Federal Register Volume 83, Issue 90 (May 9, 2018)
Page Range
21574-21682
FR Document
2018-08582
We are proposing 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 when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
Federal Register, Volume 83 Issue 90 (Wednesday, May 9, 2018)
[Federal Register Volume 83, Number 90 (Wednesday, May 9, 2018)]
[Proposed Rules]
[Pages 21574-21682]
From the Federal Register Online [www.thefederalregister.org]
[FR Doc No: 2018-08582]
[[Page 21573]]
Vol. 83
Wednesday,
No. 90
May 9, 2018
Part IV
Securities and Exchange Commission
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17 CFR Part 240
Regulation Best Interest; Proposed Rule
Federal Register / Vol. 83 , No. 90 / Wednesday, May 9, 2018 /
Proposed Rules
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-83062; File No. S7-07-18]
RIN 3235-AM35
Regulation Best Interest
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: We are proposing 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 when making a recommendation of any securities
transaction or investment strategy involving securities to a retail
customer.
DATES: Comments should be received on or before August 7, 2018.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an email to [email protected]. Please include
File Number S7-07-18 on the subject line.
Paper Comments
Send paper comments to Brent J. Fields, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090.
All submissions should refer to File Number S7-07-18. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's internet website (http://www.sec.gov/rules/proposed.shtml). Comments also are available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of
10:00 a.m. and 3:00 p.m. All comments received will be posted without
change. Persons submitting comments are cautioned that we do not redact
or edit personal identifying information from comment submissions. You
should submit only information that you wish to make publicly
available.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Lourdes Gonzalez, Assistant Chief
Counsel--Office of Sales Practices; Emily Westerberg Russell, Senior
Special Counsel; Alicia Goldin, Senior Special Counsel; Bradford
Bartels, Special Counsel; Geeta Dhingra, Special Counsel; and Stacy
Puente, 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:
Table of Contents
I. Introduction
A. Background
1. Evaluation of Standards of Conduct Applicable to Investment
Advice
2. DOL Rulemaking
3. Statement by Chairman Clayton
B. General Objectives of Proposed Approach
II. Discussion of Regulation Best Interest
A. Overview of Regulation Best Interest
B. Best Interest, Generally
1. Consistency With Other Approaches
2. Request for Comment on the Best Interest Obligation
C. Key Terms and Scope of Best Interest Obligation
1. Natural Person Who Is an Associated Person
2. When Making a Recommendation, at Time Recommendation is Made
3. Any Securities Transaction or Investment Strategy
4. Retail Customer
5. Request for Comment on Key Terms and Scope of Best Interest
Obligation
D. Components of Regulation Best Interest
1. Disclosure Obligation
2. Care Obligation
3. Conflict of Interest Obligations
E. Recordkeeping and Retention
F. Whether the Exercise of Investment Discretion Should Be
Viewed as Solely Incidental to the Business of a Broker or Dealer
III. Request for Comment
A. Generally
B. Interactions With Other Standards of Conduct
IV. Economic Analysis
A. Introduction, Primary Goals of Proposed Regulations and Broad
Economic Considerations
1. Introduction and Primary Goals of Proposed Regulation
2. Broad Economic Considerations
B. Economic Baseline
1. Market for Advice Services
2. Regulatory Baseline
C. Benefits, Costs, and Effects on Efficiency, Competition, and
Capital Formation
1. Benefits
2. Costs
D. Effects on Efficiency, Competition, and Capital Formation
E. Reasonable Alternatives
1. Disclosure-Only Alternative
2. Principles-Based Standard of Conduct Obligation
3. A Fiduciary Standard for Broker-Dealers
4. Enhanced Standards Akin to Conditions of the BIC Exemption
F. Request for Comment
V. Paperwork Reduction Act Analysis
A. Respondents Subject to Proposed Regulation Best Interest and
Proposed Amendments to Rule 17a-3(a)(25), 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. Conflict of Interest Obligations
2. Disclosure Obligation
3. Care Obligation
4. Record-Making and Recordkeeping Obligations
C. Collection of Information Is Mandatory
D. Confidentiality
E. Request for Comment
VI. Small Business Regulatory Enforcement Fairness Act
VII. Initial Regulatory Flexibility Act Analysis
A. Reasons for and Objectives of the Proposed Action
B. Legal Basis
C. Small Entities Subject to the Proposed Rule
D. Projected Compliance Requirements of the Proposed Rule for
Small Entities
1. Conflict of Interest Obligations
2. Disclosure Obligations
3. Obligation To Exercise Reasonable Diligence, Care, Skill and
Prudence
4. Record-Making and Recordkeeping Obligations
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
1. Disclosure-Only Alternative
2. Principles-Based Alternative
3. Enhanced Standards Akin to BIC Exemption
G. General Request for Comment
VIII. Statutory Authority and Text of Proposed Rule
I. Introduction
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. Broker-dealers may offer a wide
variety of brokerage (i.e., agency) services to retail customers
ranging from providing customers with execution-only services (e.g.,
discount brokerage), which typically does not involve advice, to
providing a range of services, including advice, to customers
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(i.e., full-service brokerage).\1\ Broker-dealers are typically
considered to provide advice when they make recommendations of
securities transactions or investment strategies involving securities
to customers.\2\ Broker-dealers also may offer a variety of dealer
(i.e., principal) services and investment products to retail
customers,\3\ and may make recommendations to retail customers about
such principal services, such as 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\
Like many principal-agent relationships, the relationship between a
broker-dealer and an investor has inherent conflicts of interest, which
may provide an incentive to a broker-dealer to seek to maximize its
compensation at the expense of the investor it is advising. As we
discuss below, concerns regarding the potential harm to retail
customers resulting from broker-dealer conflicts of interest, and in
particular the conflicts associated with financial incentives, have
existed for some time.
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\1\ Such ``agency'' services may include, but are not limited
to: Providing transaction-specific recommendations to buy or sell
securities for commissions; providing asset allocation services with
recommendations about asset classes, specific sectors, or specific
securities; providing generalized research, advice, and education;
providing custody and trade execution to a customer who has selected
an independent investment manager or other money manager; executing
trades placed by investment advisers in wrap fee programs; offering
margin accounts; and operating a call center (e.g., responding to a
customer request for stock quotes, information about an issuer or
industry, and then placing a trade at the customer's request). See,
e.g., 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.
\2\ See 913 Study at 124.
\3\ As the Staff noted in the 913 Study, such ``dealer''
services may include, but are not limited to: Selling securities
(such as bonds) out of inventory; buying securities from customers;
selling proprietary products (e.g., products such as affiliated
mutual funds, structured products, private equity and other
alternative investments); selling initial and follow-on public
offerings; selling other underwritten offerings; acting as principal
in Individual Retirement Accounts (``IRAs''); acting as a market
maker; and otherwise acting as a dealer. Broker-dealers may offer
solely proprietary products, a limited range of products, or a
diverse range of products. Id. at 10.
\4\ Id. at 13.
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The rule we are proposing today addresses the question of whether
changes should be made to the standard of conduct that applies to
broker-dealers when making recommendations about securities to retail
customers. As discussed below, broker-dealers are subject to regulation
under the Exchange Act and the rules of each self-regulatory
organization (``SRO'') of which the broker-dealer is a member,\5\
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. These
obligations have developed in response to and reflect the unique
structure and characteristics of the broker-dealer relationship with
retail customers--in particular, the compensation and other conflicts
presented, the variety in the frequency and level of advice services
provided (i.e., one-time, episodic or on a more frequent basis), and
the spectrum of services provided to retail customers that may or may
not include advice (such as executing unsolicited transactions). While
these obligations are extensive, there is no specific obligation under
the Exchange Act that broker-dealers make recommendations that are in
their customers' best interest.\6\
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\5\ Generally, all registered broker-dealers that deal with the
public must become members of the Financial Industry Regulatory
Authority (``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.
\6\ As discussed infra note 15, FINRA and a number of cases have
interpreted FINRA's suitability rule as requiring a broker-dealer to
make recommendations that are ``consistent with his customers' best
interests'' or are not ``clearly contrary to the best interest of
the customer,'' but this is not an explicit requirement of FINRA's
suitability rule.
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After extensive consideration of these issues, we believe it is
appropriate to make enhancements to the obligations that apply when
broker-dealers make recommendations to retail customers. Accordingly,
we are proposing a new rule under the Exchange Act that would establish
an express best interest obligation: That all broker-dealers and
natural persons who are associated persons of a broker-dealer (unless
otherwise indicated, together referred to as ``broker-dealer''), when
making a recommendation of any securities transaction or investment
strategy involving securities to a retail customer, 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 making the recommendation
ahead of the interest of the retail customer (``Regulation Best
Interest''). The proposed rule would provide that the best interest
obligation shall be satisfied if:
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, reasonably discloses 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 that are associated with the recommendation;
The broker-dealer or natural person who is an associated
person of a broker or dealer, in making the recommendation, exercises
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;
The broker or dealer establishes, maintains, and enforces
written policies and procedures reasonably designed to identify and at
a minimum disclose, or eliminate, all material conflicts of interest
that are associated with such recommendations; and
The broker or dealer establishes, maintains, and enforces
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.
Regulation Best Interest is designed to make it clear that a
broker-dealer may not put her or her firm's financial interests ahead
of the interests of her retail customer in making investment
recommendations. Our goal in designing proposed Regulation Best
Interest is to enhance investor protection, while preserving, to the
extent possible, access and choice for investors who prefer the ``pay
as you go'' model for advice from broker-dealers, as well as preserve
retail customer choice of the level and types of advice provided and
the products available. We believe that the proposed best interest
obligation for broker-
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dealers set forth in Regulation Best Interest achieves this goal.
Specifically, we believe that proposed Regulation Best Interest
will improve investor protection by enhancing the professional
standards of conduct that currently apply to broker-dealers when they
make recommendations to retail customers, in four key respects.
First, it would enhance the quality of recommendations
provided by requiring broker-dealers make recommendations in the retail
customer's ``best interest,'' which incorporates and goes beyond a
broker-dealer's existing suitability obligations under the federal
securities laws, and could not be satisfied through disclosure
alone.\7\
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\7\ As discussed herein, some of the enhancements that
Regulation Best Interest would make to existing suitability
obligations under the federal securities laws, such as the
collection of information requirement related to a customer's
investment profile, the inability to disclose away a broker-dealer's
suitability obligation, and a requirement to make recommendations
that are ``consistent with his customers' best interests,'' reflect
obligations that already exist under the FINRA suitability rule or
have been articulated in related FINRA interpretations and case law.
See infra Sections II.D and IV.D, and note 15. Unless otherwise
indicated, our discussion of how Regulation Best Interest compares
with existing suitability obligations focuses on what is currently
required under the Exchange Act.
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Second, it would establish obligations under the Exchange
Act that do not rely on disclosure alone as the solution to conflicts
arising from financial incentives--including conflicts associated with
broker-dealer compensation incentives, the sale of proprietary
products, and effecting transactions in a principal capacity.
Third, it would improve disclosure about the scope and
terms of the broker-dealer's relationship with the retail customer,
which would foster retail customer awareness and understanding of their
relationship with the broker-dealer, which aligns with our broader
effort to address retail investor confusion through our separate
concurrent rulemaking.\8\
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\8\ As discussed in more detail in Section II.D.1 in a separate,
concurrent rulemaking, we propose to: (1) Require broker-dealers and
investment advisers to deliver to retail investors a short (i.e.,
four page or equivalent limit if in electronic format) relationship
summary; (2) restrict broker-dealers and associated natural persons
of broker-dealers, when communicating with a retail investor, from
using as part of a name or title the term ``adviser'' or ``advisor''
in certain circumstances; and (3) require broker-dealers and
investment advisers, and their associated natural persons and
supervised persons, respectively, to disclose in retail investor
communications the firm's registration status with the Commission
and an associated natural person's and supervised person's
relationship with the firm. 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
(``Relationship Summary Proposal'').
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Finally, it would enhance the disclosure of material
conflicts of interest and thereby help retail customers evaluate
recommendations received from broker-dealers.
Through these enhancements, we preliminarily believe that the best
interest obligation will reduce the potential harm to retail customers
from recommendations provided in circumstances where conflicts of
interest, including those arising from financial incentives, exist
while preserving investor access to advice and choice with regard to
advice relationships and compensation methods, and is workable for the
transaction-based relationship offered by broker-dealers. Specifically,
proposed Regulation Best Interest is designed to achieve these
enhancements by building upon, and being tailored to, the unique
structure and characteristics of the broker-dealer relationship with
retail customers and existing regulatory obligations, while taking into
consideration and drawing on (to the extent appropriate) the principles
of the obligations that apply to investment advice in other contexts.
In drawing from these underlying principles, as opposed to adopting
identical or uniform obligations, we seek to apply consistent
principles across the spectrum of investment advice, and thereby
enhance investor protection while preserving investor choice across
products and advice models.
We further believe that, through the establishment of a standard of
conduct for broker-dealers under the Exchange Act, this proposed
approach would foster greater clarity, certainty, and efficiency with
respect to broker-dealer standards of conduct. In addition, by drawing
from principles that have developed under other regulatory regimes, we
seek to establish greater consistency in the level of protection
provided across the spectrum of registered investment advice and ease
compliance with Regulation Best Interest where these other overlapping
regulatory regimes are also applicable.
Before describing proposed Regulation Best Interest, we provide a
brief background on this subject, including recent Commission and other
regulators' considerations of the issues involved, the evolution of our
perspective on this subject, and our general objectives in proposing
Regulation Best Interest.
A. Background
As noted, broker-dealers are subject to comprehensive regulation
under the Exchange Act and SRO rules, and a number of obligations
attach when a broker-dealer makes a recommendation to a customer. Under
the federal securities laws and SRO rules, broker-dealers have a duty
of fair dealing,\9\ which, among other things, requires broker-dealers
to make only suitable recommendations to customers \10\ and to receive
only fair and reasonable compensation.\11\ Broker-dealers are also
subject to general and specific requirements aimed at addressing
certain conflicts of interest, including
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requirements to eliminate,\12\ mitigate,\13\ or disclose certain
conflicts of interest.\14\
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\9\ See Report of the Special Study of Securities Markets of the
Securities and Exchange Commission, H.R. Doc. No. 88-95, at 238 (1st
Sess. 1963); In re Richard N. Cea, et al., Exchange Act Release No.
8662 at 18 (Aug. 6, 1969) (Commission opinion involving excessive
trading and recommendations of speculative securities without a
reasonable basis); In re Mac Robbins & Co. Inc., Exchange Act
Release No. 6846, 41 SEC. 116 (July 11, 1962); see also FINRA Rule
2010 (Standards of Commercial Honor and Principles of Trade)
(requiring a member, in the conduct of its business, to observe high
standards of commercial honor and just and equitable principles of
trade).
\10\ See Richard N. Cea, Exchange Act Release No. 8662; F.J.
