Regulation Best Interest and the other regulatory developments,
including the rules we are adopting and interpretations we are issuing
simultaneously with Regulation Best Interest. Because many of these
factors are firm-specific and thus inherently difficult to quantify,
even if it were possible to calculate a range of potential quantitative
estimates, that range would be so wide as to not be informative about
the magnitude of the
[[Page 33435]]
benefits or costs associated with Regulation Best Interest.
---------------------------------------------------------------------------
\1156\ See supra Section III.B.3.c for discussion of the wide
range of estimates of the potential benefits of Regulation Best
Interest stemming from a reduction in investor harm, and discussion
surrounding infra footnotes 1165-1182 for other issues associated
with these estimates.
---------------------------------------------------------------------------
Broader economic forces, beyond broker-dealer and retail customer
behavioral responses to Regulation Best Interest, also make meaningful
estimates of economic impacts difficult to develop. The market for
investment advice and services is complex and vast, and as history
demonstrates, is dynamic and affected by market-specific facts
(including product developments and regulatory changes) as well as
macroeconomic factors (including general economic conditions). For
example, the introduction of indexation to the retail investment market
and the subsequent increase in index products (and providers) and
reduction in the costs of indexing for retail investors have had
substantial effects on the market for retail investment advice and
services. The more recent introduction of ETFs has had similar
unanticipated and underestimated effects, including, in general,
reducing investor costs and increasing tax efficiency, as well as
increasing the array of product offerings. Developments such as the
employer-driven shift from defined benefit plans to defined
contribution plans also have had significant effects on the market for
investment advice. We expect these and other factors, including factors
not currently identified, will continue to affect the market and,
accordingly, may change the economic effects of the rule. These sources
of uncertainty and complexity make meaningfully quantifying many of the
costs and benefits of the rule difficult and, particularly over long
time periods, inherently speculative.
a. Broad Commenter Concerns With Respect to Costs and Benefits
We received many comments regarding our analysis in the Proposing
Release of the benefits and costs. In this section, we discuss comments
that address broader aspects of our analysis. Comments that address
costs and benefits of more specific components of Regulation Best
Interest are discussed in the corresponding sections for each rule
component that follows.
Some commenters stated that our analysis in the Proposing Release
did not properly incorporate current market practices into the
baseline.\1157\ As discussed above, we have revised the discussion to
include those practices, which may reflect guidance by SROs such as
FINRA, requirements and obligations under state laws, practices
implemented by broker-dealers in response to the (now vacated) DOL
Fiduciary Rule that have not been reversed, and any practices
implemented by broker-dealers to fulfill their obligations under
existing federal securities laws.\1158\ While we acknowledged in the
Proposing Release that variation in the extent to which broker-dealers
with different business practices already engage in disclosure and
conflict mitigation activities makes quantifying Regulation Best
Interest's costs and benefits with meaningful precision difficult, we
more explicitly emphasize how this variation in current market
practices affects the costs and benefits of Regulation Best Interest in
the discussion that follows.\1159\ In general, to the extent that
broker-dealer practices are already aligned with the requirements of
Regulation Best Interest, the anticipated magnitude of both the costs
and the benefits associated with a given component of Regulation Best
Interest will be correspondingly reduced, and vice versa.
---------------------------------------------------------------------------
\1157\ See, e.g., CFA August 2018 Letter; CCMC Letters.
\1158\ See supra Section III.B.2.
\1159\ See Proposing Release at 21643.
---------------------------------------------------------------------------
As discussed above,\1160\ commenters noted the existence of
fiduciary standards in various states. One commenter provided an
overview of the fiduciary obligations of state-registered investment
advisers, ``typified by an expectation of undivided loyalty where the
adviser acts primarily for the benefit of its clients.'' \1161\ This
commenter also stated that ``[s]ome states also extend these fiduciary
obligations beyond investment advisers to brokers, especially in dual-
hatted scenarios,'' and that these fiduciary obligations were extended
even when broker-dealers handled non-discretionary accounts.\1162\ We
recognize that there is substantial variation in the sources, scope,
and application of state fiduciary law. And we acknowledge that such
state-level obligations for broker-dealers mean that they may already
engage in practices under the baseline that overlap with certain
requirements under Regulation Best Interest. To the extent that state-
level law incorporates fiduciary principles similar to those reflected
in Regulation Best Interest, the magnitude of the costs and benefits
discussed below that stem from the application of those principles to
broker-dealers will be correspondingly reduced. However, costs and
benefits that arise from obligations under Regulation Best Interest
that differ from obligations under state law, such as the Conflict of
Interest Obligation, will be maintained.\1163\
---------------------------------------------------------------------------
\1160\ See supra Section III.B.2.
\1161\ See NASAA February 2019 Letter at 22 and footnote 40.
\1162\ Id. at 23-24.
\1163\ Whether Regulation Best Interest would have a preemptive
effect on any state law would be determined in future judicial
proceedings, and would depend on the language and operation of the
particular state law at issue. We considered whether we could
determine the economic impact of possible, future state-law
preemption on retail customers, but concluded that we cannot analyze
the economic effects of the possible preemption of state law at this
point because the factors that will shape those judicial
determinations are too speculative. Among the unknown factors are:
(1) The final language in any proposed state legislation or
regulation adopting a fiduciary or other standard for broker-
dealers; (2) whether that language would constitute the type of law,
rule, or regulation that is expressly preempted by the securities
law or impliedly preempted under principles applied by courts; and
(3) whether, if there was preemption, that preclusion of state law
would have any positive or negative effects on investors when
compared with the economic effects of Regulation Best Interest.
---------------------------------------------------------------------------
Some commenters suggested that certain types of costs should remain
outside the scope of our analysis. Some stated that our analysis should
not consider, for example, costs to broker-dealers resulting from lost
revenues on securities they cease offering or costs associated with any
potential increase in arbitration claims as a result of Regulation Best
Interest, except to the extent that they are passed on to investors in
the form of higher fees.\1164\ These commenters suggested that because
these types of costs are a direct result of policies that make
investors better off, they should not factor into an assessment of
Regulation Best Interest. The Commission has an obligation to consider
the economic effect of Regulation Best Interest on affected parties,
including broker-dealers, even when those costs are associated with
benefits to investors. However, in the specific discussion of each rule
component that follows, we highlight instances where a given cost is
directly associated with a benefit to investors.
---------------------------------------------------------------------------
\1164\ See AARP August 2018 Letter; EPI Letter; Better Markets
August 2018 Letter; Cetera August 2018 Letter.
---------------------------------------------------------------------------
Commenters raised several issues related to the quantification of
costs and benefits, or lack thereof, in the Proposing Release. They
asserted that our analysis focused too much on Regulation Best
Interest's costs and did not quantify any of the benefits, such as the
reduction in investor harm.\1165\ As discussed above, some studies
present anecdotal evidence of behavior by certain broker-dealers, such
as recommending investments that are inferior to available
alternatives, that is harmful to investors.\1166\ A potential
[[Page 33436]]
benefit of Regulation Best Interest is therefore a reduction in that
harm, as asserted by commenters. However, the anecdotal evidence of
investor harm in these studies does not lend itself to aggregation.
---------------------------------------------------------------------------
\1165\ See AARP August 2018 Letter; Better Markets August 2018
Letter; CFA August 2018 Letter.
\1166\ See supra footnotes 1068 and 1075.
---------------------------------------------------------------------------
Commenters also stated that we should have incorporated the
approach used by the DOL RIA and the CEA to quantify aggregate investor
harm.\1167\ While both of these analyses surveyed a broad literature on
the relative performance of broker-sold versus direct-sold mutual
funds, they both relied on a particular study to estimate aggregate
investor harm, extrapolating the effect of ``excess loads'' on the
performance of broker-sold funds to total industry-wide AUM.\1168\ We
disagree with this approach because, as noted by commenters, we believe
these analyses misapplied the particular study's results.\1169\ When
the results of the study are correctly applied, the aggregate estimate
of investor harm obtained using this approach is negligible.\1170\
---------------------------------------------------------------------------
\1167\ See Better Markets August 2018 Letter.
\1168\ See supra footnotes 1081 and 1099.
\1169\ See, e.g., Lewis (2017), supra footnote 1099.
\1170\ See id.
---------------------------------------------------------------------------
Another commenter advocated a similar approach, claiming that risk-
adjusted returns net of fees, which calculate the excess return of an
investment above a benchmark that matches the risk of the investment,
are the only appropriate measure of whether a recommendation is in a
retail customer's best interest.\1171\ While there are studies showing
that broker-sold mutual funds underperform direct-sold funds to varying
degrees,\1172\ we do not believe, for the reasons explained below, that
applying estimates of this under-performance to industry-wide AUM
produces a meaningful estimate of the aggregate investor harm
attributable to recommendations made by broker-dealers that is
sufficiently precise to inform our policy choices. First, as discussed
above, these studies do not necessarily cleanly distinguish under-
performance attributable to broker-dealers from under-performance
attributable to investment advisers.\1173\
---------------------------------------------------------------------------
\1171\ See EPI Letter. See also Former SEC Senior Economists
Letter, stating that risk-adjusted returns are an appropriate
measure of investor harm.
\1172\ See, e.g., Bergstresser et al. (2009), supra footnote
1048; Del Guercio & Reuter (2014), supra footnote 1081.
\1173\ See supra footnote 1097.
---------------------------------------------------------------------------
Second, interpreting the relative underperformance of broker-sold
funds as a measure of investor harm due to conflicts of interest
implicitly evaluates investor harm against a benchmark that does not
include financial advice. However, that benchmark does not necessarily
reflect the appropriate alternative available to investors in broker-
sold funds. Extrapolating from these studies leads to the conclusion
that investors would do better investing on their own, yet there are
other studies showing that is not the case, at least not for all
investors.\1174\ We further note that calculating the investor harm
against a benchmark that includes the fees retail customers would pay
for equivalent advice could significantly reduce the magnitude of these
estimates.\1175\
---------------------------------------------------------------------------
\1174\ See supra footnotes 1045-1048.
\1175\ See also supra footnote 1103.
---------------------------------------------------------------------------
Finally, while risk-adjusted returns may be useful in comparing the
performance of particular mutual funds, particularly when trying to
evaluate fund manager skill, they do not necessarily reflect the
utility that investors achieve from their investments.\1176\
Heterogeneous investors value investments and the services provided by
financial professionals differently depending on their investment
profile and preferences, and risk-adjusted returns do not necessarily
represent aggregate utility across all investors in a way that permits
us to arrive at an aggregate measure of investor harm. For example,
consumers invest in various forms of insurance products in order to
hedge their exposure to bad outcomes (e.g., home insurance policies),
even though the expected returns on such investments are generally
negative. The relative underperformance of broker-sold mutual funds
also may not capture any intangible benefits investors derive from
receiving tailored financial advice.\1177\ Alternatively, the relative
performance of mutual funds sold through these two channels may reflect
other factors that are unrelated to conflicts of interest.\1178\
Accordingly, while we do not dispute the existence of broker-dealer
behavior under the baseline that is harmful to investors, based on our
analysis, including our analysis of the comments received, we continue
to believe that quantifying that harm, and therefore quantifying the
benefits associated with reducing it, depends on many contingent
factors that would render any estimates insufficiently precise to
inform our policy choices.\1179\
---------------------------------------------------------------------------
\1176\ Even in the context of evaluating fund manager skill,
there is debate about whether risk-adjusted returns are an
appropriate measure of fund performance. See e.g., Vincent Glode,
Why Mutual Funds ``Under Perform'', 99 J. Fin. Econ. 546 (2011);
Jonathan B. Berk & Jules H. van Binsbergen, Measuring Skill in the
Mutual Fund Industry, 118 J. Fin. Econ. 1 (2015).
\1177\ See, e.g., Bergstresser et al. (2009), supra footnote
1048, who note that ``[o]ne possibility is that brokers provide
other intangible benefits, which we cannot measure'' when
interpreting the relative performance of broker-sold versus direct-
sold mutual funds.
\1178\ See, e.g., The DOL RIA, supra footnote 1002, at footnote
473, noting that the relative performance of broker-sold versus
direct-sold funds ``. . . is an imperfect measure of the impact of
conflicts of interest; other factors, aside from conflicts of
interest, affect the relative performance of mutual funds sold
through the two distribution channels.''
\1179\ See Discussion following footnote 1156 for a discussion
of these factors. See also infra Section III.C.7, where we have
endeavored to estimate some of the potential benefits of Regulation
Best Interest based on many assumptions.
---------------------------------------------------------------------------
With respect to the magnitude of the costs we assessed in the
Proposing Release, some commenters asserted that our analysis
underestimated the costs of complying with Regulation Best Interest,
though only a few provided estimates of these costs.\1180\ Where
commenters provided estimates for a specific component of Regulation
Best Interest, particularly the Disclosure Obligation, we discuss those
estimates when discussing that component of Regulation Best Interest
below. Based on its experience with the DOL Rule, one commenter
provided a broad estimate of the compliance costs associated with the
entire package of rules we proposed, including Regulation Best Interest
and Form CRS, indicating that the rule package would entail initial
costs of $20 million and ongoing costs of $5 million per year for their
firm, but that these costs would be manageable.\1181\ Another commenter
stated that for a small broker-dealer with $500,000 in net capital, the
compliance costs estimated in the Proposing Release could constitute
12% of that net capital, making compliance with Regulation Best
Interest burdensome for such broker-dealers.\1182\ We acknowledge that
the costs of Regulation Best Interest could be more burdensome for
small broker-dealers and discuss any corresponding competitive effects
in Section III.D.1.
---------------------------------------------------------------------------
\1180\ See Schwab Letter; ICI Letter; Letter from James J.
Angel, Associate Professor of Finance, Georgetown University (Aug.
7, 2018) (``Angel Letter''); LPL August 2018 Letter; NSCP Letter.
\1181\ See Raymond James Letter.
\1182\ See NSCP Letter.
---------------------------------------------------------------------------
Although the majority of the industry studies provided by
commenters focused on the effects of the DOL Fiduciary Rule on broker-
dealers and their customers, one industry survey provided information
about industry beliefs about potential effects of proposed Regulation
Best Interest.\1183\
[[Page 33437]]
The survey consisted of approximately 30 individual financial
professionals across a mix of 15 companies providing financial advisory
services and products, including broker-dealers and dually registered
firms, with $23 trillion in AUM and administration and nearly 79
million investment accounts. All of the participants surveyed stated
that it was unlikely that they would reconsider their broker-dealer
registration status, while nearly 40% stated that they may alter their
investment choices and 35% could alter the services that they offer.
With respect to the costs of Regulation Best Interest and Form CRS,
approximately 36% of respondents stated that the implementation costs
could be between 1% and 5% of annual profits; however, nearly 80% of
respondents noted that costs are likely to decline over time.\1184\ We
note that one of the cost estimates provided by a commenter above is
consistent with this range.\1185\ One commenter suggested that for
firms that offer access to thousands of unique securities, many of
which likely have similar strategies (e.g., index mutual funds or
ETFs), requiring broker-dealers to ``consider reasonably available
alternatives offered by the broker-dealer as part of having a
reasonable basis for making the recommendation'' would make it cost
prohibitive for broker-dealers and financial professionals to evaluate
the costs associated with ``every similar investment product available
through the broker-dealer's platform.'' \1186\ Many survey
participants, although they believed that the Commission underestimated
the aggregate costs of Regulation Best Interest and Form CRS, agreed
that the benefits to investors were likely to justify the costs.
---------------------------------------------------------------------------
\1183\ See Center for Capital Markets Competitiveness, SEC
Regulation Best Interest Rule Proposals: Request for Information
Analysis, FTI Consulting Report Presented to the U.S. Chamber of
Commerce (Jul. 25, 2018), available at https://www.centerforcapitalmarkets.com/wp-content/uploads/2018/08/Reg-BI-Rule-Proposal-Research_8.7.18_FTI-Updated_final.pdf. See CCMC
Letters. Survey participants also addressed questions related to
beliefs regarding investor protection, choices for retail customers,
and the standard of conduct for broker-dealers.
\1184\ One commenter stated that the ``costly'' recordkeeping
requirements described in the Proposing Release ``are unnecessary as
self-interest will lead firms to keep proof of compliance'' and
should be eliminated. See Angel Letter.
\1185\ See supra footnote 1181. Relative to this commenter's
2018 fiscal year profits, its initial cost estimate of $20 million
would represent approximately 2% of annual profits for this firm.
See https://www.sec.gov/Archives/edgar/data/720005/000072000518000083/rjf-20180930x10k.htm.
\1186\ See LPL December 2018 Letter.
---------------------------------------------------------------------------
Other commenters stated that a number of elements of the Proposing
Release potentially could increase litigation exposure for some broker-
dealers. For example, one commenter discussed that, because proposed
Regulation Best Interest did not ``expressly define `financial
incentive''' for purposes of the proposed requirement of policies and
procedures designed to disclose and mitigate, or eliminate, conflicts
arising from financial incentives, broker-dealers could face challenges
to ``design and maintain effective compliance programs that
appropriately address the conflicts inherent in their particular
business models'' thereby potentially increasing litigation
risks.\1187\ Another commenter indicated that, with respect to
proprietary products, ``[s]tate courts in enforcement actions and in
review of such actions'' may find it difficult to distinguish the best
interest standard for broker-dealers from a fiduciary standard for
investment advisers, and may cause certain associated persons of
broker-dealers to ``shy away from the risks of litigation in this
regulatory environment, causing a substantial market contraction away
from middle class investors.'' \1188\
---------------------------------------------------------------------------
\1187\ See Primerica Letter.
\1188\ See Letter from Douglas M. Ommen, Iowa Insurance
Commissioner (Aug. 6, 2018) (``Iowa Insurance Commissioner
Letter'').
---------------------------------------------------------------------------
In the Proposing Release, we were able to quantify costs for
limited portions of Regulation Best Interest, particularly those
stemming from requirements related to document creation for purposes of
the Paperwork Reduction Act. While we have updated these estimates in
Section IV.B, we continue to believe that it is not possible to
meaningfully quantify the full costs and benefits of Regulation Best
Interest because such analysis would depend on many contingent factors
that render any estimate insufficiently precise to inform our policy
choices.\1189\ So while we acknowledge, for example, that Regulation
Best Interest may impose costs that are a significant portion of the
estimate of initial and ongoing costs of $20 million and $5 million by
the commenter cited above, we cannot anticipate the associated costs
for all firms because of the wide variation in size and scope of
business practices across firms as well as the many unknown factors
associated with the principles-based nature of Regulation Best
Interest. In discussing Regulation Best Interest's component
obligations below, we address any estimates provided by commenters
where we can and otherwise explain the specific factors that preclude
quantifying the costs of Regulation Best Interest with meaningful
precision beyond our Paperwork Reduction Act estimates.
---------------------------------------------------------------------------
\1189\ See Discussion following footnote 1156 for a discussion
of these factors. See also infra Section III.C.7, where we have
endeavored to estimate some of the potential benefits of Regulation
Best Interest based on many assumptions.
---------------------------------------------------------------------------
b. Broad Investor Protection Benefits
As discussed above, in addition to any enhancements provided above
and beyond current requirements and market practices, each of the
component obligations of Regulation Best Interest share features with
market best practices under the baseline, as shaped by FINRA's guidance
on relevant rules or as described in its Report on Conflicts of
Interest. Given this overlap, FINRA, in response to a congressional
request, enumerated the ways it believes Regulation Best Interest
enhances existing broker-dealer obligations under current FINRA
rules.\1190\
---------------------------------------------------------------------------
\1190\ See FINRA 2018 Letter.
---------------------------------------------------------------------------
In addition to the enhancements that each of Regulation Best
Interest's component obligations provide above and beyond existing
broker-dealer obligations under the baseline, which we discuss below,
Regulation Best Interest increases retail customer protections by
establishing these obligations under the Exchange Act so that the
Commission may enforce them directly and examine for compliance.
Additionally, to the extent that market best practices may reflect some
FINRA guidance that is not required by FINRA's rules, some broker-
dealers may not currently implement these practices. To the extent that
broker-dealers and their associated persons do not currently implement
existing best practices that will be codified in Regulation Best
Interest, retail customers will benefit because it will increase the
implementation of these best practices throughout the industry.
2. Disclosure Obligation
As adopted, the Disclosure Obligation of Regulation Best Interest's
requires a broker-dealer, prior to or at the time of the
recommendation, to provide to the retail customer, in writing, full and
fair disclosure of all material facts relating to the scope and terms
of the relationship and all material facts relating to conflicts of
interest that are associated with the recommendation. Regulation Best
Interest explicitly requires disclosure of ``all material facts
relating to the scope and terms of the relationship with the retail
customer'' including: (i) That the broker, dealer, or such natural
person is acting as a broker, dealer, or an associated person of a
broker or dealer with respect to the recommendation; (ii) the material
fees and costs that apply to the retail customer's transactions,
holdings, and accounts; and (iii) the type and scope of
[[Page 33438]]
services provided to the retail customer, including any material
limitations on the securities or investment strategies involving
securities that may be recommended to the retail customer; and all
material facts relating to conflicts of interest that are associated
with the recommendation.
Under the baseline, some disclosure obligations already exist, as
do an array of market practices with respect to the disclosure of
capacity, fees, services, and conflicts of interest.\1191\ The
Disclosure Obligation will enhance disclosure obligations that exist
under the baseline and bring greater alignment to market practices by
establishing an explicit and broad disclosure requirement under the
Exchange Act that applies to all broker-dealers when they make a
recommendation to a retail customer. We expect this change to improve
the quality and consistency of disclosures and thus (1) reduce the
information asymmetry that may exist between a retail customer and her
broker-dealer, and (2) facilitate customer comparisons of different
broker-dealers which we expect will, in turn, increase competition
among broker-dealers, including with respect to fees and costs, as
discussed below.\1192\
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\1191\ For instance, broker-dealers are subject to a number of
disclosure obligations under the Exchange Act when they effect
certain customer transactions. These disclosure obligations include
written disclosure about capacity, compensation, and third-party
remuneration related to the transaction, and disclosures about
whether the broker-dealer has any control, affiliation, or interest
in the security or the issuer of the security being offered. Broker-
dealers also face liability under the antifraud provisions of the
federal securities laws for failure to provide disclosure, such as
disclosure of ``honest and complete information'' or any material
adverse facts or materials conflicts of interest, including any
economic self-interest, when recommending a security (see supra
footnote 988). In addition, broker-dealers must comply with a number
of SRO disclosure obligations--such as FINRA Rule 2124 (Net
Transactions with Customers), FINRA Rule 2262 (Disclosure of Control
Relationship with Issuer), and FINRA Rule 2269 (Disclosure of
Participation or Interest in Primary or Secondary Distribution).
Finally, broker-dealers may also adjust their practices consistent
with existing SRO guidance on specific disclosures--such as FINRA
Regulatory Notice 13-23, Brokerage and Individual Retirement Account
Fees (July 2013) on fee disclosure. See Proposing Release at
footnotes 175, 176, 177, and 192; supra footnotes 303 and 985-988
for a more detailed discussion on existing disclosure practices.
\1192\ See supra footnote 1072 for a discussion of potential
information asymmetries between broker-dealers and retail customers.
---------------------------------------------------------------------------
Relative to the baseline, the Disclosure Obligation will change how
broker-dealers disclose information to their retail customers in
several specific ways. First, under the baseline, a broker-dealer and
its associated persons are not explicitly required to disclose that
they are acting in a broker-dealer capacity when making a
recommendation. We also clarify above that the use of the terms
``adviser'' or ``advisor'' in a name or title by (i) a broker-dealer
that is not also registered as an investment adviser, or (ii) a
financial professional that is not also a supervised person of an
investment adviser would presumptively violate this particular
disclosure requirement. Second, Regulation Best Interest requires that
any disclosure made by a broker-dealer be ``full and fair,'' meaning
that the broker-dealer is required to provide sufficient information to
enable a retail investor to make an informed decision with regard to
the recommendation, even where this information is about aspects of the
relationship between a retail customer and a broker-dealer that may
already require disclosure, implicitly or explicitly, under the
baseline. We expect the ``full and fair'' requirement to benefit retail
customers in cases where it results in disclosures that are not
currently required under broker-dealer antifraud provisions. Finally,
Regulation Best Interest requires that broker-dealers provide these
disclosures to retail customers in writing at or before the time of a
recommendation. However, we are permitting oral disclosures prior to or
at the time of a recommendation and written disclosures after a
recommendation under the circumstances outlined in Section II.C.1, Oral
Disclosure or Disclosure After a Recommendation.\1193\ We focus our
discussion of both the benefits and costs of the Disclosure Obligation
on these changes relative to the baseline.\1194\
---------------------------------------------------------------------------
\1193\ For example, when oral disclosures are used prior to or
at the time of a recommendation, broker-dealers must maintain a
record of the fact that oral disclosure was provided. See supra
footnotes 301 and 507-508 and surrounding discussion for more detail
on when oral disclosure prior to or at the time of a recommendation
and disclosure in writing after a recommendation are permitted.
\1194\ See supra footnotes 1157-1159.
---------------------------------------------------------------------------
Regulation Best Interest's Disclosure Obligation is different from
the Proposing Release's Disclosure Obligation in two ways. First, while
the Proposing Release required that a broker-dealer ``reasonably
disclose'' material facts to retail customers, Regulation Best Interest
requires that a broker-dealer provide retail customers with ``full and
fair'' disclosure of material facts. As discussed above, this change
from the Proposing Release does not have a substantive effect on the
expected economic effect of the Disclosure Obligation. Specifically, in
both the Proposing Release and Regulation Best Interest, the
formulation of the Disclosure Obligation, as described in the release
text, required that a broker-dealer provide sufficient information to
enable a retail investor to make an informed decision with regard to a
recommendation.\1195\ Therefore, we do not expect this change to affect
our assessment of Regulation Best Interest's costs and benefits.
Second, whereas the Proposing Release's Disclosure Obligation did not
explicitly require a broker-dealer to disclose particular types of
material facts relating to the scope and terms of its relationship with
a retail customer, Regulation Best Interest explicitly requires that
these material facts include the capacity in which the broker-dealer is
acting, fees and costs, and the type and scope of services provided,
including material limitations on the securities or investment
strategies that may be recommended. We include any economic effects
associated with this change in our discussion of Regulation Best
Interest's benefits and costs. Finally, while we discuss the direct
benefits and costs of the Disclosure Obligation in this section, retail
customers, broker-dealers, investment advisers, and their financial
professionals may experience indirect benefits or costs due to
competitive effects caused by the Disclosure Obligation. We discuss any
competitive effects below in Section III.D.1.
---------------------------------------------------------------------------
\1195\ See Proposing Release at Section II.D.1.c.
---------------------------------------------------------------------------
a. Benefits
Regulation Best Interest requires that brokers, dealers, or natural
persons associated with a broker-dealer disclose that they are acting
as a broker, dealer, or an associated person of a broker-dealer prior
to or at the time of a recommendation to a retail customer. Broker-
dealers are not explicitly required to disclose this information prior
to or at the time of a recommendation under the baseline, though they
may disclose it to comply with other federal securities laws and SRO
rules, or because they consider it to be a market best practice.\1196\
This requirement is most likely to have economic effects when retail
customers have both brokerage and advisory accounts with the same
financial professional, as may be the case if the financial
professional is dually-registered. It is designed to make all
[[Page 33439]]
retail customers aware of the capacity in which their broker-dealer is
acting when a recommendation is made, which may help the retail
customer better evaluate the advice they receive. For instance, the
cost to the retail customer of acting on such advice will typically
depend on whether the advice is tied to the retail customer's brokerage
or advisory account. In addition, understanding the capacity in which a
financial professional is acting may provide the retail customer with
context for, and facilitate review of, other relevant disclosures by
the broker-dealer. Knowing that she is receiving advice from a broker-
dealer, or an associated person of a broker-dealer, may focus the
retail customer's attention on any potential conflicts of interest
specifically associated with receiving a recommendation from a broker-
dealer. For example, a disclosure that a firm is acting in the capacity
of a broker-dealer may encourage a retail customer to seek additional
information about commissions, which could give the firm or its
financial professional an incentive to recommend transactions that may
be inconsistent with the client's most efficient investment strategy,
such as a buy-and-hold strategy.
---------------------------------------------------------------------------
\1196\ For example, under the baseline, broker-dealers may
decide that disclosing the capacity in which it is acting is
necessary in order to meet its duty of fair dealing under the
antifraud provisions of the federal securities laws. In addition,
broker-dealers must disclose whether they effected the transaction
as a principal or agent in the customer confirmation statement
pursuant to Exchange Act Rule 10b-10, which a retail customer
generally receives after the trade is completed.
---------------------------------------------------------------------------
While the capacity disclosure requirement and the disclosures
investors will receive in Form CRS will increase the likelihood that
retail customers understand the nature of their relationship with a
broker-dealer or financial professional, and hence how this
relationship might affect the recommendations retail customers receive,
some investors may form beliefs about the nature of their relationship
with a broker-dealer or financial professional based on their use of
particular names and titles such as ``adviser'' or ``advisor,'' as well
as how their services are marketed. In cases where these terms are used
by (i) a broker-dealer that is not also registered as an investment
adviser, or (ii) a financial professional that is not also a supervised
person of an investment adviser, some retail customers may not fully
understand that their broker-dealer or financial professional is not
acting in the capacity of an investment adviser, even though investors
receive some information about the capacity their broker-dealer or
financial professional is acting in on Form CRS or other
disclosures.\1197\
---------------------------------------------------------------------------
\1197\ Investors may not fully understand this capacity
disclosure because, for example, their financial professional is not
a supervised person of an investment adviser but works for a dual-
registrant, and they interpret Form CRS as suggesting the financial
professional also provides both types of services. Alternatively,
even if an investor's broker-dealer or financial professional solely
offers services in a broker-dealer capacity, the use of the titles
``adviser'' or ``advisor'' may leave her confused about the nature
of the services provided, despite the capacity disclosure on Form
CRS. See Relationship Summary Proposal at footnotes 411-412.
---------------------------------------------------------------------------
To the extent that, despite the disclosures provided on Form CRS,
the use of the titles ``adviser'' and ``advisor'' causes investor
confusion about the nature of the relationship retail investors have,
or will have, with a broker-dealer or financial professional, the
presumption that the use of these titles by (i) a broker-dealer that is
not also registered as an investment adviser, or (ii) a financial
professional that is not also a supervised person of an investment
adviser would violate the capacity disclosure requirement will
potentially benefit investors in two ways.\1198\ First, certain
investors may seek an advisory relationship and would be better off
receiving advice from an investment adviser. In situations where
confusion associated with titles might cause such an investor to
mistakenly engage in a relationship with a broker-dealer or an
associated person of a broker-dealer, the presumption should mitigate
costs the investor might incur associated with receiving and,
potentially, acting on recommendations from a broker-dealer, as well as
costs associated with correcting this mismatch by switching to an
investment adviser.\1199\ Second, to the extent that, as a result of
the use of the titles ``advisor'' or ``adviser,'' any confusion might
remain about the capacity in which a broker-dealer or its associated
person is acting, the presumption should alleviate that confusion and
thus increase the likelihood that retail customers focus their
attention on any potential conflicts of interest specifically
associated with receiving a recommendation from a broker-dealer. Any
benefits associated with the presumption will apply for current and
potential retail customers of the approximately 100 broker-dealers with
retail customers that are not also investment advisers and use the
terms ``adviser'' or ``advisor'' in their names, and for current and
potential retail customers of the approximately 16% of all registered
representatives that use these titles and are not dually
registered.\1200\ These benefits will be limited to the extent that
broker-dealers and their financial professionals choose other names or
titles that may indicate that they provide advisory services or use
marketing materials that hold them out as providing advisory services
but do not trigger the presumption or preclude application of the
solely incidental prong of the broker-dealer exception to the
definition of investment adviser.\1201\
---------------------------------------------------------------------------
\1198\ Several commenters generally ascribed benefits to
restricting the usage of the terms ``adviser'' and ``advisor.'' See
supra footnotes 326-330.
\1199\ See Relationship Summary Proposal at footnote 674 for
further discussion of the costs associated with a mismatch between
an investor and their preferred type of investment advice provider.
\1200\ Staff analysis found that 100 retail-facing broker-
dealers as of December 2018 use either ``adviser'' or ``advisor'' in
their firm names. See Relationship Summary Proposal at footnote 685
for more discussion of the estimate that approximately 16% of all
registered representatives use these titles and are not dually
registered.
\1201\ See supra footnotes 336-340.
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As discussed above, under the baseline, broker-dealers may, in
practice, already disclose information about the fees they charge, the
type and scope of services they provide, and any conflicts of interest
associated with their recommendations.\1202\ However, Regulation Best
Interest's explicit requirement that broker-dealers disclose all
material facts related to the scope and terms of their relationship
with a retail customer and all material facts relating to conflicts of
interest that are associated with a recommendation may provide retail
customers with useful information that they may not currently receive,
enabling them to make more informed investment decisions. The magnitude
and nature of this benefit will depend on the extent to which a broker-
dealer already discloses these material facts and how broker-dealers
choose to disclose this information. For example, if broker-dealers
choose to disclose all material facts in one consolidated document, the
disclosure may, depending on the facts and circumstances of the
disclosure, be more informative to some retail customers than
disclosures that are provided across many documents. In other cases,
layered disclosures may allow broker-dealers to target their
disclosures to their particular retail customer base at the relevant
point in time, increasing
[[Page 33440]]
the likelihood that investors read these disclosures.\1203\
---------------------------------------------------------------------------
\1202\ These disclosures may stem from implicit or explicit
requirements under federal securities laws. For example, broker-
dealers are explicitly required to disclose certain aspects of the
fees their retail customers pay, directly and indirectly, under
Exchange Act Rule 10b-10 (see, e.g., 913 Study at footnotes 256-
259). In other cases, courts have found that broker-dealers may
implicitly be required to disclose conflicts of interest or other
material facts related to the scope and terms of their relationship
with retail customers (see, e.g., 913 Study at footnotes 249-255).
See also NASD Notice to Members 92-11.
\1203\ See the discussion of layered disclosure in supra Section
II.C.1.c. See also supra footnote 540 on the potential benefits of
layered disclosure.
---------------------------------------------------------------------------
While the Proposing Release's Disclosure Obligation did not
explicitly require a broker-dealer to disclose particular types of
material facts relating to the scope and terms of its relationship with
a retail customer, Regulation Best Interest explicitly requires that
these material facts include: (1) The capacity in which the broker-
dealer is acting; (2) fees and costs; and (3) the type and scope of
services provided, including material limitations on the securities or
investment strategies that may be recommended. We generally anticipate
greater benefits under Regulation Best Interest than under the
Proposing Release. Specifically, to the extent that broker-dealers may
not have disclosed the types of information we are requiring under
Regulation Best Interest, Regulation Best Interest should increase the
consistency of disclosure practices across broker-dealers, which may
make it easier for investors to compare disclosures from and services
offered by different broker-dealers or other firms. In addition, if
some broker-dealers would not have disclosed the specific types of
information required under Regulation Best Interest, and retail
customers find that information useful, Regulation Best Interest may
facilitate more informed decisions by retail customers when they are
deciding whether or not to open an account or use a recommendation. For
example, disclosures about the scope and terms of services offered by a
broker-dealer or about their fees and costs may facilitate more
informed decisions by retail customers as to which type of account is
appropriate for them and whether they should open an account with a
given broker-dealer. Alternatively, disclosures about conflicts of
interest or fees and costs may facilitate more informed decisions by
retail customers as to whether or not they should use a recommendation
of a securities transaction or investment strategy.
Regulation Best Interest also explicitly requires that disclosures
be ``full and fair,'' and thus that a broker-dealer must provide
sufficient information to enable a retail customer to make an informed
decision with regard to a recommendation.\1204\ Broker-dealers may
disclose, for example, certain conflicts of interest associated with
their recommendations under the baseline. However, under existing
federal securities laws and SRO rules, they are not expressly required
to provide full and fair disclosure in the manner required under
Regulation Best Interest. As a result, existing disclosure practices
may not be designed to specifically help retail customers make informed
decisions about the recommendations they receive. By explicitly
requiring that broker-dealers provide sufficient information to enable
retail investors to make an informed decision with regard to a
recommendation, Regulation Best Interest imposes a minimum standard on
disclosures that may increase the consistency of disclosure practices
across broker-dealers relative to the baseline. This may also cause
such disclosures to be more useful to retail customers in evaluating
the advice they receive, thereby enabling them to make more informed
decisions about the recommendations they receive. To the extent that
disclosure obligations under the baseline already result in broker-
dealers providing sufficient information to enable a retail customer to
make an informed decision with regard to a recommendation, the
magnitude of the benefits from this component of the Disclosure
Obligation is likely to be correspondingly reduced.\1205\
---------------------------------------------------------------------------
\1204\ See discussion at supra footnotes 463-469.
\1205\ See supra footnote 1191 for more on disclosure
obligations and requirements under the baseline.
---------------------------------------------------------------------------
Regulation Best Interest's Disclosure Obligation also establishes a
standard for the form and timing of disclosures by requiring that they
be made in writing prior to or at the time of a recommendation. While
broker-dealers may already disclose information on the fees they
charge, the type and scope of services they provide, and any conflicts
of interest associated with their recommendations under the baseline,
federal securities laws and SRO rules may not explicitly specify the
form and timing of such disclosures. In cases where these requirements
are explicit, they may not require delivery at or prior to a retail
customer's evaluation of the recommendations they receive and any
corresponding investment decision. In contrast, while broker-dealers
will have some flexibility regarding the form and timing of their
disclosures under Regulation Best Interest, retail customers will
receive standardized disclosures about the fees and costs, as well as
any conflicts of interest, associated with a recommendation prior to or
at the time of receiving the recommendation. The Disclosure Obligation
should increase the consistency of disclosure practices across broker-
dealers and across different types of information relative to the
baseline, thereby increasing the likelihood that retail customers have
the information they need to make a more informed and efficient
investment decision at the time they receive a recommendation.
As noted above, we are permitting oral disclosure prior to or at
the time of a recommendation and written disclosure after a
recommendation has been made under the circumstances outlined in
Section II.C.1, Oral Disclosure or Disclosure After a
Recommendation.\1206\ Because oral disclosure is permitted in cases
where written disclosure prior to or at the time of recommendation is
not feasible or practical, investors may benefit by receiving
information that otherwise may not have been available to them at the
time they make an investment decision. In contrast, because written
disclosure is permitted in instances where existing regulations permit
disclosure after a recommendation, the benefits associated with the
form and timing of disclosures under Regulation Best Interest may be
reduced if the information in such disclosures would have been useful
to investors in making an investment decision. However, for both oral
disclosure prior to or at the time of a recommendation and written
disclosure after a recommendation has been made as permitted under the
circumstances outlined in Section II.C.1, Oral Disclosure or Disclosure
After a Recommendation, retail customers will still receive disclosures
in writing prior to a recommendation regarding the circumstances under
which oral disclosure or disclosure after a recommendation will occur
and the material facts that will be disclosed under these
circumstances.\1207\
---------------------------------------------------------------------------
\1206\ See supra footnote 1193.
\1207\ See discussion following supra footnote 301.
---------------------------------------------------------------------------
Several commenters stated that there are limits to the
effectiveness of disclosure and cited a number of studies suggesting
that disclosure alone is unlikely to solve the issues surrounding, for
example, the conflicts of interest between a broker-dealer or the
associated person of a broker-dealer and a retail customer.\1208\
Another commenter cited the 2008 RAND Study, concluding that investors
do not have the education or background to understand financial
disclosures and do not read long, formulaic documents.\1209\ Other
commenters claimed that
[[Page 33441]]
numerous academic studies demonstrate that disclosing conflicts of
interest does not adequately address the potential harm they cause to
investors.\1210\ Another commenter provided studies showing that
disclosure can encourage better behavior by broker-dealers, improving
investor welfare.\1211\
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\1208\ See Morningstar Letter; EPI Letter; Better Markets August
2018 Letter; St. John's U. Letter; Letter from Tom C.W. Lin,
Professor of Law, Temple University Beasley School of Law (Jul. 11,
2018) (``Lin Letter'').
\1209\ See Galvin Letter and discussion of 2008 RAND Study.
\1210\ See State Treasurers Letter; Better Markets August 2018
Letter; PIABA Letter.
\1211\ See Morningstar Letter.
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As discussed above, we acknowledge studies showing disclosure can
vary in its effectiveness depending on the issue it is intended to
address, its intended audience, and the format in which it is
delivered.\1212\ To the extent some retail customers are not able to
understand the information disclosed by a broker-dealer regarding the
scope of services it provides and the conflicts of interest associated
with the recommendations it makes, the benefits of the Disclosure
Obligation will not directly affect those investors, and may not
increase the efficiency of their investment decisions. However,
Regulation Best Interest is not limited to disclosure; rather, the
Disclosure Obligation is just one component of Regulation Best Interest
that as a whole will enhance the efficiency of recommendations that
broker-dealers provide to retail customers, help retail customers
evaluate the recommendations received, and improve retail customer
protection when receiving recommendations from broker-dealers. In
particular, in addition to the Disclosure Obligation, both the Care
Obligation and the Conflict of Interest Obligation, discussed below,
are designed to promote more efficient investment decisions by imposing
affirmative obligations on the broker-dealer that cannot be fulfilled
through disclosure alone, regardless of whether the retail customer
fully incorporates disclosed information into its investment decisions.
---------------------------------------------------------------------------
\1212\ See supra Section III.B.4.c.
---------------------------------------------------------------------------
Additionally, to the extent that the information disclosed by
broker-dealers as a result of Regulation Best Interest increases the
comparability of the securities and services offered by different
broker-dealers, it may foster competition between broker-dealers that
benefits even those retail customers who are not able to understand the
information disclosed by broker-dealers.\1213\ For example, if an
increase in comparability promotes competition on the basis of
recommendation quality, it may cause broker-dealers to mitigate or
eliminate conflicts even in cases where the Conflict of Interest
Obligation does not expressly require policies and procedures to
mitigate or eliminate such conflicts. Because the Disclosure Obligation
provides broker-dealers with some flexibility as to the form and timing
of their disclosures, the magnitude of this benefit will depend on the
extent to which these disclosures are comparable across broker-dealers
or to which the disclosures made by one broker-dealer draw attention to
practices at other broker-dealers that may not be in the best interest
of retail customers.
---------------------------------------------------------------------------
\1213\ See Relationship Summary Adopting Release at footnote
1035 for similar discussion of the potential benefits comparability
can have on competition.
---------------------------------------------------------------------------
The magnitude of the Disclosure Obligation's benefits will depend
on a number of factors, including which facts about the scope and terms
of their relationship with retail customers are material, the extent to
which broker-dealers already disclose information in a manner that is
consistent with the Disclosure Obligation under the baseline, the
manner in which they choose to disclose this information, the extent to
which retail customers understand such disclosures and would use them
in making investment decisions, and the extent to which such
disclosures would improve the efficiency of retail customers'
investment decisions, which varies with the specific circumstances of
each retail customer.
b. Costs
We expect broker-dealers and their financial professionals to incur
costs as a result of Regulation Best Interest's Disclosure Obligation,
and retail customers may incur indirect costs as well. In this section,
we analyze these costs in terms of how Regulation Best Interest changes
disclosure requirements for broker-dealers relative to the baseline.
The requirement that broker-dealers or their associated persons
disclose the capacity in which they or their associated persons are
acting prior to or at the time of making a recommendation may be
fulfilled by delivering the Relationship Summary, depending on the
facts and circumstances.\1214\ For example, a standalone broker-dealer
may satisfy this requirement of the Disclosure Obligation by delivering
the Relationship Summary to the retail customer, as required pursuant
to Form CRS. In contrast, for broker-dealers who are dually registered,
and associated persons who are either dually registered or who are not
dually registered but only offer broker-dealer services through a firm
that is dually registered, delivering the Relationship Summary will not
be sufficient to disclose the capacity in which they are acting. Thus,
while standalone broker-dealers that deliver the Relationship Summary
generally will not incur additional costs to comply with this
requirement of the Disclosure Obligation, dual-registrants will incur
additional costs, which could include the creation of disclosure
materials as well as policies and procedures to assist their associated
persons in determining when they are acting in a broker-dealer
capacity. However, dual-registrants and their associated persons will
have some flexibility with respect to the form, timing, or method of
satisfying this requirement of the Disclosure Obligation when they or
their associated persons make recommendations acting as brokers,
dealers, or associated persons of a broker or dealer.\1215\
---------------------------------------------------------------------------
\1214\ See supra footnotes 320-321 and surrounding discussion.
\1215\ See supra footnote 306.
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The presumption that the use of the titles ``adviser'' and
``advisor'' would violate the capacity disclosure requirement may
impose costs on certain broker-dealers and their financial
professionals, investors, and other affected parties. Broker-dealers
and their associated persons currently using names and titles
containing the terms ``adviser'' and ``advisor'' will incur direct
costs, including those associated with changing firm names, written
and/or electronic marketing materials, advertisements, and personal
communication tools that use these titles, among other items, as well
as any costs associated with voluntary outreach to customers to inform
them of these changes.\1216\ While commenters did not provide specific
estimates of these costs, they described them as ``very real costs,''
\1217\ ``significant costs and disruption,'' \1218\ and ``burdensome
and
[[Page 33442]]
costly.'' \1219\ To the extent that a broker-dealer's company name that
includes ``adviser'' or ``advisor'' is recognized as a brand in the
market and therefore represents a valuable intangible asset to the
broker-dealer, the broker-dealer may also incur indirect costs if some
of its ``brand value'' is lost following a company name change.\1220\
Additionally to the extent that investors who have a preference for
receiving advice from a broker-dealer or an associated person of a
broker-dealer search exclusively for such advice using the terms
``adviser'' or ``advisor,'' they may experience a reduction in the
choice of service providers available to them (e.g., they might only
find dual-registrants).\1221\ Finally, organizations that award
credentials or certifications to broker-dealers and financial
professionals that include the terms ``adviser'' or ``advisor'' may
lose revenues associated with a reduction in future demand for these
credentials and certifications, or lose revenues associated with the
maintenance of current credentials or certifications by awardees.\1222\
Relatedly, affected financial professionals may experience a loss
associated with any value they currently derive from the use of these
credentials or certifications.\1223\ Rather than incur any of the costs
associated with changing names and titles discussed above, some broker-
dealers may choose to register as investment advisers if they determine
it will be less costly, in which case these broker-dealers will incur
any costs associated with dual registration. The potential costs
associated with the presumption apply for the approximately 100 broker-
dealers, as of December 2018, with retail customers that are not also
investment advisers and use either ``adviser'' or ``advisor'' in their
firm names, and for the approximately 16% of all registered
representatives that use these titles and might be affected by the
presumption.\1224\
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\1216\ See e.g., HD Vest Letter (stating that ``[t]he term
`Advisor' permeates nearly every HD Vest disclosure, representative
agreement, selling agreement, client agreement, client
communication, marketing piece, and website'' and noting that
broker-dealers would need to develop compliance policies to ensure
oversight of the names and titles used by their financial
professionals); LPL August 2018 Letter (stating that ``legal
entities with so-called `doing business as' (d/b/a) names containing
the term `advisor' or `adviser'--through which many securities
professionals operate their business practices--will be required to
rename their businesses and incur significant costs and disruption
in updating all marketing materials with the prior name.''); SIFMA
August 2018 Letter; Morgan Stanley Letter.
\1217\ See HD Vest Letter.