Kaufman and Co., Securities Exchange Act Release No. 27535 (Dec. 13,
1989); FINRA Rule 2111.01 (Suitability) (``Implicit in all member
and associated person 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. The
suitability rule is fundamental to fair dealing and is intended to
promote ethical sales practices and high standards of professional
conduct.''). See also 913 Study at 51-53, 59; A Joint Report of the
SEC and the CFTC on Harmonization of Regulation (Oct. 2009),
available at http://www.sec.gov/news/press/2009/cftcjointreport101609.pdf, at 61-64.
\11\ See, e.g., FINRA Rules 2121 (Fair Prices and Commissions),
2122 (Charges for Services Performed), and 2341 (Investment Company
Securities). See also Exchange Act Sections 10(b) and 15(c).
\12\ For example, FINRA rules establish restrictions on the use
of non-cash compensation in connection with the sale and
distribution of mutual funds, variable annuities, direct
participation program securities, public offerings of debt and
equity securities, and real estate investment trust programs. These
rules generally limit the manner in which members can pay or accept
non-cash compensation and detail the types of non-cash compensation
that are permissible. See FINRA Rules 2310, 2320, 2331, and 5110.
\13\ See, e.g., FINRA Rule 3110(c)(3) (firm must have procedures
to prevent the effectiveness of an internal inspection from being
compromised due to conflicts of interest); FINRA Rule 3110(b)(6)(C)
(supervisory personnel generally cannot supervise their own
activities); FINRA Rule 3110(b)(6)(D) (firm must have procedures
reasonably designed to prevent the required supervisory system from
being compromised due to conflicts of interest). Further, a broker-
dealer may recommend a security even when a conflict of interest is
present, but that recommendation must be suitable. See FINRA Rule
2111. The antifraud provisions of the federal securities laws and
the implied obligation of fair dealing prohibit a broker-dealer
from, among other things, making unsuitable recommendations and may
impose liability on broker-dealers that do not investigate an issuer
before recommending the issuer's securities to a customer. See,
e.g., Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969). See also
Municipal Securities Disclosure, Exchange Act Release No. 26100, at
n. 75 (Sept. 22, 1988). The fair dealing obligation also requires a
broker-dealer to reasonably believe that its securities
recommendations are suitable for its customer in light of the
customer's financial needs, objectives and circumstances (customer-
specific suitability). See Richard N. Cea, Exchange Act Release No.
8662, at 18 (involving excessive trading and recommendations of
speculative securities without a reasonable basis).
\14\ 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 (2d Cir. 1970); SEC v.
Hasho, 784 F. Supp. 1059, 1110 (S.D.N.Y. 1992). For example, when
engaging in transactions directly with customers on a principal
basis, a broker-dealer violates Exchange Act Rule 10b-5 when it
knowingly or recklessly sells a security to a customer at a price
not reasonably related to the prevailing market price and charges
excessive markups (as discussed above), without disclosing the fact
to the customer. See, e.g., Grandon v. Merrill Lynch & Co., 147 F.3d
184, 189-90 (2d Cir. 1998). See also Exchange Act Rule 10b-10
(requiring a broker-dealer effecting transactions in securities to
provide written notice to the customer of certain information
specific to the transaction at or before completion of the
transaction, including the capacity in which the broker-dealer is
acting (i.e., agent or principal) and any third-party remuneration
it has received or will receive).
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Despite the breadth of a broker-dealer's existing conduct
obligations, broker-dealers are not explicitly required to make
recommendations that are in a customer's ``best interest.'' \15\ Like
many principal-agent relationships, the relationship between a broker-
dealer and a retail customer has certain inherent and unavoidable
conflicts of interest.\16\ For example, as a result of transaction-
based compensation structures, broker-dealers often make
recommendations to retail customers against a backdrop of potential
conflicts that may provide them with an incentive to seek to increase
their compensation at the expense of the investors they are advising.
In addition, other conflicts of interest arise out of business
activities that broker-dealers may choose to engage in (including,
among others, receipt of third-party compensation, principal trading,
and the sale of proprietary or affiliated products). The Commission
believes that material conflicts of interest associated with the
broker-dealer relationship need to be well understood by the retail
customer and, in some cases, mitigated or eliminated.\17\
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\15\ While not an explicit requirement of FINRA's suitability
rule, FINRA and a number of cases have interpreted the suitability
rule as requiring a broker-dealer to make recommendations that are
``consistent with his customers' best interests'' or are not
``clearly contrary to the best interest of the customer.'' See,
e.g., In re Application of Raghavan Sathianathan, Exchange Act
Release No. 54722 at 21 (Nov. 8, 2006); In re Application of Dane S.
Faber, Exchange Act Release No. 49216 at 23-24 (Feb. 10, 2004); In
re Powell & McGowan, Inc., Exchange Act Release No. 7302 (Apr. 24,
1964). In interpretive guidance, FINRA has stated that ``[t]he
suitability requirement that a broker make only those
recommendations that are consistent with the customer's best
interests prohibits a broker from placing his or her interests ahead
of the customer's interests.'' See FINRA Regulatory Notice 12-25,
Additional Guidance on FINRA's New Suitability Rule (May 2012)
(``FINRA Regulatory Notice 12-25'').
In addition, a broker-dealer may have a fiduciary duty under
certain circumstances. This duty may arise under state common law,
which varies by state. 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,
are found to owe customers a fiduciary duty similar to that of
investment advisers. See, e.g., United States v. Skelly, 442 F.3d
94, 98 (2d Cir. 2006); United States v. Szur, 289 F.3d 200, 211 (2d
Cir. 2002); Associated Randall Bank v. Griffin, Kubik, Stephens &
Thompson, Inc., 3 F.3d 208, 212 (7th Cir. 1993); MidAmerica Fed.
Savings & Loan Ass'n v. Shearson/American Express Inc., 886 F.2d
1249, 1257 (10th Cir. 1989); 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). Cf. De Kwiatkowski v. Bear, Stearns & Co.,
Inc., 306 F.3d 1293 (2d Cir. 2002) (finding that absent ``special
circumstances'' (i.e., circumstances that render the client
dependent--a client with impaired faculties, or one who has a closer
than arms-length relationship with the broker, or one who is so
lacking in sophistication that de facto control of the account is
deemed to rest in the broker-dealer), a broker-dealer does not have
a duty to give on-going advice between transactions in a non-
discretionary account, even if he volunteered advice at times;
``[I]t is uncontested that a broker ordinarily has no duty to
monitor a nondiscretionary account, or to give advice to such a
customer on an ongoing basis. The broker's duties ordinarily end
after each transaction is done, and thus do not include a duty to
offer unsolicited information, advice, or warnings concerning the
customer's investments. A nondiscretionary customer by definition
keeps control over the account and has full responsibility for
trading decisions. On a transaction-by-transaction basis, the broker
owes duties of diligence and competence in executing the client's
trade orders, and is obliged to give honest and complete information
when recommending a purchase or sale. The client may enjoy the
broker's advice and recommendations with respect to a given trade,
but has no legal claim on the broker's ongoing attention.'')
(citations omitted).
For the staff's discussion of relevant case law see 913 Study,
at 54-55. See also A Joint Report of the SEC and the CFTC on
Harmonization of Regulation (Oct. 2009), available at http://www.sec.gov/news/press/2009/cftcjointreport101609.pdf, at 8-9 and
67. See also Section II.F. for a discussion and request for comment
regarding broker-dealer exercise of discretion and the extent to
which such exercise is ``solely incidental'' to the conduct of its
business as a broker-dealer.
\16\ See infra Section IV.B.1. For instance, in the past,
brokerage firms have been fined for placing customers in fee-based
brokerage accounts that generated higher fees for the firm, where
such accounts were not appropriate for the customer. See, e.g., NASD
News Release, NASD Fines Raymond James $750,000 for Fee-Based
Account Violations (Apr. 27, 2005), available at http://www.finra.org/newsroom/2005/nasd-fines-raymond-james-750000-fee-based-account-violations (finding that Raymond James violated NASD
rules by recommending and opening fee-based brokerage accounts for
customers without first determining whether the accounts were
appropriate and by allowing those accounts to remain open). See also
NYSE Hearing Board Decision 06-133 (July 10, 2006), available at
https://www.nyse.com/publicdocs/nyse/markets/nyse/disciplinary-actions/2006/06-133.pdf (finding that A.G. Edwards had wrongfully
placed customers into non-managed fee accounts in lieu of
commission-based accounts, where non-managed fee-based brokerage
accounts were not appropriate for buy-and-hold investors or for
investors with few transactions, which resulted in such investors
paying substantially more in fees than they would have paid under a
commission-based structure); FINRA Press Release, FINRA Fines Robert
W. Baird & Co. $500,000 for Fee-Based Account, Breakpoint Violations
(Feb. 18, 2009), available at http://www.finra.org/newsroom/2009/finra-fines-robert-w-baird-co-500000-fee-based-account-breakpoint-violations (finding that Robert W. Baird & Co. failed to adequately
review customer accounts that were transferred into a fee-based
brokerage program, allowing numerous customers to remain in the
program despite conducting no trades, where the firm continued to
receive substantial fees despite inactivity on customers' accounts).
\17\ See infra Section II.D.3.
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In this regard, it has been asserted that (1) retail customers do
not sufficiently understand the broker-dealer relationship, and in
particular the conflicts presented by broker-dealer compensation
arrangements and practices when making a recommendation, and (2)
regardless of the sufficiency of the retail customer's understanding of
the broker-dealer structure, broker-dealer regulatory requirements do
not require a broker-dealer's recommendations to be in a customer's
best interest and require limited disclosure that may not appropriately
address the conflicts of interest presented.\18\
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\18\ See, e.g., Letter from Marnie C. Lambert, President, Public
Investors Arbitration Bar Association (Aug. 11, 2017) (``PIABA
Letter'') (``The Suitability Rule is not sufficient on its own to
remove and manage these conflicts and ensure that brokers have acted
in their clients' best interests. . . . Any standards adopted by the
SEC should acknowledge that conflicts of interest are pervasive
throughout the industry and firms will continue to face challenges
when trying to balance the interests of their clients with those
conflicts. Any standards adopted should require mitigation of
conflicts of interest to the extent possible.''); Letter from Kevin
R. Keller, Chief Executive Officer, CFP Board, et al., Financial
Planning Coalition (Nov. 7, 2017) (``Financial Planning Coalition
Letter'') (stating that FINRA's suitability rule ``fails to mandate
disclosure of actual or potential conflicts of interest, proscribe
appropriate mitigation mechanisms, or require that broker-dealers
put the client's interests above their own earned commissions'').
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[[Page 21578]]
These concerns are not new. The Commission has previously expressed
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.\19\ This apprehension about the potentially harmful effects
of conflicts has been reflected over the years in, among other things,
our National Examination Program's examination priorities, which have
continually included conflicts of interest as an exam focus--either
generally or specifically (e.g., the role of conflicts of interest in
and suitability of recommendations involving retirement accounts (such
as investment or rollover recommendations), complex or structured
products, variable annuities, higher yield securities, exchange traded
funds, and mutual fund share class selection (i.e., share classes with
higher loads or distribution fees))--for many years.\20\ As our exam
staff has noted, ``[c]onflicts of interest, when not eliminated or
properly mitigated and managed, are a leading indicator and cause of
significant regulatory issues for individuals, firms and sometimes the
entire market.'' \21\
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\19\ These concerns led former Chairman Arthur Levitt to form
the Committee on Compensation Practices to review industry
compensation practices, identify actual and perceived conflicts of
interest, and identify ``best practices'' to eliminate, reduce, or
mitigate these conflicts. See Report of the Committee on
Compensation Practices (Apr. 10, 1995) (``Tully Report''). The Tully
Report observed that although the commission-based compensation
system ``works remarkably well for the vast majority of investors,''
conflicts of interest persist that can damage the interest of retail
customers, and identified various ``best practices'' for addressing
broker-dealer and registered representative compensation-related
conflicts, including fee-based brokerage accounts. Id. In 2005, the
Commission adopted Rule 202(a)(11)-1 under the Advisers Act, the
principal purpose of which was to deem broker-dealers offering
``fee-based brokerage accounts'' as not being subject to the
Advisers Act. See Certain Broker-Dealers Deemed Not To Be Investment
Advisers, Exchange Act Release No. 51523 (Apr. 12, 2005) at 8
(``Release 51523'') (adopting rule 202(a)(11)-1 under the Advisers
Act). This rule was later vacated by the Court of Appeals for the
District of Columbia Circuit. See Fin. Planning Ass'n v. SEC., 482
F.3d 481 (D.C. Cir. 2007).
\20\ See Office of Compliance Inspections and Examinations
(``OCIE''), Examination Priorities for 2013 (Feb. 21, 2013),
available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2013.pdf (``2013 Exam Priorities'');
OCIE, Examination Priorities for 2014 (Jan. 9, 2014), available at
https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf; OCIE, Examination Priorities for 2015 (Jan. 13,
2015), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf; OCIE, Examination
Priorities for 2016 (Jan. 11, 2016), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf; OCIE, Examination Priorities for 2017 (Jan. 12,
2017), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2017.pdf. See also OCIE Risk Alert,
``Retirement-Targeted Industry Reviews and Examinations Initiative''
(June 22, 2015), http://www.sec.gov/about/offices/ocie/retirement-targeted-industry-reviews-and-examinations-initiative.pdf.
\21\ 2013 Exam Priorities.
---------------------------------------------------------------------------
FINRA has similarly focused on the potential risks to broker-
dealers and to retail customers presented by broker-dealer conflicts,
and impact on brokerage recommendations, as reflected in guidance
addressing and highlighting circumstances in which various broker-
dealer conflicts of interest may create incentives that are contrary to
the interest of retail customers.\22\ Most notably, in 2013, FINRA
published a report on conflicts of interest in the broker-dealer
industry to highlight effective conflicts management practices.\23\ At
the time of publication of the FINRA Conflicts Report, FINRA Chairman
and Chief Executive Officer (``CEO'') Richard Ketchum noted that
``[w]hile many firms have made progress in improving the way they
manage conflicts, our review reveals that firms should do more.'' \24\
He later observed that ``some firms continue to approach conflict
management on a haphazard basis, only implementing an effective
supervisory process after a failure event involving customer harm
occurs,'' and suggested the development of a best interest standard
that includes, among other things, ``a requirement that financial firms
establish carefully designed and articulated structures to manage
conflicts of interest that arise in their businesses.'' \25\ In 2015,
FINRA launched a targeted exam regarding incentive structures and
conflicts of interest in connection with firms' retail brokerage
business, which encompassed firms' conflict mitigation processes
regarding compensation plans for registered representatives, and firms'
approaches to mitigating conflicts of interest that arise through the
sale of proprietary or affiliated products, or products for which a
firm receives third-party payments (e.g., revenue sharing).\26\
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\22\ See, e.g., FINRA Regulatory Notice 13-45, Rollovers to
Individual Retirement Accounts: FINRA Reminds Firms of Their
Responsibilities Concerning IRA Rollovers (Dec. 2013) (``FINRA
Regulatory Notice 13-45''), available at http://www.finra.org/sites/default/files/NoticeDocument/p418695.pdf. (noting the economic
incentive a financial professional has to encourage an investor to
roll plan assets into an IRA that he will represent as either a
broker-dealer or an investment adviser representative).
\23\ See FINRA Report on Conflicts of Interest (Oct. 2013),
available at https://www.finra.org/sites/default/files/Industry/p359971.pdf (``FINRA Conflicts Report'').
\24\ See Statement from Chairman and CEO Richard G. Ketchum on
FINRA's Report on Conflicts of Interest (Oct. 14, 2013), available
at http://www.finra.org/newsroom/2013/statement-chairman-and-ceo-richard-g-ketchum-finras-report-conflicts-interest.
\25\ See Richard G. Ketchum, Remarks From the 2015 FINRA Annual
Conference (May 27, 2015), available at https://www.finra.org/newsroom/speeches/052715-remarks-2015-finra-annual-conference.
\26\ See FINRA 2016 Regulatory and Examination Priorities Letter
(Jan. 5, 2016), available at http://www.finra.org/sites/default/files/2016-regulatory-and-examination-priorities-letter.pdf. See
also Conflicts of Interest Review--Compensation and Oversight (Apr.
2015), available at http://www.finra.org/industry/conflicts-interest-review-compensation-and-oversight.
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These concerns about the potential harms that may result from
broker-dealer conflicts of interest have been echoed by commenters over
the years. Recent commenters' analyses suggest that retail customers
have been harmed by conflicted advice, such as the incentives created
by broker-dealer compensation arrangements, due to the lack of an
explicit ``best interest'' obligation applying to such advice.\27\
---------------------------------------------------------------------------
\27\ See, e.g., Letter from Monique Morrissey, Ph.D., Economist,
and Heidi Shierholz, Economist and Director of Policy; Economic
Policy Institute (Oct. 5, 2017) (``Economic Policy Institute
Letter''); Letter from Americans for Financial Reform (Sept. 22,
2017) (``AFR Letter''); Letter from Barbara Roper, Director of
Investor Protection, Consumer Federation of America (``CFA'') (Sept.
14, 2017) (``CFA 2017 Letter''); PIABA Letter (``Conflicted advice
causes substantial harm to investors. Just looking at retirement
savers, SaveOurRetirement.com estimates that investors lose between
$57 million and $117 million every day due to conflicted investment
advice, amounting to at least $21 billion annually.'')
---------------------------------------------------------------------------
At the same time, many retail customers generally and reasonably
expect that their investment firms and professionals, including broker-
dealers, will--and rely on them to--provide advice that is in their
best interest by placing investors' interest before their own. Studies
have documented that many retail customers who use the services of
broker-dealers and investment advisers are not aware of the differences
in regulatory approaches for these entities, and their associated
persons, and the differing duties that flow from them.\28\ Commenters
assert
[[Page 21579]]
that any confusion regarding the standards of conduct that apply may
only enhance the potential for harm from broker-dealer conflicts of
interest, as this confusion results in retail customers mistakenly
relying on those recommendations as being in their ``best interest.''
\29\ Commenters have further observed that having differing standards
apply to the advice broker-dealers provide, in particular with respect
to advice provided to retirement versus non-retirement assets, will
create different levels of advice depending on the type of account and
will only further this investor confusion.\30\
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\28\ In 2006, the SEC retained the RAND Corporation's Institute
for Civil Justice (``RAND'') to conduct a survey, which concluded
that the distinctions between investment advisers and broker-dealers
have become blurred, and that market participants had difficulty
determining whether a financial professional was an investment
adviser or a broker-dealer and instead believed that investment
advisers and broker-dealers offered the same services and were
subject to the same duties. RAND noted, however, that generally
investors they surveyed as part of the study were satisfied with
their financial professional, be it a representative of a broker-
dealer or an investment adviser. Angela A. Hung, et al., RAND
Institute for Civil Justice, Investor and Industry Perspectives on
Investment Advisers and Broker-Dealers (2008) (``RAND Study''). See
also Letter from Barbara Roper, Director of Investor Protection,
Consumer Federation of America, et al., (Sept. 15, 2010) (submitting
the results of a national opinion survey regarding U.S. investors
and the fiduciary standard conducted by ORC/Infogroup for the
Consumer Federation of America, AARP, the North American Securities
Administrators Association, the Certified Financial Planner Board of
Standards, Inc., the Investment Adviser Association, the Financial
Planning Association and the National Association of Personal
Financial Advisors (``CFA 2010 Survey'')).
\29\ CFA 2017 Letter.
\30\ See, e.g., Letter from Kirt A. Walker, President and Chief
Operating Officer, Nationwide Financial (Nov. 2, 2017)
((``Nationwide Letter''); Letter from Deneen L. Donnley, Executive
Vice President, Chief Legal Officer Corp, USAA (Aug. 31, 2017)
(``USAA Letter''); Letter from Dorothy M. Donohue, Acting General
Counsel, Investment Company Institute (Aug. 7, 2017) (``ICI August
2017 Letter'').
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There is broad acknowledgement of the benefits of, and support for,
the continuing existence of the broker-dealer model as an option for
retail customers seeking investment advice, notwithstanding the
concerns regarding broker-dealer conflicts (including the transaction-
based compensation model) and retail customer confusion regarding these
conflicts and the limits of the applicable regulations.\31\ Among other
things, the Commission and our staff, commenters and others have
recognized the benefits of the broker-dealer model for advice and the
access to advice and the choice of products, services and payment
options, that the brokerage model provides retail customers.\32\
Moreover, the Commission is aware that certain conflicts of interest
are inherent in other principal-agent relationships.\33\ The issue at
hand, therefore, is how we should address these concerns in a manner
that both improves investor protection and preserves these beneficial
characteristics--in particular choice regarding access to a variety of
products and advice relationships.
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\31\ See, e.g., Letter from Barbara Roper, Director of Investor
Protection, CFA to the Department of Labor (Oct. 3, 2017)
(acknowledging that some customers are better off in commission
accounts); see also Tully Report; 913 Study at 151-54 (discussing
potential costs to retail investors, including loss of choice, if
the broker-dealer exclusion from the Advisers Act were eliminated).
\32\ See id. See also Nationwide Letter; Letter from James D.
Gallagher, Executive Vice President and General Counsel, John
Hancock Life Insurance Company (U.S.A.) (Aug. 25, 2017) (``John
Hancock Letter''); Letter from Craig S. Tyle, Executive Vice
President and General Counsel, Franklin Templeton Investments
(``Franklin Templeton Letter'') (Aug. 7, 2017); ICI August 2017
Letter; USAA Letter.
\33\ Conflicts of interest are not unique to the broker-dealer
commission-based relationship. A firm may earn more revenue in a
fee-based account rather than a commission-based account, and may
therefore have an incentive to recommend such a fee-based account
even if a commission-based advice relationship would be appropriate
and less costly for the customer. Customers with low trading
activity or long-term buy-and-hold investors in particular may pay
less in a commission-based account. An asset-based fee for advice
also creates a conflict because the firm is paid regardless of
whether it services the account, creating a disincentive to act. In
addition, a firm may have an incentive to recommend that a customer
maintain assets in either a fee-based account or a commission-based
account, even though it would be more appropriate for the customer
to use assets in the account to, for example, pay off an outstanding
loan, because the firm could continue to earn either kind of fee
while the assets remain in the account.
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1. Evaluation of Standards of Conduct Applicable to Investment Advice
The Commission and its staff have been evaluating the standards
applicable to investment advice for some time. In the past, the
Commission observed that the lines between full-service broker-dealers
and investment advisers have blurred, and expressed concern when
specific regulatory obligations depend on the statute under which a
financial intermediary is registered instead of the services
provided.\34\ At the same time, we acknowledged that the Exchange Act,
the rules thereunder, and SRO rules provide substantial protections for
broker-dealer customers, and expressed that we did not believe that
requiring most or all full-service broker-dealers to treat most or all
of their customer accounts as advisory accounts would be an appropriate
response to this blurring.\35\
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\34\ See Release 51523; see also Request, infra note 40.
\35\ Release 51523 at 3, 35.
---------------------------------------------------------------------------
In 2011, the Commission staff issued the 913 Study, which was
mandated by Section 913 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 (the ``Dodd-Frank Act''), in which they
made recommendations to the Commission that the staff believed would
enhance retail customer protections and decrease retail customers'
confusion about the standard of conduct owed to them when their
financial intermediary provided them personalized investment
advice.\36\ 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.'' \37\
---------------------------------------------------------------------------
\36\ See 913 Study, supra note 1.
\37\ Id.
---------------------------------------------------------------------------
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.\38\
---------------------------------------------------------------------------
\38\ Id.
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The staff explained that the recommendations were intended to,
among other things, heighten investor protection, address retail
customer confusion about the obligations broker-dealers and investment
advisers owe to those customers, and preserve retail customer choice
without decreasing retail customers' access to existing products,
services, service providers, or compensation structures.\39\
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\39\ See 913 Study at viii, x, 101, 109, 166.
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Following the 913 Study, in 2013 the Commission issued a request
for information (``Request'') seeking additional information from the
public to assist the Commission in evaluating whether and how to
address certain standards of conduct for, and regulatory obligations
of, broker-dealers and investment advisers.\40\ The Request
[[Page 21580]]
sought information on the benefits and costs of the current standards
of conduct for broker-dealers and investment advisers, as well as
alternative approaches to the standards of conduct, including a uniform
fiduciary standard.
---------------------------------------------------------------------------
\40\ See Request for Data and Other Information: Duties of
Brokers, Dealers and Investment Advisers, Exchange Act Release No.
69013 (Mar. 1, 2013), available at http://www.sec.gov/rules/other/2013/34-69013.pdf; see also SEC Seeks Information to Assess
Standards of Conduct and Other Obligations of Broker-Dealers and
Investment Advisers (press release), available at http://www.sec.gov/news/press/2013/2013-32.htm.
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The Commission received more than 250 comment letters from industry
groups, individual market participants, and other interested persons in
response to the Request.\41\ The vast majority of commenters provided
qualitative responses to the specific assumptions contained in the
Request, while a few industry commenters submitted surveys and other
quantitative data. Most commenters expressed support for a uniform
fiduciary standard of conduct requiring firms to ``act in the best
interest'' of the investor although they had different views of what
the standard would require and expressed concerns about its
implementation.\42\
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\41\ Comments submitted in response to the Request are available
at https://www.sec.gov/comments/4-606/4-606.shtml.
\42\ For example, some commenters supported a new uniform,
rules-based fiduciary standard of conduct that is tailored to
broker-dealers' business models, but also expressed concern about,
among other things, the costs of implementation, the need to
preserve investor choice and avoid regulatory duplication or
conflict. See, e.g., Letter from Ira D. Hammerman, Senior Managing
Director and General Counsel, Securities Industry and Financial
Markets Association (``SIFMA'') (July 5, 2013). Others tended to
support a uniform fiduciary standard of conduct that is ``no less
stringent'' than the current standard under the Advisers Act (i.e.,
extending the current standard of conduct to broker-dealers), but
were concerned about ``watering down'' the current Advisers Act
standard to accommodate broker-dealers' business models. See, e.g.,
Letter from Barbara Roper, Director of Investor Protection, Consumer
Federation of America (July 5, 2013); Letter from David G.
Tittsworth, Executive Director, Investment Adviser Association (July
3, 2013).
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In November 2013, the Commission's Investor Advisory Committee
(``IAC'') adopted a recommendation on implementing a uniform fiduciary
standard (as proposed by the Investor as Purchaser Subcommittee).\43\
In the IAC's view, the current regulatory regime for broker-dealers
does not offer adequate investor protection when broker-dealers are
providing advice, as under the suitability standard, broker-dealers
generally remain free to place their own interests ahead of the
interest of their customers.\44\ The IAC also expressed its view that
any economic analysis should acknowledge the existence and importance
of investor harm that can result from the current suitability
standard.\45\ In considering the optimal regulatory approach to take
with respect to imposing a fiduciary duty on broker-dealers, the
overarching recommendation from the IAC was that ``the Commission
should weigh its various options with an eye toward determining which
will best ensure an outcome that strengthens investor protections,
preserves investor choice with regard to business models and
compensation methods, and is workable for broker-dealers and investment
advisers alike.'' \46\ The IAC recommended to the Commission two
options for imposing a fiduciary duty on broker-dealers when they are
providing personalized advice to retail investors: (1) Narrow the
broker-dealer exclusion from the definition of ``investment adviser''
under the Investment Advisers Act of 1940 (``Advisers Act'') (the IAC's
preferred approach); or (2) engage in rulemaking under Section 913 to
adopt a principles-based fiduciary duty that is ``no weaker'' than the
standard under the Advisers Act; permit certain sales-related conflicts
as long as conflicts are fully disclosed and appropriately managed; and
consider whether certain sales practices, conflicts of interest, or
compensation schemes should be prohibited or restricted.\47\
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\43\ Recommendation of the Investor Advisory Committee: Broker-
Dealer Fiduciary Duty (Nov. 2013) (``IAC Recommendation''),
available at https://www.sec.gov/spotlight/investor-advisory-committee-2012/fiduciary-duty-recommendation-2013.pdf. The IAC also
recommended that the Commission engage in rulemaking to adopt a
uniform, plain English disclosure document that includes certain
basic information (e.g., fees and conflicts of interest). Id. We are
considering this recommendation separately as part of the
Relationship Summary Proposal.
\44\ Id.
\45\ Id.
\46\ Id.
\47\ Id.
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2. DOL Rulemaking
The Department of Labor (``DOL'') has also engaged in rulemaking to
broaden the definition of ``fiduciary'' in connection with providing
investment advice under the Employee Retirement Income Security Act of
1974 (``ERISA'') and the Internal Revenue Code of 1986 (``Code'').\48\
Commission staff provided DOL staff with technical assistance and
expertise on our regulatory regime as DOL developed its rulemaking.\49\
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\48\ See Definition of the Term ``Fiduciary'' Conflict of
Interest Rule--Retirement Investment Advice, 81 FR 20945, 20958-59
(Apr. 8, 2016) (to be codified at 29 CFR pts. 2509, 2510, 2550)
(``DOL Fiduciary Rule Release''). The DOL has authority to issue
regulations under ERISA and prohibited transaction provisions under
the Code, including authority to define the circumstances in which
persons, including broker-dealers and investment advisers, are
``fiduciaries'' for purposes of ERISA and the Code as a result of
providing ``investment advice'' to plans and IRAs.
\49\ See id.
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On April 8, 2016, 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 an ERISA plan or IRA as fiduciaries in a wider array of advice
relationships than under the previous regulation (``DOL Fiduciary
Rule'').\50\ On March 15, 2018, the DOL Fiduciary Rule was vacated by
the United States Court of Appeals for the Fifth Circuit.\51\
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\50\ 29 CFR 2510.3-21 (effective June 9, 2017). This rule also
applies to the definition of fiduciary in the prohibited transaction
provisions under the Code. See 29 CFR 2510.3-21(F). See also DOL
Fiduciary Rule Release.