\1218\ See LPL August 2018 Letter. See also NAIFA Letter (noting
the ``significant costs to update all materials, marketing, signage,
legally-required disclosure documents, etc. . . .''); SIFMA August
2018 Letter (noting the ``significant costs and burdens'' that would
be involved with ``[e]xtensive repapering.'').
\1219\ See Morgan Stanley Letter.
\1220\ Academic evidence suggest corporate brands are valuable
intangible assets to firms. See, e.g., Mary E. Barth et al., Brand
Values and Capital Market Valuation, 3 Rev. Acct. Stud. 41 (1998).
\1221\ The extent of this potential cost depends on how likely
it is that investors rely on the titles ``adviser'' and ``advisor''
in finding a broker-dealer. For example, one survey suggests that
40-50% of investors find their financial professionals through
personal recommendations, not via searches for these titles (see
supra footnote 946 and discussion in Relationship Summary Adopting
Release at Section IV.B.2.a).
\1222\ See IWI Letter (noting that ``Title Restrictions, as
proposed, have a potential to impact the long-term growth of two of
the Institute's registered marks.''). This commenter did not provide
specific data or estimates on the potential magnitude of this
effect.
\1223\ See NAIFA Letter. This commenter did not provide specific
data or estimates on the potential magnitude of this effect.
\1224\ See supra footnote 1200.
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The requirement that broker-dealers disclose material facts
relating to the material fees and costs that apply to a retail
customer's transactions, holdings, and accounts may also be partially
fulfilled by delivering the Relationship Summary. Form CRS will require
broker-dealers to provide retail investors a high-level summary of
principal fees and costs, including transaction-based fees, as well as
a narrative discussion of other fees that retail investors will pay
directly or indirectly. However, while providing such high-level
summaries partially complies with the Disclosure Obligation, the
Relationship Summary is unlikely to provide retail customers with all
of the material facts about the fees and costs that apply to a
particular recommendation.\1225\ As a result, Regulation Best Interest
will impose costs on broker-dealers associated with assessing whether
facts about the fees and costs that apply to a retail customer's
transactions, holdings, and accounts are material and delivering those
material facts to retail customers.
---------------------------------------------------------------------------
\1225\ See the discussion following supra footnote 368.
---------------------------------------------------------------------------
Broker-dealers will have some flexibility in how they comply with
this requirement, which will allow them to tailor these disclosures to
the needs of their retail customers and to implement them in a manner
that is as cost efficient as possible, given their business models. In
addition, the Disclosure Obligation may be satisfied by providing
documents that broker-dealers are already required to produce or
voluntarily produce under the baseline, such as prospectuses, in which
case they may only incur costs associated with determining the timing
and method by which they deliver these disclosures.\1226\ For example,
under the baseline, broker-dealers may currently deliver prospectuses
to retail customers after the completion of a transaction under the
baseline, but would need to deliver them prior to or at the time of a
recommendation under Regulation Best Interest, unless made under the
circumstances outlined in Section II.C.1, Oral Disclosure or Disclosure
After a Recommendation, allowing them to rely on delivery of
information after the fact. In cases where required disclosures are
already produced under the baseline, broker-dealers and their
associated persons may still incur costs associated with delivering
these disclosures prior to or at the time of a recommendation if they
are not delivered by that time under the baseline.
---------------------------------------------------------------------------
\1226\ See discussion at supra footnotes 495-496.
---------------------------------------------------------------------------
Broker-dealers may also incur costs as a result of Regulation Best
Interest's requirement that they disclose material facts about the type
and scope of services provided to a retail customer, including any
material limitations on the securities or investment strategies
involving securities that may be recommended to the retail customer. As
discussed above, some broker-dealers may be able to fulfill their
obligation to disclose these material facts, such as those related to
account monitoring, account minimums, or material limitations on the
securities or investment strategies that may be recommended, by
complying with Form CRS or by using disclosures included in account
opening agreements or other customer disclosures.\1227\ For these
broker-dealers, this requirement of the Disclosure Obligation should
not cause them to incur additional costs beyond an initial assessment
of whether they can comply with the Disclosure Obligation using Form
CRS or pre-existing disclosures. In cases where a broker-dealer is not
able to disclose all material facts relating to the type and scope of
services they provide by complying with Form CRS or in combination with
existing disclosures, broker-dealers will incur costs associated with
assessing which facts about the type and scope of services provided to
retail customers are material and delivering written disclosure of
those material facts to retail customers. As discussed above, broker-
dealers will have some flexibility in how they comply with this
requirement, allowing them to tailor these disclosures to the needs of
their retail customers and to their business models and to implement
these disclosures in a cost efficient manner.
---------------------------------------------------------------------------
\1227\ See supra footnote 1203.
---------------------------------------------------------------------------
While the Proposing Release's Disclosure Obligation did not
explicitly require broker-dealers or their associated persons to
disclose particular types of material facts relating to the scope and
terms of their relationship with a retail customer, Regulation Best
Interest explicitly requires that these material facts include the
capacity in which the broker-dealer or its associated person is acting;
material fees and costs; the type and scope of services provided,
including material limitations on the securities or investment
strategies that may be recommended; and all material facts relating to
conflicts of interest that are associated with a recommendation. To the
extent that broker-dealers are not disclosing this information or are
not
[[Page 33443]]
disclosing it by the time of a recommendation, broker-dealers may incur
higher costs associated with disclosing these material facts under
Regulation Best Interest compared to the baseline.
In general, for any material facts relating to the scope and terms
of its relationship with retail customers, a broker-dealer may have to
determine how to disclose those facts in a manner that is ``full and
fair,'' as required by Regulation Best Interest, which will cause it to
incur costs. Similarly, the requirement that broker-dealers disclose
all material facts in writing prior to or at the time of a
recommendation may also impose costs on broker-dealers. For example,
even if a broker-dealer currently discloses some information about its
fees under the baseline, it may not currently disclose that information
prior to the time of a recommendation, and may incur costs updating
systems and processes to ensure the information is disclosed in a
manner that complies with Regulation Best Interest's requirements,
including any costs associated with delivery of the information to
retail customers.
Broker-dealers may incur costs associated with the full and fair
disclosure of all material facts relating to conflicts of interest that
are associated with a recommendation. As discussed below in our
analysis of the Conflict of Interest Obligation, broker-dealers
currently have obligations to disclose certain material conflicts of
interest under the baseline.\1228\ To the extent that broker-dealers
will be required to disclose material facts about conflicts of interest
that they do not currently disclose to retail customers under the
baseline, broker-dealers will incur costs associated with assessing
whether facts about these conflicts are material and delivering those
facts to retail customers. They also may incur costs associated with
identifying particular conflicts of interest to disclose.\1229\
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\1228\ See infra footnote 1261. See also supra footnotes 985-
988.
\1229\ See infra Section III.C.4 for a discussion of costs
associated with identifying conflicts of interest as part of the
Conflict of Interest Obligation.
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As discussed above, there are circumstances where broker-dealers
and their associated persons may make oral disclosures or written
disclosures after the time of a recommendation under the circumstances
outlined in Section II.C.1, Oral Disclosure or Disclosure After a
Recommendation. Where oral disclosures are made, broker-dealers and
their associated persons may incur costs associated with subsequently
documenting such disclosures. These costs may include the time spent
documenting such disclosures, the development of systems and processes
necessary to document such disclosures, training associated persons to
use these systems and processes, and supervising the compliance by
associated persons with this obligation. For both oral disclosures and
written disclosures made after a recommendation, broker-dealers and
their associated persons may incur costs associated with developing
initial disclosures about the material facts subject to oral
disclosures and written disclosures after a recommendation, the
circumstances under which such disclosures will be made, as well as
costs associated with training financial professionals to make such
disclosures in a manner that complies with Regulation Best Interest.
While most of the costs associated with preparing and delivering
disclosures are likely to be incurred by broker-dealers, their
associated persons may incur costs as well. For example, when a
financial professional is aware that the broker-dealer's disclosure is
insufficient to describe ``all material facts,'' the associated person
must supplement that disclosure, and may incur costs in developing such
disclosure on their own to ensure they are in compliance with the
Disclosure Obligation.\1230\ The magnitude of this cost will depend on
the extent to which the financial professional cannot rely on the
disclosure made by the broker-dealer.
---------------------------------------------------------------------------
\1230\ See discussion following supra footnote 307 for an
example of a case where an associated person of a broker-dealer may
be required to provide her own disclosures in order to comply with
the Disclosure Obligation.
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As discussed above, while we are unable to quantify the full costs
of Regulation Best Interest, including the Disclosure Obligation, we
are able to estimate some of the costs associated with the Disclosure
Obligation, specifically the costs related to information collection
requirements as defined by the Paperwork Reduction Act. As discussed
further below in Section IV.B.1, the Commission estimates that the
preparation and delivery of standardized language, fee schedules, and
standardized conflict disclosures that broker-dealers are required to
provide to retail customers to comply with the Disclosure Obligation
will impose on broker-dealers an initial aggregate burden of 6,216,125
hours and an additional initial aggregate cost of $42.84 million as
well as an ongoing aggregate burden of 2,101,493 hours.\1231\ Thus, the
Disclosure Obligation will impose an estimated initial aggregate cost
of at least $1,508.88 million and an ongoing aggregate annual cost of
at least $499.59 million on broker-dealers.\1232\ We note
[[Page 33444]]
that these estimates assume broker-dealers are not currently producing
and delivering documents associated with the Disclosure Obligation. To
the extent that broker-dealers are already doing so, these estimates
may overstate the costs associated with the information collection
requirements as defined by the Paperwork Reduction Act.
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\1231\ The estimate of the initial aggregate burden is based on
the following calculation: 5,630 hours + 7,560 hours + 40,200 hours
+ 2,040,000 hours + 3,780 hours + 20,100 hours + 2,040,000 hours +
3,780 hours + 15,075 hours + 2,040,000 hours = 6,216,125 hours. As
discussed in more detail in infra Section IV.B.1, 5,630, 7,560, and
40,200 hours are estimates of the initial aggregate burden for the
preparation of disclosure of capacity, type, and scope, for dual-
registrants and small and large broker-dealers, respectively.
2,040,000 hours is the estimate of the initial aggregate burden for
the delivery of the disclosure of capacity, type, and scope to
retail customers. 3,780 and 20,100 hours are estimates of the
initial aggregate burden for the preparation of disclosure of fees
for small and large broker-dealers, respectively. 2,040,000 hours is
the estimate of the initial aggregate burden for the delivery of the
disclosure of fees to retail customers. 3,780 and 15,075 hours are
estimates of the initial aggregate burden for the preparation of
disclosure of material conflicts of interest for small and large
broker-dealers, respectively. 2,040,000 hours is the estimate of the
initial aggregate burden for the delivery of the disclosure of
material conflicts of interest to retail customers. The estimate of
the initial aggregate cost is based on the following calculation:
$2.80 million + $3.80 million + $15.00 million + $1.88 million +
$9.99 million + $1.88 million + $7.49 million = $42.84 million. As
discussed in more detail in supra Section V.D, $2.80 million, $3.80
million, and $15.00 million are estimates of the initial aggregate
cost for the preparation of disclosure of capacity, type, and scope,
for dual-registrants and small and large broker-dealers,
respectively. $1.88 million and $9.99 million are estimates of the
initial aggregate cost for the preparation of disclosure of fees for
small and large broker-dealers, respectively. $1.88 million and
$7.49 million are estimates of the initial aggregate cost for the
preparation of disclosure of material conflicts of interest for
small and large broker-dealers, respectively. The estimate of the
ongoing aggregate burden is based on the following calculation:
3,941 hours + 3,024 hours + 40,200 hours + 408,000 hours + 1,512
hours + 8,040 hours + 816,000 hours + 756 hours + 4,020 hours +
816,000 hours = 2,101,493 hours. As discussed in more detail in
supra Section V.D, 3,941, 3,024, and 40,200 hours are estimates of
the ongoing aggregate burden for the preparation of disclosure of
capacity, type, and scope, for dual-registrants and small and large
broker-dealers, respectively. 408,000 hours is the estimate of the
ongoing aggregate burden for the delivery of the disclosure of
capacity, type, and scope to retail customers. 1,512 and 8,040 hours
are estimates of the ongoing aggregate burden for the preparation of
disclosure of fees for small and large broker-dealers, respectively.
816,000 hours is the estimate of the ongoing aggregate burden for
the delivery of the disclosure of fees to retail customers. 756 and
4,020 hours are estimates of the ongoing aggregate burden for the
preparation of disclosure of material conflicts of interest for
small and large broker-dealers, respectively. 816,000 hours is the
estimate of the ongoing aggregate burden for the delivery of the
disclosure of material conflicts of interest to retail customers.
\1232\ These estimates are calculated as follows: (96,125 hours
of in-house legal counsel) x ($415.72/hour for in-house counsel) +
(6,120,000 hours for delivery for each customer account) x ($233.02/
hour for registered representative) + (90,763 hours for outside
legal counsel) x ($497/hour for outside legal counsel) = $1,508.88
million, and (35,056 hours of in-house legal counsel) x ($415.72/
hour for in-house counsel) + (2,040,000 hours for delivery for each
customer account) x ($233.02/hour for registered representative) +
(26,437 hours for in-house compliance counsel) x ($365.39/hour for
outside legal counsel) = $499.59 million. The hourly wages for in-
house legal and compliance counsel and registered representatives
are obtained from SIFMA. The hourly rates for outside legal counsel
are discussed in supra Section V.D.
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Several commenters stated that we underestimated the compliance
costs of Regulation Best Interest in the Proposing Release,
particularly with respect to the potential transaction-based nature of
the Disclosure Obligation and the resultant record-making and
recordkeeping requirements.\1233\ One commenter stated that if the
Disclosure Obligation is a transaction-based requirement, its costs
were significantly underestimated in the Proposing Release, citing an
estimate that an earlier proposal of a point-of-sale disclosure
requirement would cost between $1 million and $1.2 million per
firm.\1234\ We first note that, given that there are approximately
2,766 broker-dealers with retail-facing operations, the commenter's
cited estimate implies initial costs of approximately $1.4 billion and
ongoing costs of approximately $1.4 billion,\1235\ so the commenter's
implied estimate of $1.4 billion in initial costs associated with the
Disclosure Obligation is consistent with our estimate of initial costs
above.\1236\ Second, we note that, as discussed in more detail above in
Section II.C.1.d, the Disclosure Obligation only requires that certain
disclosures be made prior to or at the time of a recommendation, and
broker-dealers may use standardized disclosures at an earlier point
than the time of a recommendation to the extent such disclosures
satisfy the Disclosure Obligation. In this regard, while the
commenter's estimate may be indicative for some firms, the cost per
firm will vary widely depending on the scope and business model of each
broker-dealer. Because Regulation Best Interest provides broker-dealers
with some flexibility regarding both the form and timing of the
Disclosure Obligation, its costs are likely to be lower than a pure
point-of-sale requirement.\1237\
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\1233\ See Schwab Letter; ICI Letter; Angel Letter; Vanguard
Letter; LPL August 2018 Letter; NSCP Letter.
\1234\ See Schwab Letter, citing April 12, 2004 comment letter
from George Kramer of the Securities Industry Association (``SIA'').
This estimate is based on a point-of-sale disclosure requirement in
proposed rule 15c2-3, for which SIA estimated that implementation
costs would be in the order of $500,000 per firm, as would annual
costs associated with maintaining and updated necessary systems and
procedures. See also SIFMA August 2018 Letter at footnote 38
referencing the same estimate.
\1235\ These estimates are calculated as follows: (2766 retail-
facing broker-dealers) x ($500,000 per firm in initial costs) =
$1.383 billion. Implied ongoing costs are calculated the same way.
\1236\ See supra footnote 1232.
\1237\ See supra footnotes 531-533 for a discussion of layered
disclosure and footnotes 541-542 for a discussion of the Disclosure
Obligation's requirements with respect to timing of disclosures.
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Beyond the estimates provided above for that are derived from
estimates developed for purposes of the Paperwork Reduction Act in
Section IV.B.1, the Commission is unable to fully quantify the costs of
the Disclosure Obligation because the magnitude of these costs depend
on firm-specific factors that are inherently difficult to quantify
given the principles-based nature of Regulation Best Interest.\1238\
These factors include the extent to which current disclosure practices
under the baseline are different from the requirements of the
Disclosure Obligation, the manner in which broker-dealers choose to
comply with the Disclosure Obligation given the flexibility it
provides, how broker-dealers assess whether facts relating to the scope
and terms of their relationship with a retail customer are material,
how they determine whether their disclosure of such material facts is
full and fair, or the extent to which they will satisfy the Disclosure
Obligation's requirements by delivering the Relationship Summary or
pre-existing documents.
---------------------------------------------------------------------------
\1238\ See supra Section III.C.1.
---------------------------------------------------------------------------
3. Care Obligation
Under the baseline, broker-dealers are subject to suitability
obligations and requirements under the anti-fraud provisions of the
federal securities laws and the Suitability Rule when making
recommendations to retail customers. The Care Obligation incorporates
and adds to existing suitability requirements applicable to broker-
dealers, thereby reducing the incidence of inefficient recommendations
to retail customers.
FINRA rules require broker-dealers making recommendations to have,
based on a particular customer's investment profile, a reasonable basis
to believe that the recommendation is suitable for that customer. In
addition, FINRA guidance and Commission opinions interpret suitability
as prohibiting a broker-dealer from placing its interests ahead of the
customer's interest and requiring the recommendations to be consistent
with the customer's best interest.\1239\ However, this obligation is
not explicitly required by FINRA's rule (or its supplementary
material). Under the baseline, a recommendation by a broker-dealer or
its associated persons may be consistent with a retail customer's best
interest but broker-dealers and their associated persons are not
required to make recommendations in the best interest of these
customers, as will be required under Regulation Best Interest. Relative
to the baseline, the Care Obligation will change how broker-dealers and
their associated persons make recommendations to retail customers in
several ways, some of which differ from the Proposing Release.
---------------------------------------------------------------------------
\1239\ See supra footnote 570 and 913 Study at footnote 270.
---------------------------------------------------------------------------
First, the Care Obligation explicitly includes cost as a factor for
consideration when determining whether a recommendation is in a retail
customer's best interest. In contrast, the Proposing Release emphasized
cost as an important factor to consider and stated that broker-dealers
may be required to consider cost as a factor when making
recommendations, but did not explicitly require its consideration when
making a recommendation.\1240\ In addition, we clarify above in Section
II.C.2 that, when determining whether a recommendation is in a retail
customer's best interest with respect to cost or other relevant
factors, broker-dealers and their associated persons should consider
reasonably available alternatives. Conversely, under FINRA suitability
obligations, broker-dealers and their associated persons are not
required to consider reasonably available alternatives when determining
whether a recommendation is suitable for a retail customer.\1241\
---------------------------------------------------------------------------
\1240\ See supra footnote 572 and preceding text.
\1241\ See id.
---------------------------------------------------------------------------
Second, under the baseline, FINRA rules require that a broker-
dealer or associated person who has actual or de facto control over a
customer's account must have a reasonable basis for believing that a
series of recommended transactions, even if suitable when viewed in
isolation, is not excessive and unsuitable for the customer when taken
together in light of the customer's investment profile. In contrast,
the Care Obligation requires that a broker-dealer or its associated
person has a reasonable basis to believe that a series of recommended
transactions is not excessive and is in that retail customer's best
interest. This is the case at all times--when the broker-dealer or
associated person has actual or de facto
[[Page 33445]]
control over a customer's account as well as when no control exists
(whether actual or de facto).
Finally, FINRA's suitability standard applies to recommendations of
rollover decisions that involve securities transactions, but not
necessarily in the absence of a securities transaction.\1242\ In
addition, FINRA's suitability standard does not explicitly apply to
recommendations of account types and implicit hold recommendations
resulting from agreed upon account monitoring.\1243\ In contrast,
Regulation Best Interest explicitly applies to account recommendations
as an ``investment strategy involving securities,'' including
recommendations of securities account types, as well as rollovers or
transfers of assets from one account to another. In addition, under
Regulation Best Interest, implicit hold recommendations resulting from
agreed upon account monitoring constitute recommendations of ``any
securities transaction or investment strategy involving securities,''
and are therefore within the scope of Regulation Best Interest.
Moreover, recommendations to open an IRA or to roll over assets into an
IRA are subject to Regulation Best Interest, including the Care
Obligation, thereby requiring a broker-dealer or its associated persons
to have a reasonable basis to believe that the IRA or IRA rollover is
in the best interest of the retail customer at the time of the
recommendation, taking into consideration the retail customer's
investment profile and other relevant factors, as well as the potential
risks, rewards, and costs of the IRA or IRA rollover compared to the
retail customer's existing 401(k) or other retirement account. We focus
our discussion of both the benefits and costs of the Care Obligation
under Regulation Best Interest on these changes relative to the
baseline.
---------------------------------------------------------------------------
\1242\ See FINRA Regulatory Notice 13-45 and supra footnote 172.
\1243\ See supra footnote 170.
---------------------------------------------------------------------------
Regulation Best Interest's Care Obligation differs from the
Proposing Release's Care Obligation in two ways that respond to
commenter concerns but that we do not expect to have significant
economic effects.\1244\ First, the general best interest standard of
conduct from the Proposing Release is incorporated into Regulation Best
Interest's Care Obligation, which, as adopted, also requires that a
broker-dealer or its associated persons have a reasonable basis to
believe that a recommendation, or series of recommendations, does not
place the financial or other interest of the broker-dealer or its
associated persons ahead of the interest of the particular retail
customer. Broker-dealers and their associated persons can comply with
Regulation Best Interest as a whole by complying with its four
component obligations, which now explicitly include the Proposing
Release's general best interest standard in elements of the Care
Obligation. This change to the Care Obligation, as compared to the
Proposing Release, is intended to emphasize the importance of
determining that each recommendation is in the best interest of the
retail customer and that it does not place the broker-dealer's
interests ahead of the retail customer's interest; however, we do not
believe there will be significant economic effects associated with this
change from the Proposing Release.\1245\ Second, Regulation Best
Interest, as adopted, does not explicitly require broker-dealers or
their associated persons to exercise ``prudence'' in making
recommendations. Instead they must exercise reasonable diligence, care,
and skill in making such recommendations. While we removed the term
``prudence'' to address commenter concerns that it might create legal
confusion and uncertainty, this does not change the requirements or
obligations under the Care Obligation as compared to the Proposing
Release.\1246\ Therefore, we do not expect this change to have a
significant economic effect, as compared to the Proposing Release.
---------------------------------------------------------------------------
\1244\ See discussion at supra footnotes 147, 606, and 577-584.
\1245\ If anything, to the extent that broker-dealers or their
associated persons might have misunderstood the Proposing Release
with respect to their obligation to provide recommendations that are
in the best interest of retail customers, Regulation Best Interest,
as adopted, emphasizes the importance of determining that each
recommendation is in the best interest of the retail customer will
benefit retail customers.
\1246\ See supra footnotes 579-585 and surrounding discussion.
---------------------------------------------------------------------------
a. Benefits
As described in the Proposing Release, the Care Obligation did not
explicitly require broker-dealers and their associated persons to
consider the costs associated with a recommendation when determining
whether it was in a retail customer's best interest, though the
Proposing Release discussed cost as a relevant factor in making this
determination, and noted that broker-dealers might be required to
consider cost as a factor when making recommendations under the
baseline.\1247\ The Care Obligation under Regulation Best Interest
includes an explicit requirement to consider the cost of a
recommendation. If this causes broker-dealers and their associated
persons to more carefully consider cost in relation to other factors,
compared to the baseline, it should reduce the incidence of
recommendations of higher cost investments from a set of reasonably
available alternatives that achieve the retail customer's objective. If
the explicit requirement to consider the cost of a recommendation
encourages broker-dealers and their associated persons to more
carefully consider cost, compared to the baseline, the final rule makes
it less likely that a broker-dealer or its associated persons could
have a reasonable basis to believe such investments are in the retail
customer's best interest because it would be difficult to have such a
belief for investments that are identical beyond their costs.
Therefore, including cost as a required factor in Regulation Best
Interest should enhance the efficiency of recommendations to retail
customers relative to the baseline.\1248\
---------------------------------------------------------------------------
\1247\ See supra footnote 572.
\1248\ See discussion surrounding supra footnotes 563-565.
---------------------------------------------------------------------------
As discussed above, while a ``quantitative suitability''
requirement applies to series of recommended transactions under the
baseline, it only applies in cases where a broker-dealer has
``control'' over a customer account. Relative to the baseline, broker-
dealers and their associated persons will be required to have a
reasonable basis to believe that any series of recommended transactions
is in the retail customer's best interest, not just series of
recommended transactions that occur in an account they control. This
change relative to the baseline should enhance investor protection by
reducing the incidence of cases where a broker-dealer or its associated
persons recommend an excessively high rate of portfolio turnover, or
``churn,'' for accounts that they do not control. In addition, the
discussion above regarding the potential benefits from the increased
standard of conduct required by the Care Obligation in the context of
individual recommendations also applies to series of recommended
transactions. Enhancing the standard of conduct that applies to series
of recommended transactions and reducing the incidence of
recommendations that result in excess portfolio turnover should result
in more efficient recommendations, benefiting retail customers. We are
unable to specifically quantify these potential benefits because, in
addition to the reasons cited above, we do not have and cannot
reasonably obtain comprehensive data on how often broker-dealers, for
accounts they do not
[[Page 33446]]
control, recommend series of transactions that result in excessive
portfolio turnover and are therefore not in the best interest of their
retail customers.
Regulation Best Interest applies to account recommendations,
including recommendations to open an IRA or to participate in an IRA
rollover. Accordingly, these types of recommendations are subject to
the Care Obligation (as well as the other components of Regulation Best
Interest). Several commenters highlighted the heightened risk of harm
associated with IRA and IRA rollover recommendations because the amount
of assets associated with such recommendations can be a significant
portion of a retail customer's net worth, and one commenter cited
academic and industry studies that identify activities that are
particularly prone to conflicts of interest, including IRA
rollovers.\1249\ We acknowledge the heightened effect that
recommendations to open an IRA or to participate in an IRA rollover can
have on the financial well-being of retail customers.\1250\ While
FINRA's suitability standard under the baseline applies to rollover
recommendations involving securities transactions, the suitability
standard does not necessarily apply to a rollover recommendation if
that recommendation does not involve a securities transaction.\1251\ To
the extent that broker-dealers and their associated persons currently
make recommendations to open an IRA or to participate in an IRA
rollover that do not involve securities transactions under the
baseline, Regulation Best Interest should result in IRA and IRA
rollover recommendations to retail customers that are more efficient
because they will be in the retail customer's best interest regardless
of whether or not they involve securities transactions.
---------------------------------------------------------------------------
\1249\ See CFA August 2018 Letter; AARP August 2018 Letter;
Morningstar Letter; CFA Institute Letter.
\1250\ See supra footnotes 191-192. See also Fiduciary
Benchmarks Letter.
\1251\ See supra footnote 1242.
---------------------------------------------------------------------------
Regulation Best Interest also applies to other account type
recommendations. Broker-dealers may offer different types of brokerage
accounts that include different levels of services and costs. The
choice of account type can have a significant effect on the financial
wellbeing of a retail customer. For example, a recommendation to open
an advisory over a brokerage account, or vice versa, can have a
substantial long-term effect on a retail customer's assets. This effect
may depend on the costs the retail customer incurs through the
particular account as well as the retail customer's investment
profile.\1252\ Regulation Best Interest should result in
recommendations regarding account type that are in the best interest of
the retail customer, particularly with respect to cost, increasing the
efficiency of the account type recommendations retail customers receive
relative to the baseline.
---------------------------------------------------------------------------
\1252\ See supra footnote 191.
---------------------------------------------------------------------------
Finally, by clarifying that implicit hold recommendations resulting
from agreed-upon account monitoring services constitute recommendations
of ``any securities transaction or investment strategy involving
securities,'' the Care Obligation will apply at the point in time at
which their broker-dealer or associated person performs the agreed-upon
monitoring, regardless of whether the broker-dealer or an associated
person communicates any recommendation. This should increase the
efficiency of the implicit hold recommendations retail customers
receive relative to the baseline.
b. Costs
We expect broker-dealers and their associated persons to incur
costs as a result of the Care Obligation, and, to the extent broker-
dealers pass these costs on to retail customers, these customers may
incur costs as well. In this section, we analyze these costs in terms
of how Regulation Best Interest, as adopted, changes the required
standard of care broker-dealers owe their retail customers relative to
the baseline. We also highlight any changes in our assessment of these
costs as compared to the Proposing Release. We discuss the costs of
complying with the Care Obligation, such as those associated with
training employees or developing policies and procedures, in Section
III.C.5.
To comply with the Care Obligation, some broker-dealers may stop
offering certain securities to retail customers, or their associated
persons may stop recommending certain securities to retail customers.
These decisions may be based on determinations that offering or
recommending those securities typically would not satisfy the Care
Obligation. To the extent that they earn revenue from offering and
recommending such securities, broker-dealers and their associated
persons may incur costs associated with the determination to cease
offering or recommending these products.
Commenters stated that our analysis should not consider lost
revenue as a cost of complying with Regulation Best Interest, except to
the extent that the lost revenue is passed on to investors in the form
of higher fees, because these types of costs are a direct result of
policies that make investors better off.\1253\ As discussed above, our
economic analysis must consider the costs Regulation Best Interest may
impose on all affected parties, including broker-dealers. However, we
believe that any loss of revenues associated with recommendations that
would not satisfy the Care Obligation is compensated by the
corresponding benefit to retail customers--namely the provision of more
efficient recommendations by their financial professionals.\1254\ In
addition, even if broker-dealers or their associated persons have a
reasonable basis to believe that a certain investment could be in the
best interest of some retail customers, they may forgo offering or
recommending the investment if, for example, they think that it may
increase their exposure to regulatory enforcement risk over their
compliance with Regulation Best Interest.\1255\ This could result in
costs to both the broker-dealer and any retail customers for whom the
investment would be an efficient investment choice.
---------------------------------------------------------------------------
\1253\ See supra footnote 1164.
\1254\ See supra Section III.A.2 for a more detailed discussion
of efficient recommendations.
\1255\ See, e.g., Iowa Insurance Commissioner Letter.
---------------------------------------------------------------------------
Because the Care Obligation holds broker-dealers and their
associated persons to an enhanced standard of conduct, they may incur
costs associated with increased legal exposure if, for example,
Regulation Best Interest results in increased retail customer
arbitrations or litigation. For example, one commenter stated that the
lack of clarity in how to weight various factors associated with the
potential risks and rewards of a recommendation could lead to arbitrary
claims regarding other alternative recommendations that, ex-post, would
have performed better.\1256\ Similarly, because the Care Obligation
also requires that a series of recommended transactions be in the best
interest of a retail customer, regardless of whether a broker-dealer or
an associated person controls the retail customer's account, a broker-
dealer could incur the same types of costs associated with increased
arbitration or litigation risk relative to the baseline. We cannot
anticipate the extent to which Regulation Best Interest will increase
retail customer claims, but many retail customer arbitrations are
already predicated in whole or in part on facts alleging that a broker-
dealer
[[Page 33447]]
breached a fiduciary duty or its suitability obligations. Additionally,
the clarity in the rule text and this release regarding the Care
Obligation, as well as the other aspects of Regulation Best Interest
that bring enhanced conduct and clarity (e.g., the policies and
procedures requirement and that Regulation Best Interest applies only
at the time a recommendation is made) should mitigate against an
increase in the likelihood and cost of such claims.
---------------------------------------------------------------------------
\1256\ See CCMC Letters.
---------------------------------------------------------------------------
The Care Obligation explicitly requires that cost be considered as
a factor when determining whether a recommendation is in the best
interest of a retail customer. Several commenters stated that the
Proposing Release's guidance emphasizing cost as a specific factor in
the Care Obligation could create uncertainty around how the cost of a
recommendation should be weighed with other factors.\1257\ As discussed
above, the inclusion of cost as a factor in the Care Obligation does
not require that the ``least expensive'' recommendation be made by a
broker-dealer or its associated person; cost is one factor, but not the
only relevant factor. Nonetheless, to the extent that the inclusion of
cost as a factor in the Care Obligation increases the arbitration or
litigation risk to which broker-dealers or their associated persons are
exposed, this change could impose additional costs on broker-dealers.
---------------------------------------------------------------------------
\1257\ See ICI Letter; CCMC Letters; LPL August 2018 Letter.
---------------------------------------------------------------------------
Regulation Best Interest also expressly applies to account
recommendations, including recommendations of securities account types,
as well as rollovers or transfers of assets from one account to
another. We also clarify above that implicit hold recommendations
resulting from agreed-upon account monitoring are within the scope of
Regulation Best Interest and are therefore subject to the Care
Obligation. Should they choose to discontinue offering certain
services, as a result of Regulation Best Interest, broker-dealers could
lose revenue associated with making recommendations for account types
(including IRAs). They may also decide to cease offering monitoring
services on retail customer accounts. However, as we discussed above
with respect to recommendations more generally, we believe that any
loss of revenues associated with recommendations that would not satisfy
the Care Obligation is compensated by the corresponding benefits to
retail customers associated with more efficient account
recommendations.
The Commission is unable to fully quantify the costs that the Care
Obligation will impose on broker-dealers, their associated persons, or
their retail customers because the magnitude of these costs depends on
firm-specific factors that are inherently difficult to quantify given
the principles-based nature of Regulation Best Interest.\1258\ These
factors include the extent to which broker-dealers and their associated
persons currently engage in practices under the baseline that would
satisfy the Care Obligation, either of their own volition or as a
result of complying with other regulations; the extent to which broker-
dealers and their associated persons will cease recommending certain
securities or investment strategies; the likelihood that retail
customers file more arbitration or litigation claims; and the extent to
which broker-dealers pass on any cost increases to their retail
customers.\1259\
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\1258\ See also supra Section III.C.1.a.
\1259\ See discussion following infra footnote 1329 for
discussion of factors affecting whether broker-dealers pass on costs
to their retail customers and the resultant competitive effects.
---------------------------------------------------------------------------
4. Conflict of Interest Obligation
The Conflict of Interest Obligation under Regulation Best Interest
is intended to reduce the agency costs that arise when a broker-dealer
and its associated persons provide a recommendation to a retail
customer by addressing the effect of the associated person's or broker-
dealer's conflicts of interest on the recommendation.
The Conflict of Interest Obligation would require that broker-
dealers establish, maintain, and enforce written policies and
procedures that are reasonably designed to address the effect of the
broker-dealer's and the associated persons' conflicts of interest on a
recommendation. At a minimum, a broker-dealer is required to address
the effect of conflicts of interest on a recommendation. At a minimum,
a broker-dealer is required to address the effect of an identified
conflict on a recommendation by disclosing the material facts
associated with that conflict and by disclosing material limitations of
the menu of securities when the conflict stems from such limitations.
In certain cases, a broker-dealer is required to address the effect of
an identified conflict by either mitigating the conflict, or, in
certain cases, by eliminating certain sales practices.
The Conflict of Interest Obligation is intended to reduce the
information asymmetry between a retail customer and a broker-dealer and
its associated persons with respect to the broker-dealer's conflicts of
interest or those of its associated persons that may have an effect on
the recommendations provided to the retail customer. This disclosure
may help the retail customer form a better assessment of the efficiency
of the recommendation received. Moreover, reducing this information
asymmetry may discourage broker-dealers from acting on incentives that
differ from retail customer objectives.
Similarly, by addressing the effect of certain conflicts of
interest through mitigation, the Conflict of Interest Obligation is
intended to reduce the effect incentives created by those conflicts may
have on a recommendation provided to the retail customer. Depending on
how effective the mitigation method is in reducing these incentives,
the efficiency of the recommendation provided to the retail customer
may increase.
Similarly, by addressing the effect of certain conflicts of
interest through elimination, the Conflict of Interest Obligation is
intended to neutralize the effect of incentives created by those
conflicts may have on a recommendation provided to the retail customer.
In this case, the efficiency of the recommendations provided to the
retail customer may increase.
The conflicts of interest that the broker-dealer or its associated
persons have, and the incentives that these conflicts create, arise
from, among other things, the manner in which broker-dealers generate
revenue and the manner in which broker-dealers compensate their
associated persons with respect to their dealings with retail
customers.
The compensation arrangement between a broker-dealer and its
associated persons may reflect the amount of revenues that the
associated persons generate for the broker-dealer from activities
performed, including providing recommendations to retail customers.
Such arrangements between the broker-dealer and its associated persons
may create incentives for the associated person to take actions
consistent with maximizing the broker-dealer's objectives (e.g.,
expected profits). For instance, if an associated person's compensation
from providing recommendations to retail customers is tied to the
amount of revenues that the associated person generates for the broker-
dealer, the associated person may have an incentive to recommend
securities or investment strategies that would bring more revenue to
the broker-dealer, relative to other comparable securities or
investment strategies. Furthermore, even if the compensation
arrangement does not create an explicit incentive for the associated
person, the
[[Page 33448]]
broker-dealer may direct the attention of the associated person to
certain securities. For instance, even if the revenues that the broker-
dealer receives when its associated persons provide recommendations to
retail customers are not passed on to the associated persons, the
broker-dealer's receipt of compensation from some securities or their
sponsors may lead the broker-dealer to emphasize to its associated
persons the securities that are the source of such compensation.
The revenues that a broker-dealer receives when a retail customer
acts on an investment recommendation may depend on the broker-dealer's
compensation arrangement with the product sponsor. The broker-dealer
may receive different compensation from different product sponsors for
distributing comparable securities or investment strategies. If the
objectives of the broker-dealer are tied to the amount of revenues it
receives from recommended securities or investment strategies, the
broker-dealer may have an incentive to advise only, or predominantly,
on securities or investment strategies that come with attractive
compensation arrangements and less so, or not at all, on other
comparable securities or investment strategies. Accordingly, the
incentives created by the compensation arrangements with the product
sponsors may cause a broker-dealer to limit the menu of securities from
which the broker-dealer or its associated persons make recommendations.
The conflicts of interest that can arise from the compensation
arrangement between the broker-dealer and its associated persons, and
from the compensation arrangement between the broker-dealer and the
product sponsors, can create incentives that may affect the broker-
dealer's or its associated persons' recommendations to retail
customers. In certain circumstances, a broker-dealer's conflicts of
interest, or its associated persons' conflicts of interest, may result
in recommendations that are not in the best interest of the retail
customer.\1260\
---------------------------------------------------------------------------
\1260\ See FINRA Conflicts Report.
---------------------------------------------------------------------------
As discussed above, in Section III.B.2, broker-dealers are
currently subject to Commission and SRO regulations and rules that
govern their business conduct. For example, with respect to the
provision of advice, courts have found broker-dealers liable under the
antifraud provisions of the federal securities laws for not giving
``honest and complete information'' or for not disclosing ``material
adverse facts of which it is aware'' with regard to certain conflicts
of interest, in certain circumstances.\1261\ Furthermore, broker-
dealers are generally prohibited from making an unsuitable
recommendation to a customer.\1262\
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\1261\ See the Suitability Rule; see also 913 Study at 55 for a
detailed discussion of the broker-dealers' disclosure obligations
and liabilities under the current regulatory regime.
\1262\ See FINRA Rule 2111.03 (Recommended Strategies).
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In addition, broker-dealers may be liable under the Exchange Act
for failure to supervise their associated persons when providing advice
to retail customers.\1263\ Broker-dealers are generally required to
establish policies and procedures that are reasonably designed to
prevent and detect violations of the federal securities laws and
regulations, as well as applicable SRO rules. Broker-dealers are also
required to establish and maintain systems for applying these
procedures (e.g., identifying and reviewing red flags with respect to
the recommendations provided by their associated persons).\1264\
---------------------------------------------------------------------------
\1263\ See 913 Study at 74.
\1264\ Id. at 75. In addition, FINRA Rule 3010 requires broker-
dealers to establish and maintain a system to supervise the
activities of their associated persons that is reasonably designed
to achieve compliance with the applicable securities laws and
regulations and FINRA rules. FINRA Rule 3120 requires broker-dealers
to have a system of supervisory control policies and procedures that
tests and verifies supervisory procedures.
---------------------------------------------------------------------------
As discussed above, a number of studies and papers provide evidence
suggesting that despite the current regulatory regime and observations
that agency costs to retail customers from broker-dealer relationships
may be trending downward, the effect of conflicts of interest on the
provision of advice remains a concern.\1265\ We also noted in Section
III.A.2 above that, more generally, the conflicts of interest of the
broker-dealer and its associated persons and the incentives that these
conflicts create may result in agency costs for the retail customers
that persist despite the current regulatory regime.
---------------------------------------------------------------------------
\1265\ See supra Section III.B.3.c.
---------------------------------------------------------------------------
The Conflict of Interest Obligation in Regulation Best Interest is
intended to reduce the agency costs associated with the conflicts of
interest of the broker-dealers and its associated persons when they
provide recommendations on securities transactions and investment
strategies to retail customers. Below we discuss the economic
implications of different requirements of this obligation, including
their benefits and costs relative to the current regulatory regime.
a. Overarching Obligation Related to Conflicts of Interest
The overarching obligation of the Conflict of Interest Obligation
states that broker-dealers must establish, maintain, and enforce
written policies and procedures reasonably designed to identify and at
a minimum disclose, or eliminate, all conflicts of interest associated
with recommendations to retail customers.
The requirement to establish written policies and procedures
reasonably designed to identify conflicts of interest is a new
requirement relative to the current regulatory regime. This requirement
may impose costs on those broker-dealers that currently do not
implement such policies and procedures voluntarily. These costs stem
from the resources that a broker-dealer would have to expend to
identify existing and potential conflicts of interest and to design
policies and procedures that can reasonably identify and manage
circumstances when a conflict of interest arises within the broker-
dealer. These circumstances would have to take into account, among
other things, how the broker-dealer generates revenue from providing
recommendations to retail customers and how associated persons of the
broker-dealer are compensated for providing recommendations. In
addition, these circumstances would have to account for the limitations
of the menu of securities from which broker-dealers provide
recommendations. Furthermore, broker-dealers may incur costs of
reviewing and updating such policies and procedures as new conflicts of
interest arise or as new circumstances develop that may cause the
broker-dealer to identify an existing conflict of interest. The
Commission is providing below a quantitative estimate of the cost to
broker-dealers associated with designing and updating such policies and
procedures under certain assumptions
The requirement to establish policies and procedures reasonably
designed to identify conflicts of interest may also create benefits for
retail customers. As noted above, the policies and procedures would
require broker-dealers to: (1) Identify existing conflicts of interest
and new circumstances in which an existing conflict of interest may
arise, and (2) new conflicts of interest and the circumstances in which
they may arise. Having a process in place to identify and address the
conflicts of interest associated with a recommendation at the time the
recommendation is made to a retail customer would reduce the likelihood
[[Page 33449]]
that a broker-dealer may fail to disclose material facts relating to
conflicts of interest. Thus, the process a broker-dealer develops as a
result of complying with the Conflict of Interest Obligation may
improve the quality of the content of the disclosure of conflicts of
interest that may affect a recommendation. To the extent such
disclosure helps retail customers make a better assessment of the
efficiency of the recommendation they receive, the requirement may
benefit the retail customers.
The Commission continues to believe that it is not possible to
meaningfully quantify the potential costs and benefits of the Conflict
of Interest Obligations because such analysis would depend on many
contingent factors that render any estimate insufficiently precise to
inform our policy choices.\1266\ For example, such an analysis of the
Conflict of Interest Obligation would require strong assumptions about
the circumstances under which a broker-dealer may fail to identify a
given conflict of interest, and also about the extent to which the
disclosure of the conflicts of interest may enhance decision making for
retail customers.
---------------------------------------------------------------------------
\1266\ See discussion following supra footnote 1156 for a
general discussion of these factors. See also infra Section III.C.7,
where we have endeavored to quantify some of the potential benefits
of Regulation Best Interest based on many assumptions.
---------------------------------------------------------------------------
The requirement to establish policies and procedures reasonably
designed to, at a minimum, disclose identified conflicts of interest
may help a retail customer evaluate the efficiency of the
recommendation provided by a broker-dealer and its associated persons,
and may affect the retail customer's decision of whether, and how, to
act on the recommendation. As noted in Section III.A.2 above, reducing
the information asymmetry between a retail customer and a broker-dealer
and its associated persons may help the retail customer form a better
assessment of the efficiency of the received recommendation.
Disclosure requirements generally are intended to reduce
information asymmetries between transacting parties. Whether such a
reduction is likely to occur depends largely on the effectiveness of
the disclosure. If the disclosure provides new information, transacting
parties may make more informed decisions than they would without this
new information, and, from this perspective, the disclosure may be
effective. However, disclosure can be effective even if no new
information is provided, to the extent the form and manner in which a
disclosure requirement reaches the transacting parties facilitates a
more informed decision. There is extensive academic literature on the
factors that contribute to disclosure effectiveness.\1267\ Among these
factors, those associated with bounded rationality, including financial
literacy, are generally important.\1268\ In particular, disclosure
effectiveness generally increases with the level of financial literacy
of the transacting party.\1269\ It is also possible that if a broker-
dealer's retail customers have different degrees of financial literacy,
the potential anticipated reaction of the retail customers that are
financially literate to the disclosure of conflicts of interest may
cause the broker-dealer to choose to eliminate certain conflicts,
which, in turn, would benefit the population of retail customers that
are less financially literate. Specifically, the requirement to
establish policies and procedures reasonably designed to, at a minimum,
disclose identified conflicts of interest may have a deterrent effect
on some broker-dealers to the extent that they anticipate that
disclosing material facts about certain conflicts of interest may be
effective in dissuading certain retail customers from seeking or
accepting recommendations from their associated persons in the future.
As noted above, such broker-dealers may choose to eliminate those
conflicts instead.
---------------------------------------------------------------------------
\1267\ See supra Section III.B.4.c for a detailed discussion of
the academic literature on disclosure effectiveness.
\1268\ Id.
\1269\ Id.
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i. Disclosing Conflicts of Interest
The requirement under the Conflict of Interest Obligation to
develop reasonably designed policies and procedures to, at a minimum,
disclose identified conflicts of interest would obligate a broker-
dealer to provide information (e.g., material facts) about its
conflicts of interest and those that its associated persons have when
making a recommendation to a retail customer. As discussed above, this
information may already be disclosed under the regulatory baseline and
by broker-dealers that adopt best practices. However, it is currently
not clear in what form and what manner this disclosure reaches the
retail customer.\1270\ Under Regulation Best Interest, the Conflict of
Interest Obligation is intended to require that such disclosure reach
the retail customer more directly and in a more timely manner.\1271\ In
addition, the material facts disclosed may increase the salience of the
conflicts of interest to retail customers as being a potential factor
contributing to an associated person's recommendation. Salience
detection is a key feature of human cognition allowing individuals to
focus their limited mental resources on a subset of the available
information and causing them to over-weight this information in their
decision making processes.\1272\ Limited attention among individuals
increases the importance of focusing on salient disclosure signals.
Research suggests that increasing signal salience is particularly
helpful in reducing limited attention of consumers with lower education
levels and financial literacy.\1273\ To the extent that this manner of
disclosure and the associated increase in salience results in more
informed decisions with respect to whether to act on a received
recommendation, the disclosure requirement resulting from the Conflict
of Interest Obligation will benefit retail customers.
---------------------------------------------------------------------------
\1270\ See e.g., 913 Study.
\1271\ Broker-dealers satisfy their current disclosure
obligations in the account opening agreement, account statements,
and information made public on their websites.