\51\ Chamber of Commerce of the U.S.A., et al. v. U.S. Dep't of
Labor, et. al., No. 17-10238 (5th Cir.) (Mar. 15, 2018).
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We understand that the DOL Fiduciary Rule would broadly expand the
circumstances in which broker-dealers making recommendations to ERISA
plans and ERISA plan participants may be fiduciaries under ERISA, and
thus subject to ERISA's prohibited transaction provisions. Similarly,
it would expand the circumstances in which broker-dealers providing
recommendations to IRAs would be subject to the prohibited transaction
provisions of the Code.\52\ Among other things, these prohibited
transactions provisions generally would prohibit such a fiduciary from
engaging in self-dealing and receiving compensation from third parties
in connection with transactions involving a plan or IRA, and from
acting on conflicts of interest, including using their authority to
affect or increase their own compensation, in connection with
transactions involving a plan or IRA, or from purchasing or selling any
property to ERISA plans or IRAs.\53\ As a result, we understand that--
in the absence of an exemption from the DOL--broker-dealers that would
be considered to be a ``fiduciary'' under the DOL Fiduciary Rule would
not only be prohibited from engaging in purchases and sales of certain
investments for their own account (i.e., engaging in principal
transactions), but more significantly, would be prohibited from
receiving
[[Page 21581]]
common forms of broker-dealer compensation (notably, transaction-based
compensation), which would effectively eliminate a broker-dealer's
ability or willingness to provide investment advice with respect to
investors' retirement assets.\54\
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\52\ See Best Interest Contract Exemption, 81 FR 21002, 21089
(Apr. 8, 2016) (``BIC Exemption Release''), as corrected Best
Interest Contract Exemption; Correction (Prohibited Transaction
Exemption 2016-01), 81 FR 44773 (July 11, 2016) (``BIC Exemption'').
DOL stated in the BIC Exemption Release that it ``anticipates that
the [DOL Fiduciary Rule] will cover many investment professionals
who did not previously consider themselves to be fiduciaries under
ERISA or the Code.''
\53\ See BIC Exemption Release at 21002.
\54\ See generally BIC Exemption; Principal Transactions
Exemption, infra note 55.
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To avoid this result, in connection with the DOL Fiduciary Rule,
DOL published two new administrative class exemptions from the
prohibited transaction provisions of ERISA and the Code--the Best
Interest Contract Exemption (``BIC Exemption'') and the Class Exemption
for Principal Transactions in Certain Assets Between Investment Advice
Fiduciaries and Employee Benefit Plans and IRAs (``Principal
Transactions Exemption'')--as well as amendments to previously granted
prohibited transaction exemptions (collectively referred to as
``PTEs'').\55\ The BIC Exemption and the Principal Transactions
Exemption would allow persons who are deemed investment advice
fiduciaries under the DOL Fiduciary Rule, such as broker-dealers, to
receive various forms of compensation (e.g., brokerage commissions) and
to engage in certain principal transactions, respectively, that in the
absence of an exemption, would be prohibited under ERISA and the
Code.\56\
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\55\ See, e.g., BIC Exemption Release (permitting certain
``Financial Institutions'' and ``Advisers'' to receive compensation
resulting from a provision of investment advice in connection with
securities transactions, including riskless principal transactions);
Class Exemption for Principal Transactions in Certain Assets Between
Investment Advice Fiduciaries and Employee Benefit Plans and IRAs
(Prohibited Transaction Exemption 2016-02), 81 FR 21089, 21105-10
(Apr. 8, 2016) (``Principal Transactions Release''); corrected at
Class Exemption for Principal Transactions in Certain Assets Between
Investment Advice Fiduciaries and Employee Benefit Plans and IRAs,
81 FR 44784 (July 11, 2016) (``Principal Transactions Exemption'')
(permitting investment advice fiduciaries to sell or purchase
certain debt securities and other investments in principal
transactions and riskless principal transactions). See also
Amendment to and Partial Revocation of Prohibited Transaction
Exemption (PTE) 86-128 for Transactions Involving Employee Benefit
Plans and Broker-Dealers; Amendment to and Partial Revocation of PTE
75-1, Exemptions from Prohibitions Respecting Certain Classes of
Transactions Involving Employee Benefit Plans and Certain Broker-
Dealers, Reporting Dealers and Banks, 81 FR 21181 (Apr. 8, 2016)
(permitting broker-dealers exercising investment discretion to
receive commissions and other fees for effecting securities
transactions as agent for a plan or IRA, under certain conditions,
including Impartial Conduct Standards like those applicable under
the BIC Exemption); DOL Fiduciary Rule Release, supra note 48, 81 FR
at 20991 (describing the new BIC Exemption, Principal Transactions
Exemption, and amendments to existing PTEs).
\56\ See generally BIC Exemption; Principal Transactions
Exemption.
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Specifically, the BIC Exemption would provide conditional relief
for an ``adviser,'' as that term is used in the context of the BIC
Exemption,\57\ 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
meets certain conditions.\58\ Generally, the BIC Exemption would
require that the advice must be provided pursuant to a written contract
executed between the adviser's firm and the investor (and enforceable
against the adviser's firm).\59\ The contract must include specific
language and disclosures, including (among others) provisions:
Acknowledging fiduciary status; committing the firm and the adviser to
adhere to standards of impartial conduct (i.e., 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''); and warranting the adoption of
policies and procedures reasonably designed to ensure that advisers
provide best interest advice and minimize the harmful impact of
conflicts of interest. The firm must also disclose information on the
firm's and advisers' conflicts of interest and the cost of their advice
and provide certain ongoing web disclosures.\60\ As noted above, we
understand that, as a practical matter, most broker-dealers offering
IRA brokerage accounts would need to meet the conditions of the BIC
Exemption to advise (i.e., make recommendations to) brokerage customers
with IRA accounts and to receive transaction-based and other
compensation (including amounts paid from third parties, such as 12b-1
fees) in connection with their securities recommendations.
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\57\ The DOL explains that by using the term ``adviser,'' it
``does not intend to limit the exemption to investment advisers
registered under the Investment Advisers Act of 1940 or under state
law,'' and that rather, for purposes of the BIC Exemption, an
adviser ``is an individual who can be a representative of a
registered investment adviser, a bank or similar financial
institution, an insurance company, or a broker-dealer.'' BIC
Exemption Release, supra note 52, 81 FR at 21003, n.2.
\58\ See BIC Exemption Release. ERISA and the Code generally
prohibit fiduciaries from receiving payments from third parties and
from acting on conflicts of interest, including using their
authority to affect or increase their own compensation, in
connection with transactions involving a plan or IRA. Certain types
of fees and compensation common in the retail market, such as
brokerage or insurance commissions, rule 12b-1 fees and revenue
sharing payments, may fall within these prohibitions when received
by fiduciaries as a result of transactions involving advice to the
plan, plan participants and beneficiaries, and IRA owners. Id.
\59\ See BIC Exemption Release.
\60\ See BIC Exemption.
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Generally, the Principal Transactions Exemption would (1) permit
certain principal transactions involving the purchase of limited
securities (i.e., certificates of deposits, interests in unit
investment trusts, and certain debt securities) \61\ by a plan or an
IRA owner and (2) more broadly permit principal transactions involving
the sale of ``securities or other investment property'' by the plan or
IRA owner, conditioned on adherence to, among other things, Impartial
Conduct Standards,\62\ as well as a contract requirement and a policies
and procedures warranty that mirror the requirements in the BIC
Exemption.\63\ The Principal Transactions Exemption also includes some
conditions that are different from those in the BIC Exemption,
including credit and liquidity standards for debt securities sold to
plans and IRAs pursuant to the exemption and additional disclosure
requirements.\64\
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\61\ Debt securities are generally registered corporate debt
securities, treasury securities, agency securities, and asset-backed
securities that are guaranteed by an agency or government sponsored
enterprise. See Principal Transactions Exemption.
\62\ In the Principal Transactions Exemption, the Impartial
Conduct Standards specifically refer to the fiduciary's obligation
to seek to obtain the best execution reasonably available under the
circumstances with respect to the transaction, rather than to
receive no more than ``reasonable compensation.'' See Principal
Transactions Exemption. The Principal Transactions Exemption
provides that the adviser may satisfy the obligation under the
exemption to obtain best execution reasonably available under the
circumstances with respect to the transaction by complying with
FINRA rules on fair pricing and best execution (Rules 2121--Fair
Prices and Commissions; 5310--Best Execution and Interpositioning).
See Principal Transactions Exemption, Section II(c)(2)(i).
\63\ See Principal Transactions Exemption; 18-Month Extension of
Transition Period and Delay of Applicability Dates; Best Interest
Contract Exemption (PTE 2016-01); Class Exemption for Principal
Transactions in Certain Assets Between Investment Advice Fiduciaries
and Employee Benefit Plans and IRAs (PTE 2016-02); Prohibited
Transaction Exemption 84-24 for Certain Transactions Involving
Insurance Agents and Brokers, Pension Consultants, Insurance
Companies, and Investment Company Principal Underwriters (PTE 84-
24), 82 FR 56545 (Nov. 29, 2017) (``DOL November Extension''),
available at https://federalregister.gov/d/2017-25760.
\64\ See Principal Transactions Exemption; DOL November
Extension.
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The revised definition of ``fiduciary,'' as well as the Impartial
Conduct Standards, became effective on June 9, 2017.\65\ Compliance
with the remaining
[[Page 21582]]
conditions of the BIC Exemption and the Principal Transaction
Exemption, such as the general contract requirement, and conditions
requiring specific written warranties and disclosures, has been delayed
until July 1, 2019.\66\ During this transition period, ``financial
institutions'' and ``advisers,'' as defined in the PTEs, are currently
only required to comply with the Impartial Conduct Standards to satisfy
the conditions of these PTEs.\67\
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\65\ See Definition of the Term ``Fiduciary''; Conflict of
Interest Rule--Retirement Investment Advice; Best Interest Contract
Exemption (Prohibited Transaction Exemption 2016-01); Class
Exemption for Principal Transactions in Certain Assets Between
Investment Advice Fiduciaries and Employee Benefit Plans and IRAs
(Prohibited Transaction Exemption 2016-02); Prohibited Transaction
Exemptions 75-1, 77-4, 80-83, 83-1, 84-24 and 86-128 Proposed Rule,
82 FR 16902, (Apr. 7, 2017) (``DOL April Extension''), available at
https://www.thefederalregister.org/fdsys/pkg/FR-2017-04-07/pdf/2017-06914.pdf. But
see Chamber of Commerce of the U.S.A., et. al. v. U.S. Dep't of
Labor, et. al., No. 17-10238 (5th Cir.) Mar. 15, 2018).
\66\ See DOL November Extension.
\67\ Id.
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3. Statement by Chairman Clayton
In light of the DOL Fiduciary Rule and related PTEs, and in
recognition of the significant developments in the marketplace that
have occurred since the Commission last solicited information from the
public in 2013, Chairman Clayton issued a statement on June 1, 2017
containing a number of questions regarding standards of conduct for
investment advisers and broker-dealers.\68\ The public input was
intended to provide the Commission with an updated assessment of the
current regulatory framework, the current state of the market for
retail investment advice, and market trends.\69\ Chairman Clayton also
invited commenters to submit data and other information that may inform
the Commission's analysis, including data covering periods since the
2013 solicitation of comment.
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\68\ Chairman Jay Clayton, Public Comments from Retail Investors
and Other Interested Parties on Standards of Conduct for Investment
Advisers and Broker-Dealers (June 1, 2017) (``Chairman Clayton
Statement''), available at https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31.
\69\ See Chairman Clayton Statement.
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To date, over 250 comments have been received from the public in
response to the Chairman Clayton Statement. While some commenters
opposed any changes to the standard of conduct \70\ and offered other
options,\71\ for the most part, commenters support changes to the
standards of conduct for investment advice, and in particular the
establishment of a fiduciary or best interest standard specific to
broker-dealers \72\ or, alternatively, a standard of conduct that
uniformly applies to investment advisers and broker-dealers.\73\
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\70\ See, e.g., Letter from Dan Pisenti, Whitehall-Parker
Securities, Inc. (July 7, 2017) (``Whitehall Letter'') (arguing that
the suitability standard is highly effective and no further
government intervention is necessary); Letter from Kevin Dunnigan
(July 5, 2017) (stating that the DOL Fiduciary Rule is government
overreach and consumers should be able to decide what to purchase).
\71\ See, e.g., Letter from Herb W. Morgan (June 2, 2017)
(stating that a more effective solution would be a simpler one,
including increasing penalties and enforcement and requiring full
fee disclosure); Letter from Mark D. Moss (June 2, 2017) (supporting
SEC involvement in standardizing nomenclature).
\72\ See, e.g., CFA 2017 Letter (supporting the Commission
taking a ``more rigorous approach'' to interpreting the fiduciary
standard by developing a new standard for brokers under the
[Securities Exchange Act of 1934] and in enforcing the existing
standard under the Advisers Act and stating that the fiduciary duty
must include a principles-based, legally enforceable best interest
standard); Letter from Gail C. Bernstein, General Counsel,
Investment Advisers Association (Aug. 31, 2017) (``IAA Letter'')
(recommending the SEC develop a best interest standard for brokers
that is as robust as the fiduciary standard under the Advisers Act);
ICI August 2017 Letter (supporting the SEC taking the lead in
establishing and enforcing a best interest standard of conduct for
broker-dealers providing recommendations to retail investors);
Letter from Kevin Carroll, Managing Director and Associate General
Counsel, SIFMA (July 21, 2017) (``SIFMA Letter'') (suggesting the
SEC consider a best interest standard for broker-dealers that
encompasses the duty of loyalty, duty of care and enhanced up-front
disclosures); Letter from Timothy E. Keehan, Vice President, Senior
Counsel, American Bankers Association (Sept. 1, 2017) (``ABA
Letter''); Letter from David Kowach, Head of Wells Fargo Advisors,
Wells Fargo & Company (Sept. 20, 2017) (``Wells Fargo Letter'')
(``[We] recommend the SEC establish and enforce a best interest
standard of conduct for broker-dealers when they provide
personalized investment advice to retail investors that is aligned
with the standard of conduct applicable to registered investment
advisors.''); Letter from Marc R. Bryant, Senior Vice President and
Deputy General Counsel, Fidelity Investments (Aug. 11, 2017)
(``Fidelity Letter'') (``Fidelity believes that the SEC should
review and consider an enhanced best interest standard of conduct
for broker-dealers that is clearly defined, disclosure and
materiality-based, and that applies across all of an investor's
brokerage accounts and interactions''); Letter from F. William
McNabb, Chairman and Chief Executive Officer, The Vanguard Group,
Inc. (Sept. 29, 2017) (``Vanguard Letter''); Letter from Derek B.
Dorn, Managing Director, Regulatory Engagement and Policy, TIAA
(Sept. 26, 2017) (``TIAA Letter'') (supporting application of a best
interest standard of conduct to all personalized investment advice
provided to retail investors through raising the broker-dealer
standard and maintaining the investment adviser standard); Letter
from Robert Grohowski, Vice President, Senior Legal Counsel--
Legislative and Regulatory Affairs, T. Rowe Price (Oct. 12, 2017)
(``T. Rowe Letter'') (``Given the history, we believe that the SEC's
best path forward would be to focus specifically on updating the
standard applicable to non-discretionary broker-dealer
recommendations, irrespective of account type.''); Letter from
Americans for Financial Reform (Sept. 22, 2017) (``AFR Letter'')
(proposing extension of a strong fiduciary ``best interest''
standard to all those who hold themselves out as advisers or offer
personalized investment advice to clients and focusing on broker-
dealer business model).
\73\ See, e.g., Letter from David Certner, Legislative Counsel &
Legislative Policy Director, Government Affairs, AARP (Sept. 6,
2017) (``AARP Letter'') (``Adoption of a uniform standard that would
apply to both broker-dealers and investment advisers when providing
personalized investment advice to retail customers, as contemplated
by Section 913. . . . is of critical importance and long
overdue.''); PIABA Letter (``The lack of a uniform standard of
conduct creates a discrepancy between the law and investors'
reasonable expectations.''); Letter from Barbara Novick, Vice
Chairman, and Nicole Rosser, Vice President, BlackRock, Inc. (Aug.
7, 2017) (``BlackRock Letter'') (supporting a best interest standard
that applies to all types of retail accounts); Letter from Ronald J.
Kruszewski, Chairman & CEO, Stifel, Nicolaus & Co. (July 25, 2017)
(``Stifel Letter'') (supporting a single standard of care applicable
to both brokerage and advisory accounts, while recognizing the
inherent differences between these relationships); Letter from
Christopher Jones, Executive Vice President of Investment Management
and Chief Investment Officer, Financial Engines (Oct. 11, 2017)
(``Financial Engines Letter'') (recommending harmonization of the
standards applicable to broker-dealers and investment advisers to
advance ``high-quality, unconflicted advice''); Letter from Gretchen
Cepek, Senior Vice President and General Counsel and Stewart D.
Gregg, Senior Counsel, Allianz Life Insurance Company of North
America (Oct. 13, 2017) (``Allianz Letter'') (supporting a uniform
``best interest'' standard of conduct applicable to both broker-
dealers and investment advises providing services to retail
investors).
---------------------------------------------------------------------------
In addition to this statement, Chairman Clayton and the staff have
continually engaged in other outreach, including meetings with retail
investors, investor advocacy groups, and industry participants, to
better understand these issues.
Commenters have also expressed their views on the effects of the
DOL Fiduciary Rule and the related PTEs--both in terms of benefits and
drawbacks--on brokerage advice relationships, at least with respect to
retirement advice. Among other things, some commenters asserted that,
because of complex and burdensome requirements imposed as part of the
BIC Exemption, and the associated litigation risk, broker-dealers are
changing the types of products and accounts offered to retirement
investors, and focusing on products or accounts with compliance-
friendly fee structures, such as level fees or lower-cost products
(e.g., eliminating the provision of advice in IRA brokerage accounts
and shifting these accounts to asset-based accounts).\74\ Commenters
expressed concerns that retirement investors will be harmed through
reduced product choice, increased cost for retirement advice (if
shifted to fee-based arrangements that may be more costly for buy-and-
hold investors, or if there are increases in account minimums for
commission-based accounts), or lost or restricted access to advice (if
investors have small account balances or cannot otherwise afford a fee-
based arrangement or the increased cost of a commission-based
account).\75\
[[Page 21583]]
Other commenters have noted, however, that such outcomes are not
mandated by the DOL Fiduciary Rule, any market disruptions will be
addressed by the market, and overall, the adjustment to the DOL
Fiduciary Rule has been positive for retirement investors, as the rule
has resulted in lower fees, advice in the best interest, and minimized
conflicts in advice provided to individuals,\76\ including, for
example, the development of new product offerings such as ``clean
shares'' that do not have any sales loads, charges or other asset-based
fee for sales or distribution.\77\
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\74\ See, e.g., BlackRock Letter; ICI August 2017 Letter.
\75\ See, e.g., Letter from Kevin Carroll, Managing Director and
Associate General Counsel, SIFMA (July 21, 2017) (``SIFMA 2017
Letter'') (stating that the impact of the new DOL Fiduciary Rule has
been to significantly shift IRAs from brokerage accounts to advisory
accounts, from personal service to call centers or the internet, and
to limit the products and fee arrangements available to IRAs);
BlackRock Letter (stating that some financial services firms have
indicated that they would not offer or would limit IRA brokerage
platforms because of the compliance complexities of the BIC
Exemption provisions that would go into effect on January 1, 2018
[now delayed until July, 2019], as well as the risk of class
action); ICI August 2017 Letter (stating that the DOL Fiduciary Rule
and related exemptions is ``limiting retirement savers' choices,
restricting their access to information they need for retirement
planning, and increasing costs, particularly for those savers who
can least afford it''); Letter from Dave Paulsen, Executive Vice
President and Chief Distribution Officer, Transamerica (Nov. 20,
2017) (``[A]s a result of the DOL Rule, many broker-dealers are no
longer selling variable annuities in an IRA, but continue to sell
variable annuities to retail investors.'').
\76\ See, e.g., AARP Letter.
\77\ See id. See also Letter from AFL-CIO, AFSCME, Alliance for
Retired Americans, et al. (Aug. 21, 2017) (``AFL-CIO Letter'');
Letter from Aron Szapiro, Director of Policy Research, Morningstar,
Inc. (Sept. 11, 2017) (``Morningstar Letter'').
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B. General Objectives of Proposed Approach
In developing this proposal, we considered the variety of products
and services, including the types of advice, that broker-dealers
provide to investors; the characteristics of investors who utilize
brokerage services; the associated cost and relative affordability of
such services; the embedded compensation conflicts associated with
these products and services; and the potential impact of such conflicts
on investor outcomes (such as evidence suggestive that the failure to
apply a ``best interest'' obligation to conflicted advice has resulted
in investor harm).\78\ We also considered the regulatory landscape
applicable to broker-dealers under the Exchange Act and SRO rules and
the investor protections provided when broker-dealers recommend
securities transactions or investment strategies to retail customers,
and any differences between those protections provided for broker-
dealer services under other regulatory regimes, particularly those that
would exist under the DOL Fiduciary Rule and the BIC Exemption.
---------------------------------------------------------------------------
\78\ See, e.g., Economic Policy Institute Letter; CFA 2017
Letter; IAC Recommendation.
---------------------------------------------------------------------------
We also considered retail customer confusion about the obligations
broker-dealers owe when making recommendations and how that confusion
may ultimately translate into or exacerbate the potential for investor
harm (such as through a misalignment of investor expectations regarding
the level of protection received and the level of protection actually
provided).\79\ We also recognized the importance of providing, to the
extent possible, clear, understandable, and consistent standards for
brokerage recommendations across a brokerage relationship (i.e., for
both retirement and non-retirement purposes) and better aligning this
standard with other advice relationships (e.g., a relationship with an
investment adviser).\80\ We also sought to preserve--to the extent
possible--investor choice and access to existing products, services,
service providers, and payment options. We sought to avoid a lack of
clarity or consistency in the applicable standards and a lack of
coordination among regulators, which could ultimately undermine
investor choice and access and create legal uncertainty in developing
effective compliance programs.
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\79\ Id.
\80\ See, e.g., Letter from Richard Foster, Senior Vice
President and Senior Counsel for Regulatory and Legal Affairs,
Financial Services Roundtable (Oct. 17, 2017) (``FSR Letter'')
(``FSR strongly believes a single standard for broker-dealers
servicing both retirement and non-retirement assets is in the best
interest of retail customers, because it would reduce customer
confusion and ultimately provide customers a higher-level of
service. A single standard also would avoid the cost of developing
and implementing compliance and supervisory programs around
different standards of conduct.''); Morningstar Letter
(``Morningstar believes that investors' confusion about standards of
conduct applicable to different kinds of relationships is likely to
continue for some time, and disclosures alone will not clarify those
standards for many investors. . . . Further, even among experienced
investors who hold investments outside of retirement accounts, most
investors do not understand the distinctions between broker-dealers
and Registered Investment Advisors and the conflicts of interest
some financial advisors may have when recommending investments'');
TIAA Letter (``Investors should understand the standards of conduct
that apply to the financial advisers who give them advice--but
today's disparate standards can easily lead to investor
confusion.''); IAA Letter (``An equally stringent standard is also
necessary to reduce confusion for investors and ensure that they do
not bear the burden of having uncertainty about the standard of
conduct that applies to the investment professional they choose.'');
PIABA Letter.
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At the same time, we are sensitive to the potential risk that any
additional regulatory burdens may cause investors to lose choice and
access to products, services, service providers, and payment
options.\81\ In particular, we sought to preserve the ability of
investors to pay for advice in the form of brokerage commissions.
Various commenters asserted that the commission-based model may be more
appropriate for many investors,\82\ and we believe that such investors
may prefer a commission-based brokerage
[[Page 21584]]
relationship over a fee-based account.\83\ We also share concerns
raised by commenters about retail customers losing access to advice
they receive through recommendations from broker-dealers, or if advice
from broker-dealers is effectively eliminated, particularly as not all
such customers have the option to move to fee-based accounts.\84\
---------------------------------------------------------------------------
\81\ See, e.g., SIFMA 2017 Letter; BlackRock Letter; ICI August
2017 Letter; Franklin Templeton Letter (``[W]hile asset-based fees
are appropriate in many circumstances, for some investors--such as
long-term, `buy-and-hold' investors--a transaction-based charge can
result in substantial savings. According to the Investment Company
Institute, investors who plan to hold fund shares for longer than
five years would end up with a higher account balance under a
commission-based approach that charges a 2.5 percent front-end fee
(plus an ongoing 12b-1 fee) than investors paying a 1 percent per
year asset-based fee.'')
\82\ See, e.g., USAA Letter (``USAA has deep reservations about
any standard of conduct that serves to advantage fee-based accounts
and serves to disadvantage other types of accounts and product
choices. Put simply, a fee-based model may not always be appropriate
for lower-balanced accounts. In many cases, these accounts will be
better served by straight-forward investments in mutual funds or
exchange-traded funds, without such accounts being assessed an
ongoing management fee.''); Letter from Stephen McManus, Senior Vice
President and General Counsel, State Farm Mutual Automobile
Insurance Company (Aug. 21, 2017) (``State Farm Letter'') (``Long a
mainstay of the financial services industry, sales commissions are
frequently preferred by middle-income consumers whose `buy-and-hold'
strategy does not require the continuous investment advice that is
more suited to a percentage fee based on assets under management.
This preference also reflects the fact that the payment of
commission-based compensation--tied as it is to a particular
transaction--is easy for consumers to understand and, in e.g., many
cases, represents good value for smaller or low-volume accounts.'').
See Letter from Sharon Cheever, Senior Vice President and General
Counsel, Pacific Life Insurance Company (Oct. 16, 2017) (``Pacific
Life Letter'') (``There is a common misconception that a fee-based
compensation model is somehow better for the consumer, in part,
because it is allegedly cheaper and less likely to lead to conflicts
of interest. This unfair discrimination against the commission-based
compensation model is truly unfounded. The expense to the client in
terms of actual money paid on an on-going basis, and thus, `fee-
drag' on their investment return, will often be more with the fee-
based compensation model. For example, annuities by nature are long-
term investments, and with the fee-based compensation model, the
adviser charges a certain percentage (1%) or dollar amount each year
for the management of the investment. Compare this to the
commission-based compensation model, where there is typically a
larger percentage charged upfront (e.g., 5-6%), and you can see that
the longer term the investment, the more expensive a fee-based
compensation model can be for the client.''); Carl B. Wilkerson,
Vice President and Chief Counsel, Securities & Litigation, American
Council of Life Insurers (Oct. 3, 2017) (``ACLI Letter'')
(``Recurrent annual fees may be ill-suited to individuals with
moderate assets needing little annual advice, and may exceed the
total value of a commissioned-based adviser.''). See also FINRA
Notice to Members 03-68, Fee-Based Compensation (Nov. 2003).
\83\ See Foy, Michael, ``What's at stake for forward-thinking
firms,'' Fiduciary Roulette, J.D. Power, available at http://www.jdpower.com/resource/wealth-management-fiduciary-roulette
(visited January 31, 2018) (finding that 59% of investors who
currently pay commissions ```probably would not' or `definitely
would not' stay with their current firm if required to switch to a
fee-based arrangement''). Irrespective of any real or perceived
investor preference, the last 12 years have seen a decline in the
number of broker-dealers from over 6,000 in 2005 to less than 4,000
in 2016, alongside a simultaneous increase in the number of
Commission-registered investment advisers from approximately 9,000
in 2005 to over 12,000 in 2016. The Commission understands that
firms have transitioned to fee-based retail business in an effort
to, among other things, provide stability, increase profitability,
lower perceived regulatory burden, provide more or better services
to retail investors, and reduce or eliminate conflicts of interest.
See discussion Section IV.C.1.c, infra.
\84\ See supra note 74; see also USAA Letter (``It is critical
that a uniform standard does not impose excessive legal and
compliance burdens on such firms, which would effectively incent
firms to curtail or even close services to these investors. A
standard that effectively bans or incents firms to abandon certain
business models will harm retail investors, especially our men and
women in uniform, by raising their costs, reducing their choices,
and restricting their access to needed investment advice.'');
Franklin Templeton Letter (``At the same time, broker-dealers should
not be subject to overly prescriptive requirements or to enforcement
through private litigation from the professional plaintiff's bar.
This will only lead to additional costs and a decrease in the
availability of investment choices and advice to those retail
investors who need it most.'').
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After extensive consideration of these issues, we are proposing to
enhance existing broker-dealer conduct obligations when they make
recommendations to a retail customer. For such recommendations, the
proposed rule would require a broker-dealer ``to act in the best
interest of the retail customer . . . without placing the financial or
other interest of the [broker-dealer] making the recommendation ahead
of the interest of the retail customer.''
The proposed best interest obligation for broker-dealers set forth
in Regulation Best Interest builds upon, and is tailored to, existing
broker-dealer relationships and regulatory obligations under the
federal securities laws and SRO rules. In particular, the existing
rules of various SROs served as an important point of reference for our
proposal. However, we tailored and enhanced these requirements to the
specific proposed best interest obligation we are seeking to establish.
Our proposal also takes into consideration and draws on (to the extent
appropriate) the principles of the obligations that apply to investment
advice in other contexts, including those described above. We
preliminarily believe it makes more sense to build upon this regulatory
regime, rather than to create a completely new standard or simply adopt
obligations and duties that have developed under a separate regulatory
regime to address a different type of advice relationship.