\1272\ See Daniel Kahneman, Thinking, Fast and Slow (2013);
Susan T. Fiske & Shelley E. Taylor, Social Cognition: From Brains to
Culture (3rd ed. 2017).
\1273\ See, e.g., Victor Stango & Jonathan Zinman, Limited and
Varying Consumer Attention: Evidence from Shocks to the Salience of
Bank Overdraft Fees, 27 Rev. Fin. Stud. 990 (2014).
---------------------------------------------------------------------------
It is also possible that the disclosure of material facts about a
broker-dealer's conflicts of interest or those of its associated
persons related to a recommendation may not benefit the retail customer
receiving that recommendation. As noted by one commenter, the academic
literature on disclosure effectiveness notes that in certain
circumstances, disclosure of financial information may induce a
``panhandler effect'', whereby disclosure increases the pressure to
comply with the advice if the advisee (e.g., the retail customer) feels
obliged to satisfy the financial interest of the advice provider (e.g.,
the associated person).\1274\
---------------------------------------------------------------------------
\1274\ See, e.g., EPI Letter at 11, noting that ``[a]s the SEC
itself noted in its analysis of one of the proposed regulations,
disclosure may even induce a `panhandler effect,' whereby clients
may go through with a transaction in response to social pressure to
meet the professional's financial interests.'' The Commenter also
notes that generally disclosure may not incentivize a financial
professional to change her behavior: ``The SEC also noted that
disclosure could have an effect on the behavior of financial
professionals through `moral licensing'--the belief that they have
already fulfilled their moral obligations through disclosure, and
`strategic biasing'--the desire to compensate for an anticipated
loss of profit from disclosure.'' As discussed above, Regulation
Best Interest recognizes that certain conflicts of interest cannot
be reasonably addressed with disclosure alone. See also supra
Section III.B.4.c, which discusses in more detail these effects.
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[[Page 33450]]
ii. Elimination of Conflicts of Interest
The policies and procedures that broker-dealers will need to
maintain and implement to comply with the Conflict of Interest
Obligation will also give them the option of addressing conflicts of
interest associated with recommendations by eliminating such conflicts
entirely, rather than just disclosing them to the retail customer.
Depending on the effectiveness of the policies and procedures that a
broker-dealer implements to comply with the Conflict of Interest
Obligation, conflicts of interest that are not required to be
eliminated and that remain may still have a significant effect on an
associated person's recommendation. If a broker-dealer considers that
the effect of a conflict of interest on the recommendations of its
associated persons cannot be adequately addressed by the broker-dealer,
as required by the Conflict of Interest Obligation (discussed further
below), the broker-dealer may consider modifying its practices to
eliminate that conflict. By eliminating a conflict, the broker-dealer
would neutralize the effect of this conflict on the recommendations
provided by the broker-dealer or its associated persons to retail
customers. The absence of this conflict of interest when the associated
person is considering reasonably available alternatives for a
recommendation to a retail customer, as noted above in the discussion
of the Care Obligation, would likely result in an increase in the
efficiency of the customers. As discussed above in Section III.A.2,
this outcome would be consistent with the goals of Regulation Best
Interest by reducing the agency costs associated with an associated
person's incentives created by these conflicts of interest, which would
benefit the retail customer.
Furthermore, the option to address conflicts of interest through
elimination allows broker-dealers to reduce the compliance costs
associated with managing conflicts of interest. For example, if a
broker-dealer determines it is too costly to just disclose a conflict
of interest as required under the Conflict of Interest Obligation, the
broker-dealer could choose to eliminate the conflict. On the other
hand, by eliminating a conflict of interest, a broker-dealer may forgo
the potential revenues associated with that conflict of interest.
b. Mitigation of Certain Incentives to the Associated Persons
The requirement to establish, maintain, and enforce written
policies and procedures reasonably designed to identify and mitigate
conflicts of interest that create an incentive for the associated
person of the broker-dealer to place the interest of the broker-dealer
or the associated person ahead of the interest of the retail customer
will likely affect the relationship between the broker-dealer and its
associated persons, the menu of securities that the broker-dealer makes
available to its associated persons, and the recommendations that the
broker-dealer and its associated persons provide to retail customers.
In the employment relationship between a broker-dealer and its
associated persons, the broker-dealer generally hires and compensates
associated persons to perform certain services (e.g., providing
recommendations on securities transactions and investment strategies to
retail customers) using the broker-dealer's framework (e.g., policies
and procedures to ensure compliance with applicable laws and rules,
supervisory systems that monitor for potential violations of policies
and procedures, etc.). The compensation that the associated person
receives from the broker-dealer may reflect the level of effort that
the broker-dealer expects the associated person to exert when
performing a service, given the broker-dealer's infrastructure. As
noted above, the broker-dealer may also structure the associated
person's compensation to create incentives that are consistent with
maximizing the broker-dealer's objectives.
The requirement to establish, maintain, and enforce written
policies and procedures reasonably designed to identify and mitigate
conflicts of interest that create an incentive for the associated
person of the broker-dealer to put the interest of the broker-dealer or
the associated person ahead of the interest of the retail customer may
affect the employment relationship between the broker-dealer and the
associated person in several ways. First, the requirement may change a
broker-dealer's existing policies and procedures that are designed to
achieve compliance with the regulatory baseline as well as the
supervisory systems that allow the broker-dealer to monitor for
potential violations by the associated persons of these policies and
procedures. To this end, broker-dealers will need to consider the
amount of time and level of resources to devote to design and establish
policies and procedures that seek to reduce the likelihood of an
associated person placing its interest or the interest of the broker-
dealer ahead of the interests of a retail customer when providing
recommendations to retail customers.
Another way that this requirement may affect the employment
relationship between the broker-dealer and the associated person is by
changing the level of effort that the associated person would have to
exert to ensure that all recommendations supplied to retail customers
are compliant with the Conflict of Interest Obligation. As a corollary,
this requirement may also affect the level of effort that a supervisor
would have to exert to ensure that the recommendations supplied by its
associated persons to a retail customer comply with the obligations of
Regulation Best Interest.
As discussed above in the context of the Care Obligation, an
associated person would have to not only consider a number of factors
when making a recommendation to a retail customer, but also ensure that
the recommendation is in the best interest of the retail customer. The
determination that a recommendation is in the retail customer's best
interest may depend on the conflicts of interest that exist at the time
the associated person makes the recommendation, and, importantly, on
how the broker-dealer complies with the requirement to establish,
maintain, and enforce policies and procedures reasonably designed to
identify and mitigate or eliminate conflicts of interest that create an
incentive for the associated person to put the interest of the broker-
dealer or the associated person ahead of the interest of the retail
customer. It is possible that more effective policies and procedures
may lower the level of effort an associated person would have to exert
to have a reasonable basis to believe that recommendations are
compliant with Regulation Best Interest, in the sense that a supervisor
or the broker-dealer would determine whether the effect of the
associated person's or the broker-dealer's conflicts of interest is
reduced to the point where the incentives created by these conflicts do
not have a negative effect on the recommendations. However, the
potential increase in the supervisor's level of effort may substitute
for the potential decrease in the associated person's level of effort.
One commenter had concerns about the discussion in the Proposing
Release about the effect of the compensation arrangements between the
broker-dealer and the associated person on the effort exerted by the
associated person when
[[Page 33451]]
providing a recommendation.\1275\ This commenter stated that if the
compensation leads to lower effort, the associated person would not
make recommendations that are in the retail customer's best interest.
As discussed above, the Commission notes that the relationship between
the effort exerted to make a recommendation and the efficiency of the
recommendation is complex, and that lower effort may not necessarily be
inconsistent with increasing the efficiency of the recommendation.
---------------------------------------------------------------------------
\1275\ See AARP August 2018 Letter.
---------------------------------------------------------------------------
Finally, the Conflict of Interest Obligation may affect the
compensation arrangement between the broker-dealer and its associated
persons. Certain compensation arrangements may create incentives for an
associated person to place his or her interest of the interest of the
broker-dealer ahead of the interest of the customer, and therefore
create conflicts of interest for the broker-dealer's associated
persons. For example, as discussed above in Section III.B.1.f, broker-
dealers commonly compensate their associated persons based on
commissions and performance-based awards. These compensation
arrangements create incentives for associated persons to recommend
securities or investment strategies that generate more commissions to
the broker-dealer and potentially themselves over other securities or
investment strategies.
The Conflict of Interest Obligation requires a broker-dealer to
have policies and procedures that are reasonably designed to identify
and disclose and mitigate, or eliminate, any conflicts of interest
associated with recommendations that create an incentive for the
associated person or the firm to place the interest of the associated
person or the firm ahead of the interest of the retail customer,
including conflicts of interest that arise from compensation
arrangements between broker-dealers and their associated persons.
Depending on how a broker-dealer complies with the Conflict of Interest
Obligation, compensation arrangements between broker-dealers and their
associated persons may change as a result of establishing these
policies and procedures. For example, as discussed above in Section
III.B.2.e, in response to the DOL Fiduciary Rule, which among other
things, was designed to restrict broker-dealer activities and reduce
the conflicts of interest of a broker-dealer and those of its
associated persons, some broker-dealers altered the compensation for
their associated persons. Specifically, some broker-dealers chose to
equalize commissions and deferred sales charges charged across similar
securities or investment strategies. Others chose to restrict or
eliminate sales quotas, contests, special awards, and bonuses,
including deferred bonuses as part of the recruitment efforts.\1276\ It
is possible that some broker-dealers may choose to comply with the
Conflict of Interest Obligation by establishing policies and procedures
that would address conflicts using these or similar methods. It is also
possible that some broker-dealers may rely on existing policies and
procedures that address conflicts through methods such as compliance
and supervisory systems that are consistent with the Conflict of
Interest Obligation.
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\1276\ However, we understand that following the decision by the
Fifth Circuit to vacate the DOL Fiduciary Rule, some broker-dealers
may have reverted back to compensation arrangements that they had in
place prior to the DOL Fiduciary Rule. For instance, as discussed in
Section III.B.2.e.ii, supra, some broker-dealers reinstated their
deferred recruiting bonuses.
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Some of these methods may reduce the overall compensation of the
associated person from providing recommendations (e.g., altering
certain bonuses). The same methods or others (e.g., altering deferred
recruiting bonuses) may complicate a broker-dealer's hiring of new
associated persons. However, to the extent that these methods address
the conflicts of interest of a broker-dealer or those of its associated
persons in an effective manner, these methods may enhance the
efficiency of the recommendations provided by a broker-dealer and its
associated persons, and, therefore benefit retail customers.
In general, if a broker-dealer implements policies and procedures
pursuant to the Conflict of Interest Obligation that may result in a
significant reduction in the overall compensation that an associated
person receives from providing recommendations, the associated person
may have an incentive to register as an investment adviser, if not
already registered as one, and provide advice mostly or only in an
investment adviser capacity.
To the extent broker-dealers establish, maintain, and enforce
policies and procedures that are effective at reducing the incentives
of an associated person to put the interest of the broker-dealer or the
associated person ahead of the interest of the retail customer, the
Conflict of Interest Obligation would reduce the effect of these
conflicts on the recommendations provided by associated persons to
retail customers. In this way, complying with the Conflict of Interest
Obligation would increase the efficiency of the recommendations for
retail customers, relative to the regulatory baseline. This, in turn,
would reduce the agency costs associated with the broker-dealer's and
its associated persons' incentives that are created by their conflicts
of interest. Lower agency costs at these broker-dealers would benefit
retail customers.
One commenter noted that the size of these benefits of Regulation
Best Interest should be quantified relative to the baseline that
includes the current regulatory regime as well as current
practices.\1277\ The Commission agrees with the commenter and notes
that, as discussed in Section III.B, broker-dealers may already have
compliance and supervisory systems in place that are effective at
reducing to a reasonable extent the effect of an associated person's
conflicts of interest on the recommendations provided to retail
customers.\1278\ Therefore, for the retail customers of these broker-
dealers, the potential benefits above may be small. In contrast, for
the retail customers of the broker-dealers that are not currently
addressing conflicts of interest in a manner consistent with Regulation
Best Interest, the potential benefits above may be large.
---------------------------------------------------------------------------
\1277\ See CFA August 2018 Letter.
\1278\ See FINRA Conflicts Report.
---------------------------------------------------------------------------
This commenter further stated that the economic analysis in the
Proposing Release did not provide a thorough discussion of the
relationship between the broker-dealer and its associated persons with
a focus on the incentives of the associated persons.\1279\ The
Commission notes that the analysis above about the incentives of the
associated persons expands the analysis in the Proposing Release and
establishes a clear link between compensation and incentives.
---------------------------------------------------------------------------
\1279\ See CFA August 2018 Letter.
---------------------------------------------------------------------------
As noted in the economic analysis of the Proposing Release,\1280\
broker-dealers may also adjust their menus of securities in response to
the requirement to establish, maintain, and enforce written policies
and procedures reasonably designed to identify and mitigate conflicts
of interest that create an incentive for the associated person to place
his or her interest or the interest of the broker-dealer ahead of the
interest of the retail customer. It is possible that some broker-
dealers may decide to expand their offerings to better comply with the
process required pursuant to the Conflict of Interest Obligation. For
instance, broker-dealers that currently
[[Page 33452]]
offer advice only on a limited set of securities (e.g., proprietary
securities) would have to disclose and evaluate their menu of
securities to ensure that their policies and procedures regarding their
limited menus of securities and the disclosures of any conflicts
associated with such limitations do not result in recommendations that
place the interest of the broker-dealer or its associated persons ahead
of the retail customer's interest.
---------------------------------------------------------------------------
\1280\ See Proposing Release at 21658.
---------------------------------------------------------------------------
Broker-dealers may also manage conflicts of interest by limiting
their menu of securities on which they offer recommendations. Broker-
dealers may prefer a limited menu of securities to better mitigate the
potential costs associated with compliance of Regulation Best Interest.
For instance, a limited menu of securities may result in more
homogenous product fees across comparable securities or investment
strategies, which would help reduce the effect of certain conflicts of
interest on the recommendations provided to retail customers. Broker-
dealers may also respond by limiting their menus of securities because
they may have conflicts of interest due to variation in the
compensation they receive from product sponsors, as discussed above.
It is possible that complying with the Conflict of Interest
Obligation in this manner may result in securities menus that limit an
associated person's choices of investments when providing a
recommendation to a retail customer.\1281\ However, as discussed below,
the requirements of the Conflict of Interest Obligation and the Care
Obligation are intended to reduce the likelihood that limitations on
securities menus result in recommendations that are not in the best
interest of the retail customer.\1282\
---------------------------------------------------------------------------
\1281\ See supra Section II.C.2.
\1282\ For example, if none of the securities on the menu would
be in the best interest of the retail customer in a given set of
circumstances, the associated person may not recommend any of the
securities on the menu to the retail customer.
---------------------------------------------------------------------------
It is also possible that broker-dealers that limit their menus of
securities in response to the Conflict of Interest Obligation may
eliminate securities or investment strategies that are inferior
relative to other securities or investment strategies in terms of
performance and costs. Recommendations based on menus of securities
that do not contain inferior securities or investment strategies are
more likely to be efficient for the retail customer. To the extent
broker-dealers eliminate inferior investments from their securities
menus as a result of complying with the Conflict of Interest
Obligation, Regulation Best Interest would provide a benefit for the
retail customers of these broker-dealers.
Broker-dealers may pass on some of the compliance costs to their
retail customers. For instance, broker-dealers may increase their fees
on the services that they provide to retail customers as part of the
relationship, or may adopt new fees. Alternatively, broker-dealers may
seek to renegotiate their compensation arrangements with the product
sponsors in the hopes of extracting greater compensation (e.g., more
attractive revenue-sharing agreements), relative to current practices.
The likelihood of a favorable outcome for the broker-dealers may depend
on whether product sponsors can charge their retail customers higher
fees. However, it is likely that product sponsors are already charging
fees that are privately optimal (e.g., maximize their revenue net of
costs), and thus any deviations from these fees would lead to a
suboptimal outcome for the product sponsors. In other words, product
sponsors may not have an incentive to increase their fees.
A number of commenters stated that policies and procedures that
address how broker-dealers manage conflicts of interest relating to
limited menus of securities could impose costs on a retail customer
when all securities on the menu have high fees or create a benefit for
retail customers if securities with high fees are eliminated.\1283\ As
noted in the Proposing Release and above, the Commission acknowledges
the benefits to the retail customers of the broker-dealers that comply
with Regulation Best Interest by eliminating inferior securities or
investment strategies. The Commission also acknowledges the potential
costs of limited menus of securities by expanding the Conflict of
Interest Obligation to include requirements that would address
specifically limited menus of securities and by providing a detailed
analysis of the economic implications of these requirements, below.
---------------------------------------------------------------------------
\1283\ See, e.g., CFA August 2018 Letter; AARP August 2018
Letter; EPI Letter; Better Markets August 2018 Letter.
---------------------------------------------------------------------------
c. Material Limitations on Recommendations to Retail Customers
The Conflict of Interest Obligation includes a requirement that
specifically addresses material limitations on recommendations to
retail customer (e.g., offering only proprietary or other limited range
of securities). This provision requires broker-dealers to establish,
maintain, and enforce written policies and procedures reasonably
designed to identify and disclose any material limitations placed on
securities or investment strategies that may be recommended to a retail
investor and any conflicts of interest associated with such limitations
in accordance with the Disclosure Obligation. It further requires such
policies and procedures to be reasonably designed to prevent such
limitations and associated conflicts of interest from causing the
broker-dealer or its associated persons to make recommendations that
place the interest of the broker-dealer or associated persons ahead of
the interest of the retail customer.
As noted above, broker-dealers may limit their menus of securities
in response to certain requirements of the Conflict of Interest
Obligation. The requirements that address limited menus of securities
are designed to help ensure that these limitations and associated
conflicts of interest do not create incentives for the broker-dealer or
its associated persons to make recommendations that are not in the best
interest of the retail customer. The second aspect of the requirement
would seek to ensure that the menu of securities is not limited to the
point where it restricts a broker-dealer and its associated persons
from complying with the Care Obligation, and in particular with the
requirement to provide recommendations that are in the customer's best
interest.\1284\ To the extent these requirements reduce the effect of
the limitations of the menu of securities and the associated conflicts
of interest on the recommendations provided by a broker-dealer or its
associated persons, the Conflict of Interest Obligation would result in
recommendations that are more likely to be efficient, relative to the
baseline.
---------------------------------------------------------------------------
\1284\ Broker-dealers that offer a limited menu of securities
may not be able to offer recommendations to certain clients. See
also supra footnote 1282.
---------------------------------------------------------------------------
The requirements that address limitations of the menu of securities
may have additional implications for certain product markets, and
ultimately, retail customers. To better understand these implications
we focus the discussion on the market for mutual funds.
As discussed in Section III.B.3, academic literature has noted that
in certain product markets, such as mutual funds, the different
distribution channels that product sponsors use to reach the retail
customer may cause these markets to fragment. In the market for mutual
fund products, some products are sold to retail customers only through
broker-dealers--the so-called ``broker-sold'' distribution channel--
while other products are sold
[[Page 33453]]
directly to retail customers--the so-called ``direct-sold''
distribution channel.\1285\ The products that are sold through the
broker-sold channel usually carry higher fees relative to comparable
products that are sold through the direct-sold channel.\1286\ Higher
fees on the broker-sold products reflect broker-dealers' compensation
for distributing the product. In general, all transactions linked to
the broker-sold distribution channel are triggered by a recommendation
provided by an associated person of the broker-dealer. Most product
sponsors currently rely on one of the two channels to distribute their
products, but not on both.\1287\
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\1285\ In this discussion, the broker-sold distribution channel
includes sales that are the result of a recommendation provided by
the broker-dealer but may also include sales that are solicited by
the retail customer where no advice or recommendation was provided
by the broker-dealer (i.e., unadvised sales). The direct-sold
distribution channel includes unadvised sales through broker-dealer
open platforms as well as sales that the retail customer solicits
directly from the product sponsor. Investment advisers may also
access products through the direct-sold distribution channel.
\1286\ See, e.g., Del Guercio & Reuter (2014).
\1287\ See, e.g., Del Guercio & Reuter (2014), supra footnote
1081, and Reuter (2015), supra footnote 1095.
---------------------------------------------------------------------------
A retail customer that has an account with a broker-dealer that
provides advice is not necessarily constrained to accessing products
only through the broker-sold channel. A retail customer could access
products from the direct-sold channel to transact on his or her own
(for example, if the broker-dealer may not provide recommendations on a
particular product).\1288\ A retail customer who has access to products
from both distribution channels and who understands the effect of fees
on a product's performance may prefer to access a product through the
broker-sold channel if, for example, the combined cost of identifying
(e.g., search costs) and accessing comparable direct-sold products
(e.g., product fee) is higher than the total cost of the broker-sold
product recommended by the associated person of the broker-
dealer.\1289\ As more direct-sold products enter the market,\1290\ the
retail customer's cost of identifying \1291\ direct-sold products that
are comparable alternatives to a broker-sold product recommended by an
associated person of the broker-dealer may become lower.\1292\ In turn,
the retail customer's demand for broker-sold products may
decline.\1293\
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\1288\ A retail customer could also access securities through
financial professionals that are not broker-dealers, including
investment advisers.
\1289\ Some broker-dealers may offer securities to retail
customers through both distribution channels, but these broker-
dealers provide recommendations only on securities offered through
the broker-sold channel. For example, some broker-dealers with open
platforms may only provide recommendations on proprietary
securities.
\1290\ See, e.g., ICI Letter, which shows an increasing trend in
the number of mutual funds with no 12b-1 fees over the past 10
years. These funds are available through the direct-sold channel.
\1291\ Broker-dealers with open platforms that allow retail
customers to access securities on this platform without a
recommendation from the broker-dealer and its associated persons
generally provide extensive research and analytical tools. The
Commission has recently adopted rule amendments that address
research reports that broker-dealers make available to their retail
customers. See Covered Investment Fund Research Reports, Release 33-
10580 (Nov 30, 2018); 83 FR 64180 (Dec. 13, 2018).
\1292\ See, e.g., Ali Hortacsu & Chad Sylverson, Product
Differentiation, Search Costs, and Competition in the Mutual Fund
Industry: A Case Study of S&P 500 Index Funds, 119 Q. J. Econ. 403
(2004), who estimate an investor's search costs for S&P500 index
funds and show that, as the number of S&P500 index funds increased
over their sample period spanning 1995 to 2000, the investor's
search costs generally declined. The authors further show that this
downward trend was driven by funds that are in lower end of the
search cost distribution and that these funds were mostly no-load
funds. These no-load funds are usually available through the direct-
sold channel.
\1293\ However, a retail customer may value the services
provided by a broker-dealer that extend beyond the provision of
recommendations on securities transactions and investment strategies
and continue to maintain an account with the broker-dealer. To
counter the potential decline in the demand for broker-sold
products, a broker-dealer may respond by offering more services and
increasing the fee for the package of services or by trying to shift
the retail customer to a potentially more profitable advisory
account (to the extent that the broker-dealer offers this type of
accounts).
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According to economic first principles, when enough retail
customers exhibit a preference for direct-sold products over broker-
sold products, the aggregate demand for broker-sold products should
decline. To remain competitive, product sponsors that rely on the
broker-sold channel to distribute their products would have to lower
the fees on their products. Lower fees on broker-sold products may
result in lower compensation for broker-dealers and their associated
persons from providing recommendations on these products. Lower fees on
broker-sold products would benefit retail customers who access mutual
fund products through the broker-sold channel.
This market mechanism would allow retail customers' demand to
affect how product sponsors compensate broker-dealers for recommending
broker-sold products. While this mechanism is currently available to
retail customers and is considered generally effective, it is not clear
how effective this mechanism is in all aspects of the market,
particularly in the short run.\1294\ As noted by one commenter, the
expense ratio for domestic equity mutual funds declined from 0.86
percent in 2007 to 0.59 percent in 2017, a 31% reduction over the ten
year period.\1295\ This commenter further notes that this downward
trend in expense ratios reflects, among other things, a ``long-running
shift by investors toward lower-cost funds.'' Because the number of
low-cost funds that enter the market over the period 2007-2017 has
increased substantially, the assessment of this commenter would appear
to be consistent with the market mechanism being effective in the long
run.\1296\
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\1294\ Recent academic research questions the effectiveness of
the market mechanism, at least in the short run. See. e.g., Yang
Sun, Does Competition Protect Retail Investors? Role of Financial
Advice (Working Paper, Apr. 2017), available at https://coller.tau.ac.il/sites/coller-english.tau.ac.il/files/media_server/Recanati/management/conferences/finance/2017/61.pdf. This research
shows that the sudden entry of several low-cost index funds caused
direct-sold actively managed funds with similar investment
objectives to cut their fees by 6.4 basis points. In contrast,
broker-sold actively managed funds with similar investment
objectives as the new entrant funds increased their fees by 12.2
basis points. The study further shows that while some of the fee
increase in the broker-sold funds is accompanied by increased levels
of active management, most of the fee increase (more than 60%) was
passed on to broker-dealers. The author argues that the broker-sold
actively managed funds are able to increase their fees only to the
extent that they can signal to the market that they are not
employing strategies that mimic index funds.
\1295\ See ICI Letter.
\1296\ Id. at 42.
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As noted above, the effectiveness of the market mechanism may
depend on a number of factors, including the retail customer's ability
to understand the effect of fees on the performance of a product and
willingness to shop around for comparable products, the product
sponsor's ability to signal how its broker-sold products stand out
among comparable products, and the broker-dealer's menu and the
disclosure about potential limitations of this menu.\1297\
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\1297\ As noted in supra footnote 1292, the effectiveness of
this market mechanism may also depend on whether broker-dealers
offer advisory accounts and whether these broker-dealers can
convince retail customers to switch to an advisory account rather
than to a self-directed account.
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The Conflict of Interest Obligation may improve the effectiveness
of this market mechanism through the requirement that broker-dealers
establish, maintain, and implement written policies and procedures
reasonably designed to identify and disclose all material limitations
of products that may be recommended and any associated conflicts of
interest. This requirement would result in disclosures that, while not
necessarily new relative to the regulatory baseline, may increase the
salience of the limitations of product menus and the associated
conflicts of
[[Page 33454]]
interest for the retail customers.\1298\ The added focus on these
limitations may cause some retail customers to question whether the
recommendations that they are receiving are taking into consideration a
reasonable set of alternatives. Thus, this disclosure may encourage
retail customers to shop for comparable products that they may prefer
(e.g., based on cost factors) over the broker-sold products that are
being recommended to them.
---------------------------------------------------------------------------
\1298\ See supra footnote 1272 and accompanying text.
---------------------------------------------------------------------------
As an example, a broker-dealer that is providing recommendations
only for proprietary products would have to disclose, the material
limitation that the products on the menu are all proprietary, and the
material fact of the conflict of interest that the broker-dealer and
its associated persons are being compensated for selling these
products. As discussed above in Section II.C.3.f, there are a number of
other potential conflicts of interest associated with proprietary
products. While broker-dealers may disclose this information under the
regulatory baseline, it is not clear the manner in which this
disclosure currently reaches the retail customer.\1299\ The new
required disclosure with respect to conflicts of interest (under the
Disclosure Obligation) is intended to be more comprehensive and more
specific, and is also intended to reach the retail customer more
directly. From this perspective, the disclosure of the limitations of
the product menu and its associated conflict of interest may better
inform retail customers' choices and, therefore, may be more effective,
compared to current disclosure forms of the same information. While,
generally, the effectiveness of disclosure depends on many factors that
are well known in the academic literature, the disclosure requirement
of the Conflict of Interest Obligation may also depend on the range of
material facts that the broker-dealer deems necessary to disclose in
order to be in compliance with the obligation.\1300\
---------------------------------------------------------------------------
\1299\ See, e.g., 913 Study.
\1300\ See supra Section III.B.4.c for a detailed discussion of
the academic literature on disclosure effectiveness.
---------------------------------------------------------------------------
The Conflict of Interest Obligation addresses limited product menus
by requiring that broker-dealers take measures through reasonably
designed written policies and procedures to evaluate and prevent the
limitations and the associated conflicts of interest from causing
associated persons of the broker-dealer to make recommendations that
are inconsistent with the requirements of Regulation Best Interest. The
requirement seeks to address specific firm-level conflicts--namely, the
conflicts associated with the establishment of a product menu--which
are likely to affect recommendations made to retail customers and may
result in recommendations that place the interest of the broker-dealer
or its associated persons ahead of the interest of the retail customer.
This requirement may have a direct effect on the relationship
between broker-dealers and product sponsors. To the extent that enough
broker-dealers decide to no longer offer recommendations on certain
types of products that carry higher fees (i.e., exclude them from the
menus), the aggregate demand for such products may decline. Product
sponsors that face declining demand for some of their products may
respond by lowering the fees on these products or by repackaging these
products into new and more competitive products that may again draw the
interest of the broker-dealers.
d. Elimination of Certain Sales Practices
As part of the Conflict of Interest Obligation in Regulation Best
Interest, broker-dealers are required to establish, maintain, and
enforce written policies and procedures reasonably designed to identify
and eliminate any sales contests, sales quotas, bonuses, and non-cash
compensation that are based on the sales of specific securities or
specific types of securities within a limited period of time. The
Commission believes that the conflicts of interest associated with
these practices that may create high-pressure situations for the
associated persons of the broker-dealer to recommend a specific
security over another cannot be reasonably addressed through disclosure
and mitigation and should be addressed through elimination in order to
comply with the requirements of Regulation Best Interest.\1301\
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\1301\ See also the discussion in Section II.C.3.g, supra.
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Relative to the regulatory baseline, this requirement would provide
benefits to retail customers. Conflicts of interest that create
incentives for the associated persons to recommend a specific security
(or specific types of securities) over another are likely to have a
significant effect on an associated person's recommendation, even if
such conflicts were disclosed and mitigated via policies and procedures
established, maintained and enforced by the broker-dealer. By
explicitly requiring policies and procedures reasonably designed to
eliminate sales practices that may result in such conflicts, the
requirement should neutralize the effect of these conflicts on the
recommendations provided by associated persons to retail customers. The
absence of these conflicts when the associated person is considering
reasonably available alternatives for a recommendation to a retail
customer, as noted in the discussion of the Care Obligation, may
increase the efficiency of the recommendation for their retail
customers. As discussed above in Section III.A.2, this outcome is
consistent with Regulation Best Interest reducing the agency costs
associated with a broker-dealer's incentives or the incentives of its
associated persons created by these conflicts of interest, which, in
turn, would benefit the retail customer.
The requirement to establish policies and procedures reasonably
designed to eliminate certain sales practices may reduce the total
compensation that a broker-dealer and its associated person receives
from providing recommendations to retail customers. As discussed above,
to the extent that the reduction in an associated person's total
compensation is sufficiently large, the associated person may have an
incentive to register as an investment adviser and provide investment
advice only in his or her advisory capacity. Furthermore, the potential
decline in the total compensation of an associated person of the
broker-dealer due to this requirement may dissuade financial
professionals from providing advice in the capacity of a broker-dealer,
and as a result, broker-dealers may find it more difficult to hire new
associated persons, relative to the baseline.
In addition, the types of sales practices that this requirement is
meant to address generally create incentives for associated persons to
recommend certain types of securities or investment strategies over
certain time periods over other types of securities or investment
strategies. By requiring broker-dealers to establish policies and
procedures reasonably designed to eliminate certain sales practices
that create these types of incentives, broker-dealers may experience a
reduction in the revenue stream associated with certain securities or
investment strategies. Thus, through this requirement, Regulation Best
Interest may impose a cost on the broker-dealers that currently rely on
these types of practices in order to incentivize sales. On the other
hand, retail customers who have born costs associated with such
practices will benefit from the cessation of these sales practices.
[[Page 33455]]
As discussed above, while we are unable to quantify the full costs
of Regulation Best Interest, including the Conflict of Interest
Obligation, we are able to estimate some of the costs associated with
the Conflict of Interest Obligation, specifically the costs related to
information collection requirements as defined by the Paperwork
Reduction Act. As discussed further in Section IV.B.1, the Commission
believes that broker-dealers would update their policies and procedures
to comply with this requirement and would incur an initial aggregate
burden of approximately 128,160 hours and an additional initial
aggregate cost of approximately $25 million, as well as an ongoing
aggregate annualized burden of approximately 27,900 hours, and an
ongoing aggregate annualized cost of approximately $2.91 million.\1302\
Furthermore, the Commission believes that in order to identify
conflicts of interest and determine whether the conflicts are material,
broker-dealers would incur an initial aggregate burden of approximately
69,150 hours and an additional initial aggregate cost of approximately
$15.71 million as well as an ongoing aggregate annualized burden of
approximately 27,660 hours.\1303\ Thus, we estimate the Conflict of
Interest Obligation of proposed Regulation Best Interest would impose
an initial aggregate cost of at least $110.73 million and an ongoing
aggregate annual cost of at least $20.44 million on broker-
dealers.\1304\
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\1302\ These estimates are based on the following calculations:
120,600 hours + 7,560 hours = 128,160 hours; $10 million + $15
million = $25 million; and 24,120 hours + 3,780 hours = 27,900
hours. As discussed in more detail in infra Section V.D, 120,600
hours and 7,560 hours are preliminary estimates for the initial
aggregate burdens for large and small broker-dealers, respectively,
$10 million and $15 million are preliminary estimates for the
initial aggregate costs for large and small broker-dealers,
respectively, and 24,120 hours and 3,780 hours are preliminary
estimates for the ongoing aggregate burdens for large and small
broker-dealers, respectively.
\1303\ The estimate of the initial aggregate burden is based on
the following calculations: 13,830 hours + 55,320 hours = 69,150
hours, where, as discussed in more detail in Section V.D, 13,830
hours and 55,320 hours are estimates for the initial aggregate
burdens for identifying conflicts of interest and determining
whether the conflicts are material for all broker-dealers,
respectively.
\1304\ These estimates are calculated as follows: (90,450 hours
of in-house legal counsel) x ($415.72/hour for in-house counsel) +
(27,660 hours for in-house compliance counsel) x ($365.39/hour for
in-house compliance counsel) + (27,660 hours for identifying
conflicts of interest) x ($229.74/hour for business line personnel)
+ (51,540 hours for review of policies and procedures) x ($309.60/
hour for in-house compliance manager) + (50,302 hours for outside
legal counsel) x ($497/hour for outside legal counsel) + (55,317
hours for modifying existing technology) x ($284/hour for outside
senior programmer) = $110.73 million, and (8,040 hours of in-house
legal counsel) x ($415.72/hour for in-house counsel) + (21,870 hours
for in-house compliance counsel) x ($365.39/hour for in-house
compliance counsel) + (21,870 hours for identifying conflicts of
interest) x ($229.74/hour for business line personnel) + (3,780
hours for review of policies and procedures) x ($309.60/hour for
compliance manager) + (3,783 hours for outside legal counsel) x
($497/hour for outside legal counsel) + (3,773 hours for outside
compliance services) x ($273/hour for outside compliance services) =
$20.44 million. The hourly wages for in-house legal and compliance
counsel, registered representatives, senior business analyst,
compliance manager, and business-line personnel are obtained from
SIFMA. The hourly rates for outside legal counsel, outside senior
programmer, systems analyst or programmer and outside compliance
services are discussed in infra Section V.D.
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5. Compliance Obligation
The Compliance Obligation of Regulation Best Interest requires
broker-dealers to establish, maintain, and enforce written policies and
procedures reasonably designed to achieve compliance with Regulation
Best Interest.\1305\ This obligation creates an affirmative obligation
under the Exchange Act with respect to Regulation Best Interest as a
whole, while providing sufficient flexibility to allow broker-dealers
to establish compliance policies and procedures that accommodate a
broad range of business models.\1306\
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\1305\ These policies and procedures are in addition to the
policies and procedures required under the Conflict of Interest
Obligation.
\1306\ See supra Section II.C.4.
---------------------------------------------------------------------------
The Compliance Obligation is designed to ensure that broker-dealers
have internal controls in place to prevent violations of Regulation
Best Interest. The policies and procedures required to comply with this
obligation would allow the Commission to identify and address potential
compliance deficiencies or failures (such as inadequate or inaccurate
policies and procedures, or failure to follow the policies and
procedures) early on, reducing the chance of retail customer
harm.\1307\
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\1307\ See supra Section II.C.4.
---------------------------------------------------------------------------
As discussed above in Section III.B.2.d, under the regulatory
baseline, broker-dealers are subject to supervisory obligations that,
among other things, require them to establish policies and procedures
reasonably designed to prevent and detect violations of, and achieve
compliance with, the federal securities laws and regulations,\1308\ as
well as applicable SRO rules.\1309\ Broker-dealers would have the
ability to update these policies and procedures to comply with the
Compliance Obligation, rather than create new policies and procedures.
---------------------------------------------------------------------------
\1308\ See Section 15(b)(4)(E) of the Exchange Act.
\1309\ See FINRA Rule 3110 (Supervision).
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The obligation indirectly benefits retail customers by ensuring
that broker-dealers have sufficient internal controls in place to
support compliance with Regulation Best Interest.
The obligation will impose compliance costs on broker-dealers.
However, these costs are likely to be smaller for those broker-dealers
that already have effective compliance systems in place, including
effective policies and procedures.
Broker-dealers may incur operational costs related to training
their associated persons and developing policies and procedures to
ensure compliance with the Care Obligation. For example, broker-dealers
may have to provide training to their employees and other associated
persons on how to make recommendations that do not place the interest
of the broker-dealer or their associated persons ahead of the interest
of the retail customer. In the Proposing Release, these training costs
were discussed as part of a separate general best interest obligation,
and our assessment of those costs has not changed.\1310\ Broker-dealers
also may incur costs related to training their associated persons on
how to determine that they have a reasonable basis to believe that a
recommendation is in a retail customer's best interest. This may
include training on how to evaluate the potential risks, rewards, and
costs associated with a recommendation as well as how a retail
customer's investment profile affects this determination. Additionally,
broker-dealers may incur costs related to training their associated
persons on any relevant factors specific to making recommendations
regarding IRAs, IRA rollovers, or other account types, as well as
implicit hold recommendations resulting from agreed-upon account
monitoring. These training costs will be lower for broker-dealers that
already operate in a manner that is consistent with the requirements of
the Care Obligation and higher for those that do not. Firms may already
comply with the requirements of the Care Obligation, to varying
degrees, either of their own volition or because they are already
subject to and comply with similar obligations.
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\1310\ See Proposing Release at Section IV.C.2.a.
---------------------------------------------------------------------------
As discussed above, while we are unable to quantify the full costs
of Regulation Best Interest, including the Compliance Obligation, we
are able to estimate some of the costs associated with the Compliance
Obligation, specifically the costs related to information collection
requirements as defined by the Paperwork Reduction
[[Page 33456]]
Act. As discussed further in Section IV.B.1, the Commission believes
that broker-dealers would update their policies and procedures to
comply with this requirement. We estimate that broker-dealers would
incur an initial aggregate burden of 524,404 hours and an additional
initial aggregate cost of approximately $76.3 million, as well as an
ongoing aggregate annualized burden of 452,524 hours, and an ongoing
aggregate annualized cost of approximately $2.91 million.\1311\ Thus,
the Compliance Obligation of Regulation Best Interest would impose an
initial aggregate cost of at least $214.66 million and an ongoing
aggregate annual cost of at least $110.86 million on broker-
dealers.\1312\
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\1311\ These estimates are based on the following calculations:
80,400 hours + 4,536 hours + 11,064 hours + 428,404 hours= 524,404
hours; $6 million + $7.5 million + $62.8 million = $76.3 million;
and 24,120 hours + 428,404 hours = 452,524 hours. As discussed in
more detail in infra Section V.D, 80,400 hours, 4,536 hours, 11,064
hours and 428,404 hours are estimates for the initial aggregate
burdens for large and small broker-dealers, updating training
module, and training, respectively. In addition, $6 million, $7.5
million, and $62.8 million are estimates for the initial aggregate
costs for large and small broker-dealers and updating training
modules, respectively. Furthermore, 24,120 hours and 428,404 hours
are estimates for the ongoing aggregate burdens for large broker-
dealers and training, respectively. Finally, $2.91 million is the
estimate of the ongoing aggregate cost for small broker-dealers.
\1312\ These estimates are calculated as follows: (65,832 hours
of in-house legal counsel) x ($415.72/hour for in-house counsel) +
(4,536 hours for in-house compliance counsel) x ($365.39/hour for
in-house compliance counsel) + (10,050 hours for reviewing policies
and procedures) x ($446.04/hour for in-house general counsel) +
(15,582 hours for reviewing policies and procedures and update
existing training systems) x ($309.60/hour for in-house compliance
manager) + (428,404 hours for training) x ($233.02/hour for
registered representative) + (27,163 hours for outside legal
counsel) x ($497/hour for outside legal counsel) + (221,127 hours
for updating training module) x ($284/hour for outside senior
programmer or systems analyst)= $214.66 million, and (8,040 hours of
in-house legal counsel) x ($415.72/hour for in-house counsel) +
(8,040 hours for in-house compliance counsel) x ($365.39/hour for
in-house compliance counsel) + (8,040 hours for updating policies
and procedures) x ($229.74/hour for business line personnel) +
(8,040 hours for reviewing policies and procedures) x ($309.60/hour
for compliance manager) + (3,783 hours for outside legal counsel) x
($497/hour for outside legal counsel) + (3,773 hours for outside
compliance services) x ($273/hour for outside compliance services) +
(428,404 hours of training) x ($233.02/hour for registered
representative) = $110.86 million. The hourly wages for in-house
legal and compliance counsel, registered representatives, senior
business analyst, compliance manager, and business-line personnel
are obtained from SIFMA. The hourly rates for outside legal counsel,
outside senior programmer, systems analyst or programmer and outside
compliance services are discussed in infra Section V.D.
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6. Record-Making and Recordkeeping
Regulation Best Interest will also impose record-making and
recordkeeping requirements on broker-dealers with respect to certain
information collected from, or provided to, retail customers. The
Commission is amending Rules 17a-3 and 17a-4 of the Exchange Act, which
specify minimum requirements with respect to the records that broker-
dealers must make, and how long those records and other documents must
be kept, respectively. We are amending Rule 17a-3 by adding a new
paragraph (a)(35) that requires a record of all information collected
from, and provided to, the retail customer pursuant to Regulation Best
Interest, as well as the identity of each natural person who is an
associated person of a broker or dealer, if any, responsible for the
account. This requirement applies to each retail customer to whom a
recommendation of any securities transaction or investment strategy
involving securities is provided. The neglect, refusal, or inability of
a retail customer to provide or update any information about the
customer investment profile will, however, excuse the broker-dealer
from obtaining that information. Rule 17a-4(e)(5) will be amended to
require that broker-dealers retain all records of the information
collected from or provided to each retail customer pursuant to
Regulation Best Interest for at least six years after the earlier of
the date the account was closed or the date on which the information
was last replaced or updated.
The requirement to create certain written records of information
collected from or provided to a retail customer under the Disclosure
Obligation will trigger a record-making obligation under paragraph
(a)(35) of Rule 17a-3 and a recordkeeping obligation under Rule 17a-
4(e)(5) that may impose additional compliance costs on broker-dealers.
In cases where broker-dealers choose to meet part of the Disclosure
Obligation orally under the circumstances outlined above in Section
II.C.1, Oral Disclosure or Disclosure After a Recommendation, the
requirement to maintain a record of the fact that oral disclosure was
provided to the retail customer will trigger a record-making obligation
under paragraph (a)(35) of Rule 17a-3 and a recordkeeping obligation
under Rule 17a-4(e)(5) that may impose additional compliance costs on
broker-dealers. Furthermore, the Care Obligation may require creating
new documents or modifying existing documents to reflect standardized
questionnaires seeking customer investment profile information. These
requirements will also trigger a record-making obligation under
paragraph (a)(35) of Rule 17a-3 and a recordkeeping obligation under
Rule 17a-4(e)(5) that will impose additional compliance costs on
broker-dealers. Currently, under Rule 17a-3(a)(17), broker-dealers that
make recommendations for accounts with a natural person as customer or
owner are required to create, and periodically update, specified
customer account information. However, the information collection
requirements of Rule 17a-3(a)(17) do not cover all aspects of the
``customer investment profile'' that broker-dealers may attempt to
obtain to make a customer-specific suitability determination under the
Suitability Rule.
As noted above, the Conflict of Interest Obligation requires
broker-dealers to establish policies and procedures that are reasonably
designed to address conflicts of interest, including disclosing
material facts associated with the conflicts. The disclosures will be
made pursuant to the Disclosure Obligation and are not expected to
trigger record-making or recordkeeping obligations outside the
Disclosure Obligation.
The Commission is providing estimates of the initial and ongoing
burden hours associated with the record-making and recordkeeping
obligations of the Disclosure, Care, and Conflict of Interest
Obligations, under certain assumptions. These estimates are discussed
in Section IV.B.5. Based on these burden hours estimates, the
Commission expects that the record-making and recordkeeping obligations
of Regulation Best Interest will impose an initial aggregate burden of
17,684,020 hours and an additional initial aggregate cost of $375,732
as well as an ongoing aggregate annualized burden of 5,520,800 hours on
broker-dealers.\1313\
[[Page 33457]]
After monetizing the burden hours, the record-making and recordkeeping
obligations will impose an initial aggregate cost of at least $4,121.73
million and an ongoing aggregate annual cost of at least $1,736.52
million on broker-dealers.\1314\
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\1313\ These estimates are based on the Commission's estimates,
discussed in Section IV.B.5, with respect to the initial and ongoing
aggregate costs and burdens imposed on broker-dealers by the record-
making obligation of proposed Rule 17a-3(a)(35) and the
recordkeeping obligation of the proposed amendment to Rule 17a-
4(e)(5) associated with all component obligations of Regulation Best
Interest. The estimate of the initial aggregate burden is based on
the following calculation: 4,020 hours + 4,080,000 hours +
13,600,000 hours = 17,684,020 hours, where, as discussed in more
detail in Section IV.B.5, 4,020 hours is the estimate of amending
the account disclosure agreement by large broker-dealers, 4,080,000
hours is the estimate of the burden associated with filling out the
information disclosed pursuant to Regulation Best Interest in the
account disclosure agreement, and 13,600,000 hours is the estimate
of the burden to broker-dealers for adding new documents or
modifying existing documents to the broker-dealer's existing
retention system. $375,732 is the estimate of amending the account
disclosure agreement by small broker-dealers pursuant to the record-
making obligation of Rule 17a-3(a)(35). The estimate of the ongoing
annual burden is 3,400,00 hours + 1,060,000 hours + 1,060,000 hours
= 5,520,800 hours where 3,400,00 hours is the estimate of complying
with the recordkeeping obligation of the amendment to Rule 17a-
4(e)(5) and 1,060,000 hours are estimates of both the record-making
and recordkeeping obligations associated with oral disclosure.
\1314\ These estimates are calculated as follows: (2,010 hours
of in-house legal counsel) x ($415.72/hour for in-house counsel) +
(17,680,000 hours for entering and adding new or modifying existing
documents in each customer account) x ($233.02/hour for registered
representative) + (2,010 hours for in-house compliance counsel) x
($365.39/hour for in-house compliance counsel) + (756 hours for
outside legal counsel) x ($497/hour for outside legal counsel) =
$4,121.73 million, and (3,400,000 hours for recordkeeping) x
($365.39/hour for in-house compliance counsel) + (1,060,000 hours
for record-making associated with oral disclosure) x ($233.02/hour
for registered representative) + (1,060,000 hours for record-keeping
associated with oral disclosure) x ($233.02/hour for registered
representative) = $1,736.52 million. The hourly wages for in-house
legal and compliance counsel and registered representatives are
obtained from SIFMA. The hourly rates for outside legal counsel are
discussed in infra Section IV.B.5.