We believe this approach would have several benefits. First, it
would enhance the quality of recommendations provided by broker-dealers
to retail customers. Second, it would enhance disclosure, helping
retail customers evaluate recommendations received from broker-dealers,
and reducing confusion regarding the nature of the broker-dealer
relationship. Third, it would facilitate more consistent regulation of
similar activity, drawing from key principles underlying the fiduciary
obligations that apply to investment advice in other contexts. Fourth,
it would better align the legal obligations of broker-dealers with
investors' expectations.
We also believe that the best interest obligation we are proposing
today would help preserve investor choice and access to affordable
investment advice and products that investors currently use. As
discussed below, Regulation Best Interest would only apply when a
broker-dealer is making a recommendation to a retail customer about a
securities transaction or an investment strategy involving securities.
The regulation would not apply to the provision of services that do not
involve or are distinct from such a recommendation, including, but not
limited to, executing an unsolicited transaction for a retail customer,
or to a broker-dealer that is dually-registered as an investment
adviser (a ``dual-registrant'') when making a recommendation in its
investment adviser capacity.\85\ In this way, our proposed best
interest obligation should enhance investor protection while generally
preserving (to the extent possible) the range of choice and access--
both in terms of services and products--that is available to brokerage
customers today.
---------------------------------------------------------------------------
\85\ See infra Section II.C.4. for further discussion.
---------------------------------------------------------------------------
We recognize that as a result of the enhanced obligations that
would apply, some broker-dealers may determine that it is not cost-
effective to continue to recommend certain products or services to
retail customers (because, for example, of the difficulty in mitigating
certain compensation related conflicts). Others may pass along the
costs to retail customers. Some retail customers may seek out a
different advice relationship that better suits their preferences after
receiving the required disclosures. As discussed in more detail in
Section IV, we preliminarily believe that any such impacts that the
proposed regulatory changes may have on retail customer access to and
availability of investment advice, and the costs to broker-dealers,
would be justified by the benefits of the enhancements to investor
protection. We also believe that for both retail customers and broker-
dealers the potential costs would be less--and the benefits would be
greater--than under the potential regulatory alternatives we
considered.\86\
---------------------------------------------------------------------------
\86\ See Section IV.
---------------------------------------------------------------------------
In proposing Regulation Best Interest, we are not proposing to
amend or eliminate existing broker-dealer obligations, and compliance
with Regulation Best Interest would 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.\87\
Furthermore, we do not believe proposed Regulation Best Interest would
create any new private right of action or right of rescission, nor do
we intend such a result.\88\
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\87\ 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.
\88\ Regulation Best Interest is being proposed, in part,
pursuant to the authority provided by Section 913(f) of the Dodd-
Frank Act and Section 15(l) of the Exchange Act. Neither Section
913(f) nor Section 15(l), by its terms, creates a new private right
of action or right of rescission.
---------------------------------------------------------------------------
Scienter would not be required to establish a violation of
Regulation Best Interest. One key difference and enhancement resulting
from the obligations imposed by Regulation Best Interest as compared to
a broker-dealer's existing suitability obligations under the antifraud
provisions of the federal securities laws, is that a broker-dealer
would not be able to satisfy its Care Obligation discussed in Section
D.2 through disclosure alone.
Similarly, the existing rules of various SROs served as an
important point of reference for our proposal. However, we tailored and
enhanced these existing
[[Page 21585]]
SRO requirements to the specific proposed best interest obligation we
were seeking to establish. As a result, we recognize that there may be
overlapping regulatory requirements applicable to the same activity. We
are mindful of potential regulatory conflicts or redundancies and have
sought in proposing Regulation Best Interest to avoid such conflicts
and minimize redundancies, but consistent with our goal of establishing
a best interest obligation for broker-dealers. Overall, we believe that
proposed Regulation Best Interest is generally designed to be
consistent with and build upon the relevant SRO requirements.\89\
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\89\ Generally, when a requirement of proposed Regulation Best
Interest is based on a similar SRO standard, we would expect--at
least as an initial matter--to take into account the SRO's
interpretation and enforcement of its standard when we interpret and
enforce our rule. At the same time, we would not be bound by an
SRO's interpretation and enforcement of an SRO rule, and our policy
objectives and judgments may diverge from those of a particular SRO.
Accordingly, we would also expect to take into account such
differences in interpreting and enforcing our rules. We have taken
the same approach in other rulemakings that include requirements
based on a similar SRO standard. See, e.g., Exchange Act Release No.
77617 (Apr. 14, 2016), 81 FR 29960, 29997 (May 13, 2016) (``Business
Conduct Standards Adopting Release'').
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We wish to underscore that proposed Regulation Best Interest
focuses on specific enhancements to the broker-dealer regulatory
regime, in light of the unique characteristics of the brokerage advice
relationship and associated services that may be provided, and
therefore would be separate and distinct from the fiduciary duty that
has developed under the Advisers Act. Further, we do not intend that
Regulation Best Interest, including the associated obligations, have
any impact on the Commission's or its staff's interpretations of the
scope or nature of an investment adviser's fiduciary obligations.\90\
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\90\ See Proposed Commission Interpretation Regarding Standard
of Conduct for Investment Advisers; Request for Comment on Enhancing
Investment Adviser Regulation, Release No. IA-4889, File No. S7-09-
18 (``Fiduciary Duty Interpretive Release'').
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II. Discussion of Regulation Best Interest
A. Overview of Regulation Best Interest
The Commission is proposing a new rule, referred to as Regulation
Best Interest, to establish an express best interest obligation that
would apply to broker-dealers when making a recommendation of any
securities transaction or investment strategy to a retail customer. The
proposed best interest obligation, which is set forth in proposed
paragraph (a)(1), would require a broker-dealer, when making a
recommendation, ``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 a natural person who is an
associated person of a broker or dealer making the recommendation ahead
of the interest of the retail customer.'' Regulation Best Interest
would specifically provide that this best interest obligation shall be
satisfied if:
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, reasonably discloses 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 that are associated with the recommendation (the ``Disclosure
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, 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 the 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 (herein, ``Care Obligation'');
The broker or dealer establishes, maintains, and enforces
written policies and procedures reasonably designed to identify and at
a minimum disclose, or eliminate, all material conflicts of interest
that are associated with recommendations; and
The broker or dealer establishes, maintains, and enforces
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
(the last two together, the ``Conflict of Interest Obligations'').
We preliminarily believe that establishing an express best interest
obligation and defining it in this manner would enhance the quality of
recommendations provided, and would align broker-dealers' obligations
more closely with retail customers' reasonable expectations.\91\ The
best interest obligation, including the specific component obligations,
that we are proposing today would address certain conflicted
recommendations and set a clear minimum standard for broker-dealer
conduct. Specifically, we believe that it would improve investor
protection and the regulation of broker-dealer recommendations in four
key ways.
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\91\ See, e.g., Letter from David Certner, Legislative Counsel &
Legislative Policy Director, Government Affairs, AARP (Sept. 6,
2017) (``AARP'') (``Investors expect financial intermediaries to be
required to act in their (the customer's) best interest.'').
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First, it fosters retail customer awareness and understanding by
requiring disclosure of the material facts relating to the scope and
terms of the relationship with the retail customer.
Second, it is designed to enhance provisions under the federal
securities laws relating to the quality of broker-dealer
recommendations by establishing an express Care Obligation that sets
forth minimum professional standards that encompass and go beyond
existing suitability obligations under the federal securities laws, and
could not be satisfied through disclosure alone.\92\
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\92\ See supra note 7.
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Third, it enhances the disclosure of material conflicts of
interest. This would help educate retail customers about those
conflicts, and help them evaluate recommendations received from broker-
dealers.
Fourth, it establishes obligations that require mitigation, and not
just disclosure, of conflicts of interest arising from financial
incentives associated with the recommendation (such as compensation
incentives, incentives to recommend proprietary products, and
incentives to effect transactions in a principal capacity).
Taken together, we preliminarily believe these enhancements will
improve investor protection by minimizing the potential harmful impacts
that broker-dealer conflicts of interest may have on recommendations
provided to retail customers. Furthermore, it is our understanding that
many broker-dealers support the establishment of a best interest
standard.\93\
---------------------------------------------------------------------------
\93\ See, e.g., SIFMA 2017 Letter.
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As discussed in more detail below, in developing proposed
Regulation Best Interest, the Commission has drawn from principles that
apply to investment advice under other regulatory regimes--most notably
SRO rules, state common law, the Advisers Act, and any duties that
would apply to broker-dealers as a
[[Page 21586]]
result of the DOL Fiduciary Rule and the related PTEs (most notably,
the BIC Exemption)--with the goal of both establishing greater
consistency in the level of protection provided across registered
investment advice relationships (while having the specific regulatory
obligations for broker-dealers and investment advisers reflect the
structure and characteristics of their relationships with retail
customers) and easing compliance with Regulation Best Interest where
these other overlapping regulatory regimes are also applicable.
In particular, as a threshold matter, it is worth noting that, in
determining how to frame proposed best interest obligation, we
considered the ``best interest'' standards outlined in other contexts,
in particular the standard set forth in Section 913(g) of the Dodd-
Frank Act \94\ and the 913 Study recommendation,\95\ as well as the
DOL's ``best interest'' Impartial Conduct Standard, even though we are
not proposing a uniform fiduciary standard under Section 913(g).\96\
Our proposed definition differs from the wording of these standards by
replacing the phrase ``without regard to the financial or other
interest'' with the phrase ``without placing the financial or other
interest . . . ahead of the interest of the retail customer.'' We are
proposing this change as we are concerned that inclusion of the
``without regard to'' language could be inappropriately construed to
require a broker-dealer to eliminate all of its conflicts (i.e.,
require recommendations that are conflict free), \97\ and we believe
that our proposed formulation appropriately reflects what we believe is
the underlying intent of the ``without regard to . . .'' formulation.
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\94\ Pursuant to Section 913(g) of the Dodd-Frank Act, ``[t]he
Commission may promulgate rules to provide that the standard of
conduct for all brokers, dealers, and investment advisers, when
providing personalized investment advice about securities to retail
customers . . . shall be 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.'' 15 U.S.C. 80b-
11(g)(1); 15 U.S.C. 78o(k)(1). Section 913(g) also provides that
``[s]uch rules shall provide that such standard of conduct shall be
no less stringent than the standard applicable to investment
advisers under Sections 206(1) and 206(2) [of the Advisers Act].''
Id.
\95\ See infra Section II.D.2.d.2 for a further discussion of
how proposed Regulation Best Interest compares to the 913 Study
recommendations.
\96\ As discussed supra note 88, Regulation Best Interest is
being proposed, in part, pursuant to the authority provided by
Section 913(f) of the Dodd-Frank Act, which 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 doing so, the Commission
is required to consider the findings, conclusions and
recommendations of the 913 Study.
\97\ Some commenters raised similar concerns of potential
confusion and uncertainty regarding the expectations associated with
including this phrase in the best interest obligation. See, e.g.,
SIFMA 2017 Letter; T. Rowe Letter; Letter from Jason Chandler, Group
Managing Director, Head of Investment Platforms and Solutions Wealth
Management Americas, and Micheal Crowl, Group Managing Director,
General Counsel, UBS Group Americas and Wealth Management Americas,
UBS AG (July 21, 2017) (``UBS Letter'').
Other commenters, however, expressed support for a ``best
interest'' obligation that included that the ``without regard to
phrase.'' See, e.g., Letter from Christine L. Owens, Executive
Director, National Employyment Law Project (Oct. 20, 2017); PIABA
2017 Letter; Wells Fargo Letter; AARP Letter.
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We understand that, like other investment firms, broker-dealers
have conflicts of interest, in particular financial interests, when
recommending transactions to retail customers. Certain conflicts of
interest are inherent in any principal-agent relationship. We do not
intend for our standard to prohibit a broker-dealer from having
conflicts when making a recommendation. Nor do we 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.\98\ 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.\99\
Moreover, Section 913(g) does not itself require the imposition of the
principal trade provisions of Advisers Act Section 206(3) on broker-
dealers.\100\ 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.\101\ We believe that
these provisions make clear that the overall intent of Section 913 was
that a ``without regard to'' standard did not prohibit, mandate or
promote particular types of products or business models, and preserved
investor choice among such services and products and how to pay for
these services and products (e.g., by preserving commission-based
accounts, episodic advice, principal trading and the ability to offer
only proprietary products to customers).\102\
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\98\ See discussion infra Section II.D.2.d.2.
\99\ See Exchange Act Section 15(k)(1) and Advisers Act Section
211(g)(1). See also 913 Study at 113.
\100\ Id. Advisers Act Section 206(3) prohibits an adviser from
engaging 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.
\101\ Id.
\102\ See 913 Study at 113.
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In lieu of adopting wording that embodies apparent tensions, we are
proposing to resolve those tensions through another formulation that
appropriately reflects what we believe is the underlying intent of
Section 913: That a broker-dealer should not put its interests ahead of
the retail customer's interests when making a recommendation to a
retail customer. In other words, the broker-dealer's financial interest
can and will inevitably exist, but these interests cannot be the
predominant motivating factor behind the recommendation. Our proposed
language makes this intention clear by stating a broker-dealer and its
associated persons are not to put their interests ahead of the retail
customer's interests. We request comment below, however, on whether our
proposed rule should instead incorporate the ``without regard to''
language set forth in Section 913 and the 913 Study recommendation,
which we believe would also generally correspond to the DOL's language
in the BIC Exemption, but interpret that phrase in the same manner as
the ``without placing the financial or other interest . . . ahead of
the interest of the retail customer'' approach set forth above.
We also appreciate the desire for clarity regarding the
interpretation of our proposed best interest obligation. In the
discussion that follows, we are addressing these concerns by providing
clarity about the requirements imposed by the proposed best interest
obligation, and offering guidance on how a broker-dealer could comply
with these requirements.
Specifically, to provide assistance to broker-dealers complying
with the requirements of Regulation Best Interest, the Commission's
proposal: (1) Provides guidance setting forth our preliminary views of
what the best interest obligation would require, generally; (2) defines
the key terms and scope of the proposed best interest obligation; and
(3) specifies by rule the specific components with which a broker-
dealer
[[Page 21587]]
would be required to comply to satisfy its best interest obligation.
B. Best Interest, Generally
Proposed Regulation Best Interest uses the term ``best interest''
in several places. Under proposed paragraph (a)(1), broker-dealers
would be required to ``act in the best interest of the retail customer
. . . without placing the financial or other interest of'' the broker-
dealer making the recommendation ``ahead of the interest of the retail
customer.'' This general requirement would be satisfied through
compliance with the four specific components of Regulation Best
Interest set forth in paragraph (a)(2): The Disclosure Obligation
described in Section II.D.1, the Care Obligation described in Section
II.D.2 and the two prongs of the Conflict of Interest Obligations
discussed in Section II.D.3. In addition, the term ``best interest'' is
included in the Care Obligation, which would require, among other
things, a broker-dealer to ``have a reasonable basis to believe that
the recommendation could be in the best interest of at least some
retail customers,'' 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,'' and ``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.''
The proposed best interest obligation, as defined by the
Disclosure, Care, and Conflict of Interest Obligations below,
encompasses and goes beyond a broker-dealer's existing suitability
obligations.\103\ As previously noted, one key difference between the
Care Obligation imposed by Regulation Best Interest and the suitability
obligation derived from the antifraud provisions of the federal
securities laws is that the antifraud provisions require an element of
fraud or deceit, which would not be required under Regulation Best
Interest. More specifically, the Care Obligation could not be satisfied
by disclosure. Second, as discussed below, our proposed interpretation
of the Care Obligation would make the cost of the security or strategy,
and any associated financial incentives, more important factors (of the
many factors that should be considered) in understanding and analyzing
whether to recommend a security or an investment strategy. Third,
beyond the Care Obligation, Regulation Best Interest imposes Disclosure
and Conflict of Interest Obligations that are intended to manage the
potential impact that broker-dealer conflicts of interest may have on
their recommendations.
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\103\ See discussion infra Section II.D.
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We are not proposing to define ``best interest'' at this time.
Instead, we 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. Furthermore, in the discussion below and
in our discussion of each of these specific obligations, we provide
further guidance regarding our views of how a broker-dealer could act
in the best interest of the retail customer, including how a broker-
dealer could make a recommendation in the ``best interest,'' and how it
compares to existing broker-dealer obligations.
As a threshold matter, we recognize that it may be in a retail
customer's best interest to allocate investments across a variety of
investment products, or to invest in riskier or more costly products.
We do not intend to limit through proposed Regulation Best Interest the
diversity of products available, the higher cost or risks that may be
presented by certain products, or the diversity in retail customers'
portfolios. This proposal is not meant to effectively eliminate
recommendations that encourage diversity in a retail customer's
portfolio through investment in a wide range of products, such as
actively managed mutual funds, variable annuities, and structured
products. We recognize that these and other products that may involve
higher risks or cost to the retail customer may be suitable under
existing broker-dealer obligations. We believe these products could
likewise continue to be recommended under Regulation Best Interest, if
the broker-dealer satisfied its obligations under proposed Regulation
Best Interest.
Rather, proposed Regulation Best Interest is designed to address
the harm associated with broker-dealer incentives to recommend products
for reasons that put the broker-dealer's interest ahead of the
customer's interest (e.g., because of higher compensation or other
financial incentives for the broker-dealer). Nevertheless, we are
sensitive to the potential that, in order to meet their obligations
under the proposed Regulation Best Interest, broker-dealers may, for
compliance and business reasons, determine to avoid offering certain
products or limit recommendations to only certain low-cost and low-risk
products that would appear on their face to satisfy the proposed best
interest obligation. We emphasize that is not the intent of this
proposal, and we request comment on the extent to which proposed
Regulation Best Interest would result in broker-dealers limiting access
to or eliminating certain products in a manner that could, in and of
itself, cause harm to certain retail customers for whom those products
are consistent with their investment objectives and in their best
interest.
Specifically, as further clarification, proposed Regulation Best
Interest would not per se prohibit a broker-dealer from transactions
involving conflicts of interest, such as the following:
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;
Recommending complex products;
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 an illiquid security); or
Accepting a retail customer's order that is contrary to
the broker-dealer's recommendations.
While these practices would 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. Rather, these practices, which generally
involve conflicts of interest between the broker-dealer and the retail
customer, would be permissible under Regulation Best Interest only to
the extent that the broker-dealer satisfies the specific requirements
of Regulation Best Interest.
While to satisfy proposed Regulation Best Interest, a broker-dealer
would not
[[Page 21588]]
be required to analyze all possible securities, other products or
investment strategies to find the single ``best'' security or
investment strategy for the retail customer, broker-dealers generally
should consider reasonably available alternatives offered by the
broker-dealer as part of having a reasonable basis for making the
recommendation, as required under the Care Obligation. Proposed
Regulation Best Interest also would 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 Disclosure, Care, and the Conflict of Interest
Obligations set forth in the relevant sections below.\104\
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\104\ As noted, infra Section II.C.2, Regulation Best Interest
is intended to address concerns regarding the impact of material
conflicts of interest, and the level of care exercised, when broker-
dealers recommend a security or investment strategy involving
securities to retail customers. Accordingly, proposed Regulation
Best Interest applies only to recommendations, and the care
exercised in making a recommendation and addressing the conflicts
associated with a recommendation that may impact a broker-dealer's
recommendation of a security or investment strategy, but would not
apply to the execution of a recommended transaction or the potential
conflicts of interest associated with executing a recommended
transaction (e.g., payments for order flow), which as discussed
below are addressed by existing broker-dealer best execution, as
well as other regulatory obligations. 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 (June 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. In addition, Exchange Act Rules 10b-
10, 606, and 607 require broker-dealers to disclose information
about payment-for-order-flow arrangements to customers at the
opening of a new account and, thereafter, on customer trade
confirmations and in public quarterly reports. Proposed Regulation
Best Interest would be separate from and would not alter these
obligations, which apply when a broker-dealer executes a
transaction, regardless of whether it was recommended. See infra
Section II.D.1.d.2.
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As discussed in the Care Obligation below, we believe that the cost
(including fees, compensation and other financial incentives)
associated with a recommendation would generally be an important
factor. However, there are also other factors that a broker-dealer
should consider in determining whether a recommendation is in the best
interest of a retail customer, as required by the Care Obligation.
Other factors that would also be important to this determination
include, among others, 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.\105\
While cost and financial incentives would generally be important, they
may be outweighed by these other factors. Accordingly, we preliminarily
believe that a broker-dealer would not satisfy its Care Obligation--and
hence Regulation Best Interest--by simply recommending the least
expensive or least remunerative security without any further analysis
of these other factors and the retail customer's investment profile.
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\105\ See discussion infra Section II.D.1.
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We preliminarily believe that, in order to meet its 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 of the security or
strategy is justified (and thus nevertheless 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. 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 above, 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.
We preliminarily believe that under the Care Obligation, a broker-
dealer could not have a reasonable basis to believe that a recommended
security is in the best interest of a retail customer if it is more
costly than a reasonably available alternative offered by the broker-
dealer and the characteristics of the securities are otherwise
identical, including any special or unusual features, liquidity, risks
and potential benefits, volatility and likely performance.\106\
Further, it would be inconsistent with the Care 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 in place that were
reasonably designed to mitigate the conflict under the Conflict of
Interest Obligations, as the broker-dealer would not have complied with
its Care Obligation, as the higher cost of the security of would not be
justified by the security's other characteristics in comparison to
reasonably available alternatives (in contrast to the examples
discussed below). By treating cost associated with a recommendation as
an important factor in this analysis, the Care Obligation would enhance
a broker-dealer's existing suitability obligations under the federal
securities laws.
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\106\ An example of identical securities with different cost
structures are mutual funds with different share classes. The
Commission has historically charged broker-dealers with violating
Sections 17(a)(2) and (3) of the Securities Act for making
recommendations of more expensive mutual fund share classes while
omitting material facts. See, e.g., In re IFG Network Sec., Inc.,
Exchange Act Release No. 54127, at * 15 (July 11, 2006) (Commission
Decision) (registered representative violated Sections 17(a)(2) and
(3) by omitting to disclose to his customers material information
concerning his compensation and its effect upon returns that made
his recommendation that they purchase Class B shares misleading;
``The rate of return of an investment is important to a reasonable
investor. In the context of multiple-share-class mutual funds, in
which the only bases for the differences in rate of return between
classes are the cost structures of investments in the two classes,
information about this cost structure would accordingly be important
to a reasonable investor.'').
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We believe 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 (e.g., self-enrichment, self-dealing, or self-
promotion), and not the customer's best interest--in other words,
putting aside the broker-dealer's self-interest, the recommendation is
not otherwise in the best interest of the retail customer based on
other factors, in light of the retail customer's investment profile,
and as compared to other reasonably available alternatives offered by
the broker-dealer. Examples would include making a recommendation to a
retail customer in order to: Maximize the broker-dealer's compensation
(e.g., commissions or other fees); further the broker-dealer's business
relationships; satisfy firm sales quotas or other targets; or win a
firm-
[[Page 21589]]
sponsored sales contest.\107\ We discuss possible methods of compliance
with the Care Obligation and mitigation requirement in Section II.D.
below.
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\107\ See infra note 321 and accompanying text.
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On the other hand, the best interest obligation would allow a
broker-dealer to recommend products that may entail higher costs or
risks for the retail customer, or that may result in greater
compensation to the broker-dealer than other products, or that may be
more expensive, provided that the broker-dealer complies with the
specific Disclosure, Care, and Conflict of Interest Obligations
described in Section II.D.
1. Consistency With Other Approaches
a. DOL Fiduciary Rule and Related PTEs
We believe that the principles underlying our proposed best
interest obligation as discussed above, and the specific Disclosure,
Care, and Conflict of Interest Obligations described in more detail
below, generally draw from underlying principles similar to the
principles underlying the DOL's best interest standard, as described by
the DOL in the BIC Exemption.\108\ By choosing language that draws on
similar principles to the principles underlying the DOL's ``best
interest'' Impartial Conduct Standard, which would currently apply to
broker-dealers relying on the BIC Exemption and or any of the related
PTEs, we believe our proposed best interest standard would result in
efficiencies for broker-dealers that have already established
infrastructure to comply with the DOL best interest Impartial Conduct
Standard. As we believe that at its core, the Best Interest Obligation
is intended to achieve the same purpose as the best interest Impartial
Conduct Standard, we preliminarily believe broker-dealers would be able
to use the established infrastructure to meet any new obligations.
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\108\ The BIC Exemption's best interest Impartial Conduct
Standard would require (as here relevant) that advice be in a
retirement investor's best interest, and further defines advice to
be in the ``best interest'' if the person providing the advice acts
``with the care, skill, prudence, and diligence under the
circumstances then prevailing that a prudent person acting in a like
capacity and familiar with the such matters would use . . . without
regard to the financial or other interests'' of the person. BIC
Exemption Release, 81 FR at 21007, 21027. BIC Exemption Section
II(c)(1); Section VIII(d).
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Under the DOL's standard, we understand that a recommendation could
not be based on a broker-dealer's own financial interest in the
transaction, nor could a broker-dealer recommend the investment unless
it meets the objective prudent person standard of care.\109\ As a
general example, the DOL explained that under this standard, an adviser
(such as a broker-dealer's registered representative), in choosing
between two investments, could not select an investment because it is
better for the adviser's bottom line even if it is a worse choice for
the investor.\110\
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\109\ Id.
\110\ Id.
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Further, the proposed Disclosure Obligation, Care Obligation and
Conflict of Interest Obligations described in more detail below,
establish standards of professional conduct that, among other things,
would require the broker-dealer to employ reasonable care when making a
recommendation. According to the DOL, the BIC Exemption's best interest
standard incorporates ``objective standards of care and undivided
loyalty'' that would require adherence to a professional standard of
care in making investment recommendations that are in the investor's
best interest, and not basing recommendations on the advice-giver's own
financial interest in the transaction, nor recommending an investment
unless it meets the objective prudent person standard of care.\111\
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\111\ Id. at 21028.
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Like our proposed best interest obligation, we understand that the
DOL best interest standard as set forth in the BIC Exemption and in
related PTEs, among other things, does not: Prohibit a broker-dealer
from being paid, or receiving commissions or other transaction-based
payments; \112\ prohibit a broker-dealer from restricting
recommendations in whole or in part to proprietary products and/or
products that generate third-party payments \113\ or engaging in
``riskless principal transactions'' \114\ or certain transactions on a
principal basis; \115\ require the identification of the single
``best'' investment; \116\ nor impose an ongoing monitoring obligation,
so long as the conditions under the BIC exemption or other applicable
PTEs are satisfied.\117\
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\112\ See, e.g., BIC Exemption Release, 81 FR at 21032.
\113\ We understand, however, that the BIC Exemption provides
that a broker-dealer that restricts recommendations, in whole or in
part, to proprietary products or investments that generate third-
party payments, may rely on the exemption provided (among other
conditions) the recommendation is prudent, the fees reasonable, the
conflicts disclosed (so that the customer can fairly be said to have
knowingly assented to the compensation arrangement), and the
conflicts are managed through stringent policies and procedures that
keep the focus on the customer's best interest, rather than any
competing financial interest. See BIC Exemption, Section IV; BIC
Exemption Release, 81 FR at 21029, 21052-57.
\114\ The BIC Exemption provides exemptive relief (if all
applicable conditions are met) for compensation received as part of
riskless principal transactions, which are defined as ``a
transaction in which a Financial Institution, after having received
an order from a Retirement Investor to buy or sell an investment
product, purchases or sells the same investment product for the
Financial Institution's own account to offset the contemporaneous
transaction with the Retirement Investor.'' See BIC Exemption
Release, 81 FR at 21016, 21064. The DOL provided a separate
exemption for investment advice fiduciaries to engage in principal
transactions involving specified investments, but subject to
additional protective conditions. See Principal Transactions
Exemption.
\115\ Separate from the BIC Exemption, the DOL granted a new
exemption for certain principal transactions, which permits ERISA
fiduciaries to sell or purchase certain debt securities and other
investments in principal transactions and riskless principal
transactions with plans and IRAs under certain conditions. See
Principal Transactions Exemption. Among other conditions, this
exemption requires adherence to Impartial Conduct Standards
identical to those in the BIC Exemption, including to provide advice
in the ``best interest'' as defined above, with the exception that
the Principal Transactions Exemption specifically refers to the
fiduciary's obligation to seek to obtain the best execution
reasonably available under the circumstances with respect to the
transaction, rather than to receive no more than ``reasonable
compensation.'' See id.
\116\ BIC Exemption Release, 81 FR at 21029.
\117\ Id.
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We understand that our proposed Regulation Best Interest does not
reflect the other Impartial Conduct Standards that the broker-dealer:
(1) Make no misleading statements; and (2) receive no more than
reasonable compensation. We are not proposing standards similar to
these Impartial Conduct Standards because existing broker-dealer
obligations under the federal securities laws and SRO rules already
prohibit misleading statements and require broker-dealers to receive
only fair and reasonable compensation. Specifically, the antifraud
provisions of the federal securities laws prohibit broker-dealers from
making misleading statements.\118\ In addition, FINRA rules address
broker-dealers' communications with the public and specifically require
broker-dealer communications to be based on principles of fair dealing
and good faith and to be fair and balanced.\119\ Furthermore, FINRA
rules generally require broker-dealer prices for securities and
compensation for services to be fair and reasonable taking into
consideration all relevant circumstances.\120\ For these reasons, we do
not believe that including these two components of the DOL's Impartial
Conduct Standards would add meaningful additional protections for
retail customers. In contrast to proposed
[[Page 21590]]
Regulation Best Interest, which would add enhancements to existing
broker-dealer obligations, we believe proposing new rules addressing
areas already covered by the federal securities laws and SRO rules--
without also enhancing those obligations--may cause confusion about how
these new obligations would differ from current requirements.
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\118\ See, e.g., Exchange Act Sections 10(b) and 15(c).
\119\ See FINRA Rule 2210 (Communications with the Public).