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7. Approaches to Quantifying the Potential Benefits
As discussed above, several commenters suggested that we quantify
the existing harm to investors under the baseline and the corresponding
benefit resulting from Regulation Best Interest. We continue to believe
that it is not possible to quantify, with meaningful precision, either
the existing harm or the specific benefits we expect to flow from
Regulation Best Interest. Such an analysis, including one that would
produce ranges, depends on many contingent factors that render any
estimate insufficiently precise to inform our policy choices.\1315\
Nonetheless, the Commission has endeavored to estimate some of the
potential benefits that may result from Regulation Best Interest using
a variety of methodologies, which are explained below in more detail
along with certain caveats and the principal assumptions relied on.
Specifically, we have attempted to estimate the benefit that may result
from a reduction in fees due to increased competition; we also consider
the potential benefit arising from a reduction in the relative
performance differences of broker-sold and direct-sold mutual funds.
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\1315\ See supra footnote 1156 and subsequent text for a
discussion of these factors. For these reasons and because we
believe that quantification of the costs and benefits of the
alternatives discussed in infra Section III.E would require still
further assumptions, lead to additional imprecision, and yield less
meaningful results, we have not included quantified estimates of the
economic effects of these alternatives.
---------------------------------------------------------------------------
The quantification exercise below provides an estimate for some of
the potential benefits associated with Regulation Best Interest. For
example, as discussed in more detail below, a potential reduction in
fees can benefit retail customers in other ways beyond reducing the
total dollar amount paid for investment services. Furthermore, as
discussed elsewhere in this economic analysis, the rule is expected to
generate other benefits for retail customers that we are not able to
meaningfully quantify.
a. Benefit to Investors Due to a Potential Reduction in Fees
As discussed above, Regulation Best Interest may reduce the
attractiveness of certain products to broker-dealers due to the Care
Obligation (e.g., the emphasis on the need to consider cost, among
other things) and the Conflict of Interest Obligation (e.g., addressing
conflicts of interest, including product menu limitations) and/or may
reduce retail customers' aggregate demand for certain products due to
the Disclosure Obligation (e.g., due to a reduction in any information
asymmetry with respect to fees). To the extent that Regulation Best
Interest produces these effects on certain products, the affected
product sponsors may react by lowering the fees that they charge retail
customers on these products to be more competitive, or by repackaging
these products into new products that are more competitively priced.
The increased competition generated by the lower fees for affected
products may further incentivize other product sponsors (i.e., those
not directly affected by Regulation Best Interest) to lower their fees
as well.\1316\ Alternatively, a product sponsor may preempt the
potential decline in the aggregate demand for its products by lowering
the fees before other sponsors do.
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\1316\ A product sponsor that does not lower its fees on a given
product may risk experiencing low retail customer aggregate demand
or low demand from broker-dealers as a result of Regulation Best
Interest. To stay competitive this product sponsor may have to lower
the fees on its product.
---------------------------------------------------------------------------
For the purposes of calculation, we assume that this potential
competition in prices results in a new long-run equilibrium in this
product market, in which product sponsors charge fees that are close to
or equal to their marginal costs. Lower fees translate into direct
savings to retail customers. If a portion of fees collected from retail
customers serves to compensate broker-dealers for selling certain
investment products, then lowering those fees could also translate into
less severe conflicts of interest. Thus, a reduction in fees may
improve the efficiency of the recommendations that broker-dealers make
to retail customers. This potential increase in the efficiency of the
recommendations received also benefits retail customers.\1317\
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\1317\ For purposes of this analysis, we assume that product
sponsors respond to competitive pressures by lowering their fees.
However, competition may affect quality in addition to price. For
example, product sponsors may choose to offer higher quality
products which may be costlier to produce (e.g., because they must
hire more skilled managers or apply more costly technology) and as
such require higher fees. Alternatively, product sponsors may lower
fees by reducing the quality of their product (e.g., hiring fewer
skilled managers) and, as a result, offering lower fee products that
may produce lower average returns. Competition along both of these
dimensions may allow retail customers to choose different
combinations of quality and price, depending on their individual
preferences.
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The market for mutual fund products may illustrate the potential
for attaining such a new long-run equilibrium as a result of Regulation
Best Interest. We focus on mutual funds for this analysis because of
the available data for mutual funds, but we expect the same or similar
dynamics could apply to other financial products. As this market
transitions toward this new long-run equilibrium, total fund expenses
(i.e., distribution expenses and management fees) that are in excess of
the marginal cost of distributing and operating the fund may be reduced
in a number of ways, including by lowering fees, reliance on
alternative distribution channels, or exiting the market in whole or in
part (i.e., by limitations on offerings). Below we attempt to quantify
the benefits associated with this potential long-run equilibrium in the
market for mutual fund products as a result of such reduction in fees,
relative to the baseline, assuming all funds reduced fees to marginal
costs. To this end, we start with the current distribution of fees of
funds within each Center for Research in Security Prices (CRSP)
objective class.\1318\ We focus on funds that have reported this
information in 2018 in CRSP. We perform the analysis using total fees
(i.e., fund expense ratios). As an alternative, we also perform the
analysis using the component of the total fees that are allocated
toward distribution and
[[Page 33458]]
marketing expenses, and that we can observe, namely 12b-1 fees.\1319\
---------------------------------------------------------------------------
\1318\ Calculated based on data from the Center for Research in
Security Prices (CRSP), University of Chicago Booth School of
Business. Funds with different objectives may incur different
marginal costs due to the frequency of trading in the markets that
are reflective of the objective of the fund, advertising to reach a
certain clientele, distribution costs, etc. The CRSP Mutual Fund
dataset includes a breakdown of mutual funds by their objective
types.
\1319\ 12b-1 fees are paid out of fund assets to cover the costs
of marketing and selling fund shares. ``Distribution fees'' include
fees to compensate brokers and others who sell fund shares, and to
pay for advertising and printing and mailing prospectuses to new
investors. ``Shareholder service fees'' are fees that cover the cost
of responding to investor inquiries and providing investors with
information. This analysis excludes loads because, unlike 12b-1
fees, loads cannot be separately broken out.
---------------------------------------------------------------------------
We estimate the marginal cost of distributing and operating a non-
index fund in a given CRSP objective class (i.e., strategy) as the
minimum total fee of the funds in that class, after excluding index
funds. Similarly, we estimate the marginal cost of operating an index
fund in a given CRSP objective class as the minimum total fee of the
index funds in that class. We then calculate the maximum ``excess fee''
for a fund (index or non-index) as the difference between the actual
total fee of the fund and the marginal cost of the CRSP objective class
that contains the fund. By construction, the excess fee cannot be
negative.
We obtain an aggregate amount of reduced fees of approximatively
$22.2 billion for non-index funds and $1.4 billion for index funds
annually at the new potential equilibrium.\1320\ The aggregate amount
of saved fees across index and non-index funds becomes approximatively
$23.6 billion. Similarly, if we focus on 12b-1 fees only, the aggregate
amount of saved fees are $9.13 billion for non-index funds and $0.32
billion for index funds, or $9.45 billion across both index and non-
index funds.
---------------------------------------------------------------------------
\1320\ We calculate the dollar value associated with these
excess fees by multiplying the excess fees of a fund with total net
assets (TNA) of the fund and then aggregating across funds. This
amount represents the capital that would be reallocated towards more
efficient funds and can be thought of as ``fees saved'' by retail
customer as this product market shifts from the baseline equilibrium
to the new equilibrium.
---------------------------------------------------------------------------
Using certain assumptions to calculate the present value of this
potential fee reduction,\1321\ we calculate the net benefit of the new
equilibrium as the difference between the two present values of
declining perpetuities that pay the dollar value associated with excess
fees under the baseline equilibrium and the new equilibrium,
respectively, for each of the three scenarios. When using the total
fees, we obtain an expected net benefit of $35.21 billion in the
moderate decay scenario, $59.15 billion in the accelerated decay
scenario, and $76.49 billion in the rapid decay scenario. Similarly,
when using 12b-1 fees only, we obtain an expected net benefit of $14.10
billion in moderate decay scenario, $23.69 billion in the accelerated
decay scenario, and $30.63 billion in the rapid decay scenario.
---------------------------------------------------------------------------
\1321\ First, we note that expense ratios for equity mutual
funds have declined at a rate of about 3% per year since 2000. This
rate doubles to 6% if we focus on the period following FINRA's
adoption of the Suitability Rule in 2011. We assume that under the
current equilibrium, or ``baseline equilibrium,'' excess fees--as
defined above--would continue to decline at the rate of 3% per year.
This rate of decay corresponds to a half-life of approximatively 23
years. We further assume that as the product market shifts towards
the new equilibrium, excess fees decline at a rate that is at least
as high as the post-2011 rate. Because Regulation Best Interest
enhances the broker-dealer standard of conduct established by the
Suitability Rule--particularly with respect to the disclosure,
mitigation, or elimination of conflicts of interest, which is not
addressed by the Suitability Rule--and the federal securities laws,
we believe that a rate of decay that is at least as large as the one
observed in the post-2011 period is not unreasonable. Under this
assumption, we consider three scenarios: (1) Moderate decay at 6%;
(2) accelerated decay at 9%; and (3) rapid decay at 12%. The half-
life for each of these scenarios is 11.5 years, 7.7 years, and 5.8
years, respectively. Finally, we assume that the opportunity cost of
the excess fees is equal to the expected rate of return on the
value-weighted market portfolio, as defined in CRSP, as these fees
encumber capital that would have otherwise been invested in
efficient funds. To estimate the expected return on the market
portfolio, we assume that the discount rate is the geometric average
of the annual rate of return on the market portfolio over the period
1927-2018, namely 9.76%.
---------------------------------------------------------------------------
b. Benefits to Investors Due to a Potential Reduction in the Relative
Underperformance of Broker-Versus Direct Sold Mutual Funds
Another way to estimate the potential benefits of Regulation Best
Interest is to use aspects of the approach used in the CEA Study and
the DOL RIA, as suggested by several commenters.\1322\ Specifically, we
rely on academic literature claiming that, to varying degrees, broker-
sold mutual funds underperform direct-sold mutual funds and assume that
underperformance reflects agency costs associated with the conflicts of
interest that may be present in recommendations provided by broker-
dealers. Although this literature addresses only a portion of the AUM
affected by Regulation Best Interest, we use methods from these studies
to estimate the monetary effect the final rule might produce by
reducing the effect that conflicts of interest have on the
recommendations provided by broker-dealers.
---------------------------------------------------------------------------
\1322\ See supra footnote 1167.
---------------------------------------------------------------------------
Total AUM of load and no-load long-term mutual funds in the U.S. as
of the end of 2018 are approximately $12.4 trillion, with $10.4
trillion attributable to no-load funds and $2.1 trillion attributable
to load funds.\1323\ To estimate the monetary effect of potential
conflicts of interest as they pertain to mutual funds, we use estimates
of the difference in net returns (gross returns on a fund's performance
less fees and other expenses associated with the fund) between broker-
sold funds and funds that are direct-sold from Reuter (2015).\1324\ We
then apply this difference to the aggregate market capitalization of
load funds, which we assume are sold with a recommendation from a
broker-dealer because we cannot identify the channel through which
mutual funds are sold or whether each sale through the broker-sold
channel involves a recommendation. To the extent that no-load funds are
also sold by broker-dealers, this assumption may cause us to
underestimate the portion of mutual fund AUM that are sold with a
recommendation from a broker-dealer.\1325\ Because the data in Reuter
(2015) ends in 2012, for the purposes of this approach we assume that
the relative underperformance of broker-sold funds, and hence our
application of this underperformance to load funds as a proxy for funds
sold with a recommendation from a broker-dealer, remains unchanged from
2012.\1326\
---------------------------------------------------------------------------
\1323\ See Investment Company Institute 2019 Fact Book, Figure
6.12.
\1324\ See Reuter (2015), supra footnote 1095. In contrast to
the DOL RIA, we do not base our analysis on excess loads, as
estimated in Christoffersen et al. (2013), supra footnote 1081.
Prior commenters noted that the average excess load, by definition,
is zero and would likely yield a much lower estimate of aggregate
harm, than the estimate published by the CEA and include in the DOL
RIA. See, e.g., Lewis (2017), supra footnote 1099. See also supra
footnotes 1169 and 1170.
\1325\ Brokers may still be compensated for selling no-load
funds by 12b-1 fees, revenue sharing, or other arrangements.
\1326\ See supra footnote 1102 for discussion of how trends in
the relative performance of load funds may have changed in more
recent years.
---------------------------------------------------------------------------
Reuter (2015) employs a variety of methods in computing the
difference in net returns between broker-sold and direct-sold actively
managed funds, including different ways of computing net returns (e.g.,
net return, net return plus 12b-1 fees, net alphas, and ordinary least-
squares and weighted least-squares regression methods), different
samples (e.g. ``non-specialized domestic equity''), and different
weighting schemes (e.g. equally weighted or value weighted returns).
Reuter concludes by noting that the performance difference between
broker-sold and direct-sold actively managed mutual funds is likely to
fall between 0.20% and 0.47%, depending whether or not 12b-1 fees are
included in the estimation. Given that the underperformance only
affects broker-sold funds, and applying these underperformance
estimates to load funds, the estimated monetized underperformance of
broker-sold funds
[[Page 33459]]
ranges from $4.1 billion per year to $9.7 billion per year.
As discussed elsewhere in this release, we expect Regulation Best
Interest will reduce the severity of conflicts of interest that may
contribute to the underperformance between broker-sold and direct-sold
mutual funds. However, the range noted above most likely overestimates
the expected reduction in harm associated with broker-sold mutual funds
due to Regulation Best Interest for a number of reasons. First, as
discussed by Bergstresser et al. (2009), broker-sold funds can be sold
by both broker-dealers and investment advisers (e.g., dually registered
investment advisers), and the data these studies relied upon is not
sufficiently granular to identify the fraction of broker-sold funds
sold by each type of financial professional.\1327\ Because Regulation
Best Interest applies to registered broker-dealers, this range would
need to be narrowed to reflect the proportion of broker-sold funds sold
by registered broker-dealers.
---------------------------------------------------------------------------
\1327\ See Bergstresser et al. (2009), supra footnote 1048.
---------------------------------------------------------------------------
Second, the estimated range fully attributes the differences
between direct-sold funds and broker-sold funds to conflicts of
interest between retail customers and broker-dealers. This might over-
estimate the benefits of Regulation Best Interest because there might
be other unobservable systematic differences between investors who
choose direct-sold funds versus those who choose to employ a financial
professional. For example, retail customers that buy broker-sold funds
might be willing to pay more for those funds if they receive intangible
benefits from a broker-dealer's recommendation that are not reflected
in the relative performance between funds sold through these two
channels. Furthermore, not all sales in the broker-sold channel are
triggered by recommendations provided by broker-dealers or their
associated persons. For example, customer-directed transactions may not
involve a recommendation at all.
Third, measuring a fund's performance using its net return relative
to a benchmark might not be the most accurate measure of a fund
manager's skill or the value created by a fund to an investor.\1328\
Therefore, estimating investor harm assuming this definition of the
value created by a fund might potentially overstate or understate this
harm.
---------------------------------------------------------------------------
\1328\ See supra footnote 1176.
---------------------------------------------------------------------------
Taking into account these caveats,\1329\ to the extent that
Regulation Best Interest mitigates, and in the limit, eliminates the
adverse effects of conflicts of interest on broker-dealers'
recommendations, we estimate that the benefits attributable to
Regulation Best Interest could be as large as $4.1 billion per year to
$9.7 billion per year when estimated assuming that the relative
underperformance of broker-sold mutual funds estimated in the academic
literature reflects conflicts of interest that will eventually be
eliminated.
---------------------------------------------------------------------------
\1329\ See supra footnotes 1172-1178 for further discussion of
the limitations that apply in using the relative underperformance of
broker-sold mutual funds as an estimate of investor harm and,
therefore, the benefits of Regulation Best Interest.
---------------------------------------------------------------------------
As with our other estimates of the benefits above, we assume that
there is already a decreasing trend in the underperformance gap under
the baseline that is consistent with the decreasing trend in mutual
fund expense ratios of 3%, and that Regulation Best Interest will
accelerate this trend to a decay rate under three scenarios: (1)
Moderate decay at 6%; (2) accelerated decay at 9%; and (3) rapid decay
at 12%. Similarly, we assume a discount rate of 9.76% as above to value
these cash flows. Under these assumptions, the present value of the
potential benefits of Regulation Best Interest in the mutual fund
sector, relative to the baseline, from limiting or eliminating the
adverse effects of conflicts of interest could be as large as
approximately $6.8 to $16 billion in the moderate decay scenario, $11.4
to $26.7 billion in the accelerated decay scenario, and $14.7 to $34.5
billion in the rapid decay scenario.
Finally, we can obtain an approximate estimate of the present value
of the costs associated with Regulation Best Interest using the costs
estimated in Section IV for purposes of the Paperwork Reduction Act,
which imply aggregate initial costs of approximately $5.96 billion and
ongoing costs of $2.37 billion. Assuming the initial costs are incurred
one year from the rule's enactment, and using a discount rate of 9.76%
as above, the present value of these costs is approximately $27.5
billion. Note that this cost estimate cannot be directly compared with
the benefit estimates above as the benefits estimates are with respect
to mutual funds only.
D. Efficiency, Competition, and Capital Formation
As discussed above, Regulation Best Interest is designed to address
the agency costs that arise when an associated person of the broker-
dealer provides a recommendation to a retail customer that may not be
fully addressed by the regulatory baseline. Regulation Best Interest is
intended to reduce agency costs and other costs by enhancing the
standard of conduct of broker-dealers, increasing the effectiveness of
disclosure to allow retail customers to make a more informed decision
with respect to the recommendation they receive and by requiring
broker-dealers to implement policies and procedures reasonably designed
to reduce the effect of conflicts of interest on recommendations to
retail customers. Specifically, the Disclosure Obligation and Conflict
of Interest Obligation require broker-dealers to disclose information
that, while not necessarily new in all instances, will reach retail
customers more directly and more timely than under the regulatory
baseline. In addition, the disclosed information would raise a retail
customer's salience of fees, scope of the relationship, conflicts of
interest, and limitations of the menu of securities from which the
retail customer receives recommendations as potential factors affecting
the recommendations of a broker-dealer or its associated persons. The
content and form of disclosure may help some retail customers make more
informed decisions with regards to whether to act on a recommendation
provided by an associated person of the broker-dealer. Regulation Best
Interest may also reduce the agency costs faced by these retail
customers.
The Conflict of Interest Obligation also requires broker-dealers to
implement policies and procedures to reduce the effect of conflicts of
interest and securities menu limitations on recommendations to retail
customers. For broker-dealers that implement more effective policies
and procedures, the obligation may increase the efficiency of the
recommendations for their retail customers. As a result, Regulation
Best Interest may reduce the agency costs faced by these retail
customers.
The Care Obligation requires a broker-dealer and its associated
persons to have a reasonable basis to believe that a recommendation
provided to a retail customer is in the customer's best interest. This
reasonable basis should include factors similar to those identified by
the Suitability Rule of the current regulatory regime as well as
additional factors. For example, relative to the regulatory baseline,
the Care Obligation requires that a broker-dealer and its associated
persons consider costs, among other factors, and establish a direct
link between the attributes of a security or investment strategy and
the retail customer's best interest. By
[[Page 33460]]
requiring consideration of costs and by including an explicit link
between the investment-related factors and the best interest, the
obligation may increase the efficiency of the recommendations for the
retail customer. As a result, Regulation Best Interest may reduce the
agency costs faced by these retail customers.
Through these effects, as discussed below, Regulation Best Interest
may have an effect on competition, capital formation, and efficiency.
1. Competition
Regulation Best Interest may have competitive effects for the
market for investment advice and may affect how broker-dealers compete
with each for retail customers. As discussed in Section III.C, the
brokerage industry currently recognizes that broker-dealers and their
associated persons may have conflicts of interest that create
incentives for broker-dealers or their associated persons to make
recommendations that, while suitable for their retail customers, may
not be in the best interest of (and may not be the most efficient
recommendations for) such customers. As noted above in Section
III.B.2.c, a FINRA survey suggested that broker-dealers currently
employ different methods for managing conflicts of interest, with some
methods being more effective than others at reducing the effect of
conflicts of interest on recommendations. These methods generally
depend on the size and complexity of a broker-dealer's business model.
Against this backdrop, the cost of complying with Regulation Best
Interest, scaled by the size and complexity of a broker-dealer's
business activities, may be higher for broker-dealers that currently
employ less effective methods for managing conflicts of interest.
Relative to broker-dealers that face lower compliance costs,
broker-dealers that face higher compliance costs may be at a
disadvantage when competing for retail customers and may not be able to
fully pass on these costs to their retail customers. For example, the
presumption related to the titles ``adviser'' and ``advisor'' may
impose higher costs on broker-dealers that use these terms in their
names or titles, but that are not dual-registrants.\1330\ The extent to
which broker-dealers are able to pass on costs to their retail
customers depends on a number of factors that include the availability
of close substitutes for the services provided by broker-dealers and
the cost to retail customers of switching accounts to a competing
broker-dealer, investment adviser, or other financial services
provider. If broker-dealers are unable to pass costs through to
customers, it is possible that some of the broker-dealers that face
high compliance costs may decide to exit the market for investment
advice in the capacity of a broker-dealer.
---------------------------------------------------------------------------
\1330\ See supra footnotes 1216-1220.
---------------------------------------------------------------------------
The potential competitive effects associated with compliance costs
could be further exacerbated by how broker-dealers choose to comply
with the component obligations of Regulation Best Interest. As
discussed in Section III.C.4, broker-dealers are given flexibility when
addressing conflicts of interest through policies and procedures.
Because Regulation Best Interest and the component obligations are
generally principles-based, a broker-dealer would have to determine
what constitutes effective means of addressing a given conflict of
interest, and how it should relate to the size and complexity of a
broker-dealer's business model. For a broker-dealer that is dually
registered or for a broker-dealer that is affiliated with an investment
adviser, the overall costs of complying with Regulation Best Interest
may encourage the broker-dealer to exit the market for providing
investment advice in the capacity of a broker-dealer and, instead,
provide advice only in the capacity of an investment adviser. Whereas
broker-dealers have explicit requirements to establish written policies
and procedures reasonably designed to disclose, mitigate or eliminate
identified conflicts of interest that create an incentive for the
associated persons to place their interest ahead of the retail
customer, the fiduciary standard for investment advisers relies on full
and fair disclosure and informed consent to address conflicts of
interest.\1331\ Investment advisers must also adopt and implement
written policies and procedures reasonably designed to prevent
violations of the Advisers Act, including violations related to
undisclosed conflicts of interest.\1332\ More generally, compliance
costs may drive such firms to no longer offer advice in the capacity of
a broker-dealer if firms anticipate the profitability of their broker-
dealer business under Regulation Best Interest to be lower than the
profitability of their advisory business.
---------------------------------------------------------------------------
\1331\ As discussed in supra Section I.C, some broker-dealer
commenters also expressed the view that by requiring mitigation of
financial incentives, Regulation Best Interest would require more of
broker-dealers than what is required of investment advisers under
their fiduciary duty, which could create a competitive issue for
broker-dealers that could further encourage migration from the
broker-dealer to investment adviser model and result in a loss of
choice for retail customers. Because of this competitive issue,
dually registered financial professionals could be incentivized to
recommend advisory accounts through compensation.
\1332\ See Advisers Act Rule 206(4)-7.
---------------------------------------------------------------------------
Similar concern over costs of complying with Regulation Best
Interest may deter some broker-dealers from entering the market for
investment advice. Higher entry costs may have long-run competitive
effects on prices paid by retail customers, as incumbents adjust their
strategic behavior to reflect a lower threat of competition from new
entrants, relative to the baseline.\1333\ Regulation Best Interest may
also encourage competition for retail customers to the extent that the
Disclosure Obligation increases the retail customers' salience to
variables such as fees and conflicts of interest that would facilitate
comparability across broker-dealers. For example, retail customers may
form preferences over some or all of the disclosed variables, such as
fees, securities or service offerings, and range of conflicts of
interest, and may choose one broker-dealer over another or over an
investment adviser based on these preferences. In turn, if firms
anticipate that there is a possibility that retail customers may use
the disclosed variables for comparability purposes, broker-dealers may
compete over some or all of these variables to attract more retail
customers. This potential competition may result in greater securities
or service offerings, or lower fees for retail customers.
---------------------------------------------------------------------------
\1333\ See, e.g., Mas-Colell et al. (1995).
---------------------------------------------------------------------------
Regulation Best Interest may also affect how broker-dealers compete
with each other when negotiating with investment sponsors for access to
securities. The findings of the aforementioned FINRA survey suggest
that broker-dealers may face different degrees of competition when
negotiating with product sponsors for access to certain securities. For
instance, the survey observed that some product sponsors rate the
broker-dealers that are interested in distributing their securities
based on criteria such as product expertise and experience, the quality
of the control environment, and the strength of their sales practices.
Broker-dealers that have higher ratings, based on these criteria may be
given access to a broader range of securities, including more complex
securities. In contrast, broker-dealers that have lower ratings may be
given access to a narrower range of securities. To the extent
Regulation Best Interest has the effect of increasing and homogenizing
the product expertise and experience (e.g., the Care Obligation) and
the quality of the
[[Page 33461]]
control environment (e.g., the Conflict of Interest Obligation) across
the complying broker-dealers, the final rule may increase the
competition across firms when negotiating with product sponsors. This
increased competition may allow product sponsors to economize on the
distribution costs, and may result in lower fees for retail customers.
Regulation Best Interest may also have competitive effects for the
market for investment advice, more generally. Regulation Best Interest
may affect how broker-dealers compete with firms that provide advice in
a capacity other than as a broker-dealer, such as an investment
adviser. Under the regulatory baseline, investment advisers owe a
fiduciary duty to their clients. Some commenters describe this standard
of conduct as a ``higher'' standard compared to the standard of conduct
applies to broker-dealers under the regulatory baseline.\1334\
---------------------------------------------------------------------------
\1334\ See Letter from Ken Fisher, Fisher Investments (Jul. 31,
2018) (``Fisher Letter''); PIABA Letter; FPC Letter; NASAA August
2018 Letter; U. of Miami Letter; Rhoades August 2018 Letter.
---------------------------------------------------------------------------
For some retail customers the duty owed to them by their firm or
financial professional may be a determining factor when deciding which
type of firm or financial professional they want to use. As previously
noted, key elements of the standard of conduct that applies to broker-
dealers, at the time a recommendation is made, under Regulation Best
Interest will be substantially similar to key elements of the standard
of conduct that applies to investment advisers pursuant to their
fiduciary duty under the Advisers Act. As such, the standard of conduct
under Regulation Best Interest may make broker-dealers more attractive
to certain retail customers who seek recommendations for securities
transactions or investment strategies in a more cost effective manner,
but worry about the duties owed to them by their financial
professional. As a result, Regulation Best Interest may increase the
competition between broker-dealers and investment advisers for retail
customers interested in obtaining investment advice. In competing for
business, broker-dealers and investment advisers may lower their fees,
resulting in retail customers paying less for obtaining investment
advice. To the extent that this potential lower cost causes an increase
in the demand for investment advice in the capacity of a broker-dealer,
this positive competitive effect may offset some of the negative
potential competitive effects of Regulation Best Interest, such as
higher cost of entry in the market for investment advice in the
capacity of a broker-dealer relative to the baseline, as discussed
above.
The Disclosure Obligation may also encourage competition for retail
customers across broker-dealers and investment advisers. As noted
above, the Disclosure Obligation would require broker-dealers to make
full and fair disclosure of all material facts relating to the scope
and terms of the relationship with the retail customer and all material
facts relating to conflicts of interest that are associated with a
recommendation. Investment advisers are also required to provide full
and fair disclosure of material facts about similar elements under the
current regulatory regime. To the extent that the Disclosure Obligation
raises the salience of variables that may facilitate comparison across
broker-dealers and investment advisers, Regulation Best Interest may
encourage competition between broker-dealers and investment advisers.
Regulation Best Interest may also have competitive effects for
financial professionals that offer investment advice in a capacity
other than that of a broker-dealer (e.g., investment advisers and other
financial professionals that are not registered with the Commission,
such as insurance companies, banks, and trust companies). As discussed
above in Section III.C.4, depending on the effectiveness of disclosure
and the effectiveness of policies and procedures that address
securities menu limitations (e.g., the Disclosure Obligation and
Conflict of Interest Obligation), Regulation Best Interest may reduce
the retail customers' aggregate demand for certain securities that are
distributed by broker-dealers and securities on which broker-dealers or
their associated persons provide recommendations. Instead, retail
customers may access some of these or comparable securities from other
financial professionals. For example, a retail customer may access
certain securities offered by broker-dealers through corporate
fiduciaries such as commercial banks or trust companies. Alternatively,
a retail customer may open an advisory account and access securities
that are comparable to those offered by the broker-dealer. To the
extent that Regulation Best Interest causes a potential reduction in
the retail customers' aggregate demand for securities offered by
broker-dealers, retail customers' aggregate demand may increase for
securities offered by non-broker-dealers. Regulation Best Interest may
also affect how product sponsors compete for flows from retail
customers. As discussed above in Section III.C.4, depending on the
effectiveness of disclosure and the effectiveness of policies and
procedures that address limitations of the menu of securities (e.g.,
Disclosure and Conflict of Interest Obligations), Regulation Best
Interest may reduce the aggregate demand for certain sponsors'
securities. To remain competitive, product sponsors that face decreased
demand as a result of Regulation Best Interest may reprice their
securities (e.g., by offering different share classes), lower their
fees, or seek alternative distribution channels that are not affected
by Regulation Best Interest. For example, product sponsors may choose
to distribute their securities through investment advisers or through
commercial banks to the extent that the banks can engage in limited
broker-dealer activity, subject to certain conditions, without having
to register as broker-dealers.\1335\ Finally, product sponsors may
choose to distribute their securities directly to retail investors
rather than indirectly, through broker-dealers. The potential
competitive effect of Regulation Best Interest on product sponsors may
manifest itself in lower product fees for retail customers.
---------------------------------------------------------------------------
\1335\ See Exchange Act Sections 3(a)(4)(B) and 3(a)(5)(B) and
rules thereunder (providing banks exceptions from ``broker'' and
``dealer'' status for specified securities activities).
---------------------------------------------------------------------------
2. Capital Formation and Efficiency
Regulation Best Interest is designed to reduce the agency and other
costs to retail customers associated with obtaining recommendations
from broker-dealers. As discussed above, to reduce these costs,
Regulation Best Interest would impose obligations on broker-dealers
that are designed to increase the efficiency of the recommendations to
retail customers relative to the recommendations that broker-dealers
and their associated persons provide to retail customers under the
regulatory baseline.
To the extent retail customers receive recommendations that are
more efficient relative to the baseline, Regulation Best Interest would
increase the efficiency of the portfolio allocation that a retail
customer makes as a result of the recommendation received. As discussed
above in Sections III.A.2 and III.C, this would occur when a retail
customer increases the allocative efficiency of his or her portfolio
when the recommendation leads to a reallocation of resources across
time and market and economic conditions that generate a higher net
benefit to the retail customer, relative to the baseline. Thus, to the
extent that Regulation Best Interest
[[Page 33462]]
increases the efficiency of the associated persons' recommendations to
retail customers, the final rule would have a positive effect on the
retail customers' allocative efficiency.
Regulation Best Interest may also increase the efficiency of the
recommendations involving rollovers or transfers of assets from
retirement accounts to other taxable or non-taxable accounts, relative
to the baseline. As noted above, the incentives associated with this
type of recommendation are particularly acute because of the size of
the transaction and the importance to the retail customer (e.g., given
that the amount of assets associated with such recommendations can be a
significant portion of a retail customer's net worth). The potential
increase in the efficiency of this type of recommendation may improve
the allocative efficiency of assets held in retirement accounts, and
may encourage retail customers to consider a rollover or transfer of
assets recommendation to potentially increase the efficiency of their
retirement asset allocation.
Similarly, Regulation Best Interest may increase the efficiency of
the recommendations regarding account types. As discussed above,
currently, a dual-registrant may have an incentive to recommend the
account type that benefits the dual-registrant at the expense of the
retail customer. The potential increase in the efficiency of this type
of recommendation under Regulation Best Interest relative to a similar
recommendation that the dual-registrant may provide under the baseline
may improve the allocative efficiency of the retail customer's assets
held in this account.
The possibility that Regulation Best Interest may increase the
efficiency of the recommendations provided by the associated persons of
the broker-dealer may enhance the attractiveness of broker-dealer
services for those investors who currently do not invest through
broker-dealers. Although there are costs associated with these
requirements, the protections deriving from these requirements may
benefit investors, issuers, and intermediaries by helping to create a
marketplace where a higher number of retail customers invest through
broker-dealers, relative to the current regulatory regime. If retail
customers are more willing to participate in the securities markets
through broker-dealers, Regulation Best Interest would have a positive
effect on capital formation.
E. Reasonable Alternatives
Regulation Best Interest establishes a new standard of conduct for
broker-dealers under the Exchange Act that is intended to address the
agency costs that retail customers face when obtaining recommendations
of securities transactions and investment strategies from broker-
dealers and their associated persons. This new standard is intended to
enhance investor protection, while preserving, to the extent possible,
retail investor access (in terms of choice and cost) to differing types
of investment services and securities. As noted above, the Commission
considered several reasonable alternative policy choices, including (1)
applying the fiduciary standard under the Advisers Act to broker-
dealers, and (2) adopting a ``new'' uniform fiduciary standard of
conduct applicable to both broker-dealers and investment advisers, such
as that recommended by the staff in the 913 Study. The Commission also
considered adopting similar standards to those the DOL had provided
under its fiduciary rule to broker-dealers and investment
advisers.\1336\ We examine the effects of these primary alternatives,
as well as several other alternatives that we considered both in the
Proposing Release and in response to comments.
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\1336\ We had additionally discussed in the Proposing Release an
alternative of a principles-based best interest standard. See
Proposing Release at 21663. Some of the economic effects of this
alternative would be similar to the economic effects of any of the
fiduciary alternatives, which would also be principles-based.
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1. Fiduciary Standard for Broker-Dealers
As discussed in the Proposing Release and as raised by commenters,
instead of adopting our approach in Regulation Best Interest, the
Commission could have alternatively imposed a form of fiduciary
standard on broker-dealers providing recommendations to retail
customers. The Commission recognized that fiduciary standards vary
among investment advisers, banks acting as trustees or fiduciaries, or
ERISA plan providers, but fiduciaries are generally required to act in
the best interest of their clients.\1337\
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\1337\ See Proposing Release at footnotes 328-329. For example,
an investment adviser's fiduciary duty under the Advisers Act
comprises a duty of care and a duty of loyalty. This combination of
care and loyalty obligations has been characterized as requiring the
investment adviser to act in the ``best interest'' of its client at
all times. See Fiduciary Interpretation.
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Under any of the options considered, the Commission would have to
craft a mechanism to apply a uniform standard of conduct to all
financial professionals regardless of how they engage with their retail
customers. This approach was advocated by certain commenters, many of
whom asserted that it would reduce retail investor confusion as it
would ensure that investors are provided the same standard of care and
loyalty regardless of what type of financial professional they
engage.\1338\ As discussed above and in detail further below we
believe, in practice, that such uniformity would be difficult to
implement and disruptive to pursue as a result of various factors,
including the key differences in the ways broker-dealers and investment
advisers engage with retail clients. Achieving such uniformity could
require narrowing the type and scope of services permitted to be
provided by various types of financial professionals. If we were to
pursue such an approach, it could reduce retail customers' confusion
with respect to the duties owed to them by the broker-dealers and
investment advisers and could reduce potential costs to some investors
associated with choosing a type of relationship that is not well suited
to them, because under a uniform standard, retail customers of each
type of financial professional would be subject to the same standard of
conduct.
---------------------------------------------------------------------------
\1338\ See, e.g., Better Markets Letter at 24.
---------------------------------------------------------------------------
However, this uniformity could come at a cost to both investors and
financial service providers. Such an approach could result in a
standard of conduct for broker-dealers that is not appropriately
tailored to the structure and characteristics of the broker-dealer
model (i.e., transaction specific recommendations and compensation),
and might not properly take into account, or build upon, existing
obligations that apply to broker-dealers, including under FINRA
rules.\1339\ A potential implication of this paradigm shift would be
that broker-dealers would face significant compliance costs, at least
in the short run, relative to the regulatory baseline. Potentially
higher compliance costs could increase the incentive to offer
investment advice in the capacity of investment adviser and could
decrease the incentive to offer investment advice in the capacity of
broker-dealer. To the extent broker-dealers act on the increased
incentives and decide to participate in the market for investment
advice only in the capacity of investment advisers, retail customers
could experience an increase in the cost of obtaining investment
advice, relative to the baseline. Furthermore, as noted above, the
potential exit of broker-dealers from the market for investment advice
in the broker-dealer capacity could limit how retail customers would
access certain securities or investment strategies and how they would
pay for investment advice, which, in turn, could increase
[[Page 33463]]
their costs of obtaining investment advice, relative to the
baseline.\1340\ To the extent broker-dealers decide to continue to
participate in the market for investment advice in the capacity of
broker-dealers, they could pass on increased compliance costs, in full
or in part, to their retail customers. As a result, retail customers
could experience an increase in the cost of obtaining investment
advice, relative to the baseline. The potential increase in the cost of
accessing investment advice could push some retail customers outside
the market for investment advice from Commission-registered broker-
dealers and investment advisers.\1341\
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\1339\ See also 913 Study at 139-143.
\1340\ See supra Section III.D.1.
\1341\ See supra Section I.A for a discussion of access to
investment advice in the context of the DOL Fiduciary Rule.
---------------------------------------------------------------------------
We discuss each of the three options for applying a uniform
fiduciary standard in more detail below. We compare each of the three
alternatives against the regulatory baseline, which is the current
broker-dealer regulatory regime. In addition, we briefly discuss the
differences between the standard of conduct imposed by Regulation Best
Interest and the fiduciary standard under the Advisers Act. As
discussed above in Section I, we believe that our approach in adopting
Regulation Best Interest will best achieve the Commission's important
goals of enhancing retail investor protection and decision making,
while preserving, to the extent possible, retail investor access (in
terms of choice and cost) to differing types of investment services and
securities.
a. Fiduciary Standard Under the Advisers Act Applied to Broker-Dealers
A number of commenters discussed the viability of this alternative
and stated that it would provide superior investor protection benefits
relative to the standard that the Commission proposed.\1342\ At the
outset, we note that, at the time a recommendation is made, key
elements of the standard of conduct that applies to broker-dealers
under Regulation Best Interest will be substantially similar to key
elements of the standard of conduct that applies to investment advisers
pursuant to their fiduciary duty under the Advisers Act. Both standards
of conduct require that, when making a recommendation or providing
advice, firms and financial professionals act in the best interest of
the retail investor and not place the financial professionals'
interests ahead of the retail investor.\1343\ Both standards provide
methods for addressing conflicts of interest, although the mechanics of
those methods and their outcomes may be different,\1344\ and both
standards require full and fair disclosure of material facts that
affect the relationship, including costs. Both standards allow each
type of financial professional to agree to provide account monitoring
services to retail investor accounts, although continuous monitoring is
embedded in the regulatory regime and market practices for investment
advisers, whereas a broker-dealer may agree to provide account
monitoring services only to the extent that it is solely incidental to
the primary brokerage business.\1345\
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\1342\ See Betterment Letter; Warren Letter; Fein Letter; State
Treasurers Letter; AARP August 2018 Letter; ACLI Letter; Schwab
Letter.
\1343\ See supra Section I.A.
\1344\ Whereas, pursuant to Regulation Best Interest, broker-
dealers are required to (i) to establish written policies and
procedures reasonably designed to identify and at a minimum,
disclose, or eliminate, all conflicts of interest; and (ii) to
establish written policies and procedures reasonably designed to
mitigate or eliminate identified conflicts of interest, the
fiduciary standard for investment adviser relies on full and fair
disclosure and informed consent.
\1345\ See Solely Incidental Interpretation. See also supra
Section II.B.2.b.
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We recognize that there are certain notable differences between the
Advisers Act fiduciary standard and the Regulation Best Interest
standard we are adopting. In particular, the investment adviser
fiduciary duty is generally principles-based, in keeping with the
regulatory tradition and market practices for advisers,\1346\ whereas
Regulation Best Interest, while also largely principles-based,
establishes minimum, obligations that are generally more prescriptive
than the fiduciary obligations under Advisers Act. Further, advisers
are able to address conflicts of interest through full and fair
disclosure and informed consent,\1347\ while broker-dealers must have
policies and procedures that are reasonably designed to identify and
disclose and mitigate, or eliminate, any conflicts of interest
associated with recommendations that create an incentive for the
broker-dealer or its associated persons to place the interest of the
broker-dealer or its associated persons ahead of the interest of the
retail customer. With regard to the substance of both standards, the
investment adviser fiduciary duty generally is broader and applies to
the entire relationship between adviser and client, including providing
non-securities advice,\1348\ whereas Regulation Best Interest only
applies at the time of a recommendation of any securities transaction
or investment strategy by a broker-dealer to its retail
customers.\1349\ Where application of the Advisers Act fiduciary
standard to broker-dealers would impose on broker-dealers obligations
similar to those of Regulation Best Interest, we anticipate similar
economic effects; in contrast, where this alternative would result in
different obligations, it would generate economic effects distinct from
those of Regulation Best Interest.
---------------------------------------------------------------------------
\1346\ See Fiduciary Interpretation.
\1347\ See id.
\1348\ For example, an investment adviser may consider both
securities annuity products (e.g., variable annuities) and non-
securities annuity products (e.g., fixed annuities) when providing
advice on annuity products to a client with an advisory retirement
account.
\1349\ However, under the current legal and regulatory regime,
broker-dealers are subject to other rules that apply outside the
context of a recommendation, including rules regarding how broker-
dealers market securities and services (communications with the
public), how they execute trades (best execution), and the fees that
they charge (fair and reasonable compensation obligations).
Moreover, broker-dealers always a have a duty of fair dealing with
their retail customers under SRO rules. In addition, broker-dealers
are subject to a number of obligations that attach when a broker-
dealer makes a recommendation to a customer, as well as general and
specific requirements aimed at addressing certain conflicts of
interest, including requirements to eliminate, mitigate, or disclose
certain conflicts of interest. See Proposing Release Section I.A.1.
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i. Fiduciary Standard Under the Advisers Act Relative to the Baseline
Relative to the regulatory baseline, the fiduciary standard of this
alternative applied to broker-dealers could benefit retail customers in
some circumstances by extending the obligations of all firms and
financial professionals to act in the best interest of retail customers
(and to not place the interest of the firm or the interest of the
financial professionals ahead of those of the retail customers) to
aspects of the relationship other than providing personalized
investment advice through recommendations. For example, retail
customers might benefit if broker-dealers were required (as advisers
are under their current fiduciary standard) to disclose any material
conflicts related to their execution of trades for retail customers in
the case when the broker-dealer has not provided a recommendation
regarding the transaction (e.g., self-directed trade). In addition,
under the fiduciary standard that applies to investment advisers, if an
investment adviser cannot fully and fairly disclose a material conflict
of interest to a client such that the client could reasonably be
expected to provide informed consent, the investment adviser would be
expected to either eliminate the conflict or adequately mitigate (i.e.,
modify its practices to reduce) the conflict to the point where full
and fair disclosure of the conflict to the client and informed
[[Page 33464]]
consent is possible.\1350\ To the extent that this approach of
addressing conflicts of interest would extend to the fiduciary standard
in this alternative, a broker-dealer would also have to eliminate or
modify a conflict of interest to the point where full and fair
disclosure and informed consent is possible. The potential reduction in
the effect of conflicts of interest on recommendations and the
potential reduction in the information asymmetry between a retail
customer and a broker-dealer would likely increase the efficiency of
the recommendation provided by the firm to the retail customer,
relative to the baseline. Thus, this alternative may reduce the agency
costs of the relationship between a broker-dealer and a retail
customer, which would benefit retail customers, relative to the
baseline.
---------------------------------------------------------------------------
\1350\ See Fiduciary Interpretation.
---------------------------------------------------------------------------
However, any such benefits would come at a cost. As an initial
matter, the fiduciary standard under this alternative is a principles-
based regime and shaped by decades of case law specific to investment
advisory model. In contrast, the standard of conduct that applies to
broker-dealers under the baseline is more prescriptive, and governed by
detailed SRO rules. Therefore, if this alternative were adopted,
broker-dealers would face increased compliance costs resulting from
having to conform their advice models to a regulatory regime that was
not formed for a transaction-based model governed by detailed SRO
rules.
The potential increased compliance costs associated with applying
the fiduciary standard in this alternative to broker-dealers would
likely increase the broker-dealers' incentives to offer investment
advice in the capacity of investment adviser and may decrease their
incentive to continue offering investment advice in the capacity of
broker-dealer dealer (on a transaction-by-transaction basis), relative
to the baseline.\1351\ For example, if this alternative were to create
situations where the compensation to a broker-dealer for providing a
recommendation in a commission-based brokerage account would be less
than the compensation under a fee-based advisory account and/or where
the perceived regulatory burden for an investment adviser is lower,
relative to the baseline, a broker-dealer's incentive to offer advice
in the capacity of investment adviser would likely increase, relative
to the baseline.\1352\
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\1351\ See Vivek Bhattacharya, Gaston Illanes, & Manisha Padi,
Fiduciary Duty and the Market for Financial Advice (Working Paper,
Apr. 2019) for a recent paper providing an empirical analysis on the
effect of state-level standards of conduct on the structure of the
market for investment advice in the context of variable annuities.
The study finds differences in broker-dealer behavior when comparing
states with and without a fiduciary obligation for broker-dealers.
The states with the obligation are associated with fewer variable
annuity sales and are also associated with some broker-dealers
exiting the industry. Specifically, the paper observes, among other
things, that a state-level obligation reduces the number of broker-
dealers that are not dually registered by about 16% but has no
meaningful effect on the number of dual-registrants. The authors
argue that this compositional shift in the number of broker-dealers
is due to firms exiting the market. The paper also observes that a
state-level obligation on broker-dealers may cause a compositional
shift in the pool of variable annuities sold by broker-dealers
toward annuities that offer a larger and more diverse set of
investment options, which, in certain circumstances, may also
generate higher expected returns for retail customers. The paper
also observes that under certain circumstances a state-level
obligation on broker-dealers may increase the quality of the
variable annuities sold by broker-dealers. ``Quality'' is defined by
the authors as ``the return on variable annuities assuming optimal
allocation.'' The authors interpret these results as suggesting that
a state-level obligation on broker-dealers may (i) cause some
broker-dealers to exit the market, and (ii) cause a compositional
shift in the variable annuities sold by the broker-dealers that do
not exit the market toward annuities of higher quality as defined in
the paper. However, the limitations of the data sample and of the
empirical methodology make it difficult to (i) generalize these
results to the entire market of annuities sold by broker-dealers,
(ii) extrapolate these results to the entire universe of securities
that broker-dealers offer advice on, (iii) extrapolate the results
to the population of broker-dealers not captured by the data sample,
or (iv) use the results as a basis for comparing the investor
protections offered by state-level standards of conduct, SRO rules,
existing federal standards of conduct, and Regulation Best Interest.
See also supra footnote 1163 and surrounding discussion noting that
there is substantial variation in the sources, scope, and
application of state fiduciary law.
\1352\ Broker-dealers that choose to deregister would eliminate
the costs of complying with FINRA rules, which are broader than
retail customer sales practice obligations, and submitting to FINRA
examinations as well as compliance with other specific rules, which
do not apply to advisers.
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To the extent broker-dealers act on the increased incentives and
decide to participate in the market for investment advice only in the
capacity of investment advisers--for example, dual-registrants may
prefer to offer investment advice only in the capacity of investment
adviser--retail customers may experience an increase in the cost of
obtaining investment advice, relative to the baseline. Furthermore, as
noted above, the potential exit of broker-dealers from the market for
investment advice in the capacity of broker-dealer may limit how retail
customers can access certain securities or investment strategies and
how they can pay for investment advice, which, in turn, may further
increase the cost of obtaining investment advice, relative to the
baseline.\1353\ Alternatively, to the extent broker-dealers decide to
continue to participate in the market for investment advice in the
capacity of broker-dealers, they may pass on the increased compliance
costs, in full or in part, to their retail customers in the form of
higher prices for services rendered. In particular, retail customers
may experience an increase in the cost of obtaining investment advice,
relative to the baseline.
---------------------------------------------------------------------------
\1353\ See supra Section III.D.1.
---------------------------------------------------------------------------
It is also possible that the fiduciary standard of this alternative
may result in a different menu of choices that allows retail customers
to access investment advice in a more cost-efficient manner relative to
the baseline. For example, if more financial professionals decide to
participate in the market for investment advice in the capacity of
investment advisers, competitive pressure may result in investment
advisers providing better pricing and/or more choices of accessing
investment advice for retail customers.
To the extent that the cost of accessing investment advice
increases under the fiduciary standard of this alternative, some retail
customers may be pushed outside the market for investment advice. For
example, currently, a retail customer that prefers to receive
recommendations from a broker-dealer or its associated persons to
implement a buy-and-hold strategy may find a brokerage account to be
better suited to his or her needs compared to an advisory
account.\1354\ Under the fiduciary standard in this alternative, this
retail customer may have to pay more for the broker-dealer services
that come with his or her account, including obtaining investment
advice, relative to the baseline. If this increase in the cost for
broker-dealer services outweighs the benefits of the potential improved
efficiency of the recommendations provided by the
[[Page 33465]]
broker-dealer for this retail customer, as noted above, the retail
customer may prefer to switch to a more-limited brokerage account that
does not come with personalized investment advice (e.g., an execution-
only brokerage account).\1355\ Alternatively, and as noted by one
commenter, the retail customer may switch to a light version of an
advisory account that implements automated investment strategies
tailored around a retail customer's goals.\1356\ However, this type of
advisory account may not offer the flexibility of personalized
investment advice to the evolving needs of the customer and may not be
as responsive to market movements not anticipated by the automated
investment strategies.
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\1354\ For example, Del Guercio & Reuter (2014), supra footnote
1081, document (Table 1 on page 1682) that retail customers can
access index funds through both broker-dealers (i.e., the broker-
sold channel, as discussed above) and directly from the fund sponsor
(i.e., the direct-sold channel). Furthermore, in their sample, the
average expense ratio for an index fund is 0.86 if sold through the
broker-sold channel and 0.44 if sold through the direct channel.
Assuming that a retail customer is interested in implementing a buy-
and-hold strategy using index funds that carry no loads, the cost to
the retail customer of implementing this strategy through a broker-
dealer would be on average 86 basis points of the assets invested
per year. In contrast, the cost to the retail customer of
implementing the same strategy through an investment adviser would
be on average 44 basis points plus the investment adviser's AUM-
based fee per year. Assuming that in the investment adviser's fee is
100 basis points of AUM per year, the cost to the retail customer of
implementing his or her strategy with an investment adviser would be
on average 144 basis points.
\1355\ Relative to a brokerage account that offers personalized
investment advice, execution-only brokerage accounts may also come
with enhanced research tools, more investment choices, and,
potentially, other forms of impersonal advice.
\1356\ See, e.g., CFA August 2018 Letter at 79, noting that
``[f]or example, Vanguard charges 0.30% for its Personal Advisor
Services, Schwab charges 0.28% for its Intelligent Advisory
Services, and Betterment charges 0.25% for its Digital offering and
0.40% for its Premium offering.''
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b. Uniform Fiduciary Standard Under 913(g)
Another alternative approach to the standard of conduct imposed by
Regulation Best interest is a ``new'' uniform fiduciary standard of
conduct applicable to both broker-dealers and investment advisers, such
as that recommended by the staff in the 913 Study.\1357\ The fiduciary
standard under this alternative would require firms ``to act in the
best interest of the customer without regard to the financial or other
interest of the broker, dealer, or investment adviser providing the
advice.'' Based on the Commission staff's recommendations about ways in
which the fiduciary standard proposed by the 913 study could be
implemented, the fiduciary standard under this alternative could have
imposed any or all of the following requirements: (1) Eliminate or
disclose conflicts of interest; (2) prohibit certain conflicts of
interest by requiring firms to mitigate conflicts through specific
action, or to impose specific disclosure and consent requirements; and
(3) specify the basis a broker-dealer or investment adviser has in
making a recommendation to a retail customer by referring to and
expanding upon broker-dealers' existing suitability requirements.
---------------------------------------------------------------------------
\1357\ One of the staff's primary recommendations was that the
Commission engage in rulemaking to adopt and implement a uniform
fiduciary standard of conduct for broker-dealers and investment
advisers when providing personalized investment advice about
securities to retail customers. The staff's recommended standard
would require firms ``to act in the best interest of the customer
without regard to the financial or other interest of the broker,
dealer, or investment adviser providing the advice.'' The staff made
a number of specific recommendations for implementing the uniform
fiduciary standard of conduct, including that the Commission should:
(1) Require firms to eliminate or disclose conflicts of interest;
(2) consider whether rulemaking would be appropriate to prohibit
certain conflicts, to require firms to mitigate conflicts through
specific action, or to impose specific disclosure and consent
requirements; and (3) consider specifying uniform standards for the
duty of care owed to retail customers, such as specifying what basis
a broker-dealer or investment adviser should have in making a
recommendation to a retail customer by referring to and expanding
upon broker-dealers' existing suitability requirements. See 913
Study.
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Some of the benefits of the investment advisers' fiduciary standard
of the previous alternative would carry over to the new uniform
standard of this alternative. In particular, relative to the baseline,
the new fiduciary standard of this alternative applied to broker-
dealers could benefit retail customers in some circumstances by
extending the obligations of all firms and financial professionals to
act in the best interest of retail customers (and to not place the
interest of the firm or those of the financial professionals ahead of
the interest of the retail customer) to aspects of the relationship
other than providing personalized investment advice through
recommendations.
In addition, the new fiduciary standard of this alternative applied
to broker-dealers may create additional benefits for their retail
customers, relative to the baseline. For example, requirements (1) and
(2) may enhance the obligations under the baseline by requiring broker-
dealers to disclose conflicts of interest and to take actions to
mitigate or eliminate certain conflicts of interest. To the extent that
these requirements reduce of the effect of the conflicts of interest on
the recommendation provided by a broker-dealer or its associated
persons and reduce the information asymmetry between retail customers
and broker-dealers, the new fiduciary standard of this alternative may
increase, relative to the baseline, the efficiency of the
recommendations made by broker-dealers and their associated persons.
Furthermore, requirement (3) may enhance the existing suitability
requirements that apply to broker-dealers and, to the extent that this
requirement results in recommendations that are better aligned with the
objectives of the retail customers, the new fiduciary standard of
conduct of this alternative may further increase, relative to the
baseline, the efficiency of the recommendations provided by broker-
dealers and their associated persons. The potential increase in the
efficiency of the recommendations provided by broker-dealers and their
associated persons under the new fiduciary standard of this alternative
would benefit retail customers, relative to the baseline.
Similarly, the new fiduciary standard of this alternative applied
to investment advisers may create benefits for their clients, relative
to the baseline. Requirements (1) and (2) would enhance the obligations
of the investment advisers under the current fiduciary standard that
applies to investment advisers by requiring investment advisers to take
actions to mitigate or eliminate certain conflicts of interest. To the
extent that these requirements reduce of the effect of the conflicts of
interest on the recommendation provided by an investment adviser or its
associated persons and reduce the information asymmetry between retail
customers and investment advisers, the new fiduciary standard under
this alternative may increase the efficiency of the recommendations
made by investment advisers and their associated persons, relative to
the baseline.
The new fiduciary duty of this alternative may also result in
increased competition across financial professionals for retail
customers or clients, relative to the baseline. This potential increase
in competition, relative to the baseline, may benefit retail customers
of broker-dealers and clients of investment advisers in the form of
lower prices for investment advice.
Turning to the potential costs imposed by this alternative, we note
that some of the costs of the investment advisers' fiduciary standard
of the previous alternative carry over to the new fiduciary standard of
this alternative. As noted above, this alternative would impose a new
regulatory paradigm on broker-dealers relative to the baseline. The
fiduciary standard of this alternative would be principles-based and
shaped by common law. In contrast, the standard of conduct that applies
to broker-dealers under the baseline is more prescriptive and governed
by detailed SRO rules. A paradigm shift from the standards of conduct
under the current baseline to the uniform standard in this alternative
may increase compliance costs relative to the baseline.\1358\
---------------------------------------------------------------------------
\1358\ See also 913 Study at 156-159.
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Furthermore, the potential increased compliance costs associated
with applying the fiduciary standard of this alternative to broker-
dealers may increase, relative to the baseline, a broker-dealer's
incentives to offer investment advice in the capacity of an
[[Page 33466]]
investment adviser and may decrease their incentive to offer investment
advice in the capacity of broker-dealer. For example, if this
alternative creates situations where the compensation to a broker-
dealer for providing a recommendation in a commission-based brokerage
account would be less than the compensation under a fee-based advisory
account while the perceived regulatory burden is equal to that of an
investment adviser, a broker-dealer's incentive to offer advice in the
capacity of investment adviser may increase, relative to the
baseline.\1359\
---------------------------------------------------------------------------
\1359\ See supra footnote 1351.
---------------------------------------------------------------------------
To the extent broker-dealers act on the increased incentives and
decide to participate in the market for investment advice only in the
capacity of investment advisers--for example, dual-registrants may
prefer to offer investment advice only in the capacity of investment
adviser--retail customers may experience an increase in the cost of
obtaining investment advice, relative to the baseline. Alternatively,
to the extent broker-dealers decide to continue to participate in the
market for investment advice in the capacity of broker-dealers, they
may pass on the increased compliance costs, in full or in part, to
their retail customers in the form of higher prices for services
rendered, relative to the baseline. In particular, retail customers may
experience an increase in the cost of obtaining investment advice,
relative to the baseline.\1360\
---------------------------------------------------------------------------
\1360\ See also 913 Study at 159-162.
---------------------------------------------------------------------------
Similarly, the new fiduciary standard of this alternative may also
impose additional compliance costs for investment advisers relative to
the baseline.\1361\ For example, to the extent that investment advisers
currently provide investment advice to their clients in a manner that
is not fully consistent with the requirements (2) and (3), investment
advisers may incur compliance costs in adhering to these potentially
more stringent requirements.
---------------------------------------------------------------------------
\1361\ See id. at 159.
---------------------------------------------------------------------------
Investment advisers would likely pass on the potential increase in
the costs of complying with the new fiduciary standard of this
alternative to their clients. In turn, under the new fiduciary standard
of this alternative, clients may experience an increase in the cost of
obtaining investment advice, relative to the baseline.
It is also possible that the new fiduciary standard of this
alternative may result in a different menu of choices that allows
retail customers and clients to access investment advice in a more
cost-efficient manner relative to the baseline. For example, if more
financial professionals decide to participate in the market for
investment advice as investment advisers, competitive pressure may
result in better pricing and/or greater choice in accessing investment
advice for retail customers and clients that choose to use an
investment adviser.
However, to the extent that the cost of accessing investment advice
increases under the new fiduciary standard of this alternative, some
retail customers may be pushed outside the market for investment
advice, relative to the baseline. For example, currently, a retail
customer who prefers to receive recommendations from a broker-dealer or
its associated persons to implement a buy-and-hold strategy may find a
brokerage account to be better suited to his or her needs than an
advisory account. Under the new fiduciary standard of this alternative,
this retail customer may have to pay more for the broker-dealer
services that come with his or her account, including obtaining
investment advice, relative to the baseline. If, from the perspective
of a retail customer, this increase in the cost for broker-dealer
services outweighs the expected benefits of the potential improved
efficiency of the recommendations provided by the broker-dealer, the
retail customer may prefer to switch to a more limited brokerage
account that does not come with personalized investment advice (e.g.,
an execution-only brokerage account).\1362\
---------------------------------------------------------------------------
\1362\ Relative to a brokerage account that offers personalized
investment advice, execution-only brokerage accounts may also come
with enhanced research tools, more investment choices, and,
potentially, other forms of impersonal advice.
---------------------------------------------------------------------------
Alternatively, and as noted by one commenter, the retail customer
may switch to an advisory account that implements automated investment
strategies.\1363\ However, this type of advisory account may not offer
the flexibility of personalized investment advice to the evolving needs
of the customer, the level of contact a retail customer seeks from a
relationship with a financial professional, and may not be as
responsive to market movements not anticipated by the automated
investment strategies.
---------------------------------------------------------------------------
\1363\ See, e.g., CFA August 2018 Letter at 79, noting that
``[f]or example, Vanguard charges 0.30% for its Personal Advisor
Services, Schwab charges 0.28% for its Intelligent Advisory
Services, and Betterment charges 0.25% for its Digital offering and
0.40% for its Premium offering.''
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Similarly, under the new fiduciary standard of this alternative,
clients of investment advisers may experience an increase in the cost
of obtaining investment advice. Some of these clients may not be able
to afford the additional cost and may be pushed outside the market for
investment advice, relative to the baseline. As noted above, the
options available to these clients may not offer the flexibility of
tailored investment advice that may benefit a client with evolving
needs.
c. Fiduciary Standard Under the DOL Rule and BIC Exemption
A third alternative approach to addressing the agency costs
associated with obtaining advice from broker-dealers is a fiduciary
standard coupled with a series of disclosures and other requirements
akin to the full complement of conditions of the DOL's BIC Exemption
adopted in connection with the DOL Fiduciary Rule. This alternative
would mirror the key conditions that apply to an ``adviser'' under the
BIC Exemption.\1364\ This alternative approach would apply to broker-
dealers when providing recommendations to retail customer for all types
of retail accounts rather than retirement accounts only. At least one
commenter signaled support for this alternative.\1365\
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\1364\ For a discussion of key conditions of the BIC Exemption,
see Section I.A.2 of the Proposing Release at 21581. As discussed
above, the DOL Fiduciary Rule--including the BIC Exemption--was
vacated by the United States Court of Appeals for the Fifth Circuit
on March 15, 2018, although some firms may continue to seek comply
with certain of its conditions under a DOL temporary enforcement
policy. See also supra Section III.B.2.e. See also supra footnote
32.
\1365\ See Galvin Letter.
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Unlike other alternatives considered in this section, or Regulation
Best Interest, this alternative can be analyzed, at least in part,
based upon its previous adoption by the DOL and partial implementation.
Because this alternative was already partly implemented, the market for
investment advice, the securities market, and, ultimately investors
have had an opportunity to partially adjust to it. Section III.B.2.e.ii
summarizes the evidence about the response of firms, investors and
product markets in response to the DOL Fiduciary Rule.
The requirements of the standard of conduct in this alternative
would enhance the obligations under the baseline by requiring broker-
dealers to adhere to the impartial conduct standard, which included
requirements to act in their retail customers' best interest, disclose
material conflicts of interest and designate a person responsible for
addressing material conflicts of interest and monitoring the adherence
of the associated persons of the broker-dealer to the impartial conduct
standard. To the extent that
[[Page 33467]]
these requirements reduce the effect of the conflicts of interest on
the recommendation provided by a broker-dealer or its associated
persons and reduce the information asymmetry between retail customers
and broker-dealers, the new standard of conduct in this alternative
would increase the efficiency of the recommendations made by broker-
dealers and their associated persons, relative to the regulatory
baseline. Furthermore, the requirement to act in the retail customers'
best interest would enhance the existing suitability standard that
applies to broker-dealers and, to the extent that the new standard of
conduct of this alternative would result in recommendations that are
better aligned with the objectives of the retail customers, this new
standard would further increase the efficiency of the recommendations
provided by broker-dealers and their associated persons, relative to
the regulatory baseline. The potential increase in the efficiency of
the recommendations provided by broker-dealers and their associated
persons under the new standard in this alternative would benefit retail
customers, relative to the baseline.
This alternative may also affect product markets. As discussed
above in Section III.B.2.ii, certain product sponsors introduced new
products in the market for mutual funds, such as clean and T shares
that were designed to facilitate compliance with various anticipated
regulations, including the DOL Fiduciary Rule. In certain
circumstances, these products may come with lower fees for retail
customers. To the extent that this alternative would enhance this trend
in product innovation, retail customers may benefit from this trend.
However this alternative would also impose costs on broker-dealers
and retail customers.
Compliance costs would include costs associated with the contract
provision, and the disclosure, policies and procedure, and record-
making and recordkeeping requirements. It is possible that broker-
dealers would pass on these direct compliance costs, in part or in
full, to retail customers.
In addition to these costs, this alternative would likely cause
some broker-dealers to change their current practices, which, in turn,
may impose further costs on them or their retail customers. As
discussed above in Section III.B.2.e.ii some studies find evidence
suggesting that firms have adjusted their practices, at least in the
short-run, in response to the DOL fiduciary Rule. In particular,
certain of these studies observe that in certain cases some broker-
dealers have either eliminated or reduced access to brokerage advice
services. Other studies observe that some broker-dealers migrated
toward fee-based advisory services or limited brokerage services (i.e.,
no provision of advice) and, in the process, offered their retail
customers the option to shift from commission-based brokerage accounts
to fee-based accounts, automated investment accounts or self-directed
accounts. Some of their customers chose to not move to a fee-based
account.
Certain studies provide evidence suggesting that some broker-
dealers adjusted the range of their offerings.\1366\ Specifically,
according to these studies, some of the respondents reduced or
eliminated access to certain assets or share classes, such as certain
mutual funds or mutual fund share classes, and or annuity securities
offered.
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\1366\ See supra Section III.B.2.e.ii.
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Finally, there is some anecdotal evidence that suggests that
certain firms changed the compensation structure for their associated
persons.\1367\ Specifically, some firms equalize commissions and
deferred sales charges across similar securities, while other firms
banned sales quotas, contests, and certain bonuses.
---------------------------------------------------------------------------
\1367\ See id.
---------------------------------------------------------------------------
To the extent that the fiduciary standard in this alternative would
result in similar responses by broker-dealers, the alternative would
impose cost on retail customers relative to the baseline. For example,
switching a retail customer from a commission-based brokerage account
to a different type of account, such as fee-based advisory account, may
leave a customer worse off in certain circumstances. For instance, a
retail customer who is a buy-and-hold investor may overpay for the
advice typically associated with this type of investment strategy if
the retail customer were to shift from a brokerage account to a fee-
based account.\1368\ As another example, a retail customer would lose
access to occasional personalized advice if he or she were to shift
from his or her brokerage account to a self-directed account.
---------------------------------------------------------------------------
\1368\ See supra footnote 1354.
---------------------------------------------------------------------------
The cost to retail customers from switching to a suboptimal account
is particularly important in the context of IRA brokerage accounts,
because of the larger size of these accounts and the importance of
these accounts for retail investors to meet their retirement needs.
These costs may also be higher for IRA brokerage accounts than for
other account types to the extent that these accounts include long-
term, buy-and-hold investments. As discussed in Section III.B.2.e.ii,
one study provided an estimate for this potential cost.\1369\ However,
as discussed above, the estimates provided by various studies,
including this one, or by commenters are generally subject to
assumptions or methodological limitations which may affect the
inferences based on such estimates.
---------------------------------------------------------------------------
\1369\ See SIFMA Study.
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In addition to the evidence discussed above, there are other
potential economic implications of this alternative. For instance, this
alternative may exclude from the market for investment advice those
retail customers that have account balances that are below the account
minimum for typical advisory accounts. The investment advisory industry
might adjust to a lack of supply by accommodating lower account
balances. However, because investment advisers have a fiduciary duty to
all their clients, and because they have limited time and resources,
there is likely a limit to how much an investment adviser can lower his
or her account minimum to accommodate more advisory clients. Similarly,
the product market may adjust by innovating new products to accommodate
retail customers with account balances that are below the typical
advisory account minimum. For example, hybrid products that implement
automated investment strategies tailored to a retail customer's goals
may substitute for the services of an investment adviser for customers
with lower account balances.
2. Prescribed Format for Disclosure
Although Regulation Best Interest specifies the required content of
disclosure necessary to meet a broker-dealer's Disclosure Obligation,
it does not prescribe a specific format for that disclosure. As an
alternative, and as suggested by commenters,\1370\ we
[[Page 33468]]
considered requiring broker-dealers to use a specific form similar to,
for example, Form ADV.
---------------------------------------------------------------------------
\1370\ See, e.g., LPL August 2018 Letter that notes that ``all
investors should be provided with general disclosures somewhat akin
to those contained in Form ADV Part 2A--e.g., which set forth the
ranges of remuneration payable to a broker-dealer in connection with
its recommendations of different products . . . [W]e believe that
detailed product-specific disclosures should be required prior to or
at the time of a recommendation only in instances where the
remuneration associated with the recommendation exceeds the
previously disclosed range or where the recommendation implicates a
conflict of interest that has not previously been disclosed. In all
other cases, a broker-dealer should be permitted to satisfy its
Disclosure Obligation by directing an investor in writing to review
the recommended product's offering documents and providing
hyperlinks to those documents (or providing a hyperlink to a central
page on the broker-dealer's website that contains hyperlinks to the
product documents), either prior to the recommendation via a general
Form ADV Part 2A-like disclosure document or shortly thereafter via
a trade confirmation.'' See also Morningstar Letter, noting
``publicly available disclosures with a standard taxonomy work best
because they empower third parties such as `fintech' and `reg-tech'
firms to analyze and contextualize critical information and amplify
a call to action for ordinary investors.'' See also Letter from
Peter J. Chepucavage (May 31, 2018) (``Chepucavage Letter''), noting
that ``[c]osts for the small bd's however can be reduced with a
commission approved standard disclosure which would add certainty
and ought to be considered especially for the small investor. [. .
.] A standard disclosure document would also be useful for the small
bd that cannot afford the legal assistance needed to evaluate this
1,000 page proposal and draft appropriate documents. [. . .] The
Commission should therefore reconsider the impact of its proposal on
small investors and small bd's with the assumption that retirement
accounts are significantly more important than regular brokerage
accounts especially for small and elderly investors. A standard
disclosure for small firms would reduce costs for the firms and
their customers.''
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Because this alternative would still impose all the obligations of
Regulation Best Interest, all the benefits and the costs identified in
Regulation Best Interest would carry over to this alternative as well.
However, by changing the way broker-dealers would meet the Disclosure
Obligation, this alternative may create additional benefits and impose
additional costs.
The requirement to use a form similar to Form ADV to meet the
Disclosure Obligation would put more structure on the disclosure of
material facts relating to the scope and terms of the relationship with
the retail customer and material facts relating to conflicts of
interest that are associated with a recommendation. This added
structure would facilitate retail customers' comparison of multiple
broker-dealers, which would benefit retail customers. For example, the
evidence provided by the investor testing surveys suggests that retail
customers form preference over various variables that are being
disclosed.\1371\ On the backdrop of this evidence, the structured
disclosure provided by a specific form may enhance a retail customer's
ability to select a broker-dealer in a manner consistent with his or
her preferences. In addition, the structured disclosure provided by a
form may allow a third party to collect the information disclosed by
firms, process it, and present it to retail customers in a way that
would make it easier for the retail customer to select a broker-dealer.
To the extent the format of disclosure under this alternative would
result in this potential outcome, the alternative would further benefit
retail customers.
---------------------------------------------------------------------------
\1371\ See Relationship Summary Adopting Release for a
discussion of the evidence provided by the investor testing surveys.
---------------------------------------------------------------------------
However, the requirement to use a form similar to Form ADV to meet
the Disclosure Obligation may also impose costs on broker-dealers, at
least in the short run, to the extent that this form of disclosure is
different from the form of disclosure that firms employ currently to
satisfy their disclosure obligations and liabilities under the
baseline. In general it may be difficult to design a form that, while
comprehensive in terms of capturing the diversity of business practices
that broker-dealers employ, remains easy to understand for retail
customers. In general, given that there is a wide variety of business
models and practices, there is value in providing broker-dealers with
flexibility to enable them to better tailor disclosure and information
that their retail customers can understand and may be more likely to
read at relevant points in time, rather than, for example, mandating a
standardized all-inclusive (and likely lengthy) disclosure. Depending
on the specific form that is eventually mandated, some firms may incur
more costs than others. To the extent firms pass on those costs to
retail customers, the alternative would impose a cost on retail
customers.
3. Disclosure-Only
Another potential alternative to addressing the agency costs of
obtaining advice from broker-dealers is a disclosure-only alternative,
which would require that broker-dealers satisfy only the Disclosure
Obligation of Regulation Best Interest. In other words, broker-dealers
would be required to provide the retail customer, in writing, full and
fair disclosure of all material facts relating to the scope of the
relationship with the retail customer and all material facts relating
to the conflicts of interest associated with the recommendations to the
retail customer, prior to or at the time of the recommendation.
However, this alternative would not impose either the Care Obligation
or the Conflict of Interest Obligation.
As discussed in Sections III.C.2 and III.C.4, there may be
substantial overlap between the disclosure requirements of Regulation
Best Interest and the disclosure requirements under the regulatory
baseline. From this perspective, relative to the regulatory baseline,
the cost of this alternative to the broker-dealers may be small, at
least for some broker-dealers. However, as pointed out above, a
disclosure-only alternative is not likely to address the agency costs
associated with obtaining advice from broker-dealers. As a result, the
Commission believes both specific disclosure and mitigation
requirements are needed to address those conflicts. Also, we noted
above that sales contests, sales quotas, bonuses, and non-cash
compensation that are based on the sales of specific securities within
a limited period of time create high-pressure situations for associated
persons to increase the sales of specific securities by compromising
the best interest of their customers; the Commission does not believe
such conflicts of interest can be reasonably mitigated, let alone
disclosed, in a manner that adequately prevents harm to retail
customers and, accordingly, believes that these conflicts must be
eliminated in their entirety.
Finally, as we discussed earlier, commenters noted that there are
limits to the effectiveness of disclosure and cited a number of studies
suggesting that disclosure alone is unlikely to solve the issues
surrounding, for example, the conflicts of interest between a broker-
dealer (or their associated persons) and a retail customer.\1372\
---------------------------------------------------------------------------
\1372\ See supra footnote 1208 and accompanying text. See also
supra Section III.B.4.c for a discussion of the literature on the
effectiveness of disclosure.
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IV. Paperwork Reduction Act
Certain provisions of Regulation Best Interest and the rule
amendments that we are adopting today contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\1373\ The Commission submitted
Regulation Best Interest and the rule amendments to the Office of
Management and Budget (``OMB'') for review and approval in accordance
with the PRA.\1374\ The Commission's earlier PRA assessments have been
revised to reflect the modifications to the rule and amendments from
the Proposing Release, as well as additional information and data
provided to the Commission by commenters. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
The titles and OMB control numbers for the collections of information
are:
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\1373\ 44 U.S.C. 3501 et seq.
\1374\ See 44 U.S.C. 3507(d); 5 CFR 1320.11.
\1375\ See 17 CFR 240.17a-3. The addition of paragraph (a)(35)
to Rule 17a-3 would amend the existing PRA for Rule 17a-3.
\1376\ See 17 CFR 240.17a-4. The amendment to Rule 17a-4(e)(5)
would amend the existing PRA for Rule 17a-4.
[[Page 33469]]
------------------------------------------------------------------------
OMB control
Rule Rule title No.
------------------------------------------------------------------------
Rule 15l-1.................... Regulation Best Interest
Rule 17a-3.................... Records to be made by 3235-0033
certain exchange
members, brokers and
dealers \1375\.
Rule 17a-4.................... Records to be preserved 3235-0279
by certain exchange
members, brokers and
dealers \1376\.
------------------------------------------------------------------------
Regulation Best Interest enhances the broker-dealer standard of
conduct beyond existing suitability obligations, and aligns the
standard of conduct with retail customers' reasonable expectations by
requiring broker-dealers, among other things, to: (1) Comply with
specific obligations to make recommendations that are in the best
interest of the retail customer, and that do not place the broker-
dealer's interests ahead of the interests of the retail customer; and
(2) address conflicts of interest by fully and fairly disclosing
material facts about conflicts of interest, and in instances where we
believe disclosure is insufficient to reasonably address the conflict,
establish, maintain and enforce policies and procedures reasonably
designed to mitigate or, in certain instances, eliminate the conflict.
Generally, in crafting Regulation Best Interest, we aimed to provide
broker-dealers flexibility in determining how to satisfy the component
obligations. For purposes of this analysis, we have made assumptions
regarding how a broker-dealer would comply with the obligations of
Regulation Best Interest, as well as the amendments under Rule 17a-
3(a)(35) and Rule 17a-4(e)(5).
In the Proposing Release, we requested comment on the matters
discussed in the PRA, including our estimates for the new and recurring
burdens and associated costs described in connection with Regulation
Best Interest and the amendments under Rule 17a-3(a)(35) and Rule 17a-
4(e)(5).\1377\ In particular, we sought comment on estimates as to: (1)
The number of natural persons who are associated persons; (2) the
number of broker-dealers that make securities-related recommendations
to retail customers; (3) the number of natural persons who are
associated persons that make securities-related recommendations to
retail customers; and (4) any other costs or burdens \1378\ associated
with proposed Regulation Best Interest that had not been identified in
the Proposing Release.
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\1377\ The Proposing Release proposed to add new paragraph
(a)(25) of Rule 17a-3. As noted above, we are adopting the provision
substantially as proposed but redesignating it as new paragraph
(a)(35) of Rule 17a-3. See supra footnote 820 and accompanying text.
\1378\ Throughout the PRA analysis in the Proposing Release, the
burdens on in-house personnel were measured in terms of burden
hours, and external costs were expressed in dollar terms.
---------------------------------------------------------------------------
As discussed in Sections I, II, and III, we received comments that
addressed whether we could minimize the burden of the proposed
collections of information. We received several comments suggesting
that our estimated burdens and costs for the rule as a whole were too
low.\1379\ In addition, the Commission received some comments
specifically addressing the costs to smaller broker-dealers.\1380\
Also, as discussed in the Economic Analysis section above, we received
comments regarding the potential costs and burdens of proposed
Regulation Best Interest on broker-dealers.\1381\ In response, we have
modified several substantive requirements to the rule by, among other
things, providing more specificity in the rule text in the Disclosure
and Conflict of Interest Obligations, which we believe will mitigate
some of these burdens and costs relative to the Proposing
Release.\1382\ At the same time, certain modifications, such as
maintaining a written record of oral disclosure, resulted in new
burdens and costs, relative to those addressed in the Proposing
Release, which are reflected below.
---------------------------------------------------------------------------
\1379\ See, e.g., NSCP Letter; see also CCMC Letters (costs to
implement the proposal were underestimated and greater than 40% of
firms surveyed anticipate having to spend a moderate or substantial
amount to implement Regulation Best Interest and Form CRS); Raymond
James Letter (noting the significant implementation costs of
Regulation Best Interest and Form CRS for the industry); SIFMA
August 2018 Letter (stating that implementation costs of Regulation
Best Interest and Form CRS would be significant).
\1380\ See, e.g., Chepucavage Letter (finding that the estimates
in the proposal are severely understated unless they are excluding
time needed for review of the proposal and final rule and suggesting
the Commission reconsider the impact on small investors and small
broker-dealers); NSCP Letter (requesting the Commission to consider
the financial and operational impacts of the proposed rule,
particularly on small firms, and to minimize those impacts, given
that small firms do not have compliance departments adequate to deal
with increasing regulatory demands). See also, e.g., Iowa Insurance
Commissioner Letter; Letter from David S. Addington, National
Federation of Independent Business (May 30, 2018) (``NFIB Letter'').
\1381\ See supra Section III.
\1382\ Throughout this PRA analysis, the burdens on in-house
personnel are measured in terms of burden hours, and external costs
are expressed in dollar terms.
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A. Respondents Subject to Regulation Best Interest and Amendments to
Rule 17a-3(a)(35) and Rule 17a-4(e)(5)
1. Broker-Dealers
Regulation Best Interest imposes a best interest obligation on a
broker-dealer when making recommendations of any securities transaction
or investment strategy involving securities to retail customers. Except
where noted, we have assumed that a dually registered firm, already
subject to the Advisers Act, would be subject to new, distinct burdens
under Regulation Best Interest.
As of December 31, 2018, 3,764 broker-dealers were registered with
the Commission, either as standalone broker-dealers or as dually
registered entities.\1383\ Based on data obtained from Form BR, the
Commission believes that approximately 73.5% of this population, or
2,766 broker-dealers, have retail customers and therefore would be
subject to Regulation Best Interest and the amendments under Rules 17a-
3(a)(35) and 17a-4(e)(5).\1384\ Further, based on FOCUS Report
data,\1385\ the Commission estimates that as of December 31, 2018,
approximately 985 broker-dealers may be deemed small entities under the
Regulatory Flexibility Act.\1386\ Of these,
[[Page 33470]]
approximately 756 have retail business.\1387\ Therefore, we estimate
that 2,010 broker-dealers would qualify as large broker-dealers with
retail customers for purposes of this analysis.\1388\
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\1383\ The Commission estimated the number of respondents in the
Proposing Release as of December 31, 2017. The Commission is
updating its estimated number of broker-dealers to reflect the
number of broker-dealers registered with the Commission as of
December 31, 2018.
\1384\ As of December 31, 2018, 3,764 broker-dealers filed Form
BD. Retail sales by broker-dealers were obtained from Form BR. As
discussed above in Section III.B.1.a, the number of broker-dealers
that serve retail customers (i.e., 2,766) likely overstates the
number of broker-dealers that will be subject to Regulation Best
Interest, because not all broker-dealers that serve retail investors
provide recommendations to retail investors. We do not have reliable
data to determine the precise number of broker-dealers that provide
recommendations, and as a result, we have assumed, for purposes of
this analysis that 2,766 broker-dealers will be subject to
Regulation Best Interest.
\1385\ FOCUS Reports, or ``Financial and Operational Combined
Uniform Single'' Reports, are monthly, quarterly, and annual reports
that broker-dealers are generally required to file with the
Commission and/or SROs pursuant to Exchange Act Rule 17a-5. See 17
CFR 240.17a-5.
\1386\ See infra Section V for an explanation of which brokers-
dealers, subject to Regulation Best Interest, are ``small
entities,'' for purposes of the Regulatory Flexibility Act analysis.
The Commission's estimate is obtained from Form BD filings.
Although Form BD filings are updated on a more frequent basis than
annually, FOCUS data, which also informs this baseline with respect
to broker-dealers, is only sparsely updated throughout the year.
Moreover, instead, broker-dealers tend to make their most complete
updates in the fourth calendar quarter of each year. Therefore, in
order to minimize discrepancies in the broker-dealer data between
Form BD and FOCUS data, we have normalized all of the data to the
most recently complete FOCUS data, which is for December 2018.
\1387\ Id.
\1388\ This calculation was made as follows: (2,766 total retail
broker-dealers)-(756 total small retail broker-dealers) = 2,010
large retail broker-dealers.
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2. Natural Persons Who Are Associated Persons of Broker-Dealers
As with broker-dealers, Regulation Best Interest imposes a best
interest obligation on natural persons who are associated persons of
broker-dealers when making recommendations of any securities
transaction or investment strategy involving securities to retail
customers.
The Commission believes that approximately 428,404 natural persons
would qualify as retail-facing, registered representatives at
standalone broker-dealers or dually registered firms,\1389\ and would
therefore be subject to Regulation Best Interest.\1390\
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\1389\ See supra Section III.B.1 at Table 5. This estimate is
based on the following calculation: (504,005 total licensed
representatives (including representatives of investment advisers))
x (15% (the percentage of total licensed representatives who are
standalone investment adviser representatives)) = approximately
75,601 representatives at standalone investment advisers. To isolate
the number of representatives at standalone broker-dealers and
dually registered firms, we have subtracted 75,601 from 504,005, for
a total of 428,404 retail-facing, licensed representatives at
standalone broker-dealers or dually registered firms.
\1390\ Unless otherwise noted, for purposes of the PRA, we use
the term ``registered representatives'' to refer to associated
persons of broker-dealers who are registered, have series 6 or 7
licenses, and are retail-facing, and we use the term ``dually
registered representatives of broker-dealers'' to refer to
registered representatives who are dually registered and are
associated persons of a standalone broker-dealer (who may be
associated with an unaffiliated investment adviser) or a dually
registered broker-dealer.
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B. Summary of Collections of Information
Regulation Best Interest requires broker-dealers and their
associated persons \1391\ when making a recommendation of any
securities transaction or investment strategy involving securities to a
retail customer to act in the best interest of the retail customer at
the time the recommendation is made, without placing the financial or
other interest of the broker-dealer ahead of the interest of the retail
customer. As discussed above, Regulation Best Interest specifically
provides that this best interest obligation shall be satisfied if the
broker-dealer complies with the specific Disclosure, Care, Conflict of
Interest, and Compliance Obligations.
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\1391\ However, in certain instances, as described more fully
below, the Commission assumes that broker-dealers will undertake
certain Disclosure Obligations on behalf of their registered
representatives. See, e.g., infra footnote 1396.
---------------------------------------------------------------------------
Rule 17a-3 requires a broker-dealer to make and keep current
certain records. The Commission is amending this rule by adding new
paragraph (a)(35) to impose new record-making obligations on broker-
dealers subject to Regulation Best Interest. Rule 17a-4 requires a
broker-dealer to preserve certain records if it makes or receives them.
The Commission is amending Rule 17a-4(e)(5) to impose new record
retention obligations on broker-dealers subject to Regulation Best
Interest.
The obligations arising under Regulation Best Interest and the
amendments under Rule 17a-3(a)(35) and Rule 17a-4(e)(5) would give rise
to distinct collections of information and associated costs and burdens
for broker-dealers subject to the rules. The collections of information
associated with Regulation Best Interest and rule amendments are
described below.
1. Disclosure Obligation
The Disclosure Obligation under Regulation Best Interest requires a
broker, dealer, or natural person who is an associated person of a
broker or dealer, prior to or at the time of recommending a securities
transaction or strategy involving securities to a retail customer, to
provide the retail customer, in writing, full and fair disclosure of:
(1) All material facts relating to the scope and terms of the
relationship with the retail customer, including (a) that the broker,
dealer, or such natural person is acting as a broker, dealer, or an
associated person of a broker or dealer with respect to the
recommendation, (b) the fees and costs that apply to the retail
customer's transactions, holdings, and accounts, and (c) the type and
scope of services provided to the retail customer, including any
material limitations on the securities or investment strategies
involving securities that may be recommended to the retail customer;
and (2) all material facts relating to conflicts of interest that are
associated with the recommendation. The Commission believes that
requiring broker-dealers to disclose to a retail customer, in writing,
all material facts relating to the scope and terms of the relationship
with the retail customer would facilitate the retail customer's
understanding of the nature of his or her account, the broker-dealer's
fees and costs, as well as the nature of services that the broker-
dealer provides, as well as any limitations to those services. It would
also provide retail customers with information to better understand the
differences among certain financial service providers, such as broker-
dealers, investment advisers, and dually registered firms and dually
registered financial professionals. In addition, the obligation to
disclose all material facts relating to conflicts of interest that are
associated with a recommendation would raise retail customers'
awareness of the potential effects of conflicts of interest, and
increase the likelihood that broker-dealers would make recommendations
that are in the retail customer's best interest.
We are explicitly requiring in the rule text of Regulation Best
Interest, items that the Proposing Release had only provided as
examples of ``material facts relating to the scope and terms of the
relationship with the retail customer'' that must be disclosed, namely:
(1) That the broker, dealer or such natural person is acting as a
broker, dealer or an associated person of a broker-dealer with respect
to the recommendation; (2) the material fees and costs that apply to
the retail customer's transactions, holdings, and accounts; and (3) the
type and scope of services provided to the retail customer, including:
any material limitations on the securities or investment strategies
involving securities that may be recommended to the retail customer. We
generally believe the proposed burdens and costs identified in the
Proposing Release were accurate but have updated estimates to reflect
changes in the number of broker-dealers and costs of certain services
since the last estimate. The collections of information associated with
the Disclosure Obligation, as well as the associated record-making and
recordkeeping obligations are addressed below.
a. Obligation To Provide to the Retail Customer Full and Fair
Disclosure, in Writing, of all Material Facts Relating to the Scope and
Terms of the Relationship With the Retail Customer
The Commission assumes for purposes of this analysis that broker-
dealers would meet the obligation to disclose to the retail customer,
in writing, the material facts related to the scope and terms of the
relationship with the retail customer through a
[[Page 33471]]
combination of delivery of the Relationship Summary, creating account
disclosures to include standardized language related to capacity and
type and scope of services, and the development of fee schedules.
(1) Disclosure of Capacity
As discussed above, the Commission believes that a standalone
broker-dealer would be able to satisfy its obligation to disclose that
it is acting in a broker-dealer capacity by providing the retail
customer with the Relationship Summary in the manner prescribed by the
rules and guidance in the Relationship Summary Adopting Release.\1392\
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\1392\ See Relationship Summary Adopting Release.
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We assume, for purposes of this PRA analysis, that a dually
registered broker-dealer would satisfy its obligation to disclose it is
acting in a broker-dealer capacity by creating an account disclosure
with standardized language, and by providing it to the retail customer
at the beginning of the relationship. The account disclosure would set
forth when the broker-dealer would be acting in a broker-dealer
capacity, and the method the broker-dealer planned to use to clarify
its capacity at the time of the recommendation. We understand that many
broker-dealers already include such information in account disclosures.
(2) Disclosure of Fees and Costs and Type and Scope of Services,
Including Any Material Limitations on the Securities or Investment
Strategies That may be Recommended
While many broker-dealers provide fee information to retail
customers in a fee schedule, the Commission believes that to comply
with the Disclosure Obligation broker-dealers will either amend their
existing schedules or develop a new standardized fee schedule to
disclose the fees and costs applicable to retail customers'
transactions, holdings, and accounts. This fee schedule would be
delivered to retail customers at the beginning of a relationship. If,
at the time the recommendation is made, the disclosure made to the
retail customer is not current or does not contain all material facts
regarding the fees and costs of the particular recommendation, the
broker-dealer would need to deliver an amended fee schedule or provide
an oral update, under the circumstances outlined in Section II.C.1.
With respect to disclosure of the type and scope of services
provided by the broker-dealer, including any material limitations on
the securities or investment strategies that may be recommended to the
retail customer, we assume for purposes of this PRA analysis that a
broker-dealer would satisfy the Disclosure Obligation by including this
information in the account disclosure provided to the retail customer
at the beginning of the relationship, as described above. The broker-
dealer would need to deliver an amended account disclosure to the
retail customer in the case of any material changes made to the type
and scope of services or provide an oral update, under the
circumstances outlined in Section II.C.1.
b. Obligation To Provide to the Retail Customer Full and Fair
Disclosure, in Writing, of All Material Facts Relating to Conflicts of
Interest That are Associated With the Recommendation
Regulation Best Interest requires a broker-dealer to provide the
retail customer, in writing, full and fair disclosure of all material
facts relating to conflicts of interest that are associated with a
recommendation.
As discussed above, we assume that broker-dealers will satisfy the
obligation to disclose all material facts relating to conflicts of
interest through the use of: (1) A standardized, written disclosure
document provided to all retail customers and (2) supplemental
disclosure provided to certain retail customers for recommendations of
specific products.
We assume for purposes of this analysis that delivery of written
disclosure will occur at the beginning of a relationship, such as
together with the account opening agreement. For existing retail
customers, the disclosure will need to occur ``prior to or at the
time'' of a recommendation. Subsequent disclosures may be delivered or
the broker-dealer may provide an oral update, under the circumstances
outlined in Section II.C.1, in the event of a material change or if the
broker-dealer determines additional disclosure is needed for certain
types of products.
The corresponding estimated total annual reporting costs and
burdens are addressed below.\1393\
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\1393\ The costs and burdens arising from the obligation to
identify all material conflicts of interest that are associated with
the recommendation are addressed below, in the context of the
Conflict of Interest Obligation, in Section V.B.1.
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c. Estimated Costs and Burdens
(1) Disclosure of Capacity, Type and Scope of Services
Standalone broker-dealers will satisfy the obligation to disclose
the capacity in which they are acting through the delivery to retail
customers of the Relationship Summary, in accordance with the rules and
guidance set forth in the Relationship Summary Adopting Release.
Additionally, although we understand that many dual-registrants and
standalone broker-dealers, as a matter of best practice, already
disclose the capacity in which they are acting as well as the and type
and scope of services they offer to retail customers, for purposes of
this analysis, we assume that dual-registrants would create new account
disclosure related to capacity and all broker-dealers would create or
update account disclosure related to type and scope of services
specifically for purposes of compliance with Regulation Best Interest.
The Commission assumes that broker-dealers would provide the account
disclosure to each retail customer account, regardless of whether the
retail customer has multiple accounts with the broker-dealer.
While the Commission recognizes that the Disclosure Obligation
applies to the broker-dealer entity and its associated persons, we do
not expect associated persons to incur any initial or ongoing burdens
with respect to the scope and terms of the relationship, as we assume
for purposes of this analysis that this information would be addressed
by the broker-dealer entity's account disclosure.\1394\ With regard to
disclosure of the capacity in which the associated person is acting,
the Commission believes that dually registered representatives of
broker-dealers will incur initial and ongoing burdens.\1395\
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\1394\ A broker-dealer or an associated person may satisfy the
Disclosure Obligation by using oral disclosure if it has previously
provided written disclosure to the retail customer beforehand as
well as the method it planned to use to clarify the disclosure at
the time of the recommendation. In addition, a record of the fact of
such oral disclosure having been made must be created and retained.
We assume that any disclosure required of a registered
representative will be made orally, and that any ongoing costs and
burdens will be associated with the record-making memorializing the
fact of the oral disclosure. See Section IV.B.5 (discussing the
costs and burdens associated with record-making).
\1395\ See supra Section IV.B.5 (discussing the costs and
burdens associated with record-making).
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Following is a discussion of the estimated initial and ongoing
burdens and costs.
i. Initial Costs and Burdens
Because, as noted above, standalone broker-dealers will satisfy the
obligation to disclose the capacity in which they are acting through
the delivery to retail customers of the Relationship Summary, we
estimate zero burden hours for standalone broker-dealers to disclose
the capacity in which they are acting.
[[Page 33472]]
We estimate that a dually registered firm will incur an initial
internal burden of 10 hours for in-house counsel and in-house
compliance \1396\ to draft language regarding the capacity in which
they are acting for inclusion in the standardized account disclosure
that is delivered to the retail customer.\1397\
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\1396\ The ten hour estimate includes five hours for in-house
counsel to draft and review the standardized language, and five
hours for consultation and review of compliance personnel.
\1397\ As discussed above, the following estimates include the
costs and burdens that broker-dealers would incur in drafting
standardized account disclosure language related to the scope and
terms of the relationship on behalf of their dually registered
representatives. For purposes of this analysis, the Commission
assumes that broker-dealers will undertake these tasks on behalf of
their registered representatives. See Section IV.B.5 (discussing the
costs and burdens associated with record-making).
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In addition, we estimate that dual-registrants will incur an
estimated external cost of $4,970 for the assistance of outside counsel
in the preparation and review of standardized language regarding
capacity.\1398\ For the estimated 563 dually registered firms with
retail business,\1399\ we project an aggregate initial burden of 5,630
hours,\1400\ and $2.8 million in aggregate initial costs relating to
disclosure of the capacity in which they are acting.\1401\
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\1398\ Data from the Securities Industry Financial Markets
Association's Management & Professional Earnings in the Securities
Industry 2013 (``SIFMA Management and Professional Earnings
Report''), modified by Commission staff to account for an 1,800-hour
work-year and inflation, and multiplied by 5.35 (professionals) or
2.93 (office) to account for bonuses, firm size, employee benefits,
and overhead, suggests that costs for this position is $497 per
hour. The SIFMA Management and Professional Earnings Report was
updated in 2019 to reflect inflation. The numbers in the report are
higher than the numbers we used in the Proposing Release. This
estimate is based on the following calculation: (10 hours for
outside counsel review/drafting) x ($497/hour for outside counsel
services) = $4,970 in initial outside counsel costs.
\1399\ See supra Section III.B.1.a, at Table 1, Panel B. The
number of dually registered broker-dealers includes broker-dealers
that are also Commission- and state-licensed investment advisers.
\1400\ This estimate is based on the following calculation: (563
dually registered retail firms) x (10 hours) = 5,630 initial
aggregate burden hours.
\1401\ This estimate is based on the following calculation: (563
dually registered retail firms) x ($4,970 in external cost per firm)
= $2.8 million in aggregate initial costs.
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Similarly, to comply with Regulation Best Interest, we believe that
broker-dealers \1402\ will draft standardized language for inclusion in
the account disclosure to provide the retail customer with more
specific information regarding the type and scope of services that they
provide. We expect that the associated costs and burdens will differ
between small and large broker-dealers, as large broker-dealers
generally offer more products and services and therefore will need to
evaluate a larger number of products and services.
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\1402\ In the Proposing Release, we inadvertently referred to
``standalone broker-dealers'' in this discussion, but our subsequent
references and estimates reflected our intent to capture initial
costs and burdens relating to disclosure of type and scope of
services on all broker-dealers (distinguishing between small and
large).
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Given these assumptions, we estimate that a small broker-dealer
will incur an internal initial burden of 10 hours for in-house counsel
and in-house compliance to draft this standardized language.\1403\ In
addition, a small broker-dealer will incur an estimated external cost
of $4,970 for the assistance of outside counsel in the preparation and
review of this standardized language.\1404\ For the estimated 756 small
broker-dealers,\1405\ we project an aggregate initial burden of 7,560
hours,\1406\ and aggregate initial costs of $3.8 million.\1407\
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\1403\ The 10-hour estimate includes 5 hours for in-house
counsel to draft and review the standardized language, and 5 hours
for consultation and review by in-house compliance.
\1404\ This estimate is based on the following calculation: (10
hours for outside counsel review/drafting) x ($497/hour for outside
counsel services) = $4,970 in initial outside counsel costs.
\1405\ See supra footnote 1384 and accompanying text.
\1406\ This estimate is based on the following calculation: (756
small broker-dealers) x (10 hours per small broker-dealer) = 7,560
initial aggregate burden hours.
\1407\ This estimate is based on the following calculation: (756
small broker-dealers) x ($4,970 in external cost per small broker-
dealer) = $3.8 million in aggregate initial outside counsel costs.
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Given the broader array of products and services offered, we
estimate that a large broker-dealer will incur an internal burden of
twenty hours to draft this standardized language.\1408\ A large broker-
dealer will also incur an estimated cost of $7,470 for the assistance
of outside counsel in the preparation and review of this standardized
language.\1409\ For the estimated 2,010 large retail broker-dealers, we
estimate an aggregate initial burden of 40,200 hours \1410\ and $15
million in aggregate initial costs.\1411\
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\1408\ The 20-hour estimate includes 10 hours for in-house
counsel to draft and review the standardized language, and 10 hours
for consultation and review by in-house compliance.
\1409\ This estimate is based on the following calculation: (15
hours for outside counsel review/drafting) x ($497/hour for outside
counsel services) = $7,455 in initial outside counsel costs.
\1410\ This estimate is based on the following calculation:
(2,010 large broker-dealers) x (20 burden hours) = 40,200 aggregate
initial burden hours.
\1411\ This estimate is based on the following calculation:
(2,010 large broker-dealers) x ($7,455 initial outside counsel
costs) = $15 million in aggregate initial costs.
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We estimate that all broker-dealers will each incur approximately
0.02 burden hours \1412\ for delivery of the account disclosure
document.\1413\ Based on FOCUS data, we estimate that the 2,766 broker-
dealers that report retail activity have approximately 139 million
customer accounts, and that approximately 73.5%, or 102 million, of
those accounts belong to retail customers.\1414\ We therefore estimate
that broker-dealers will have an aggregate initial burden of 2,040,000
hours, or approximately 738 hours \1415\ per broker-dealer for the
first year after Regulation Best Interest is in effect.\1416\
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\1412\ This is the same estimate the Commission makes in the
Relationship Summary Adopting Release. It is also the same estimate
the Commission made in the Amendments to Form ADV Adopting Release,
and for which we received no comment. See Amendments to Form ADV, 17
CFR parts 275 and 279 at 49259. We expect that delivery requirements
will be performed by a general clerk. The general clerk's time is
included in the initial burden estimate.
\1413\ As noted above, for new retail customers, we expect
delivery to occur at the beginning of the relationship; for existing
customers, we expect delivery to occur prior to or at the time of a
recommendation.
\1414\ We have revised our estimates from the Proposing Release
to reflect the updated FOCUS Report data. Therefore, the 2,766
broker-dealers (including dual-registrants) with retail customers
report 139 million customer accounts. See Section III.B.1.a, at
Table 1, Panel B. Assuming the amount of retail customer accounts is
proportionate to the percentage of broker-dealers that have retail
customers, or 73.5% of broker-dealers, then the number of retail
customer accounts would be 73.5% of 139 million accounts = 102
million retail customer accounts. This number likely overstates the
number of deliveries to be made due to the double-counting of
deliveries to be made by dual-registrants to a certain extent, and
the fact that one customer may own more than one account.
\1415\ These estimates are based on the following calculations:
(0.02 hours per customer account x (102 million retail customer
accounts) = 2,040,000 aggregate burden hours. Conversely, (2,040,000
hours)/(2,766 broker-dealers) = approximately 738 burden hours per
broker-dealer for the first year after Regulation Best Interest is
in effect.
\1416\ We estimate that broker-dealers will not incur any
incremental postage costs because we assume that they will make such
deliveries with another mailing the broker-dealer was already
delivering to retail customers.
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We estimate a total initial aggregate burden for all broker-dealers
to develop and deliver to retail customers account disclosures relating
to capacity and type and scope of services of 2,093,390 burden
hours.\1417\ We estimate a total initial aggregate cost of $21.6
million.\1418\
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\1417\ This estimate is based on the following calculation:
(5,630 aggregate initial burden hours for dual-registrants) + (7,560
aggregate initial burden hours for small broker-dealers) + (40,200
burden hours for large broker-dealers) + (2,040,000 aggregate
initial burden hours for all broker-dealers to deliver the account
disclosures) = 2,093,390 total aggregate initial burden hours.
\1418\ This estimate is based on the following calculation:
($2.8 million in initial aggregate costs for dual-registrants) +
($3.8 million in initial aggregate costs for small broker-dealers) +
($15 million in initial aggregate costs for large broker-dealers) =
$21.6 million in total initial aggregate costs.
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[[Page 33473]]
ii. Ongoing Costs and Burdens
For purposes of this analysis, we assume that broker-dealers will
review and amend the standardized language in the account disclosure,
on average, once a year.\1419\ Further, we assume that broker-dealers
will not incur outside costs in connection with updating account
disclosures, as in-house personnel will be more knowledgeable about
changes in capacity, and the type and scope of services offered by the
broker-dealer. Additionally, with respect to standalone broker-dealers,
because they will meet their obligation to disclose capacity by
delivering the Relationship Summary, and will be subject to
requirements to amend the Relationship Summary consistent with Form
CRS, we estimate zero burden hours annually for ongoing costs relating
to disclosure of capacity under the Disclosure Obligation.
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\1419\ We believe this annual timeframe is consistent with other
obligations imposed on broker-dealers. For example, FINRA rules set
an annual supervisory review as a minimum threshold for broker-
dealers, for example, in FINRA Rules 3110 (requiring an annual
review of the businesses in which the broker-dealer engages), 3120
(requiring an annual report detailing a broker-dealer's system of
supervisory controls, including compliance efforts in the areas of
antifraud and sales practices); and 3130 (requiring each broker-
dealer's CEO or equivalent officer to certify annually to the
reasonable design of the policies and procedures for compliance with
relevant regulatory requirements).
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We estimate that each dually registered broker-dealer will incur
approximately five burden hours annually for in-house compliance and
business-line personnel to review changes in the dual-registrant's
capacity,\1420\ and another two burden hours annually for in-house
counsel to amend the account disclosure to disclose material changes to
the dual-registrant's capacity, for a total of seven burden hours. The
estimated ongoing aggregate burden to amend dual-registrants' account
disclosures to reflect changes in capacity is therefore 3,941 hours per
year.\1421\
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\1420\ In the Proposing Release, we referred to capacity and
type and scope of services, however, we captured the ongoing costs
and burdens relating to disclosure of type and scope of services in
the paragraphs that followed, where we inadvertently referred to
``small standalone broker-dealers'' and ``large standalone broker-
dealers,'' but where our calculations reflected the burdens on all
``small broker-dealers'' and all ``large broker-dealers.'' See
Proposing Release, footnotes 600-601. We believe it is appropriate
to distinguish between standalone and dually registered broker-
dealers in assessing the costs and burdens relating to disclosure of
capacity, and to distinguish between small and large firms in
assessing the costs and burdens relating to disclosure of type and
scope of services, as reflected in this section.
\1421\ This estimate is based on the following calculation: (7
burden hours per dually registered firm per year) x (563 dually
registered broker-dealers) = 3,941 ongoing aggregate burden hours
per year.
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With respect to small broker-dealers, we estimate an internal
burden of two hours for in-house compliance and business-line personnel
to review and update changes in types or scope of services, and another
two burden hours annually for in-house counsel to amend the account
disclosure to disclose material changes to type and scope of services--
for a total of four burden hours. The estimated ongoing aggregate
burden for small broker-dealers to amend account disclosures to reflect
changes in type and scope of services is therefore 3,024 hours per
year.\1422\
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\1422\ This estimate is based on the following calculation: (4
burden hours per broker-dealer per year) x (756 small broker-
dealers) = 3,024 ongoing aggregate burden hours per year.
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We estimate that large broker-dealers would incur ten burden hours
annually for in-house compliance and business-line personnel to review
and update changes the type and scope of services, and another ten
burden hours annually for in-house counsel to amend the account
disclosure to disclose material changes to the type and scope of
services, for a total of twenty burden hours. We therefore believe the
ongoing, aggregate burden is 40,200 hours per year for large broker-
dealers.\1423\
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\1423\ This estimate is based on the following calculation: (20
burden hours per broker-dealer per year) x (2,010 large broker-
dealers) = 40,200 ongoing aggregate burden hours per year.
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With respect to delivery of the amended account agreements in the
event of material changes to the capacity disclosure or disclosure
related to type and scope of services, we estimate that this would take
place among 20% of a broker-dealer's retail customer accounts annually.
We therefore estimate broker-dealers to incur a total annual aggregate
burden of 408,000 hours, or 148 hours per year per broker-dealer.\1424\
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\1424\ (20%) x (102 million retail customer accounts) x (.02
hours for delivery to each customer account) = 408,000 aggregate
burden hours. Conversely, 408,000 aggregate burden hours/2,766
broker-dealers = 148 burden hours per year per broker-dealer.
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The total ongoing aggregate burden for all broker-dealers to
review, amend, and deliver updated account disclosures to reflect
changes in capacity, type and scope of services would be 455,165 burden
hours per year.\1425\
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\1425\ This estimate is based on the following calculation:
(3,941 ongoing aggregate burden hours for dually registered broker-
dealers) + (3,024 ongoing aggregate burden hours for small broker-
dealers) + (40,200 ongoing aggregate burden hours for large broker-
dealers) + (408,000 ongoing aggregate burden hours for delivery of
amended account disclosures) = 455,165 total ongoing aggregate
burden hours per year.
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The Commission acknowledges that the types of services and product
offerings vary greatly by broker-dealer, and therefore the costs and
burdens associated with updating the account disclosure might also
vary.
(2) Disclosure of Fees and Costs
The Commission assumes for purposes of this analysis that a broker-
dealer will disclose its fees and costs through a standardized fee
schedule, delivered to the retail customer at the beginning of the
relationship, or, for existing retail customers, prior to or at the
time of a recommendation and, as discussed below, will amend such fee
schedules in the event of material changes. Although we understand that
many broker-dealers already provide fee schedules to retail customers,
we are assuming for purposes of this analysis that a fee schedule would
be created specifically for purposes of compliance with Regulation Best
Interest.\1426\ While the Commission recognizes that the fee disclosure
included in Disclosure Obligation applies to the broker-dealer entity
and its associated persons, we do not expect any burdens or costs on
associated persons related to the fees and costs as this information
would be addressed in the broker-dealer entity's fee schedule.
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\1426\ Our estimates may be higher than actual, since firms may
be able to use or simply update existing disclosures depending on
the facts and circumstances.
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i. Initial Costs and Burdens
We assume that, for purposes of this analysis, the associated costs
and burdens will differ between small and large broker-dealers, as
large broker-dealers generally offer more products and services and
therefore will need to evaluate a wider range of fees in their fee
schedules. As stated above, while we anticipate that many broker-
dealers may already create fee schedules, we believe that small broker-
dealers will initially spend five hours for in-house compliance and
large broker-dealers will spend ten hours for in-house compliance to
internally create a new fee schedule in consideration of the
requirements of Regulation Best Interest. We additionally estimate a
one-time external cost of $2,485 for small broker-dealers \1427\ and
$4,970 for larger broker-dealers for outside counsel to review the fee
schedule.\1428\ We therefore estimate the initial aggregate burden for
small broker-dealers to be 3,780 burden
[[Page 33474]]
hours,\1429\ and the initial aggregate cost to be $1.88 million.\1430\
We estimate the aggregate burden for large broker-dealers to be 20,100
burden hours,\1431\ and the aggregate cost to be $9.99 million.\1432\
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\1427\ This cost estimate is based on the following calculation:
(5 hours of review) x ($497/hour for outside counsel services) =
$2,485 outside counsel costs.
\1428\ This cost estimate is based on the following calculation:
(10 hours of review) x ($497/hour for outside counsel services) =
$4,970 outside counsel costs.
\1429\ This estimate is based on the following calculation: (5
burden hours of review per small broker-dealer) x (756 small broker-
dealers) = 3,780 aggregate initial burden hours.
\1430\ This estimate is based on the following calculation:
($2,485 for outside counsel costs per small broker-dealer) x (756
small broker-dealers) = $1.88 million in aggregate initial outside
costs.
\1431\ This estimate is based on the following calculation: (10
burden hours of review per large broker-dealer) x (2,010 large
broker-dealers) = 20,100 aggregate initial burden hours.
\1432\ This estimate is based on the following calculation:
($4,970 for outside counsel costs per large broker-dealer) x (2,010
large broker-dealers) = $9.99 million in aggregate initial costs.
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Similar to delivery of the account disclosure regarding capacity
and type and scope of services, we estimate the burden for broker-
dealers to make the initial delivery of the fee schedule to new retail
customers, at the beginning of the relationship, and existing retail
customers, prior to or at the time of a recommendation, will require
approximately 0.02 hours to deliver to each retail customer.\1433\ As
stated above, we estimate that the 2,766 broker-dealers that report
retail activity have approximately 139 million customer accounts, and
that approximately 73.5%, or 102 million, of those accounts belong to
retail customers.\1434\ We therefore estimate that broker-dealers will
have an aggregate initial burden of 2,040,000 hours, or approximately
738 hours per broker-dealer for the first year after Regulation Best
Interest is in effect.\1435\
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\1433\ See supra footnote 1411.
\1434\ See supra footnote 1412.
\1435\ This estimate is based on the following calculation: (102
million retail customer accounts) x (.02 hours for delivery to each
customer account) = 2,040,000 aggregate burden hours. Conversely,
(2,040,000 aggregate burden hours)/(2,766 broker-dealers) = 738
burden hours per broker-dealer for the first year after Regulation
Best Interest is in effect.
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The total aggregate initial burden for broker-dealers is therefore
estimated at 2,063,880 \1436\ hours, and the total aggregate initial
cost is estimated at $11.87 million.\1437\
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\1436\ This estimate is based on the following calculations:
(3,780 aggregate burden hours for small broker-dealers) + (20,100
burden hours for large broker-dealers) + (2,040,000 burden hours for
delivery) = 2,063,880 total aggregate initial burden hours.
\1437\ This estimate is based on the following calculation:
($1.88 million for small broker-dealer costs) + ($9.99 million large
broker-dealer costs) = $11.87 million in total initial aggregate
costs.
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ii. Ongoing Costs and Burdens
For purposes of this PRA analysis, we assume that broker-dealers
will review and amend the fee schedule on average, once a year. With
respect to small broker-dealers, we estimate that reviewing and
updating the fee schedule will require approximately two hours for in-
house compliance per year, and for large broker-dealers, we estimate
that the recurring, annual burden to review and update the fee schedule
will be four hours for in-house compliance for each large broker-
dealer. Based on these estimates, we estimate the recurring, aggregate,
annualized burden will be 1,512 hours for small broker-dealers \1438\
and 8,040 hours for large broker-dealers.\1439\ We do not anticipate
that small or large broker-dealers will incur outside legal,
compliance, or consulting fees in connection with updating their
standardized fee schedule since in-house personnel would be more
knowledgeable about these facts, and we therefore do not expect
external costs associated with updating the fee schedule.
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\1438\ This estimate is based on the following calculation: (2
burden hours per broker-dealer) x (756 small broker-dealers) = 1,512
aggregate burden hours per broker-dealer per year.
\1439\ This estimate is based on the following calculation: (4
burden hours per broker-dealer) x (2,010 large broker-dealers) =
8,040 aggregate burden hours per broker-dealer per year.
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With respect to delivery of the amended fee schedule in the event
of a material change, we estimate that this would take place among 40%
of a broker-dealer's retail customer accounts annually, and that
broker-dealers will require approximately 0.02 hours to deliver the
amended fee schedule to each retail customer.\1440\ We therefore
estimate broker-dealers would incur a total annual aggregate burden of
816,000 hours, or 295 hours per broker-dealer.\1441\
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\1440\ See supra footnote 1411.
\1441\ This estimate is based on the following calculation: (40%
of 102 million retail customer accounts) x (.02 hours) = 816,000
aggregate burden hours. Conversely, (816,000 aggregate burden
hours)/(2,766 broker-dealers) = 295 burden hours per broker-dealer
per year.
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The total ongoing aggregate burden for all broker-dealers to
review, amend, and deliver updated account disclosures to reflect
changes in fees and costs would be 825,552 burden hours per year.\1442\
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\1442\ This estimate is based on the following calculation:
(1,512 ongoing aggregate burden hours for small broker-dealers) +
(8,040 ongoing aggregate burden hours for large broker-dealers) +
(816,000 ongoing aggregate burden hours for delivery of amended
account disclosures) = 825,552 total ongoing aggregate burden hours
per year.
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The Commission acknowledges that the type of fee schedule may vary
greatly by broker-dealer, and therefore that the costs or burdens
associated with updating the standardized fee schedule might similarly
vary.
(3) Disclosure of All Material Facts Relating to Conflicts of Interest
Associated With the Recommendation
Regulation Best Interest requires broker-dealers to provide a
retail customer, in writing, full and fair disclosure of all material
facts relating to conflicts of interest that are associated with the
recommendation. Because the Disclosure Obligation applies to both the
broker-dealer entity and its associated persons, the Commission expects
that the broker-dealer entity and its associated persons will incur
initial and ongoing burdens. However, as with the disclosure of the
capacity in which they are acting and type and scope of services, we
assume for purposes of this analysis that the broker-dealer entities
will incur the costs and burdens of disclosing material conflicts of
interest on behalf of their associated persons.\1443\
---------------------------------------------------------------------------
\1443\ See Section IV.B.5 (discussing the costs and burdens
associated with record-making, including for associated persons of a
broker-dealer).
---------------------------------------------------------------------------
i. Initial Costs and Burdens
The Disclosure Obligation provides broker-dealers with the
flexibility to choose the form and manner of conflict disclosure.
However, we believe that many or most broker-dealers will develop a
standardized conflict disclosure document and deliver it to their
retail customers.\1444\ We also assume for purposes of this PRA
analysis that broker-dealers will update and deliver the standardized
conflict disclosure document yearly on an ongoing basis, following the
broker-dealer's annual conflicts review process.
---------------------------------------------------------------------------
\1444\ As noted above, we assume that delivery for new customers
will occur at the beginning of the relationship, and that delivery
for existing customers will occur prior to or at the time a
recommendation is made.
---------------------------------------------------------------------------
For purposes of this PRA analysis, we assume that a standardized
conflict disclosure document will be developed by in-house counsel and
reviewed by outside counsel. For small broker-dealers, we estimate it
will take in-house counsel, on average, five burden hours to create the
standardized conflict disclosure document and outside counsel five
hours to review and revise the document. We estimate that the initial
aggregate burden for the development of a standardized disclosure
document, based on an estimated 756 small broker-dealers, will be 3,780
burden hours.\1445\ We additionally estimate an initial cost of
[[Page 33475]]
$2,485 per small broker-dealer,\1446\ and an aggregate initial cost of
$1.88 million for all small broker-dealers.\1447\
---------------------------------------------------------------------------
\1445\ This estimate is based on the following calculation: (5
hours) x (756 small broker-dealers) = 3,780 aggregate initial burden
hours.
\1446\ This estimate is based on the following calculation:
($497/hour) x (5 hours) = $2,485 in initial costs.
\1447\ This estimate is based on the following calculation:
($497/hour x 5 hours) x (756 small broker-dealers) = $1.88 million
in aggregate initial costs.
---------------------------------------------------------------------------
We expect the development and review of the standardized conflict
disclosure document to take longer for large broker-dealers because, as
discussed above, we believe large broker-dealers generally offer more
products and services and employ more individuals, and therefore will
need to disclose a larger number of conflicts. We estimate that for
large broker-dealers, it will take 7.5 burden hours for in-house
counsel to create the standardized conflict disclosure document, and
outside counsel will take another 7.5 hours to review and revise the
disclosure document. As a result, we estimate the initial aggregate
burden, based on an estimated 2,010 large broker-dealers, to be
approximately 15,075 burden hours.\1448\ We additionally estimate
initial costs of $3,728 per broker-dealer,\1449\ and an aggregate
initial cost for large broker-dealers of approximately $7.49
million.\1450\
---------------------------------------------------------------------------
\1448\ This estimate is based on the following calculation: (7.5
hours x 2,010 large broker-dealers) = 15,075 aggregate initial
burden hours.
\1449\ This estimate is based on the following calculation:
($497/hour) x (7.5 hours) = $3,728 in initial costs per broker-
dealer.
\1450\ This estimate is based on the following calculation:
($497/hour) x (7.5 hours) x 2,010 large broker-dealers) = $7.49
million in aggregate costs.
---------------------------------------------------------------------------
We assume that broker-dealers will deliver the standardized
conflict disclosure document to new retail customers at the inception
of the relationship, and to existing retail customers prior to or at
the time of a recommendation. We estimate that broker-dealers will
require approximately 0.02 hours to deliver the standardized conflict
disclosure document to each retail customer.\1451\ We therefore
estimate that broker-dealers will incur an aggregate initial burden of
2,040,000 hours, or approximately 738 hours per broker-dealer for
delivery of the standardized conflict disclosure document the first
year after Regulation Best Interest is in effect.\1452\
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\1451\ See supra footnote 1411. For purposes of this PRA
analysis, we have assumed any initial disclosures made by the
broker-dealer related to material conflicts of interest will be
delivered together.
\1452\ These estimates are based on the following calculations:
(0.02 hours per customer account x 102 million retail customer
accounts) = 2,040,000 aggregate initial burden hours. Conversely,
(2,040,000 hours)/(2,766 broker-dealers) = 738 burden hours per
broker-dealer.
---------------------------------------------------------------------------
The total aggregate initial burden for broker-dealers is therefore
estimated at 2,058,855 \1453\ hours, and the total aggregate initial
cost is estimated at $9.37 million.\1454\
---------------------------------------------------------------------------
\1453\ This estimate is based on the following calculations:
(3,780 aggregate burden hours for small broker-dealers) + (15,075
burden hours for large broker-dealers) + (2,040,000 burden hours for
delivery) = 2,058,855 total aggregate initial burden hours.
\1454\ This estimate is based on the following calculation:
($1.88 million for small broker-dealer costs) + ($7.49 million large
broker-dealer costs) = $9.37 million in total aggregate initial
costs.
---------------------------------------------------------------------------
ii. Ongoing Costs and Burdens
We believe that broker-dealers will incur ongoing annual burdens
and costs to update the disclosure document to include newly identified
conflicts. We assume for purposes of this analysis that broker-dealers
will update their conflict disclosure document annually, after
conducting an annual conflicts review. We estimate that the conflicts
disclosures will be updated internally by both small and large broker-
dealers.
We estimate that in-house counsel at a small broker-dealer will
require approximately one hour per year to update the standardized
conflict disclosure document, for an ongoing aggregate, annual burden
of approximately 756 hours.\1455\ For large broker-dealers, we estimate
that the ongoing, aggregate annual burden would be two hours for each
broker-dealer: One hour for in-house compliance and one hour for in-
house counsel for legal personnel. We therefore estimate the ongoing,
aggregate burden for large broker-dealers to be approximately 4,020
burden hours.\1456\ We do not anticipate that small or large broker-
dealers will incur outside legal, compliance, or consulting fees in
connection with updating their standardized conflict disclosure
document, since in-house personnel would presumably be more
knowledgeable about conflicts of interest.
---------------------------------------------------------------------------
\1455\ This estimate is based on the following calculation: (1
hour per broker-dealer) x (756 small broker-dealers) = 756 aggregate
burden hours per year.
\1456\ This estimate is based on the following calculation: (2
hours per broker-dealer) x (2,010 large broker-dealers) = 4,020
aggregate burden hours per year.
---------------------------------------------------------------------------
With respect to ongoing delivery of the updated conflict disclosure
document, we estimate that this will take place among 40% of a broker-
dealer's retail customer accounts annually, and that broker-dealers
will require approximately 0.02 hours to deliver the updated conflict
disclosure document to each retail customer.\1457\ We therefore
estimate that broker-dealers will incur an ongoing, aggregate annual
burden of 816,000 hours, or 295 burden hours per broker-dealer.\1458\
The total aggregate ongoing burden for broker-dealers is therefore
estimated at 820,776 hours.\1459\
---------------------------------------------------------------------------
\1457\ See supra footnote 1411. The Commission estimates that
broker-dealers will update their disclosures of fees and costs and
material facts relating to conflicts of interest that are associated
with their recommendation more frequently than disclosure related to
capacity or type and scope of services.
\1458\ This estimate is based on the following calculation: (40%
of 102 million retail customer accounts) x (.02 hours) = 816,000
aggregate burden hours per year. Conversely, (816,000 aggregate
burden hours)/(2,766 broker-dealers) = 295 hours per broker-dealer
per year.
\1459\ This estimate is based on the following calculations:
(756 aggregate burden hours for small broker-dealers) + (4,020
aggregate burden hours for large broker-dealers) + (816,000
aggregate burden hours for delivery) = 820,776 total aggregate
ongoing burden hours.
---------------------------------------------------------------------------
Based on the calculation describe above, we estimate that broker-
dealers will incur an aggregate total initial burden of 6,216,125 hours
\1460\ and a total initial cost of $42.84 million,\1461\ as well as an
aggregate total ongoing annual burden of 2,101,493 hours \1462\ to
comply with the Disclosure Obligation.
---------------------------------------------------------------------------
\1460\ This estimate is based on the following calculation:
(2,093,390 aggregate initial burden hours for initial compliance
with disclosure of capacity and type and scope of services) +
(2,063,880 aggregate initial burden hours for initial compliance
with disclosure of fees and costs) + (2,058,855 aggregate initial
burden hours for initial compliance with disclosure of all material
facts regarding disclosure of conflicts of interest associated with
the recommendation) = 6,216,125 total aggregate initial burden hours
for compliance with the Disclosure Obligation.
\1461\ This estimate is based on the following calculation:
($21.6 million aggregate initial cost for compliance with disclosure
of capacity and type and scope of services) + ($11.87 million
aggregate initial cost for compliance with disclosure of fees and
costs) + ($9.37 aggregate initial cost for compliance with
disclosure of all material facts regarding disclosure of conflicts
of interest associated with the recommendation) = $42.84 million
total aggregate initial cost for compliance with the Disclosure
Obligation.
\1462\ This estimate is based on the following calculation:
(455,165 aggregate annual burden hours for ongoing compliance with
disclosure of capacity and type and scope of services) + (825,552
aggregate annual burden hours for ongoing compliance with disclosure
of fees and costs) + (820,776 aggregate annual burden hours for
ongoing compliance with disclosure of all material facts regarding
disclosure of conflicts of interest associated with the
recommendation) = 2,101,493 total aggregate burden hours per year
for ongoing compliance with the Disclosure Obligation.
---------------------------------------------------------------------------
2. Care Obligation
The Care Obligation requires a broker-dealer to have a reasonable
basis to believe, based on its understanding of the potential risks,
rewards, and costs of the recommended security or investment strategy
involving securities,
[[Page 33476]]
and in light of the retail customer's investment profile, that the
recommendation is in the best interest of the particular retail
customer and does not place the broker-dealer's interest ahead of the
retail customer's interest. However, any PRA burdens or costs
associated with the Care Obligation are duplicative of costs associated
with other obligations in Regulation Best Interest, including the
Disclosure Obligation and the Record-Making Obligation under Rule 17a-
3(a)(35) and Recordkeeping Obligation under Rule 17a-4(e)(5).
3. Conflict of Interest Obligation
The Conflict of Interest Obligation creates an overarching
obligation to require broker-dealers \1463\ to establish written
policies and procedures reasonably designed to identify and at a
minimum disclose, pursuant to the Disclosure Obligation, or eliminate
all conflicts of interest associated with a recommendation. More
specifically, broker-dealers are specifically required to establish,
maintain, and enforce written policies and procedures reasonably
designed to: (i) Identify and mitigate any conflicts of interest
associated with recommendations that create an incentive for a natural
person who is an associated person of a broker or dealer to place the
interest of the broker or dealer, or such natural person making the
recommendation, ahead of the interest of the retail customer; (ii) (A)
identify and disclose any material limitations placed on the securities
or investment strategies involving securities that may be recommended
to a retail customer and any conflicts of interest associated with such
limitations, in accordance with the Disclosure Obligation, and (B)
prevent such limitations and associated conflicts of interest from
causing the broker, dealer, or a natural person who is an associated
person of the broker or dealer to make recommendations that place the
interest of the broker, dealer, or such natural person ahead of the
interest of the retail customer; and (iii) identify and eliminate sales
contests, bonuses, and non-cash compensation that are based on the
sales of specific securities or specific types of securities within a
limited period of time.\1464\
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\1463\ As discussed above, the Conflict of Interest Obligation
and Compliance Obligation apply solely to the broker or dealer
entity, and not to the associated persons of a broker or dealer.
\1464\ Rule 15l-1 under the Exchange Act.
---------------------------------------------------------------------------
Written policies and procedures developed pursuant to the Conflict
of Interest Obligation of Regulation Best Interest would help a broker-
dealer to develop a process reasonably designed for its business, for
identifying conflicts of interest, and then determining whether to
eliminate, or disclose and/or mitigate the conflict and the appropriate
means of eliminating, disclosing and/or mitigating the conflict. In
addition, establishing and maintaining written policies and procedures
would generally (1) assist a broker-dealer in supervising its
associated persons and assessing compliance with the Conflict of
Interest Obligation; and (2) assist the Commission and SRO staff in
connection with examinations and investigations.\1465\
---------------------------------------------------------------------------
\1465\ See Section II.C.3.a.
Any written policies and procedures developed pursuant to
Regulation Best Interest would be required to be retained pursuant
to Exchange Act Rule 17a-4(e)(7), which requires broker-dealers to
retain compliance, supervisory, and procedures manuals (and any
updates, modifications, and revisions thereto) describing the
policies and procedures of the broker-dealer with respect to
compliance with applicable laws and rules, and supervision of the
activities of each associated, for a specified period of time. The
record retention requirements of Rule 17a-4(e)(7) include any
written policies and procedures that broker-dealers may produce
pursuant to the Conflict of Interest Obligation of Regulation Best
Interest.
---------------------------------------------------------------------------
In light of the modifications to several substantive requirements
of the rule relative to the Proposing Release, including the Conflict
of Interest Obligation, as discussed in more detail above, we believe
these changes will allow broker-dealers' to more easily incorporate the
requirements of Regulation Best Interest into existing supervisory and
compliance systems and streamline compliance with Regulation Best
Interest.\1466\ Therefore, we generally believe our proposed burdens
and costs are accurate but have updated estimates to reflect changes in
the number of broker-dealers and costs of certain services since the
last estimate in the Proposing Release.
---------------------------------------------------------------------------
\1466\ See Section II.C.3.
---------------------------------------------------------------------------
Following is a detailed discussion of the estimated costs and
burdens associated with the Conflict of Interest Obligation.
a. Written Policies and Procedures
i. Initial Costs and Burdens
We believe that most broker-dealers have policies and procedures in
place to address conflicts of interest, but do not necessarily have
written policies and procedures regarding the identification and
management of conflicts as required by Regulation Best Interest. To
comply with the Conflict of Interest Obligation, we believe that
broker-dealers would utilize a combination of in-house and outside
legal and compliance counsel to update existing policies and
procedures.\1467\ We assume that, for purposes of this analysis, the
associated costs and burdens would differ between small and large
broker-dealers, as large broker-dealers generally offer more products
and services and therefore would need to evaluate and address a greater
number of potential conflicts of interest. As discussed above, we
estimate that 2,010 broker-dealers would qualify as large broker-
dealers for purposes of this analysis and 756 would qualify as small
broker-dealers that have retail business.\1468\
---------------------------------------------------------------------------
\1467\ See footnote 1381 and accompanying text.
\1468\ See footnote 1387 and accompanying text.
---------------------------------------------------------------------------
In the Proposing Release, we estimated that a large broker-dealer
would incur a one-time internal burden of 60 hours for in-house legal
and in-house compliance counsel to update existing policies and
procedures to comply with Regulation Best Interest.\1469\ We also
estimated a cost of $4,720 for outside counsel to review updated
policies and procedures on behalf of a large broker-dealer, with an
aggregate initial burden of 123,300 burden hours and aggregate initial
cost of $9.70 million for large broker-dealers.\1470\
---------------------------------------------------------------------------
\1469\ See Proposing Release at 21666.
\1470\ Id.
---------------------------------------------------------------------------
In the Proposing Release, we assumed that small broker-dealers
would primarily rely on outside counsel to update existing policies and
procedures, as small broker-dealers generally have fewer in-house legal
and compliance personnel. Given that smaller broker-dealers generally
have fewer conflicts of interest, we estimated that 40 hours of outside
legal counsel services would be required, for a one-time cost of
$18,800 per small broker-dealer, and an aggregate cost of $15.1 million
for all small broker-dealers, and we also expected that in-house
compliance personnel would require 10 hours to review and approve the
updated policies and procedures, for an aggregate burden of 8,020
hours.\1471\ Therefore, we estimated the total initial aggregate burden
to be 131,320 hours and the total initial aggregate cost to be $24.8
million.\1472\
---------------------------------------------------------------------------
\1471\ Id.
\1472\ Id.
---------------------------------------------------------------------------
We believe our estimates are generally accurate in light of the
increased specificity in Regulation Best Interest as to how a broker-
dealer must address specified conflicts of interest but due to changes
in the number of broker-dealers and cost estimates for certain
services, we are revising our burden and cost estimates.\1473\
---------------------------------------------------------------------------
\1473\ We have revised our cost estimates to reflect the updated
SIFMA Management and Professional Earnings Report which was updated
in 2019 to reflect inflation. Therefore, the hourly rates used here
for certain services, for example, outside legal counsel and outside
compliance costs, are higher than the numbers in the Proposing
Release.
---------------------------------------------------------------------------
[[Page 33477]]
For purposes of Regulation Best Interest as adopted, we estimate
that a large broker-dealer would incur an initial burden of 50 hours
for in-house counsel and in-house compliance to update existing
policies and procedures to comply with Regulation Best Interest and an
initial burden of 5 hours for general counsel and 5 hours for a Chief
Compliance Officer to review and approve the updated policies and
procedures, for a total of 60 burden hours.\1474\ We also estimate ten
hours of outside counsel services will be required at a cost of $4,970
to review updated policies and procedures on behalf of a large broker-
dealer.\1475\ We therefore estimate the aggregate initial burden for
large broker-dealers to be of 120,600 burden hours \1476\ and initial
aggregate cost of approximately $10.0 million for large broker-
dealers.\1477\
---------------------------------------------------------------------------
\1474\ This estimate is based on the following calculation: (50
hours of review for in-house counsel and in-house compliance
counsel) + (5 hours of review for general counsel) + (5 hours of
review for Chief Compliance Officer) = 60 initial burden hours per
large broker-dealer.
\1475\ Data from the SIFMA Management and Professional Earnings
Report suggests that the average hourly rate for legal services is
$497/hour. This cost estimate is therefore based on the following
calculation: (10 hours of review) x ($497/hour for outside counsel
services) = $4,970 in outside counsel costs per large broker-dealer.
\1476\ This estimate is based on the following calculation: (60
burden hours of review per large broker-dealer) x (2,010 large
broker-dealers) = 120,600 aggregate burden hours for large broker-
dealers.
\1477\ This estimate is based on the following calculation:
($4,970 for outside counsel costs per large broker-dealer) x (2,010
large broker-dealers) = approximately $10.0 million in outside
counsel costs for large broker-dealers.
---------------------------------------------------------------------------
For small broker-dealers, we believe that they would primarily rely
on outside counsel to update existing policies and procedures, as small
broker-dealers generally have fewer in-house legal and compliance
personnel. Given that smaller broker-dealers generally have fewer
conflicts of interest, we estimate that 40 hours of outside legal
counsel would be required to update existing policies and procedures,
for a one-time cost of $19,880 per small broker-dealer,\1478\ and an
aggregate cost of $15.0 million for all small broker-dealers.\1479\ We
also expect that in-house compliance would require 10 hours to review
and approve the updated policies and procedures, for an aggregate
burden of 7,560 hours.\1480\ Therefore, we estimate the total initial
aggregate burden to be 128,160 hours \1481\ and the total initial
aggregate cost to be approximately $25.0 million.\1482\
---------------------------------------------------------------------------
\1478\ This cost estimate is based on the following calculation:
(40 hours of review) x ($497/hour for outside counsel services) =
$19,880 in outside counsel costs per small broker-dealer.
\1479\ This cost estimate is based on the following calculation:
($19,880 for outside attorney costs per small broker-dealer) x (756
small broker-dealers) = approximately $15.0 million in outside
counsel costs for small broker-dealers.
\1480\ This estimate is based on the following calculation: (10
burden hours) x (756 small broker-dealers) = 7,560 aggregate burden
hours.
\1481\ This estimate is based on the following calculation:
(120,600 aggregate burden hours for large broker-dealers) + (7,560
aggregate burden hours for small broker-dealers) = 128,160 total
aggregate burden hours.
\1482\ This estimate is based on the following calculation: ($10
million in aggregate costs for large broker-dealers) + ($15.0
million in aggregate costs for small broker-dealers) = $25.0 million
total aggregate costs.
---------------------------------------------------------------------------
ii. Ongoing Costs and Burdens
For purposes of this analysis, we assume that small and large
broker-dealers would review and update policies and procedures on an
annual basis to accommodate the addition of, for example, new products
or services, new business lines, and/or new personnel. We also assume
that broker-dealers would review and update their policies and
procedures for compliance with the Conflict of Interest Obligation on
an annual basis, and in-house personnel would perform the review and
make any updates.
In the Proposing Release, we estimated that large broker-dealers
would incur an annual internal burden of 12 hours to review and update
existing policies and procedures to identify new conflicts for an
ongoing, aggregate burden of 24,660 hours with no ongoing costs as they
would rely on internal personnel.\1483\ We assumed small broker-dealers
would rely on outside legal counsel and compliance consultants to
review and update policies and procedures, with final review and
approval from in-house compliance \1484\ with an aggregate, annual
ongoing cost of $3.08 million per year.\1485\ In addition to these
costs, we believed that small broker-dealers would incur an internal an
ongoing, aggregate burden of 28,670 hours. While the Commission
believes our time estimates from the Proposing Release are generally
accurate, we have revised our burdens and estimates to account for
changes in both the number of broker-dealers and external costs of
services.
---------------------------------------------------------------------------
\1483\ Proposing Release at 21667.
\1484\ Id.
\1485\ Id.
---------------------------------------------------------------------------
We estimate that large broker-dealers, which generally have more
numerous and complex products and services, as well as and higher rates
of hiring and turnover would incur an annual internal burden of 12
hours to review and update existing policies and procedures: Four hours
for in-house counsel, four hours for in-house compliance, and four
hours for business-line personnel to identify new conflicts. We
therefore estimate an ongoing, aggregate burden for large broker-
dealers of approximately 24,120 hours.\1486\ Because we assume that
large broker-dealers would rely on internal personnel to update
policies and procedures on an ongoing basis, we do not believe large
broker-dealers would incur ongoing external costs.
---------------------------------------------------------------------------
\1486\ This estimate is based on the following calculation: (12
burden hours per large broker-dealer) x (2,010 large broker-dealers)
= 24,120 aggregate ongoing burden hours.
---------------------------------------------------------------------------
We assume for purposes of this analysis that small broker-dealers,
generally have fewer and less complex products and lower rates of
hiring. We also assume they would primarily rely on outside legal
counsel and outside compliance consultants for review and update of
their policies and procedures, with final review and approval from an
in-house compliance manager. We estimate that outside legal counsel
would require approximately five hours per year to update policies and
procedures, for an annual cost of $2,485 for each small broker-
dealer.\1487\ The projected aggregate, annual ongoing cost for outside
legal counsel to update policies and procedures for small broker-
dealers would be $1.88 million per year.\1488\ In addition, we expect
that small broker-dealers would require five hours of outside
compliance services per year to update their policies and procedures,
for an ongoing cost of $1,365 per year,\1489\ and an aggregate ongoing
cost of $1.03 million.\1490\ The total aggregate, ongoing cost for
small
[[Page 33478]]
broker-dealers is therefore projected at $2.91 million per year.\1491\
---------------------------------------------------------------------------
\1487\ This estimate is based on the following calculation: (5
hours per small broker-dealer) x ($497/hour for outside counsel
services) = $2,485 in outside counsel costs.
\1488\ This estimate is based on the following calculation:
($2,485 in outside counsel costs per small broker-dealer) x (756
small broker-dealers) = $1.88 million in aggregate, ongoing outside
legal costs per year.
\1489\ We believe that performance of this function will most
likely be equally allocated between a senior compliance examiner and
a compliance manager. Data from the SIFMA Management and
Professional Earnings Report suggests that costs for these positions
are $237 and $309 per hour, respectively for an average of $273 per
hour. This cost estimate is based on the following calculation: (5
hours of review) x ($273/hour for outside compliance services) =
$1,365 in outside compliance service costs.
\1490\ This estimate is based on the following calculation:
($1,365 in outside compliance costs per small broker-dealer) x (756
small broker-dealers) = $1.03 million in aggregate, ongoing outside
compliance costs per year.
\1491\ This estimate is based on the following calculation:
($1.88 million for outside legal counsel costs) + ($1.03 million for
outside compliance costs) = $2.91 million total aggregate ongoing
costs per year.
---------------------------------------------------------------------------
In addition to the costs described above, we additionally believe
small broker-dealers would incur an internal burden of approximately 5
hours for an in-house compliance manager to review and approve the
updated policies and procedures per year. The ongoing, aggregate burden
for small broker-dealers would be 3,780 hours for in-house compliance
manager review.\1492\
---------------------------------------------------------------------------
\1492\ This estimate is based on the following calculation: (5
hours compliance manager review per small broker-dealer) x (756
small broker-dealers) = 3,780 aggregate ongoing burden hours per
year.
---------------------------------------------------------------------------
We therefore estimate the total ongoing aggregate ongoing burden to
be 27,900 hours per year \1493\ and the total ongoing aggregate cost to
be $2.91 million per year.\1494\
---------------------------------------------------------------------------
\1493\ This estimate is based on the following calculation:
(24,120 aggregate ongoing burden hours for large broker-dealers) +
(3,780 aggregate ongoing burden hours for small broker-dealers) =
27,900 total aggregate ongoing burden hours per year.
\1494\ This estimate is based on the following calculation:
($2.91 million per year in total aggregate ongoing costs for small
broker-dealers) + ($0 projected ongoing costs for large broker-
dealers) = $2.91 million per year in total aggregate ongoing costs.
---------------------------------------------------------------------------
The Commission acknowledges that policies and procedures may vary
greatly by broker-dealer, given the differences in size and the
complexity of broker-dealer business models. Accordingly, we expect
that the need to update policies and procedures might also vary
greatly.
b. Identification and Management of Conflicts of Interest
With respect to identifying and determining whether a conflict of
interest exists in connection with a recommendation and whether it
needs to be addressed through disclosure, mitigation and/or
elimination, a broker-dealer would first need to establish mechanisms
to proactively and systematically identify conflicts of interest in its
business on an ongoing or periodic basis.\1495\ For purposes of this
analysis, we assume that most broker-dealers already have an existing
technological infrastructure in place, and we assume it would need to
be modified to comply with the Conflict of Interest Obligation.
---------------------------------------------------------------------------
\1495\ See supra Section III.C.3.
---------------------------------------------------------------------------
i. Initial Costs and Burdens
As stated in the Proposing Release, we believed that costs and
burdens may vary greatly depending on the size of the broker-dealer,
but we expected that modification of a broker-dealer's existing
technology would initially require the retention of an outside
programmer as well as coordination between the programmer and the
broker-dealer's in-house compliance manager. The costs and burdens for
this process were estimated to be $15.43 million and 14,285 burden
hours.\1496\ In addition to these costs and burdens, we expected that a
broker-dealer would spend time to determine whether the conflict of
interest identified were material and would have required an additional
14,285 burden hours for all broker-dealers for an aggregate burden of
28,570 hours for identification of conflicts of interest.\1497\
---------------------------------------------------------------------------
\1496\ Proposing Release at 21667.
\1497\ Id.
---------------------------------------------------------------------------
As stated above, we believe the process would be largely the same
as set forth in the Proposing Release but have revised our estimates
and costs below to account for changes in the number of broker-dealers
and external costs as well as to account for some changes to the
structure of the Conflict of Interest Obligation.
To comply with the Conflict of Interest Obligation, we expect that
broker-dealers will modify existing technology through the work of an
outside programmer which would require, on average, an estimated 20
hours, for an estimated cost per broker-dealer of $5,680.\1498\ We
additionally continue to estimate (as was set forth in the Proposing
Release) that coordination between the programmer and the broker-
dealer's compliance manager would involve five burden hours.\1499\ The
aggregate initial costs and burdens for the modification of existing
technology to identify conflicts of interest would therefore be $15.71
million,\1500\ and 13,830 burden hours.\1501\
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\1498\ Data from the SIFMA Management and Professional Earnings
Report suggests that the average hourly rate for technology services
in the securities industry is $284. This cost estimate is based on
the following calculation: (20 hours of review) x ($284/hour for
technology services) = $5,680.
\1499\
\1500\ This cost estimate is based on the following calculation:
($5,680 in outside programmer costs per broker-dealer) x (2,766
broker-dealers) = $15.71 million in aggregate outside programmer
costs.
\1501\ This burden estimate is based on the following
calculation: (5 burden hours for in-house compliance manager) x
(2,766 broker-dealers) = 13,830 aggregate burden hours.
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As a result of the changes made to the rule text of the Conflict of
Interest Obligation, we believe that broker-dealers would incur burdens
to: (1) Identify conflicts of interest and determine whether the
conflict involves an incentive to an associated person to place the
interest of the broker-dealer or natural person making the
recommendation ahead of the interest of the retail customer, a material
limitation on the product menu, or a sales practice that is based on
the sales of specific securities or specific types of securities within
a limited period of time and (2) determine whether and how the conflict
would be disclosed, disclosed and mitigated, or eliminated in
accordance with the Conflict of Interest Obligation. In order to
complete this process, we believe a broker-dealer, on average, would
require approximately 20 hours \1502\ of review per broker-
dealer,\1503\ for an aggregate of 55,320 burden hours for all broker-
dealers.\1504\ We therefore estimate the total initial aggregate burden
for identification and management of conflicts of interest is 69,150
hours.\1505\
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\1502\ In light of the changes made to the rule text of the
Conflict of Interest Obligation and the comments received, we have
increased our estimate to 20 burden hours per broker-dealer.
\1503\ This burden estimate consists of 10 hours for review by
business line personnel, and 10 hours for review by in-house
compliance manager.
\1504\ This burden estimate is based on the following
calculation: (20 burden hours) x (2,766 broker-dealers) = 55,320
aggregate burden hours.
\1505\ This burden estimate is based on the following
calculation: (13,830 burden hours for modification of technology) +
(55,320 burden hours for evaluation of managing conflicts) = 69,150
total aggregate burden hours.
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ii. Ongoing Costs and Burdens
To maintain compliance with the Conflict of Interest Obligation, we
assume for purposes of this analysis that a broker-dealer would seek to
identify additional conflicts of interest as its business evolves. As
noted above, the Commission recognizes that broker-dealers vary in the
types of services and product offerings and therefore vary in the types
of conflicts of interest that exist within and across broker-
dealers.\1506\
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\1506\ See supra Section II.C.3.
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However, for purposes of the PRA analysis in the Proposing Release,
we assumed that broker-dealers would, at a minimum, engage in a
material conflicts identification process on an annual basis, and we
estimated that in the aggregate broker-dealers would spend
approximately 28,570 hours each to complete this process per
year.\1507\ Similar to the Proposing Release, we believe that for
purposes of this analysis, broker-dealers would, through the help of
the business line and compliance personnel, spend on average 10 hours
\1508\ to perform an annual
[[Page 33479]]
conflicts review using the modified technology infrastructure.\1509\
Therefore, the Commission estimates that the aggregate ongoing burden
for an annual conflicts review, based on an estimated 2,766 retail
broker-dealers, would be approximately 27,660 burden hours per
year.\1510\ Because we assume that broker-dealers would use in-house
personnel to identify and evaluate new, potential conflicts, we
continue to believe they would not incur additional ongoing external
costs.
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\1507\ See Proposing Release at 21668.
\1508\ This burden estimate consists of five hours for review by
business line personnel, and five hours for review by an in-house
compliance manager.
\1509\ FINRA rules set an annual supervisory review as a minimum
threshold for broker-dealers. See, e.g., FINRA Rules 3110 (requiring
an annual review of the businesses in which the broker-dealer
engages); 3120 (requiring an annual report detailing a broker-
dealer's system of supervisory controls, including compliance
efforts in the areas of antifraud and sales practices); and 3130
(requiring each broker-dealer's CEO or equivalent officer to certify
annually to the reasonable design of the policies and procedures for
compliance with relevant regulatory requirements).
\1510\ This estimate is based on the following calculation: (10
hours per retail broker-dealer) x (2,766 retail broker-dealers) =
27,660 aggregate burden hours per year.
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c. Training
As discussed in the Proposing Release, we expect that broker-
dealers would develop training programs to comply with Regulation Best
Interest, including the Conflict of Interest Obligation. However, we
believe that any burdens and costs associated with a training program
would fall under the new Compliance Obligation as it would be developed
to comply with Regulation Best Interest as a whole, including each of
the component obligations.
In total, to comply with the Conflict of Interest Obligation, the
Commission estimates that the total initial burdens and costs to be
197,310 hours \1511\ and $40.71 million,\1512\ and the total ongoing
burdens and costs to be 55,560 hours \1513\ per year and $2.91 million
per year.\1514\
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\1511\ This estimate is based on the following calculation:
(128,160 initial burden hours for policies and procedures) + (69,150
initial burden hours for identification and management of conflicts
of interest) = 197,310 initial burden hours to comply with the
Conflict of Interest Obligation.
\1512\ This estimate is based on the following calculation:
($25.0 million initial costs for policies and procedures) + ($15.71
million initial costs for identification and management of conflicts
of interest) = $40.71 million initial total costs to comply with the
Conflict of Interest Obligation.
\1513\ This estimate is based on the following calculation:
(27,900 ongoing burden hours for policies and procedures) + (27,660
ongoing burden hours for identification and management of conflicts
of interest) = 55,560 aggregate ongoing burden hours per year to
comply with Conflict of Interest Obligation.
\1514\ This estimate is based on the following calculation:
($2.91 million ongoing costs for policies and procedures) + ($0
ongoing costs for identification and management of conflicts of
interest) = $2.91 million aggregate ongoing total costs per year to
comply with the Conflict of Interest Obligation.
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4. Compliance Obligation
As discussed above, in response to comments that we should require
policies and procedures to comply with Regulation Best Interest as a
whole, we are adopting the Compliance Obligation.\1515\ The Compliance
Obligation requires that the broker-dealer \1516\ establish, maintain
and enforce written policies and procedures reasonably designed to
achieve compliance with Regulation Best Interest. This Compliance
Obligation creates an explicit obligation under the Exchange Act with
respect to Regulation Best Interest as a whole. Similar to the policies
and procedures requirement of the Conflict of Interest Obligation,
broker-dealers will have flexibility to design policies and procedures
that are reasonable for the scope, size and risks associated with the
operations of the firm and the types of business in which the broker-
dealer engages. Because we did not include the Compliance Obligation in
the Proposing Release, we did not previously include costs and burdens
associated with the Compliance Obligation, but we have provided a
detailed explanation of these costs and burdens below.\1517\
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\1515\ Section II.C.4.
\1516\ See supra footnote 1462 and accompanying text.
\1517\ We note that any burdens and costs to comply with the
Conflict of Interest Obligation are included in the estimates in
Section IV.B.3 above.
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a. Written Policies and Procedures
i. Initial Costs and Burdens
While the Compliance Obligation creates an explicit requirement
under the Exchange Act, we believe that broker-dealers would likely
establish policies and procedures to comply with Regulation Best
Interest pursuant to Section 15(b)(4)(E) and SRO rules by adjusting
their current systems of supervision and compliance, as opposed to
creating new systems. While broker-dealers must already have policies
and procedures in place to address other Commission and SRO rules, they
would need to update their systems of supervision and compliance to
account for Regulation Best Interest.
To comply with the Compliance Obligation, we believe that broker-
dealers would employ a combination of in-house and outside legal and
compliance counsel to update existing policies and procedures to
account for the Disclosure and Care Obligations.\1518\ We assume that,
for purposes of this analysis, the associated costs and burdens would
differ between small and large broker-dealers, as large broker-dealers
generally offer more products and services and employ more individuals
and therefore would need to evaluate and update a greater number of
systems. As discussed above, we estimate that 2,010 broker-dealers
would qualify as large broker-dealers for purposes of this analysis and
756 would qualify as small broker-dealers that have retail
business.\1519\
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\1518\ Id.
\1519\ See supra footnote 1387 and accompanying text.
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For purposes of this analysis we estimate that a large broker-
dealer would incur a one-time average internal burden of 30 hours for
in-house legal personnel and in-house compliance counsel to update
existing policies and procedures to comply with the Compliance
Obligation and a one-time burden of five hours for general counsel and
five hours for a Chief Compliance Officer to review and approve the
updated policies and procedures, for a total of 40 burden hours.\1520\
We also estimate six hours of outside counsel services a cost of $2,982
for outside counsel to review updated policies and procedures on behalf
of a large broker-dealer.\1521\ We therefore estimate the aggregate
burden for large broker-dealers to be of 80,400 burden hours \1522\ and
aggregate cost of $6.0 million for large broker-dealers.\1523\
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\1520\ This estimate is based on the following calculation: (30
hours of review for in-house legal and in-house compliance) + (5
hours of review for general counsel) + (5 hours of review for Chief
Compliance Officer) = 40 burden hours.
\1521\ Data from the SIFMA Management and Professional Earnings
Report suggests that the average hourly rate for legal services is
$497/hour. This cost estimate is therefore based on the following
calculation: (6 hours of review) x ($497/hour for outside counsel
services) = $2,982 in outside counsel costs.
\1522\ This estimate is based on the following calculation: (40
burden hours of review per large broker-dealer) x (2,010 large
broker-dealers) = 80,400 aggregate burden hours.
\1523\ This estimate is based on the following calculation:
($2,982 for outside counsel costs per large broker-dealer) x (2,010
large broker-dealers) = $6.0 million in outside counsel costs.
---------------------------------------------------------------------------
For small broker-dealers, we believe that they would primarily rely
on outside counsel to update existing policies and procedures, as small
broker-dealers generally have fewer in-house legal and compliance
personnel. We estimate that only 20 hours of outside legal counsel
services would be required, for a one-time cost of $9,940 per small
broker-dealer,\1524\ and an aggregate cost of $7.5 million for all
[[Page 33480]]
small broker-dealers.\1525\ We also expect that in-house compliance
personnel would require 6 hours to review and approve the updated
policies and procedures, for an aggregate burden of 4,536 hours.\1526\
Therefore, we estimate the total initial aggregate burden to be 84,936
hours \1527\ and the total initial aggregate cost to be $13.5
million.\1528\
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\1524\ This cost estimate is based on the following calculation:
(20 hours of review) x ($497/hour for outside counsel services) =
$9,940 in outside counsel costs.
\1525\ This cost estimate is based on the following calculation:
($9,940 for outside counsel costs per small broker-dealer) x (756
small broker-dealers) = $7.5 million in outside counsel costs.
\1526\ This estimate is based on the following calculation: (6
burden hours) x (756 small broker-dealers) = 4,536 initial aggregate
burden hours.
\1527\ This estimate is based on the following calculation:
(80,400 aggregate burden hours for large broker-dealers) + (4,536
aggregate burden hours for small broker-dealers) = 84,936 total
initial aggregate burden hours.
\1528\ This estimate is based on the following calculation: ($6
million in aggregate costs for large broker-dealers) + ($7.5 million
in aggregate costs for small broker-dealers) = $13.5 million total
initial aggregate costs.
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ii. Ongoing Costs and Burdens
For purposes of this analysis, we assume that small and large
broker-dealers would review and update policies and procedures on a
periodic basis to accommodate the addition of, among other things, new
products or services, new business lines, and/or new personnel. We also
assume that broker-dealers would review and update their policies and
procedures for compliance with Regulation Best Interest on an annual
basis, and for purposes of this analysis, we assume they would perform
the review and update using in-house personnel. Under the Compliance
Obligation, we do not believe that broker-dealers would incur any costs
or burdens associated with compliance with the Conflict of Interest
Obligation, as those are included in the discussion above, but would
for ongoing compliance with the Disclosure and Care Obligations.
For large broker-dealers with more numerous and complex products
and services, as well as higher rates of hiring and turnover, we
estimate that each broker-dealer would annually incur an internal
burden of 12 hours to review and update existing policies and
procedures: four hours for legal personnel, four hours for compliance
personnel, and four hours for business-line personnel. We therefore
estimate an ongoing, aggregate burden for large broker-dealers of
approximately 24,120 hours per year.\1529\
---------------------------------------------------------------------------
\1529\ This estimate is based on the following calculation: (12
burden hours per large broker-dealer) x (2,010 large broker-dealers)
= 24,120 aggregate ongoing burden hours per year.
---------------------------------------------------------------------------
We assume for purposes of this analysis that small broker-dealers,
who generally have fewer and less complex products, and lower rates of
hiring and turnover, would mostly rely on outside legal counsel and
compliance consultants for review and update of their policies and
procedures, with final review and approval from an in-house compliance
manager. We estimate that outside counsel would require approximately
five hours per year to update policies and procedures, for an annual
cost of $2,485 for each small broker-dealer.\1530\ The projected
aggregate, annual ongoing cost for outside legal counsel to update
policies and procedures for small broker-dealers would be $1.88
million.\1531\ In addition, we expect that small broker-dealers would
require five hours of outside compliance services per year to update
their policies and procedures, for an ongoing cost of $1,365 per
year,\1532\ and an aggregate ongoing cost of $1.03 million.\1533\ The
Commission estimates the total aggregate, ongoing cost for small
broker-dealers is therefore $2.91 million per year.\1534\
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\1530\ Data from the SIFMA Management and Professional Earnings
Report suggests that the average hourly rate for legal services is
$497/hour. This estimate is therefore based on the following
calculation: (5 hours per small broker-dealer) x ($497/hour for
outside counsel services) = $2,485 in outside counsel costs per
year.
\1531\ This estimate is based on the following calculation:
($2,485 in outside counsel costs per small broker-dealer) x (756
small broker-dealers) = $1.88 million in aggregate, ongoing legal
costs per year.
\1532\ We believe that performance of this function will most
likely be equally allocated between a senior compliance examiner and
a compliance manager. Data from the SIFMA Management and
Professional Earnings Report suggests that costs for these positions
are $237 and $309 per hour, respectively for an average of $273 per
hour. This estimate is therefore based on the following calculation:
(5 hours per small broker-dealer) x ($273/hour for outside counsel
services) = $1,365 in outside compliance service costs per year.
\1533\ This estimate is based on the following calculation:
($1,365 in outside compliance costs per small broker-dealer) x (756
small broker-dealers) = $1.03 million in aggregate, ongoing outside
compliance costs per year.
\1534\ This estimate is based on the following calculation:
($1.88 million for outside legal counsel costs) + ($1.03 million for
outside compliance costs) = $2.91 million total aggregate ongoing
costs per year.
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b. Training
Pursuant to the Compliance Obligation's requirement to ``maintain
and enforce'' written policies and procedures, we additionally believe
broker-dealers will develop training programs that promote compliance
with Regulation Best Interest. We believe that a training program would
cover compliance with Regulation Best Interest as a whole and would
therefore cover the Disclosure, Care and Conflict of Interest
Obligations. The initial and ongoing costs and burdens associated with
such a training program are estimated below.
i. Initial Costs and Burdens
We believe that broker-dealers would likely use a computerized
training model to train their associated persons regarding the policies
and procedures pertaining to Regulation Best Interest. We estimate that
a broker-dealer would retain an outside systems analyst, outside
programmer, and an outside programmer analyst to create the training
module, at 20 hours, 40 hours, and 20 hours, respectively. The total
cost to develop the training module would be approximately
$20,920,\1535\ for an aggregate initial cost of $62.8 million.\1536\
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\1535\ Data from the SIFMA Management and Professional Earnings
Report suggests that the average hourly rate in the securities
industry is $263 for a systems analyst, $271 for a programmer, and
$241 for a programmer analyst.. This cost estimate is based on the
following calculation: ((20 hours for a systems analyst) x ($263/
hour)) + ((40 hours of labor for a programmer) x ($271/hour)) + ((20
hours of labor for a programmer analyst) x ($241/hour)) = $20,920 in
external technology costs per broker-dealer.
\1536\ This estimate is based on the following calculation:
(2,766 broker-dealers) x ($20,920in external technology costs per
broker-dealer) = $57.9 million in aggregate costs for technology
services.
---------------------------------------------------------------------------
Additionally, we expect that the training module would require the
approval of the Chief Compliance Officer, as well as in-house counsel,
each of whom would require approximately 2 hours to review and approve
the training module. The initial aggregate burden for broker-dealers is
therefore estimated at 11,064 burden hours.\1537\
---------------------------------------------------------------------------
\1537\ This estimate is based on the following calculation:
(2,766 broker-dealers) x (4 burden hours per broker-dealer) = 11,064
burden hours.
---------------------------------------------------------------------------
In addition, broker-dealers would incur an initial cost for
associated persons to undergo training through the training module. We
estimate the training time at one hour per associated person, for an
aggregate burden of 428,404 burden hours, or an initial burden of 154.9
hours per broker-dealer.\1538\ We estimate the total initial aggregate
burden to approve the training module and implement the training
program would be 439,486 burden hours.\1539\
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\1538\ This estimate is based on the following calculation: (1
burden hour) x (428,404 registered representatives at standalone or
dually registered broker-dealers) = 428,404 aggregate burden hours.
Conversely, (428,404 aggregate burden hours)/(2,766 retail broker-
dealers) = 154.9 initial burden hours per broker-dealer per year.
\1539\ This estimate is based on the following calculation:
(428,404 burden hours for training of registered representatives) +
(11,064 burden hours to approve training program) = 439,468 total
aggregate burden hours per year.
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[[Page 33481]]
ii. Ongoing Costs and Burdens
We believe that, as a matter of best practice, broker-dealers would
likely require registered representatives to repeat the training module
for Regulation Best Interest on an annual basis. The ongoing aggregate
cost for the one-hour training would be 428,404 burden hours per year,
or 154.9 burden hours per broker-dealer per year.\1540\
---------------------------------------------------------------------------
\1540\ This estimate is based on the following calculation: (1
burden hour) x (428,404 registered representatives at standalone or
dually registered broker-dealers) = 428,404 burden hours.
Conversely, (428,404 aggregate burden hours) / (2,766 retail broker-
dealers) = 154.9 initial burden hours per broker-dealer.
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In total, to comply with the Compliance Obligation, the Commission
estimates the total initial burdens and costs to be 524,414 hours
\1541\ and $71.4 million,\1542\ and the total ongoing burdens and costs
to be 463,588 hours \1543\ and $2.91 million.\1544\
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\1541\ This estimate is based on the following calculation:
(84,946 initial burden hours for policies and procedures) + (439,468
initial burden hours training) = 524,414 initial burden hours to
comply with the Compliance Obligation.
\1542\ This estimate is based on the following calculation:
($13.5 million initial costs for policies and procedures) + ($57.9
million initial costs for training) = $71.4 million initial total
costs to comply with the Compliance Obligation.
\1543\ This estimate is based on the following calculation:
(24,120 ongoing burden hours for policies and procedures) + (439,468
ongoing burden hours for training) = 463,588 ongoing burden hours to
comply with Compliance Obligation.
\1544\ This estimate is based on the following calculation:
($2.91 million ongoing costs for policies and procedures) + ($0
million ongoing costs for training) = $2.91 million ongoing costs to
comply with the Compliance Obligation.
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5. Record-Making and Recordkeeping Obligations
The record-making and recordkeeping obligations will impose record-
making and recordkeeping requirements on broker-dealers with respect to
certain information collected from, or provided to, retail customers.
Specifically, the Commission is amending Rules 17a-3 and 17a-4 of the
Exchange Act, which set forth minimum requirements with respect to the
records that broker-dealers must make, and how long those records and
other documents must be kept, respectively. Records made and retained
in accordance with the amendments to Rule 17a-3(a)(35) and 17a-4(e)(5)
will (1) assist a broker-dealer in supervising and assessing internal
compliance with Regulation Best Interest; and (2) assist the Commission
and SRO staff in connection with examinations and investigations.
Due to changes in the number of broker-dealers and costs estimated
for certain services, we are revising our estimates from those in the
Proposing Release. However, while we understand commenters' concerns
that the estimates are lower than what would actually be required to
comply with Regulation Best Interest, we believe the estimates are
generally accurate in light of the increased specificity in Regulation
Best Interest on how to comply with the component obligations,
including the Disclosure Obligation.\1545\ The record-making and
recordkeeping costs and burdens associated with the amendments to Rule
17a-3(a)(35) and Rule 17a-4(e)(5) are addressed below.
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\1545\ See, e.g., Raymond James Letter; CCMC Letters; SIFMA
August 2018 Letter.
---------------------------------------------------------------------------
a. Record-Making Obligation
We are amending Rule 17a-3 by adding a new paragraph (a)(35) that
requires a record of all information collected from, and provided to,
the retail customer pursuant to Regulation Best Interest, as well as
the identity of each natural person who is an associated person of a
broker or dealer, if any, responsible for the account.\1546\ This
requirement applies with respect to each retail customer to whom a
recommendation of any securities transaction or investment strategy
involving securities is provided. The neglect, refusal, or inability of
a retail customer to provide or update any such information will,
however, excuse the broker-dealer from obtaining that information.
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\1546\ As indicated in the Proposing Release, we understand that
broker-dealers likely make such records in the ordinary course of
their business pursuant to Exchange Act Rules 17a-3(a)(6) and (7).
We continue to believe, for purposes of compliance with Rule 17a-
3(a)(35), that broker-dealers would need to create a record, or
modify an existing record, to identify the associated person, if
any, responsible for the account in the context of Regulation Best
Interest. See Proposing Release at 21673.
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We indicated in the Proposing Release, and we continue to believe
that broker-dealers currently make records of relevant customer
investment profile information, and we therefore assume that no
additional record-making obligations would arise as a result of broker-
dealers' or their registered representatives' collection of information
from retail customers.\1547\ In addition, we continue to believe that
broker-dealers likely make records of the ``identity of each natural
person who is an associated person, if any, responsible for the
account.'' However, we are assuming, for purposes of compliance with
Rule 17a-3(a)(35), that broker-dealers will need to create a record, or
modify an existing record, to identify the associated person, if any,
responsible for the account in the context of Regulation Best Interest.
In addition, in cases where broker-dealers choose to meet part of the
Disclosure Obligation orally under the circumstances outlined in
Section II.C.1, Oral Disclosure or Disclosure After a Recommendation,
we believe the requirement to maintain a record of the fact that oral
disclosure was provided to the retail customer will trigger a record-
making obligation under paragraph (a)(35) of Rule 17a-3 and a
recordkeeping obligation under paragraph (e)(5) of Rule 17a-4 that may
impose additional compliance costs and burdens on broker-dealers.
---------------------------------------------------------------------------
\1547\ The PRA burdens and costs arising from the requirement
that a record be made of all information provided to the retail
customer are accounted for in Regulation Best Interest and the
Relationship Summary Adopting Release. With respect to the
requirement that a record be made of all information from the retail
customer, we believe that Rule 17a-3(a)(35) will not impose any new
substantive burdens on broker-dealers. As discussed above, we
continue to believe that the obligation to exercise reasonable
diligence, care, and skill will not require a broker-dealer to
collect additional information from the retail customer beyond that
currently collected in the ordinary course of business even though a
broker-dealer's analysis of that information and any resulting
recommendations will need to adhere to the enhanced best interest
standard of Regulation Best Interest. See supra Section II.C.2.
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i. Initial Costs and Burdens
In the Proposing Release, we assumed that broker-dealers would
satisfy the record-making requirement of the proposed amendment to Rule
17a-3(a)(25) by amending an existing account disclosure document to
include the ``identity of each natural person who is an associated
person, if any, responsible for the account.'' We estimated that the
inclusion of this information in an account disclosure document would
require an approximate total aggregate initial burden of 3,808,000
hours, or approximately 1,333 hours per broker-dealer for the first
year after Regulation Best Interest is in effect.\1548\
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\1548\ These estimates were based on the following calculations:
(0.04 hours per customer account) x (95.2 million retail customer
accounts) = 3,808,000 aggregate burden hours. Conversely, (3,808,000
aggregate burden hours)/(2,857 broker-dealers) = 1,333 hours per
broker dealer for the first year after Regulation Best Interest is
in effect. See Proposing Release at 21673.
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As discussed above, we continue to believe that broker-dealers will
satisfy the record-making requirements of the amendment to Rule 17a-
3(a)(35) by amending an existing account disclosure document to include
the ``identity of each natural person who is an associated person, if
any, responsible for the account.'' We believe that the inclusion of
this information in an account disclosure document will require, on
average, approximately 1
[[Page 33482]]
hour per year for outside legal counsel at small broker-dealers, at an
updated average rate of $497/hour, for an average annual cost of $497
for each small broker-dealer to update an account disclosure document.
The projected aggregate initial cost for small broker-dealers is
therefore estimated to be $375,732 per year.\1549\ For broker-dealers
that are not small entities, we estimate that the initial burden will
be 2 hours for each broker-dealer: 1 hour for compliance personnel and
1 hour for legal personnel. We therefore estimate the aggregate initial
burden for broker-dealers that are not small entities to be
approximately 4,020 burden hours.\1550\ Finally, we estimate it will
require an additional 0.04 hours for the registered representative
responsible for the information (or other clerical personnel) to fill
out that information in the account disclosure document, for an
approximate total aggregate initial burden of 4,080,000 hours, or
approximately 1,475 hours per broker-dealer for the first year after
Regulation Best Interest is in effect.\1551\ Because we have already
included the costs and burdens associated with the creation of a record
to memorialize an oral disclosure, and the delivery of the amended
account disclosure document discussed above, they are not included in
this section of the analysis.\1552\
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\1549\ This estimate is based on the following calculation: (1
hour per small broker-dealer) x (756 small broker-dealers) x ($497/
hour) = $375,732 in aggregate costs per year.
\1550\ This estimate is based on the following calculation: (2
burden hours per broker-dealer) x (2,010 large broker-dealers) =
4,020 aggregate burden hours per year.
\1551\ These estimates are based on the following calculations:
(0.04 hours per customer account) x (102 million retail customer
accounts) = 4,080,000 aggregate burden hours. Conversely, (4,080,000
burden hours)/(2,766 broker-dealers) = 1,475 hours per broker-dealer
for the first year after Regulation Best Interest is in effect.
\1552\ See supra Section IV.B.1.
---------------------------------------------------------------------------
The total aggregate initial burden for broker-dealers is therefore
estimated at 4,084,020 hours,\1553\ and the total aggregate initial
cost is estimated at $375,732.\1554\
---------------------------------------------------------------------------
\1553\ This estimate is based on the following calculation: (0
aggregate burden hours for small broker-dealers) + (4,020 burden
hours for large broker-dealers) + (4,080,000 burden hours for
personnel to fill out information in the account disclosure
document) = 4,080,000 initial burden hours.
\1554\ This estimate is based on the following calculation:
($375,732 for small broker-dealer costs) + ($0 for large broker-
dealer costs) = ($375,732 in total aggregate initial costs).
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ii. Ongoing Costs and Burdens
We do not believe that the identity of the registered
representative responsible for the retail customer's account will
change. Accordingly, we continue to believe that there are no ongoing
costs and burdens associated with this record-making requirement of the
amendment to Rule 17a-3(a)(35).
With respect to memorializing oral disclosures in cases where
broker-dealers choose to meet part of the Disclosure Obligation orally
under the circumstances outlined in Section II.C.1, Oral Disclosure or
Disclosure After a Recommendation, we estimate that this would take
place among 52% of a broker-dealer's retail customer accounts (and thus
52% of a registered representative's retail customer accounts)
annually.\1555\ We therefore estimate broker-dealers to incur a total
annual aggregate burden of 1.06 million hours, or 383.5 burden hours
per year per broker-dealer.\1556\
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\1555\ We believe (and our experience indicates) that broker-
dealers will use oral disclosure rarely, and primarily when making
disclosures regarding a change in capacity. We do not have reliable
data to determine the precise number of retail customers that have
both a brokerage and an advisory account with a dually registered
associated person. As indicated above, approximately 52% of
registered representatives were dually registered as investment
adviser representatives at the end of 2018. See supra footnote 945
and accompanying text. As a result, we have assumed for purposes of
this analysis that this will take place among 52% of all retail
customer accounts at broker-dealers annually. This estimate is
likely over inclusive, as it includes all retail customer accounts
at all broker-dealers (as opposed to only retail customer accounts
where the retail customer has both a brokerage and advisory account
with a dually registered financial professional), and under
inclusive, as it assumes that such an oral disclosure will happen
annually (as opposed to multiple times a year).
\1556\ (52%) x (102 million retail customer accounts) x (0.02
hours for recording each oral disclosure relating to a retail
customer's account) = 1,060,800 aggregate burden hours. Conversely,
1,060,800 aggregate burden hours/2,766 broker-dealers = 383.5 burden
hours per broker-dealer per year.
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b. Recordkeeping Obligation
We are amending Rule 17a-4(e)(5) to require that broker-dealers
retain all records of the information collected from or provided to
each retail customer pursuant to Regulation Best Interest for at least
six years after the earlier of the date the account was closed or the
date on which the information was last replaced or updated. We assume
that, for purposes of this analysis, the following records would likely
be retained pursuant to amended Rule 17a-3(a)(35): (1) Existing account
disclosure documents; (2) comprehensive fee schedules; (3) disclosures
identifying material conflicts; and (4) memorialized oral disclosures
under the circumstances outlined in Section II.C.1, Oral Disclosure or
Disclosure After a Recommendation.\1557\
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\1557\ In the Proposing Release, we identified four records that
would likely need to be retained pursuant to amended Rule 17a-
3(a)(25) (now reflected as Rule 17a-3(a)(35)): (1) A standardized
Relationship Summary document; (2) existing account disclosure
documents; (3) a comprehensive fee schedule; and (4) disclosures
identifying material conflicts. However, in calculating the
estimated burden for broker-dealers to add new documents or modify
existing documents to the broker-dealer's existing retention system,
we erroneously assumed a broker-dealer would upload or file five
account documents, as opposed to the four account documents
identified in the Proposing Release. See Proposing Release at 21673-
21674. In addition, while the burden for broker-dealers to retain a
standardized relationship summary was included in the Regulation
Best Interest Proposing Release, it is excluded here because its
associated burden is reflected in the Relationship Summary Proposal
and Relationship Summary Adopting Release.
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i. Initial Costs and Burdens
We believe that, to reduce costs and for ease of compliance,
broker-dealers will utilize their existing recordkeeping systems in
order to retain the forgoing records made pursuant to Regulation Best
Interest, and as required to be kept under the amendment to Rule 17a-
4(e)(5). As noted above, broker-dealers currently are subject to
recordkeeping obligations pursuant to Rule 17a-4, which require, for
example, broker-dealers to ``preserve for a period of not less than six
years, the first two years in an easily accessible place, all records
required to be made pursuant to'' Rule 17a-3(a)(1), (a)(2), (a)(3),
(a)(5), (a)(21), (a)(22), and analogous records created pursuant to
paragraph 17a-3(f). Thus, for example, broker-dealers are already
required to maintain documents such as account blotters and ledgers for
six years.
We continue to believe that broker-dealers will utilize their
existing recordkeeping systems to include any additional or amended
records required by Regulation Best Interest or pursuant to the
amendment to Rule 17a-4(e)(5), and would similarly utilize their
existing recordkeeping systems to account for any differences in the
retention period. Thus, where broker-dealers currently retain documents
on an electronic database to satisfy existing Rule 17a-4 or otherwise,
we continue to expect broker-dealers to maintain any additional
documents required by Regulation Best Interest or the amendment to Rule
17a-4(e)(5) by the same means. Likewise, where broker-dealers maintain
documents required by existing Rule 17a-4 by paper, we would expect
broker-dealers to continue to do so.
Based on our belief that broker-dealers will rely on existing
infrastructures to satisfy the recordkeeping obligations of Regulation
Best Interest and the amendment to Rule 17-a(4)(e)(5), we believe the
burden for broker-dealers to add new documents or
[[Page 33483]]
modify existing documents to the broker-dealer's existing retention
system will be approximately 13.6 million burden hours for all broker-
dealers, assuming a broker-dealer will need to upload or file each of
the four account documents discussed above for each retail customer
account.\1558\ We do not believe there will be additional substantive
internal or external costs relating to the uploading or filing of the
documents. In addition, because we have already included the costs and
burdens associated with the delivery of the amended account opening
agreement and other documents above, we do not include them in this
section of the analysis.
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\1558\ This estimate is based on the following calculation: (4
documents per customer account) x (102 million retail customer
accounts) x (2 minutes per document)/60 minutes = 13,600,000
aggregate burden hours. As indicated above, the following records
would likely need to be retained: (1) Existing account disclosure
documents; (2) comprehensive fee schedules; (3) disclosures
identifying material conflicts; and (4) memorialized oral
disclosures under the circumstances outlined in Section II.C.1,
Disclosure Obligation, Oral Disclosure or Disclosure After a
Recommendation.
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ii. Ongoing Costs and Burdens
We estimate that the approximate ongoing burden associated with the
recordkeeping requirement of the amendment to Rule 17a-4(e)(5) is 4.46
million burden hours per year.\1559\ We do not believe that the ongoing
costs associated with ensuring compliance with the retention schedule
would change from the current costs of ensuring compliance with
existing Rule 17a-4 and as outlined above.
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\1559\ This estimate is based on the percentage of account
records we expect would be updated each year as described in Section
IV.B.1, supra, and the following calculation: (40% of fee schedules
x 102 million retail customer accounts) x (2 minutes per document) +
(40% of conflict disclosure forms x 102 million retail customer
accounts) x (2 minutes per document) + (20% of account opening
documents x 102 million retail customer accounts) x (2 minutes per
document) = 204 million minutes/60 minutes = 3.4 million aggregate
ongoing burden hours. In addition, with respect to ongoing
memorialization of the updated oral disclosures, we estimate that
this will take place among 52% of a broker-dealer's retail customer
accounts annually. We therefore estimate that broker-dealers will
incur an aggregate ongoing burden of 1.06 million hours per year
(calculated as follows: (52% of updated oral disclosures x 102
million retail customer accounts) x (1.2 minutes per document) =
63.6 million minutes/60 minutes = 1.06 million aggregate ongoing
burden hours); or 383.5 burden hours per broker-dealer (1.06 million
hours/2,766 broker-dealers = 383.5). 3.4 million burden hours per
year + 1.06 million burden hours per year = 4,460,000 total
aggregate ongoing burden hours per year.
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V. Final Regulatory Flexibility Act Analysis
The Commission has prepared this Final Regulatory Flexibility
Analysis (``FRFA'') in accordance with the provisions of the Regulatory
Flexibility Act (``RFA'') \1560\ relating to Regulation Best Interest.
An Initial Regulatory Flexibility Analysis (``IRFA'') was prepared in
accordance with the RFA and included in the Proposing Release.\1561\
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\1560\ 5 U.S.C. 603.
\1561\ See Proposing Release, supra footnote 7, at Section VII.
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A. Need for and Objectives of the Rule
Broker-dealers play an important role in helping Americans organize
their financial lives, accumulate and manage retirement savings, and
invest toward other important long-term goals, such as buying a house
or funding a child's college education.
As discussed in Section I, concerns exist regarding: (1) The
potential harm to retail customers resulting from broker-dealer
recommendations provided in the presence of conflicts of interest and
(2) the insufficiency of existing broker-dealer regulatory requirements
to address these conflicts when broker-dealers make recommendations to
retail customers. More specifically, there are concerns that existing
requirements do not require a broker-dealer's recommendations to be in
the retail customer's best interest.
As a result, we are adopting Regulation Best Interest, which
creates an enhanced standard of conduct applicable to broker-dealers at
the time they recommend to a retail customer a securities transaction
or investment strategy involving securities. This includes
recommendations of account types and rollovers or transfers of assets
and also covers implicit hold recommendations, resulting from agreed-
upon account monitoring. When making a recommendation, a broker-dealer
must act in the retail customer's best interest and cannot place its
own interests ahead of the customer's interests. This General
Obligation is satisfied only if the broker-dealer complies with four
specified component obligations: (1) Disclosure Obligation, (2) Care
Obligation, (3) Conflict of Interest Obligation, and (4) Compliance
Obligation. In addition, the Commission is amending Rules 17a-3 and
17a-4 of the Exchange Act, which set forth minimum requirements with
respect to the records that broker-dealers must make, and how long
those records and other documents must be kept, respectively.
First, as described in Section II.C.1, under the Disclosure
Obligation, before or at the time of making a recommendation, a broker-
dealer must disclose, in writing,\1562\ material facts about the scope
and terms of its relationship with the customer. This includes a
disclosure that the broker-dealer or associated person is acting in a
broker-dealer capacity; the material fees and costs the customer will
incur; and the type and scope of the services to be provided, including
any material limitations on the recommendations that could be made to
the retail customer. Moreover, the broker-dealer must disclose all
material facts relating to conflicts of interest associated with the
recommendation that might incline a broker-dealer to make a
recommendation that is not disinterested, including, for example,
proprietary products, payments from third parties, and compensation
arrangements.
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\1562\ As discussed above, there are circumstances where broker-
dealers and their associated persons may make oral disclosures or
written disclosures after the time of a recommendation under the
circumstances outlined in Section II.C.1, Disclosure Obligation,
Oral Disclosure or Disclosure After a Recommendation.
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Second, as described in Section II.C.2, under the Care Obligation,
a broker-dealer must exercise reasonable diligence, care, and skill
when making a recommendation to a retail customer. The broker-dealer
must understand potential risks, rewards, and costs associated with the
recommendation. The broker-dealer must then consider those risks,
rewards, and costs in light of the retail customer's investment profile
and have a reasonable basis to believe that the recommendation is in
the customer's best interest and does not place the broker-dealer's
interest ahead of the retail customer's interest. When recommending a
series of transactions, the broker-dealer must have a reasonable basis
to believe that the transactions taken together are not excessive, even
if each is in the retail customer's best interest when viewed in
isolation.
Third, as described in Section II.C.3, under the Conflict of
Interest Obligation, a broker-dealer must establish, maintain, and
enforce reasonably designed written policies and procedures addressing
conflicts of interest associated with its recommendations to retail
customers. These policies and procedures must be reasonably designed to
identify all such conflicts and at a minimum disclose or eliminate
them. Additionally, the policies and procedures must be reasonably
designed to mitigate conflicts of interests that create an incentive
for an associated person of the broker-dealer to place its interests or
the
[[Page 33484]]
interest of the firm ahead of the retail customer's interest. Moreover,
when a broker-dealer places material limitations on recommendations
that may be made to a retail customer (e.g., offering only proprietary
or other limited range of products), the policies and procedures must
be reasonably designed to disclose the limitations and associated
conflicts and to prevent the limitations from causing the associated
person or broker-dealer to place the associated person's or broker-
dealer's interests ahead of the customer's interest. Finally, the
policies and procedures must be reasonably designed to identify and
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.
Fourth, as described in Section II.C.4, under the Compliance
Obligation, a broker-dealer must also establish, maintain, and enforce
written policies and procedures reasonably designed to achieve
compliance with Regulation Best Interest as a whole. Thus, a broker-
dealer's policies and procedures must address not only conflicts of
interest but also compliance with its Disclosure and Care Obligations
under Regulation Best Interest.
The enhancements contained in Regulation Best Interest will improve
investor protection by enhancing the quality of broker-dealer
recommendations to retail customers and reducing the potential harm to
retail customers that may be caused by conflicts of interest.
Regulation Best Interest will complement the related rules,
interpretations, and guidance that the Commission is concurrently
issuing.\1563\ Individually and collectively, these actions are
designed to help retail customers better understand and compare the
services offered by broker-dealers and investment advisers and make an
informed choice of the relationship best suited to their needs and
circumstances, provide clarity with respect to the standards of conduct
applicable to investment advisers and broker-dealers, and foster
greater consistency in the level of protections provided by each
regime, particularly at the point in time that a recommendation is
made.
---------------------------------------------------------------------------
\1563\ See Relationship Summary Adopting Release; Fiduciary
Interpretation; Solely Incidental Interpretation.
---------------------------------------------------------------------------
All of these requirements are discussed in detail in Section II
above. The costs and burdens of these requirements on small broker-
dealers are discussed below as well as above in our Economic Analysis
and PRA Analysis, that discuss the costs and burdens on all broker-
dealers.
B. Significant Issues Raised by Public Comments
The Commission is sensitive to the burdens that the new rule may
have on small entities. In the Proposing Release, we requested comment
on matters discussed in the IRFA. In particular, we sought comments on
the number of small entities that may be affected by proposed
Regulation Best Interest, and whether proposed Regulation Best Interest
would have an effect on small entities that had not been considered. We
requested that commenters describe the nature of any impact on small
entities and provide empirical data to support the extent of such
impact. We also requested comment on the proposed compliance burdens
and the effects these burdens would have on smaller entities.
As discussed in the Economic Analysis and PRA Analysis above, we
received comments regarding the potential costs and burdens of the
proposal on broker-dealers, including those that are small
entities.\1564\ Additionally, the Commission received some comments
specifically addressing the costs to smaller broker-dealers.
---------------------------------------------------------------------------
\1564\ See supra Sections III and IV.
---------------------------------------------------------------------------
One commenter stated that for a small firm with $500,000 in net
capital, a compliance cost of $60,000 \1565\ could constitute 12% of
that net capital, making compliance with the rule burdensome for such
firms and potentially forcing many small firms to hire additional
compliance personnel.\1566\ Another commenter raised concerns that
replacing the term ``suitable'' with ``best interest'' could create
legal risk and cause smaller and mid-sized professional firms to leave
the market.\1567\ As noted above in Section III, we acknowledge that
the costs of the rule could be more burdensome for small firms and
discuss any corresponding competitive effects in Section III.D.1.\1568\
Further, as described above, we acknowledge the requests by commenters
for further clarity on what it means to ``act in the best interest'' of
the retail customer, and particularly what it means to make a
recommendation in a retail customer's ``best interest'' under the Care
Obligation. Consequently, in Section II.A, and in the detailed
discussion of each of the Disclosure, Care, Conflict of Interest, and
Compliance Obligations in Section II.C, we have provided further
clarity on how a broker-dealer can comply with Regulation Best
Interest. However, with respect to the comment concerning the term
``suitable,'' we are adopting a ``best interest'' standard as
proposed--which enhances the broker-dealer standard of conduct beyond
existing suitability obligations--in light of our goal to enhance
retail investor protection and decision making.
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\1565\ See NSCP Letter (``Consider the estimated $60,000 in
additional compliance costs referenced in the Release which would
represent 12% of net capital of a $500,000 firm.'')
\1566\ See id (``Several small firms estimate that they incur
approximately $80,000 in compliance costs to meet basic ongoing
regulatory requirements. Notably, this amount does not include
expenses associated with new rules, regulatory changes, regulatory
exams or running a compliance department. In isolation, it may seem
that this single proposal by one regulatory agency would have
manageable marginal impact on costs. But in fact, it would be one of
many changes (and importantly, a major change) that smaller firms
must address. Many small firms do not have large Compliance
Departments adequate to shoulder these ever increasing regulatory
demands. In fact, many small firm Compliance Departments are
comprised of just one or two persons.''). See also, generally, NFIB
Letter (``America's small and independent businesses in the
financial industry cannot afford the army of lawyers and clerks
needed to comply with the welter of complex rules issued or proposed
by the U.S. Department of Labor (DOL) (Reference 1 above), the U.S.
Securities and Exchange Commission (SEC) (Reference 2 above), and
the several states to govern the duties of financial businesses
toward their retail customers.'')
\1567\ See Iowa Insurance Commissioner Letter (``Striking
``suitability,'' and its history and legal precedence, will usher in
an age of legal and marketing confusion. Additionally, smaller and
mid-sized professional firms, to avoid the risks of this confusion
and the resulting litigation, will leave the market, and the larger
firms will remain, increasing market concentration. A decision to
replace the term ``suitable'' in the text of traditional suitability
rules with the phrase ``best interest'' will disrupt the market,
decrease competition, increase the price of services out of the
reach of thousands of middle class Americans, and significantly
reduce consumer options for selecting valuable professional
services.'') But see NAIFA Letter (``NAIFA supports a best interest
standard of conduct for securities-licensed firms and individuals,
and we appreciate the SEC's considerable efforts to establish such a
standard without imposing unduly prescriptive or burdensome
implementation or compliance requirements. The SEC's general
approach, we believe, will preserve choices for consumers at all
income levels and account sizes--and should not unnecessarily
increase costs for consumers or businesses.'')
\1568\ See also infra Section V.E., noting that we believe that
Regulation Best Interest will result in multiple investor protection
benefits, and these benefits should apply to retail customers of
smaller entities as well as retail customers of large broker-
dealers.
---------------------------------------------------------------------------
Another commenter stated that costs for small broker-dealers could
be reduced if the Commission approved a standard disclosure, which
would add certainty and reduce costs for small firms and their
customers.\1569\ We
[[Page 33485]]
considered, as an alternative to the Disclosure Obligation, mandating a
standardized disclosure.\1570\ However, as described in Section II.C.1,
after careful consideration of the comments concerning the proposed
Disclosure Obligation, we have decided not to require any standard
written disclosures under Regulation Best Interest at this time. We
recognize the wide variety of business models and practices and we
continue to believe it is important to provide broker-dealers with
flexibility to enable them to better tailor disclosure and information
that their retail customers can understand and may be more likely to
read at relevant points in time, rather than, for example, mandating a
standardized all-inclusive (and likely lengthy) disclosure.
---------------------------------------------------------------------------
\1569\ See Chepucavage Letter (``Costs for the small bd's
however can be reduced with a commission approved standard
disclosure which would add certainty and ought to be considered
especially for the small investor. [. . .] A standard disclosure
document would also be useful for the small bd that cannot afford
the legal assistance needed to evaluate this 1,000 page proposal and
draft appropriate documents. [. . .] The Commission should therefore
reconsider the impact of its proposal on small investors and small
bd's with the assumption that retirement accounts are significantly
more important than regular brokerage accounts especially for small
and elderly investors. A standard disclosure for small firms would
reduce costs for the firms and their customers.'')
\1570\ See supra Section III.E and infra Section V.E.
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The vast majority of commenters supported the Commission's
rulemaking efforts to address the standards of conduct that apply to
broker-dealers when making recommendations, but nearly all commenters
suggested modifications to proposed Regulation Best Interest. These
suggestions touch on almost every aspect of the proposal, as summarized
in Section I.C above and as discussed in more detail, along with
explanations of modifications made in light of the comments, throughout
the release.
C. Small Entities Subject to the Rule
For purposes of a Commission rulemaking in connection with the RFA,
a broker-dealer will be deemed a small entity if it: (i) Had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the date in the prior fiscal year as of which its audited financial
statements were prepared pursuant to Rule 17a-5(d) under the Exchange
Act,\1571\ or, if not required to file such statements, had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the last business day of the preceding fiscal year (or in the time
that it has been in business, if shorter); and (ii) is not affiliated
with any person (other than a natural person) that is not a small
business or small organization.\1572\
---------------------------------------------------------------------------
\1571\ 17 CFR 240.17a-5(d).
\1572\ See 17 CFR 240.0-10(c).
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As discussed in Section IV above, the Commission estimates that as
of December 31, 2018, approximately 2,766 retail broker-dealers will be
subject to Regulation Best Interest and the amendments to Rules 17a-3
and 17a-4.\1573\ Based on FOCUS Report data,\1574\ the Commission
estimated that as of December 31, 2018, approximately 756 of those
retail broker-dealers might be deemed small entities for purposes of
this analysis.\1575\ For purposes of this RFA analysis, we refer to
broker-dealers that might be deemed small entities under the RFA as
``small entities,'' and we continue to use the term ``broker-dealers''
to refer to broker-dealers generally, as the term is used elsewhere in
this release.\1576\ Of these 756 small entities, the Commission
estimates that 623 are standalone broker-dealers and 133 are dually
registered as investment advisers.\1577\
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\1573\ As noted above, this estimate likely overstates the
number that would be impacted by Regulation Best Interest. See supra
Section III.C.1.a.
\1574\ See supra footnote 1384.
\1575\ See supra footnote 1386.
\1576\ Consistent with the PRA, unless otherwise notes, we use
the terms ``registered representative'' and ``dually registered
representative of a broker-dealer'' herein.
\1577\ These estimate are based on FOCUS Report Data, see supra
footnote 1384
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D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
The new requirements impose certain reporting and compliance
requirements on certain broker-dealers, including those that are small
entities. The new requirements are summarized in this FRFA (Section
V.A. above). All of these requirements are also discussed in detail, in
Section II above, and these requirements as well as the costs and
burdens on broker-dealers, including those that are small entities, are
discussed above in Sections III and IV (the Economic Analysis and PRA
Analysis) and below.
1. Disclosure Obligation
The Disclosure Obligation under Regulation Best Interest requires a
broker-dealer or its associated persons, prior to or at the time of
recommending a securities transaction or strategy involving securities
to a retail customer, to provide the retail customer, in writing, full
and fair disclosure of: (1) All material facts relating to the scope
and terms of the relationship with the retail customer, including: (a)
That the broker, dealer, or such natural person is acting as a broker,
dealer, or an associated person of a broker or dealer with respect to
the recommendation, (b) the fees and costs that apply to the retail
customer's transactions, holdings, and accounts, and (c) the type and
scope of services provided to the retail customer, including any
material limitations on the securities or investment strategies
involving securities that may be recommended to the retail customer;
and (2) all material facts relating to conflicts of interest that are
associated with the recommendation. The estimated costs and burdens
incurred by small entities in relation to this Disclosure Obligation
are discussed in detail below.\1578\
---------------------------------------------------------------------------
\1578\ For a discussion of additional costs and burdens as well
as monetized burdens, related to the Disclosure Obligation, see
supra Section III.C.2.b.
---------------------------------------------------------------------------
a. Obligation To Provide to the Retail Customer Full and Fair
Disclosure, in Writing, of All Material Facts Relating to the Scope and
Terms of the Relationship With the Retail Customer
The Commission assumes for purposes of this analysis that small
entities would meet the obligation to disclose to the retail customer,
in writing, the material facts related to the scope and terms of the
relationship with the retail customer through a combination of delivery
of the Relationship Summary,\1579\ creating account disclosures to
include standardized language related to the capacity in which they are
acting and type and scope of services, and the development of fee
schedules.
---------------------------------------------------------------------------
\1579\ See Exchange Act Rule 17a-14 and Relationship Summary
Adopting Release, supra footnote 12.
---------------------------------------------------------------------------
b. Estimated Costs and Burdens
In addition to the costs described below, additional costs
associated with Regulation Best Interest are described above in Section
III.C.\1580\
---------------------------------------------------------------------------
\1580\ See Sections III.C.2.b, III.C.3.b, III.C.4, III.C.5, and
III.C.6.
---------------------------------------------------------------------------
(1) Disclosure of Capacity, Type and Scope of Services
As explained above, standalone broker-dealers that are small
entities will satisfy the obligation to disclose the capacity in which
they acting through the delivery to the retail customer of the
Relationship Summary, and accordingly, we estimate zero burden hours
for standalone broker-dealers that are small entities to disclose the
capacity in which they are acting.
We estimate that a dually registered firm that is a small entity
will incur an initial internal burden of 10 hours for in-house counsel
and in-house compliance to draft language regarding the capacity in
which it is acting for inclusion in the standardized account disclosure
that is delivered to the retail customer.\1581\ In addition, we
estimate
[[Page 33486]]
that dual-registrants that are small entities will incur an estimated
external cost of $4,970 for the assistance of outside counsel in the
preparation and review of standardized language regarding
capacity.\1582\ For the estimated 133 dually registered broker-dealers
that are small entities, we project an aggregate initial burden of
1,330 hours,\1583\ and $661,010 in aggregate initial costs for drafting
language regarding capacity.\1584\
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\1581\ See supra footnotes 1395-1396.
\1582\ See supra footnote 1397.
\1583\ See supra footnote 1395. This estimate is based on the
following calculation: (133 dually registered retail firms that are
small entities) x (10 hours) = 1,330 initial aggregate burden
hours.) The professional skills associated with the estimated burden
hours are specified in Section IV above.
\1584\ This estimate is based on the following calculation: (133
dually registered retail firms that are small entities) x ($4,970 in
external cost per firm) = $661,010 in aggregate initial costs.
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Similarly, to comply with Regulation Best Interest, we believe that
small entities will draft standardized language for inclusion in the
account disclosure to provide the retail customer with more specific
information regarding the type and scope of services that they provide.
We estimate that a small entity will incur an internal initial burden
of 10 hours for in-house counsel and in-house compliance to draft this
standardized language.\1585\ In addition, a small entity will incur an
estimated external cost of $4,970 for the assistance of outside counsel
in the preparation and review of this standardized language.\1586\ For
the estimated 756 small entities,\1587\ we project an aggregate initial
burden of 7,560 hours,\1588\ and aggregate initial costs of $3.8
million for drafting language regarding type and scope of
services.\1589\
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\1585\ See supra footnote 1402.
\1586\ See supra footnote 1403.
\1587\ See supra footnote 1385 and accompanying text.
\1588\ See supra footnote 1405.
\1589\ See supra footnote 1406.
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We estimate that small entities will each incur approximately 0.02
burden hours \1590\ for delivery of the account disclosure
document.\1591\ Based on FOCUS data, we believe that the 756 small
entities have a total of 5,281 customer accounts, and that
approximately all of those accounts belong to retail customers.\1592\
We therefore estimate that small entities will have an aggregate
initial burden of 106 hours, or approximately 0.14 hours \1593\ per
small entity for the first year after Regulation Best Interest is in
effect for delivery of the account disclosure document.\1594\
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\1590\ See supra footnote 1411.
\1591\ See supra footnote 1412.
\1592\ This estimate may overstate the number of retail customer
accounts at small entities and/or may overstate the number of
deliveries to be made due to the double-counting of deliveries to be
made by dual-registrants to a certain extent, and the fact that one
customer may own more than one account.
\1593\ These estimates are based on the following calculations:
(0.02 hours per customer account x (5,281 retail customer accounts)
= 106 aggregate burden hours. Conversely, (106 hours) / (756 small
entities) = approximately 0.14 burden hours per small entity for the
first year after Regulation Best Interest is in effect.
\1594\ See supra footnote 1415.
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We therefore estimate a total initial aggregate burden for small
entities to develop and deliver to retail customers account disclosures
relating to the capacity in which they are acting and type and scope of
services of 7,666 burden hours.\1595\
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\1595\ This estimate is based on the following calculation:
(1,330 aggregate initial burden hours for dually registered broker-
dealers that are small entities) + (6,230 aggregate initial burden
hours for standalone broker-dealers that are small entities) + (106
aggregate initial burden hours for small entities to deliver the
account disclosures) = 7,666 total aggregate initial burden hours.
---------------------------------------------------------------------------
In terms of ongoing costs, we estimate that each dually registered
broker-dealer that is a small entity will incur approximately 5 burden
hours annually for in-house compliance and business-line personnel to
review changes in the dual-registrant's capacity, and another 2 burden
hours annually for in-house counsel to amend the account disclosure to
disclose material changes to the dual-registrant's capacity, for a
total of 7 burden hours. The estimated ongoing aggregate burden to
amend account disclosures of dual-registrants that are small entities
to reflect changes in capacity is therefore 931 hours per year.\1596\
---------------------------------------------------------------------------
\1596\ This estimate is based on the following calculation: (7
burden hours per dually registered firm per year) x 133 dually
registered broker-dealers that are small entities) = 931 ongoing
aggregate burden hours per year.
---------------------------------------------------------------------------
With respect to small entities, we estimate an internal burden of 2
hours for in-house compliance and business-line personnel to review and
update changes in types or scope of services,\1597\ and another 2
burden hours annually for in-house counsel to amend the account
disclosure to disclose material changes to type and scope of services--
for a total of 4 burden hours per year. The estimated ongoing aggregate
burden for standalone broker-dealers that are small entities to amend
account disclosures to reflect changes in type and scope of services is
therefore 2,492 hours per year.\1598\
---------------------------------------------------------------------------
\1597\ As noted above, we estimate zero burden hours annually
for standalone broker-dealers that are small entities relating to
disclosure of capacity under the Disclosure Obligation. See supra
Section IV.B.1.a.ii.
\1598\ This estimate is based on the following calculation: (4
burden hours per small entity per year) x (623 standalone broker-
dealers that are small entities) = 2,492 ongoing aggregate burden
hours per year.
---------------------------------------------------------------------------
With respect to delivery of the amended account agreements in the
event of material changes to the capacity disclosure or disclosure
related to type and scope of services, we estimate that this would take
place among 20% of a small entity's retail customer accounts annually.
We therefore estimate small entities to incur a total annual aggregate
burden of 21 hours, or 0.03 hours per small entity per year.\1599\
---------------------------------------------------------------------------
\1599\ (20%) x (5,281 retail customer accounts) x (0.02 hours
for delivery to each customer account) = 21 aggregate burden hours
per year. Conversely, 21 aggregate burden hours/756 small entities =
0.03 burden hours per small entity per year.
---------------------------------------------------------------------------
The total ongoing aggregate burden for small entities to review,
amend, and deliver updated account disclosures to reflect changes in
capacity, type and scope of services would be 3,444 burden hours per
year.\1600\
---------------------------------------------------------------------------
\1600\ This estimate is based on the following calculation: (931
ongoing aggregate burden hours for dually registered broker-dealers
that are small entities) + (2,492 ongoing aggregate burden hours for
standalone broker-dealers that are small entities) + (21 ongoing
aggregate burden hours for delivery of amended account disclosures)
= 3,444 total ongoing aggregate burden hours per year.
---------------------------------------------------------------------------
The Commission acknowledges that the types of services and product
offerings vary greatly by broker-dealer, and therefore the costs or
burdens associated with updating the account disclosure might also
vary.
(2) Disclosure of Fees and Costs
As stated above, while we anticipate that many small entities may
already create fee schedules, we believe that small entities will
initially spend 5 hours to internally create a new fee schedule in
consideration of the requirements of Regulation Best Interest. We
additionally estimate a one-time external cost of $2,485 for small
entities.\1601\ We therefore estimate the initial aggregate burden for
small entities to be 3,780 burden hours,\1602\ and the initial
aggregate cost to be $1.88 million.\1603\
---------------------------------------------------------------------------
\1601\ See supra footnote 1426.
\1602\ See supra footnote 1428.
\1603\ See supra footnote 1429.
---------------------------------------------------------------------------
Similar to delivery of the account disclosure regarding capacity
and type and scope of services, we estimate the burden for small
entities to make the initial delivery of the fee schedule to new retail
customers, at the inception of the relationship, and existing retail
customers, prior to or at the time of a recommendation, will require
approximately 0.02 hours to deliver to each retail customer.\1604\ We
therefore estimate that small entities will have an aggregate initial
burden of 106 hours, or
[[Page 33487]]
approximately 0.14 hours per small entity for the first year after
Regulation Best Interest is in effect.\1605\
---------------------------------------------------------------------------
\1604\ See supra footnote 1411.
\1605\ This estimate is based on the following calculation:
(5,281 retail customer accounts) x (0.02 hours for delivery to each
customer account) = 106 aggregate burden hours. Conversely, (106
aggregate burden hours) / (756 small entities) = 0.14 burden hours
per small entity for the first year after Regulation Best Interest
is in effect.
---------------------------------------------------------------------------
With respect to small entities, we estimate that reviewing and
updating the fee schedule will require approximately 2 hours per year.
Based on these estimates, we estimate the recurring, aggregate,
annualized burden will be 1,512 hours for small entities.\1606\ We do
not anticipate that small entities will incur outside legal,
compliance, or consulting fees in connection with updating their
standardized fee schedule since in-house personnel would be more
knowledgeable about these facts, and we therefore do not expect
external costs associated with updating the fee schedule.
---------------------------------------------------------------------------
\1606\ See supra footnote 1437.
---------------------------------------------------------------------------
With respect to delivery of the amended fee schedule in the event
of a material change, we estimate that this would take place among 40%
of a small entity's retail customer accounts annually, and that small
entities will require approximately 0.02 hours to deliver the amended
fee schedule to each retail customer. We therefore estimate small
entities would incur a total annual aggregate burden of 42 hours, or
0.06 hours per small entity.\1607\
---------------------------------------------------------------------------
\1607\ This estimate is based on the following calculation: (40%
of 5,281 retail customer accounts) x (0.02 hours) = 42 aggregate
burden hours. Conversely, (42 aggregate burden hours)/(756 small
entities) = 0.06 burden hours per small entity per year.
---------------------------------------------------------------------------
The Commission acknowledges that the type of fee schedule may vary
greatly by small entity and therefore that the costs or burdens
associated with updating the standardized fee schedule might similarly
vary.
(3) Disclosure of All Material Facts Relating to Conflicts of Interest
Associated With the Recommendation
We believe that many or most small entities will develop a
standardized conflict disclosure document and deliver it to their
retail customers.\1608\ For small entities, we estimate it will take
in-house counsel, on average, 5 burden hours to create the standardized
conflict disclosure document and outside counsel 5 hours to review and
revise the document. We estimate that the initial aggregate burden for
the development of a standardized disclosure document, based on an
estimated 756 small entities, will be 3,780 burden hours.\1609\ We
additionally estimate an initial cost of $2,485 per small entity,\1610\
and an aggregate initial cost of $1.88 million for all small broker-
dealers.\1611\
---------------------------------------------------------------------------
\1608\ See supra footnote 1443.
\1609\ See supra footnote 1444.
\1610\ See supra footnote 1445.
\1611\ See supra footnote 1446.
---------------------------------------------------------------------------
We assume that small entities will deliver the standardized
conflict disclosure document to new retail customers at the inception
of the relationship, and to existing retail customers prior to or at
the time of a recommendation. We estimate that small entities will
require approximately 0.02 hours to deliver the standardized conflict
disclosure document to each retail customer.\1612\ We therefore
estimate that small entities will incur an aggregate initial burden of
106 hours, or approximately 0.14 hours per small entity for delivery of
the standardized conflict disclosure document the first year after
Regulation Best Interest is in effect.\1613\ Accordingly, the total
aggregate initial burden for small entities is estimated at 3,886
hours,\1614\ and the total aggregate initial cost is estimated at $1.88
million.\1615\
---------------------------------------------------------------------------
\1612\ See supra footnote 1411. For purposes of this analysis,
we have assumed any initial disclosures made by the small entities
related to material conflicts of interest will be delivered
together.
\1613\ These estimates are based on the following calculations:
(0.02 hours per customer account x 5,281 retail customer accounts) =
106 aggregate burden hours. Conversely, (106 hours)/(756 small
entities) = 0.14 burden hours per small entity for the first year
after Regulation Best Interest is in effect.
\1614\ This estimate is based on the following calculation:
(3,780 aggregate initial burden hours for the development of a
standardized conflict disclosure document) + (106 burden hours for
delivery of the standardized conflict disclosure document) = 3,886
aggregate initial burden hours.
\1615\ See supra footnote 1429.
---------------------------------------------------------------------------
We believe that small entities will incur ongoing annual burdens
and costs to update the disclosure document to include newly identified
conflicts. We estimate that in-house counsel at a small entity will
require approximately 1 hour per year to update the standardized
conflict disclosure document, for an ongoing aggregate burden of
approximately 756 hours per year.\1616\ We do not anticipate that small
entities will incur outside legal, compliance, or consulting fees in
connection with updating their standardized conflict disclosure
document, since in-house personnel would presumably be more
knowledgeable about conflicts of interest.
---------------------------------------------------------------------------
\1616\ See supra footnote 1453.
---------------------------------------------------------------------------
With respect to ongoing delivery of the updated conflict disclosure
document, we estimate that this will take place among 40% of a small
entity's retail customer accounts annually, and that small entities
will require approximately 0.02 hours to deliver the updated conflict
disclosure document to each retail customer.\1617\ We therefore
estimate that small entities will incur an aggregate ongoing burden of
42 hours, or 0.06 burden hours per small entity per year.\1618\
---------------------------------------------------------------------------
\1617\ See supra footnote 1455.
\1618\ This estimate is based on the following calculation: (40%
of 5,281 retail customer accounts) x (0.02 hours) = 42 aggregate
burden hours. Conversely, (42 aggregate burden hours per year)/(756
small entities) = 0.06 hours per small entity per year.
---------------------------------------------------------------------------
2. Care Obligation
As discussed above in Section IV.B.2, we believe that any burdens
or costs associated with the Care Obligation are accounted for in other
obligations under Regulation Best Interest, including the Disclosure
Obligation and the Record-making Obligation under Rule 17a-3(a)(35) and
Recordkeeping Obligation under Rule 17a-4(e)(5). Other costs applicable
to broker-dealers, including small entities, associated with the Care
Obligation are discussed above in Section III.C.3.b.
3. Conflict of Interest Obligation
As described more fully above in Section IV.B.3, the Conflict of
Interest Obligation would generally include the obligation to: (1)
Update written policies and procedures to comply with Regulation Best
Interest and (2) establish mechanisms to proactively and systematically
identify and manage conflicts of interest in its business on an ongoing
or periodic basis.\1619\
---------------------------------------------------------------------------
\1619\ See supra Section IV.B.3. For a discussion of additional
costs and burdens, as well as monetized burdens, related to the
Conflict of Interest Obligation, see supra Section III.C.4.
---------------------------------------------------------------------------
a. Written Policies and Procedures
i. Initial Costs and Burdens
To initially comply with this obligation, we believe that small
entities would primarily rely on outside counsel to update existing
policies and procedures, as small broker-dealers generally have fewer
in-house legal and compliance personnel. We estimate that 40 hours of
outside legal counsel services would be required, for a one-time
initial cost of $19,880 per small entity,\1620\ and an aggregate
initial cost of $15.0 million for all small entities.\1621\ We also
expect that in-
[[Page 33488]]
house compliance would require 10 hours to review and approve the
updated policies and procedures, for an initial aggregate burden of
7,560 hours.\1622\ Therefore, we estimate the total initial aggregate
burden for small entities to be 128,160 hours \1623\ and the total
initial aggregate cost to be $25.0 million.\1624\
---------------------------------------------------------------------------
\1620\ See supra footnote 1477.
\1621\ See supra footnote 1478.
\1622\ See supra footnote 1479.
\1623\ See supra footnote 1480.
\1624\ See supra footnote 1481.
---------------------------------------------------------------------------
We believe that the related ongoing costs for small entities
(relating to outside counsel reviewing and updating policies and
procedures on a periodic basis) would be $2,485 annually for each small
entity,\1625\ and the projected aggregate, annual ongoing cost for
small entities (relating to outside legal counsel) would be $1.88
million.\1626\ In addition, we expect that small entities would require
five hours of outside compliance services per year to update their
policies and procedures, for an ongoing cost of $1,365 per year per
small entity,\1627\ and an aggregate ongoing cost of $1.03 million per
year.\1628\ The total aggregate, ongoing cost for small entities is
therefore projected at $2.91 million per year.\1629\
---------------------------------------------------------------------------
\1625\ See supra footnote 1486.
\1626\ See supra footnote 1487.
\1627\ See supra footnote 1488.
\1628\ See supra footnote 1489.
\1629\ See supra footnote 1490.
---------------------------------------------------------------------------
In addition to the costs described above, we additionally believe
small broker-dealers would incur an internal burden of approximately
five hours for an in-house compliance manager to review and approve the
updated policies and procedures per year. The ongoing, aggregate burden
for small broker-dealers would be 3,780 hours for in-house compliance
manager review per year.\1630\
---------------------------------------------------------------------------
\1630\ See supra footnote 1491.
---------------------------------------------------------------------------
b. Identification and Management of Conflicts of Interest
To comply with Regulation Best Interest, we expect that small
entities would modify existing technology through an outside programmer
which would require, on average, an estimated 20 hours, for an
estimated initial cost per small entity of $5,680.\1631\ We
additionally continue to project that coordination between the
programmer and the small entity's compliance manager would involve five
initial burden hours. The aggregate initial costs and burdens for small
entities for the modification of existing technology to identify
conflicts of interest would therefore be $4.29 million,\1632\ and 3,780
burden hours.\1633\
---------------------------------------------------------------------------
\1631\ See supra footnote 1497.
\1632\ This cost estimate is based on the following calculation:
($5,680 in outside programmer costs per broker-dealer) x (756 small
entities) = $4.29 million in aggregate initial outside programmer
costs.
\1633\ This burden estimate is based on the following
calculation: (5 burden hours) x (756 small entities) = 3,780
aggregate initial burden hours.
---------------------------------------------------------------------------
As a result of the changes made to the rule text of the Conflict of
Interest Obligation of Regulation Best Interest, we believe that small
entities would incur burdens to determine how to manage the conflict of
interest. We believe that small entities would require approximately 20
hours per small entity,\1634\ for an aggregate of 15,120 initial burden
hours for all small entities.\1635\ The total initial aggregate burden
for small entities for identification and management of conflicts of
interest is therefore 18,900 initial burden hours.\1636\
---------------------------------------------------------------------------
\1634\ See supra footnotes 1501 and 1502.
\1635\ This burden estimate is based on the following
calculation: (20 burden hours) x (756 small entities) = 15,120
aggregate initial burden hours.
\1636\ This burden estimate is based on the following
calculation: (3,780 burden hours for modification of technology) +
(15,120 burden hours for evaluation of managing conflicts) = 18,900
total aggregate initial burden hours.
---------------------------------------------------------------------------
To maintain compliance with the Conflict of Interest Obligation, we
believe that for purposes of this analysis, small entities would,
through the help of the business line and compliance personnel, spend
on average 10 hours \1637\ to perform an annual conflicts review using
the modified technology infrastructure.\1638\ Therefore, the aggregate
ongoing burden for an annual conflicts review, based on an estimated
756 small entities, would be approximately 7,560 burden hours per
year.\1639\ Because we assume that small entities would use in-house
personnel to identify and evaluate new, potential conflicts, we
continue to believe they would not incur additional ongoing costs.
---------------------------------------------------------------------------
\1637\ See supra footnote 1507.
\1638\ See supra footnote 1508.
\1639\ This estimate is based on the following calculation: (10
hours of labor per small entity per year) x (756 small entities) =
7,560 aggregate burden hours per year.
---------------------------------------------------------------------------
c. Training
As discussed in the Proposing Release, we expect that small
entities would develop training programs to comply with Regulation Best
Interest, including the Conflict of Interest Obligation. However, we
believe that any burdens and costs associated with a training program
would fall under the new Compliance Obligation as it would be developed
to comply with the rule as a whole, including each of the component
obligations.
In total, to comply with the Conflict of Interest Obligation, the
Commission estimates that the total initial burdens and costs for small
entities to be 135,720 hours \1640\ and $29.29 million \1641\ and the
total ongoing burdens and costs for small entities to be 11,340 hours
\1642\ and $2.91 million.\1643\
---------------------------------------------------------------------------
\1640\ This estimate is based on the following calculation:
(128,160 burden hours for written policies and procedures) + (7,560
burden hours for identification and management of conflicts of
interest) = 135,720 hours.
\1641\ This estimate is based on the following calculation: ($25
million initial aggregate costs relating to written policies and
procedures) + ($4.29 million initial aggregate costs for
modification of existing technology to identify conflicts of
interest) = $29.29 million initial aggregate costs.
\1642\ This estimate is based on the following calculation:
(3,780 burden hours for reviewing and approving the updated policies
and procedures) + (7,560 burden hours for annual conflicts review) =
11,340 initial aggregate burden hours.
\1643\ See supra footnote 1629.
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4. Compliance Obligation
As discussed above, in response to comments that we should require
policies and procedures to comply with the rule as a whole, we are
adopting the Compliance Obligation.\1644\ Because we did not include
the Compliance Obligation in the Proposing Release, we did not include
costs and burdens associated with the Compliance Obligation, but have
provided a detailed explanation in Section IV.B.4 above, and a summary
below.
---------------------------------------------------------------------------
\1644\ Section II.C.4.
---------------------------------------------------------------------------
To comply with the Compliance Obligation, we believe that small
entities would primarily rely on outside counsel to update existing
policies and procedures, and that 20 hours of outside legal counsel
services would be required, for a one-time cost of $9,940 per small
entity,\1645\ and an aggregate initial cost of $7.5 million for all
small entities.\1646\ We also expect that in-house compliance personnel
would require 6 hours to review and approve the updated policies and
procedures, for an aggregate initial burden of 4,536 hours.\1647\
---------------------------------------------------------------------------
\1645\ See supra footnote 1523.
\1646\ See supra footnote 1524.
\1647\ See supra footnote 1525.
---------------------------------------------------------------------------
In terms of ongoing costs, we assume for purposes of this analysis
that small entities would mostly rely on outside legal counsel and
compliance consultants for review and update of their policies and
procedures, with final review and approval from an in-house compliance
manager. We estimate that outside counsel would require approximately
five hours per year to update policies and procedures, for an
[[Page 33489]]
annual cost of $2,485 for each small entity.\1648\ The projected
aggregate, annual ongoing cost for outside legal counsel to update
policies and procedures for small entities would be $1.88 million per
year.\1649\ In addition, we expect that a small entity would require
five hours of outside compliance services per year to update its
policies and procedures, for an ongoing cost of $1,365 per year,\1650\
and an aggregate ongoing cost of $1.03 million per year.\1651\ The
total aggregate, ongoing cost for small entities is therefore projected
at $2.91 million per year.\1652\
---------------------------------------------------------------------------
\1648\ See supra footnote 1529.
\1649\ See supra footnote 1530.
\1650\ See supra footnote 1531.
\1651\ See supra footnote 1532.
\1652\ See supra footnote 1533.
---------------------------------------------------------------------------
a. Training
Pursuant to the obligation to ``maintain and enforce'' written
policies and procedures, we additionally believe small entities will
develop training programs that promote compliance with Regulation Best
Interest.
We estimate that a small entity would retain an outside systems
analyst, outside programmer, and an outside programmer analyst to
create a training module, at 20 hours, 40 hours, and 20 hours,
respectively. The total cost to develop the training module would be
approximately $20,920 per small entity,\1653\ for an aggregate initial
cost to small entities of $17.18 million.\1654\
---------------------------------------------------------------------------
\1653\ See supra footnote 1534.
\1654\ This estimate is based on the following calculation: (756
small entities) x ($20,920 initial costs per broker-dealer) = $15.81
million in aggregate initial costs for technology services.
---------------------------------------------------------------------------
Additionally, we expect that the training module would require the
approval of the Chief Compliance Officer, as well as in-house counsel,
each of whom would require approximately 2 hours to review and approve
the training module. The initial aggregate burden for small entities is
therefore estimated at 3,024 initial burden hours.\1655\
---------------------------------------------------------------------------
\1655\ This estimate is based on the following calculation: (756
small entities) x (4 initial burden hours per small entity) = 3,024
initial burden hours.
---------------------------------------------------------------------------
In addition, small entities would incur an initial cost for
registered representatives to undergo training through the training
module. We estimate the training time at one hour per associated
person, for an aggregate initial burden of 5,094 burden hours, or an
initial burden of 6.7 hours per small entity.\1656\ The total aggregate
burden to approve the training module and implement the training
program would be 8,118 initial burden hours.\1657\
---------------------------------------------------------------------------
\1656\ This estimate is based on the following calculation: (1
burden hour) x (5,094 registered representatives at small entities)
= 5,094 aggregate initial burden hours. Conversely, (5,094 aggregate
burden hours)/(756 small entities) = 6.7 initial burden hours per
broker-dealer.
\1657\ This estimate is based on the following calculation:
(5,094 burden hours for training of registered representatives) +
(3,024 burden hours to approve training program) = 8,118 total
aggregate initial burden hours.
---------------------------------------------------------------------------
For purposes of this analysis, we assume that small entities would
likely require registered representatives to repeat the training module
for Regulation Best Interest on an annual basis. The ongoing aggregate
cost for the one-hour training would be 5,094 burden hours per year, or
6.7 burden hours per small entity per year.\1658\
---------------------------------------------------------------------------
\1658\ See supra footnote 1656.
---------------------------------------------------------------------------
In total, for small entities to comply with the Compliance
Obligation, the Commission estimates the total initial burdens and
costs to be 12,654 hours \1659\ and $23.31 million,\1660\ and the total
ongoing burdens and costs to be 5,094 hours \1661\ and $2.91
million.\1662\
---------------------------------------------------------------------------
\1659\ This estimate is based on the following calculation:
(4,536 initial burden hours for policies and procedures) + (8,118
initial burden hours training) = 12,654 initial burden hours to
comply with Compliance Obligation.
\1660\ This estimate is based on the following calculation:
($7.5 million initial costs for policies and procedures) + ($15.81
million initial costs for training) = $23.31 million initial total
costs to comply with Compliance Obligation.
\1661\ This estimate is based on the following calculation: (0
ongoing burden hours for policies and procedures) + (5,094 ongoing
burden hours for training) = 5,094 ongoing burden hours to comply
with Compliance Obligation.
\1662\ This estimate is based on the following calculation:
($2.91 million ongoing costs for policies and procedures) + ($0
ongoing costs for training) = $2.91 million ongoing total costs to
comply with Compliance Obligation.
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5. Record-Making and Recordkeeping Obligations
The record-making and recordkeeping obligations will impose record-
making and recordkeeping requirements on broker-dealers with respect to
certain information collected from, or provided to, retail customers.
a. Record-Making Obligation
As discussed above, we continue to believe that small entities will
satisfy the record-making requirements of the amendment to Rule 17a-
3(a)(35) by amending an existing account disclosure document to include
certain information.\1663\ We believe that the inclusion of this
information in an account disclosure document will require, on average,
approximately 1 hour per year for outside counsel at small entities, at
an updated average rate of $497/hour, for an annual cost of $497 for
each small entity to update an account disclosure document. The
projected initial, aggregate cost for small entities is therefore
estimated to be $375,732.\1664\ Finally, we estimate it will require an
additional 0.04 hours for the registered representative responsible for
the information (or other clerical personnel) to fill out that
information in the account disclosure document, for an approximate
total aggregate initial burden of 211 hours, or approximately 0.28
hours per small entity for the first year after the rule is in
effect.\1665\
---------------------------------------------------------------------------
\1663\ See supra Section IV.B.5.a.i.
\1664\ See supra footnote 1548.
\1665\ These estimates are based on the following calculations:
(0.04 hours per customer account) x (5,281 retail customer accounts
at small entities) = 211 aggregate initial burden hours. Conversely,
(211 burden hours)/(756 small entities) = 0.28 initial burden hours
per broker-dealer.
---------------------------------------------------------------------------
Because we have already included the costs and burdens associated
with the creation of a record to memorialize an oral disclosure, and
the delivery of the amended account disclosure document in Section
V.D.1., we need not include them in this section of the analysis.
We do not believe that the identity of the registered
representative responsible for the retail customer's account will
change. Accordingly, we continue believe that there are no ongoing
costs and burdens associated with this record-making requirement of the
amendment to Rule 17a-3(a)(35). With respect to memorializing oral
disclosures, we estimate that this would take place among 52% of a
small entity's retail customers (and thus 52% of a registered
representative's retail customer accounts) annually.\1666\ We therefore
estimate that small entities will incur a total annual aggregate
ongoing burden of 55 hours or 0.07 hours per small entity per
year.\1667\
---------------------------------------------------------------------------
\1666\ See supra footnote 1554.
\1667\ (52%) x (5,281 retail customer accounts at small
entities) x (0.02 hours for recording each oral disclosure relating
to a retail customer's account) = 55 aggregate burden hours per
year. Conversely, 55 aggregate burden hours/756 small entities =
0.07 ongoing burden hours per small entity per year.
---------------------------------------------------------------------------
b. Recordkeeping Obligation
For purposes of this analysis, we assume the following records
would likely be retained pursuant to amended Rule 17a-3(a)(35): (1)
Existing account disclosure documents; (2) comprehensive fee schedules;
(3) disclosures identifying material conflicts; and (4) memorialized
oral disclosures under the circumstances outlined in Section II.C.1,
Oral Disclosure or Disclosure After a Recommendation.
Based on our belief that small entities will rely on existing
infrastructures to satisfy the recordkeeping obligations of Regulation
Best Interest and the amendment to Rule 17-a(4)(e)(5), we
[[Page 33490]]
believe the burden for small entities to add new documents or modify
existing documents to the small entity's existing retention system will
be approximately 704 burden hours for small entities, assuming a small
entity will need to upload or file each of the four account documents
discussed above for each retail customer account.\1668\ We do not
believe there will be additional internal or external costs relating to
the uploading or filing of the documents. In addition, because we have
already included the costs and burdens associated with the delivery of
the amended account opening agreement and other documents in Section
V.D.1 above, we do not include them in this section of the analysis.
---------------------------------------------------------------------------
\1668\ This estimate is based on the following calculation: (4
documents per customer account) x (5,281 retail customer accounts at
small entities) x (2 minutes per document)/60 minutes = 704
aggregate burden hours.
---------------------------------------------------------------------------
We estimate that the approximate ongoing burden associated with the
recordkeeping requirement of the amendment to Rule 17a-4(e)(5) is 231
burden hours per year.\1669\ We do not believe that the ongoing costs
associated with ensuring compliance with the retention schedule would
change from the current costs of ensuring compliance with existing Rule
17a-4 and as outlined above.
---------------------------------------------------------------------------
\1669\ This estimate is based on the percentage of account
records we expect would be updated each year as described in Section
IV.B.1, supra, and the following calculation: ((40% of fee schedules
x 5,281 retail customer accounts at small entities) x (2 minutes per
document) + (40% of conflict disclosure forms x 5,281 retail
customer accounts at small entities) x (2 minutes per document) +
(20% of account opening documents x 5,281 retail customer accounts
at small entities) x (2 minutes per document)) = 10,560 minutes/60
minutes = 176 aggregate ongoing burden hours. In addition, with
respect to ongoing memorialization of the updated oral disclosures,
we estimate that this will take place among 52% of a small entity's
retail customer accounts annually. We therefore estimate that small
entities will incur an aggregate ongoing burden of 55 hours, or 0.07
burden hours per broker-dealer (calculated as follows: (52% of
updated oral disclosures x 5,281 retail customer accounts at small
entities) x (1.2 minutes per document) = 3,295 minutes/60 minutes =
55 aggregate ongoing burden hours (or 55 aggregate burden hours/756
small entities = 0.07 burden hours per small entity)). 176 hours +
55 hours = 231 total aggregate ongoing burden hours.
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E. Agency Action To Minimize Effect on Small Entities
The RFA directs the Commission to consider significant alternatives
that would accomplish the stated objective, while minimizing any
significant adverse impact on small entities. As described in the
Proposing Release we considered the following alternatives for small
entities in relation to the new requirements: (1) The establishment of
differing compliance or reporting requirements or timetables that take
into account the resources available to small entities; (2) the
clarification, consolidation, or simplification of compliance and
reporting requirements for small entities; (3) the use of performance
rather than design standards; and (4) an exemption from coverage of the
new requirements, or any part thereof, for such small entities.
Regarding the first alternative, the Commission does not believe
that we could effectively achieve our stated objectives by establishing
different requirements applicable to broker-dealers of different sizes.
We considered adopting tiered compliance dates so that smaller broker-
dealers would have had more time to comply. However, as discussed in
Section II.E above, we believe the operational capability needed to
develop processes to comply with Regulation Best Interest is
sufficiently established by firms of all sizes and resources. The
Commission has determined, in light of the importance of the
protections afforded by Regulation Best Interest to retail customers,
that a Compliance Date of one year after the Effective Date is an
appropriate timeframe for firms to conduct the requisite operational
changes to their systems to establish internal processes to comply with
Regulation Best Interest. Further, as discussed above in Section III,
each of the component obligations in Regulation Best Interest shares
features with existing market best practices, as shaped by FINRA's
guidance on relevant rules or as described in its Report on Conflicts
of Interest.\1670\ To the extent that broker-dealer (and small entity)
practices are already aligned with the requirements of Regulation Best
Interest, the anticipated magnitude of the costs associated with a
given component of the rule will be correspondingly reduced.\1671\
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\1670\ See supra Section III.C.1.b.
\1671\ See supra text following footnote 1159.
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As discussed above, we believe that Regulation Best Interest will
result in important investor protection benefits, and these benefits
apply to retail customers of smaller entities as well as retail
customers of large broker-dealers. For example, a primary objective of
this rulemaking is to enhance the quality of recommendations provided
by broker-dealers to retail customers, by establishing under the
Exchange Act a ``best interest'' obligation. We do not believe that the
interest of investors who are retail customers would be served by
establishing differing compliance or reporting requirements or
timetables for broker-dealers that are small entities under Regulation
Best Interest and the amendments to Rules 17a-3 and 17a-4(e)(5).
Moreover, we continue to believe that providing an exemption or
different requirements for small entities would be inconsistent with
our goal of facilitating more consistent regulation, in recognition of
the importance for both investors and broker-dealers of having the
applicable standards for brokerage recommendations be clear,
understandable, and as consistent as possible across a brokerage
relationship (i.e., whether for retirement or non-retirement purposes)
and better aligned with other advice relationships (e.g., a
relationship with an investment adviser). Further, as discussed above,
broker-dealers are subject to regulation under the Exchange Act and the
rules of each SRO of which the broker-dealer is a member, including a
number of obligations that attach when a broker-dealer makes a
recommendation to a customer, as well as general and specific
requirements aimed at addressing certain conflicts of interest. We note
that these existing requirements do not generally distinguish between
small entities and other broker-dealers.
For the same reasons as described in the Proposing Release, we
still do not believe that additional clarification, consolidation, or
simplification of compliance and reporting requirements would be
appropriate for small entities. We note, however, in crafting
Regulation Best Interest, we generally aimed to provide broker-dealers
flexibility in determining how to satisfy the component obligations. We
continue to believe that this flexibility reflects a general
performance-based approach, rather than design-based approach.
As discussed in the Economic Analysis in Section III.E above, the
Commission also considered a number of alternatives as they affect all
firms, including small entities. Specifically, the Commission
considered three different options for imposing a fiduciary standard on
broker-dealers: (1) Applying the fiduciary standard under the Advisers
Act to broker-dealers; (2) adopting a ``new'' uniform fiduciary
standard of conduct applicable to both broker-dealers and investment
advisers, such as that recommended by the staff in the 913 Study, and,
or (3) adopting similar standards to what the DOL had provided under
its fiduciary rule to broker-dealers and investment advisers. The
Commission further considered requiring broker-dealers to use a
specific form for disclosure, similar to, for example, Form ADV Part II
in lieu of the flexible approach of the Disclosure Obligation, or in
the alternative, developing a disclosure-only standard,
[[Page 33491]]
which would require that broker-dealers satisfy only the Disclosure
Obligation of the final rule.
We acknowledge certain commenters urged the Commission to take
additional or different regulatory actions than the approach we have
adopted, including the alternatives discussed above. We do not believe
that any rulemaking governing retail investor-advice relationships can
solve for every issue presented. After careful consideration of the
comments and additional information we have received, we believe that
Regulation Best Interest, as modified, appropriately balances the
concerns of the various commenters in a way that will best achieve the
Commission's important goals of enhancing retail investor protection
and decision making, while preserving, to the extent possible, retail
investor access (in terms of choice and cost) to differing types of
investment services and products.
VI. Statutory Authority and Text of the Rule
Pursuant to Dodd-Frank Wall Street Reform and Consumer Protection
Act Section 913(f), Public Law 111-203, 124 Stat. 1376, 1827 (2010),
and Exchange Act sections 3, 10, 15, 15(c)(6), 15(l), 17, 23 and 36
thereof, 15 U.S.C. 78c, 78j, 78o, 78o(c)(6), 78o(l), 78q, 78w and 78mm,
the Commission is adopting Sec. 240.15l-1 and adopting amendments to
Sec. 240.17a-3 by adding new paragraph (a)(25), and to revise Sec.
240.17a-4(e)(5) of Title 17 of the Code of Federal Regulations in the
manner set forth below.
List of Subjects in 17 CFR Part 240
Brokers, Reporting and recordkeeping requirements, Securities.
Text of the Rule
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 is amended by adding sectional
authorities for section 240.15l-1 to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20,
80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq.; and
8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; and
Pub. L. 111-203, 939A, 124 Stat. 1887 (2010); and secs. 503 and 602,
Pub. L. 112-106, 126 Stat. 326 (2012), unless otherwise noted.
* * * * *
Section 240.15l-1 is also issued under Pub. L. 111-203, sec.
913, 124 Stat. 1376, 1827 (2010).
* * * * *
0
2. Add Sec. 240.15l-1 to read as follows:
Sec. 240.15l-1 Regulation Best Interest.
(a) Best interest obligation. (1) A broker, dealer, or a natural
person who is an associated person of a broker or dealer, when making a
recommendation of any securities transaction or investment strategy
involving securities (including account recommendations) to a retail
customer, shall act in the best interest of the retail customer at the
time the recommendation is made, without placing the financial or other
interest of the broker, dealer, or natural person who is an associated
person of a broker or dealer making the recommendation ahead of the
interest of the retail customer.
(2) The best interest obligation in paragraph (a)(1) of this
section shall be satisfied if:
(i) Disclosure obligation. The broker, dealer, or natural person
who is an associated person of a broker or dealer, prior to or at the
time of the recommendation, provides the retail customer, in writing,
full and fair disclosure of:
(A) All material facts relating to the scope and terms of the
relationship with the retail customer, including:
(1) That the broker, dealer, or such natural person is acting as a
broker, dealer, or an associated person of a broker or dealer with
respect to the recommendation;
(2) The material fees and costs that apply to the retail customer's
transactions, holdings, and accounts; and
(3) The type and scope of services provided to the retail customer,
including any material limitations on the securities or investment
strategies involving securities that may be recommended to the retail
customer; and
(B) All material facts relating to conflicts of interest that are
associated with the recommendation.
(ii) Care obligation. The broker, dealer, or natural person who is
an associated person of a broker or dealer, in making the
recommendation, exercises reasonable diligence, care, and skill to:
(A) Understand the potential risks, rewards, and costs 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, rewards,
and costs associated with the recommendation and does not place the
financial or other interest of the broker, dealer, or such natural
person ahead of the interest of the retail customer;
(C) Have a reasonable basis to believe that a series of recommended
transactions, even if in the retail customer's best interest when
viewed in isolation, is not excessive and is in the retail customer's
best interest when taken together in light of the retail customer's
investment profile and does not place the financial or other interest
of the broker, dealer, or such natural person making the series of
recommendations ahead of the interest of the retail customer.
(iii) Conflict of interest obligation. The broker or dealer
establishes, maintains, and enforces written policies and procedures
reasonably designed to:
(A) Identify and at a minimum disclose, in accordance with
paragraph (a)(2)(i) of this section, or eliminate, all conflicts of
interest associated with such recommendations;
(B) Identify and mitigate any conflicts of interest associated with
such recommendations that create an incentive for a natural person who
is an associated person of a broker or dealer to place the interest of
the broker, dealer, or such natural person ahead of the interest of the
retail customer;
(C)(1) Identify and disclose any material limitations placed on the
securities or investment strategies involving securities that may be
recommended to a retail customer and any conflicts of interest
associated with such limitations, in accordance with subparagraph
(a)(2)(i), and
(2) Prevent such limitations and associated conflicts of interest
from causing the broker, dealer, or a natural person who is an
associated person of the broker or dealer to make recommendations that
place the interest of the broker, dealer, or such natural person ahead
of the interest of the retail customer; and
(D) Identify and eliminate any sales contests, sales quotas,
bonuses, and non-cash compensation that are based on the sales of
specific securities or specific types of securities within a limited
period of time.
(iv) Compliance obligation. In addition to the policies and
procedures
[[Page 33492]]
required by paragraph (a)(2)(iii) of this section, the broker or dealer
establishes, maintains, and enforces written policies and procedures
reasonably designed to achieve compliance with Regulation Best
Interest.
(b) Definitions. Unless otherwise provided, all terms used in this
rule shall have the same meaning as in the Securities Exchange Act of
1934. In addition, the following definitions shall apply for purposes
of this section:
(1) Retail customer means a natural person, or the legal
representative of such natural person, who:
(i) Receives a recommendation of any securities transaction or
investment strategy involving securities from a broker, dealer, or a
natural person who is an associated person of a broker or dealer; and
(ii) Uses the recommendation primarily for personal, family, or
household purposes.
(2) Retail customer investment profile includes, but is not limited
to, the retail customer's age, other investments, financial situation
and needs, tax status, investment objectives, investment experience,
investment time horizon, liquidity needs, risk tolerance, and any other
information the retail customer may disclose to the broker, dealer, or
a natural person who is an associated person of a broker or dealer in
connection with a recommendation.
(3) Conflict of interest means an interest that might incline a
broker, dealer, or a natural person who is an associated person of a
broker or dealer --consciously or unconsciously--to make a
recommendation that is not disinterested.
0
3. Amend Sec. 240.17a-3 by adding reserved paragraphs (a)(24) through
(34) and paragraph (a)(35) to read as follows:
Sec. 240.17a-3 Records to be made by certain exchange members,
brokers and dealers.
(a) * * *
(24)-(34) [Reserved].
(35) For each retail customer to whom a recommendation of any
securities transaction or investment strategy involving securities is
or will be provided:
(i) A record of all information collected from and provided to the
retail customer pursuant to Sec. 240.15l-1, as well as the identity of
each natural person who is an associated person, if any, responsible
for the account.
(ii) For purposes of this paragraph (a)(35), the neglect, refusal,
or inability of the retail customer to provide or update any
information described in paragraph (a)(35)(i) of this section shall
excuse the broker, dealer, or associated person from obtaining that
required information.
* * * * *
0
4. Amend Sec. 240.17a-4 by revising paragraph (e)(5) to read as
follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(e) * * *
(5) All account record information required pursuant to Sec.
240.17a-3(a)(17) and all records required pursuant to Sec. 240.17a-
3(a)(35), in each case until at least six years after the earlier of
the date the account was closed or the date on which the information
was collected, provided, replaced, or updated.
* * * * *
By the Commission.
Dated: June 5, 2019.
Vanessa Countryman,
Acting Secretary.
[FR Doc. 2019-12164 Filed 7-11-19; 8:45 am]
BILLING CODE 8011-01-P