\120\ See, e.g., FINRA Rules 2121 (Fair Prices and Commissions),
2122 (Charges for Services Performed), and 2341 (Investment Company
Securities). See also Exchange Act Sections 10(b) and 15(c).
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b. Recommendations of 913 Study
Our proposed Regulation Best Interest diverges from the
recommendation of the 913 Study, in that it does not propose to
establish a uniform fiduciary standard of conduct for both investment
advisers and broker-dealers, but rather focuses on establishing a best
interest obligation for broker-dealers.\121\ The 913 Study recommended
that the Commission consider rulemakings that would apply expressly and
uniformly to both broker-dealers and investment advisers, when
providing personalized investment advice about securities to retail
customers, a fiduciary standard no less stringent than currently
applied to investment advisers under Advisers Act Sections 206(1) and
(2), which the staff interpreted ``to include at a minimum, the duties
of loyalty and care as interpreted and developed under Advisers Act
Section 206(1) and 206(2).'' Specifically, the 913 Study recommended
that the Commission should establish a uniform fiduciary standard of
conduct requiring broker-dealers and investment advisers, ``when
providing personalized investment advice about securities to retail
customers . . . 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.'' Further, the Study
recommended that the Commission engage in rulemaking and/or issue
interpretive guidance addressing the components of the uniform
fiduciary standard: The duties of loyalty (e.g., disclosure and
potentially prohibition and mitigation of certain conflicts) and care
(e.g., suitability).\122\
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\121\ We note that proposed Regulation Best Interest only
addresses issues related to the 913 Study's recommendations
regarding a standard of conduct for broker-dealers, and does not
involve unrelated recommendations of the 913 Study, notably, the
recommendations relating to harmonization of the legal frameworks
governing broker-dealers and investment advisers more generally. See
913 Study at 129 et seq. In a separate concurrent release, we
request comment on whether there should be certain potential
enhancements to investment advisers' legal obligations by looking to
areas where the current broker-dealer framework provides investor
protections that may not have counterparts in the investment adviser
context. See Fiduciary Duty Interpretive Release.
\122\ See generally 913 Study at 110-23.
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We have given extensive consideration to the 913 Study
recommendation related to a uniform fiduciary standard of conduct, the
information that the public has submitted over the years following the
913 Study, and our extensive experience regulating broker-dealers and
investment advisers. Based on our evaluation, we have determined at
this time to propose a more tailored approach focusing on enhancements
to broker-dealer regulation to address our current concerns. We
preliminarily believe it makes more sense to build upon this regulatory
regime and the underlying expertise, and in this way reflect the unique
characteristics of the relationship (e.g., its transaction-based
nature, the variety of services the broker-dealer may provide, which
may or may not involve advice, and that the broker-dealer may provide
services in a principal or agent capacity), rather than to create a new
standard out of whole cloth or simply adopt obligations and duties that
have developed under a separate regulatory regime to address a
different type of advice relationship (e.g., a relationship that exists
primarily for the provision of advice about investments, and typically
involves portfolio management, often on a discretionary basis
\123\).\124\
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\123\ Many investment advisers manage portfolios for retail
investors and exercise investment discretion over the accounts,
while others provide advice to non-discretionary accounts, provide
financial planning, and sponsor or act as portfolio managers in wrap
fee programs. See, e.g., 913 Study.
\124\ See discussion infra Section II.F.
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Nevertheless, the recommendations of the 913 Study were useful to
us in evaluating how to specifically enhance investor protection and
improve the obligations that apply to broker-dealers when making
recommendations to retail customers. While we are not proposing a
uniform fiduciary standard, as recommended in the 913 Study, we
nevertheless preliminarily believe that the proposed best interest
obligation draws from principles underlying and reflects the underlying
intent of many of the recommendations of the 913 Study. As a
consequence, we also believe the rule draws upon the duties of loyalty
and care as interpreted under Section 206(1) and (2) of Advisers Act,
even if not the same as the 913 Study recommendations or the duties
interpreted under the Advisers Act.\125\
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\125\ See Fiduciary Duty Interpretive Release.
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As discussed above, our proposed best interest obligation would
generally track key elements of both the language of Section 913 of the
Dodd-Frank Act and the 913 Study recommendation for the wording of a
uniform fiduciary standard (with the exception of the proposed
replacement of ``without regard to'' language), and would reflect the
principles underlying the 913 Study recommendations related to a
uniform fiduciary standard of conduct.
Specifically, as noted, the 913 Study recommended that the
Commission engage in rulemaking and/or issue interpretive guidance
addressing the components of the uniform fiduciary standard: The duties
of loyalty (e.g., disclosure and potentially prohibition and mitigation
of certain conflicts) and care (e.g., suitability). As discussed in
more detail in the relevant sections below, in framing the recommended
duties of loyalty and care under the recommended uniform fiduciary
standard of conduct, the 913 Study looked to the duties of loyalty and
care under the Advisers Act as a baseline for the uniform fiduciary
standard--consistent with the ``no less stringent'' mandate of Section
913(g). For example, in framing the duty of loyalty under the
recommended uniform fiduciary standard of conduct, the 913 Study stated
that by reference to Advisers Act Section 206(1) and 206(2), the duty
of loyalty would require an investment adviser or broker-dealer ``to
eliminate, or provide full and fair disclosure about its material
conflicts of interest.'' \126\
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\126\ See 913 Study at 112-13.
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Further, taking into consideration the express provisions of
Section 913(g) of the Dodd-Frank Act, the 913 Study explains that the
recommended uniform standard would neither require the absolute
elimination of any particular conflicts (in the absence of another
requirement to do so) nor impose on broker-dealers a continuing duty of
loyalty or care; nor would the receipt of commissions or other standard
compensation, sale of proprietary products, or engaging in transactions
on a principal basis, in and of themselves, violate the fiduciary
standard.\127\ Similarly, in framing the duty of care under the
recommended uniform fiduciary standard of conduct, the 913 Study
considered the duty of care obligations interpreted under the Advisers
Act and current broker-dealer conduct obligations, in recommending that
the Commission consider specifying uniform, minimum standards for the
duty of care.\128\ The 913 Study noted that the Commission could
articulate such minimum standards by referring to and expanding upon,
as appropriate, the explicit minimum standards of conduct relating to
the duty
[[Page 21591]]
of care applicable to broker-dealers (e.g., suitability), and could
also take into account Advisers Act principles related to the duty of
care (e.g., duty to provide suitable investment advice).\129\
---------------------------------------------------------------------------
\127\ See 913 Study at 113.
\128\ See 913 Study at 120-21.
\129\ See 913 Study at 121.
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We believe the proposed best interest obligation reflects many of
these same principles of what would be required or prohibited under the
uniform standard recommended by the 913 Study, as discussed above. In
addition, as discussed in Section II.D, consistent with the 913 Study
recommendation, to satisfy our proposed best interest obligation, we
are proposing that broker-dealers must comply with specific
requirements: Namely, the Disclosure, Care and Conflict of Interest
Obligations. This specificity is intended to both: (1) Provide clarity
to broker-dealers about their obligations under Regulation Best
Interest generally and how they relate to existing obligations when
making recommendations (i.e., suitability); and (2) particularly
address the material conflicts of interest resulting from financial
incentives. As we discuss in more detail in the relevant sections
specifically addressing these obligations, we believe the Disclosure,
Care and Conflict of Interest Obligations generally draw from
principles underlying the duties of care and loyalty as recommended in
the 913 Study,\130\ while having the specific regulatory obligations
reflect the unique structure and characteristics of broker-dealer
relationships with retail customers.
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\130\ See infra discussion in Section II.D.1 and 2 comparing the
Care and Conflict recommendations of the 913 Study.
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2. Request for Comment on the Best Interest Obligation
The Commission requests comment on defining the proposed best
interest obligation to require broker-dealers ``to act in the best
interest of the retail customer . . . without placing the financial or
other interest of the [broker-dealer] making the recommendation ahead
of the interest of the retail customer,'' as well as comment on the
application of this standard and the types of practices that would be
consistent or inconsistent with this standard.
Do commenters believe that we should adopt a best interest
obligation for broker-dealers?
Do commenters agree with the general approach of the best
interest obligation of building on existing requirements? Are there
alternative approaches or additional steps that the Commission should
take? If so, what?
Would the Best Interest Obligation cause a broker-dealer
to act in a manner that is consistent with what a retail customer would
reasonably expect from someone who is required to act in their best
interest? If so, how? If not, what further steps should the Commission
take? Why or why not?
Does the obligation enhance retail customer protection? If
so, how? If not, what further steps should the Commission take? Why or
why not?
Do commenters agree with our assessment of how the Best
Interest Obligation compares with the DOL's best interest Impartial
Conduct Standard, as incorporated in the BIC Exemption? Do commenters
believe that proposed Regulation Best Interest provides similar
protections to the DOL's best interest Impartial Conduct Standard, as
incorporated in the BIC Exemption? If not, what are the differences and
what impact would those differences have on retail customers? Do
commenters believe it would be desirable to maintain consistency with
the DOL requirements and guidance in this area, as set forth in the BIC
exemption?
As discussed herein, we propose that the best interest
obligation would require a broker-dealer, when making a recommendation,
not to put the interests of a broker-dealer or its associated persons
ahead of the retail customer's interest. Does this formulation meet the
Commission's goal of protecting retail customers and clarifying the
standards that apply when broker-dealers are providing advice?
It is our intent that our proposal would make it clear
that, insofar as existing broker-dealer obligations have been
interpreted to stand for the principle that broker-dealers may put
their own interests ahead of their retail customers' when making a
recommendation, those interpretations would be inconsistent with
Regulation Best Interest. Does the rule text achieve this objective? To
the extent that it does not, or it does not do so with appropriate
clarity and certainty, what changes could be made to the proposed rule?
Should we provide a clarifying note?
To best capture this obligation, we are proposing that a
broker-dealer must act in the best interest of the retail customer
``without placing the financial or other interest of the [broker-
dealer] making the recommendation ahead of the interest of the retail
customer.'' Do commenters agree with our proposed approach, or should
the Commission take an alternative approach, such as provide that to
act in the best interest, a broker-dealer must act in the best interest
of the retail customer ``without regard to the financial or other
interest of the [broker-dealer] making the recommendation'' or ``by
placing the interest of the retail customer ahead of the broker-
dealer''? Why or why not? What practical impact would the inclusion or
exclusion of the Commission's proposed approach or the potential
alternative approach have on the obligations of the proposed best
interest obligation as described? Will it lead to retail customer
confusion? Would courts interpret the standard differently? Is there
different language that the Commission should consider?
Should the Commission provide further guidance on the
proposed best interest obligation? Should the guidance be with respect
to particular transactions or relationships? If so, please provide
examples of scenarios that should be deemed to meet or not meet this
standard.
Are the guidance and interpretations provided by the
Commission appropriate? Should any of it be included in the rule text?
Please be specific.
Should the Commission define the term ``best interest'' in
the rule text? Should the Commission define ``best interest'' with
respect to particular transactions or relationships? If so, what
definitions should the Commission consider and why? What are the
advantages and disadvantages of any proposed alternatives in this
context? Please explain with specificity what duties any suggested
definitions would entail.
Do commenters agree with the Commission's guidance on what
practices should not be per se prohibited by Regulation Best Interest
(provided the terms of the proposed rule are satisfied)? Why or why
not? Should any of these practices be per se prohibited? Why or why
not?
Do commenters agree with our view that recommending a more
expensive or more remunerative alternative for identical securities
would be inconsistent with Regulation Best Interest? Are there any
additional practices that the Commission should specifically identify
as consistent or inconsistent with Regulation Best Interest? Please
identify any such practices and why they should be viewed as consistent
or inconsistent with this obligation.
Are any changes in Regulation Best Interest necessary to
make it clear that broker-dealers who offered a limited scope of
products nevertheless can satisfy the standard?
Do commenters believe that proposed Regulation Best
Interest would result in broker-dealers limiting access to or
eliminating certain products in a
[[Page 21592]]
manner that could, in and of itself, cause harm to certain retail
customers for whom those products are consistent with their investment
objectives and in their best interest? If so, what products do
commenters think would be limited or eliminated? Would any changes in
Regulation Best Interest minimize or avoid these outcomes?
Do commenters believe that our proposed rule is
sufficiently clear that a broker-dealer is not required to monitor a
retail customer's account as part of its obligations unless
specifically contracted for? If not, what modifications should be made
to Regulation Best Interest? Do commenters believe that retail
customers understand that a broker-dealer is not required to monitor
retail customers' accounts? If so, what is the basis for that
understanding (e.g., firm disclosures)? What specific obligations do
broker-dealers typically take on if they contract to monitor customer
accounts?
Should Regulation Best Interest apply when broker-dealers
agree to provide ongoing monitoring of the retail customer's investment
for purposes of recommending changes in investments? Why or why not?
Alternatively, should broker-dealers who provide ongoing monitoring be
considered investment advisers?
Do commenters agree with the Commission's assessment that
no new private right of action or right of rescission is created by
Regulation Best Interest?
Despite the Commission's assertion that Regulation Best
Interest is limited to broker-dealers and is not intended to impact the
fiduciary obligations under the Advisers Act, do commenters have
concerns regarding the potential impact of this best interest
obligation on the legal obligations under other standards? If so, what
are these concerns? Do commenters have any suggestions on how to
provide further clarification on this issue?
In defining a broker-dealer's obligation when making a
recommendation to a retail customer, the Commission is not proposing to
impose additional requirements, such as requirements related to the
receipt of fair and reasonable compensation or the prohibition against
misleading statements that are part of DOL's Impartial Conduct
Standards, because broker-dealers already have these obligations.
Should the Commission consider incorporating these or other
requirements into the proposed rule? If so, what requirements should be
added and why? How should those requirements be defined? How would the
suggested requirements be different from current broker-dealer
obligations and enhance investor protection? To the extent broker-
dealers already have existing obligations related to suggested
additional requirements, should the Commission consider modifying the
existing broker-dealer regulatory obligations, and if so, how?
Do commenters agree with our proposed approach of a
tailored standard for broker-dealers as opposed to a uniform standard
of conduct for both broker-dealers and investment advisers?
Do commenters believe that we should explicitly adopt
FINRA's suitability standard, and then add any desired changed or
enhancements to that standard, in order to simplify the best interest
obligation? Are there specific benefits or problems with that approach?
C. Key Terms and Scope of Best Interest Obligation
1. Natural Person Who Is an Associated Person
The Commission proposes to define ``natural person who is an
associated person'' as a natural person who is an associated person as
defined under Section 3(a)(18) of the Exchange Act: ``any partner,
officer, 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).''
In defining in this manner, we intend to require not only the
broker-dealer entity, but also individuals that are associated persons
of a broker-dealer (e.g., registered representatives) to comply with
specified components of Regulation Best Interest when making
recommendations, as described below. We have limited the definition
only to a ``natural person who is an associated person'' to avoid the
application of Regulation Best Interest to ``all associated persons of
a broker-dealer,'' as the latter definition would capture affiliated
entities of the broker-dealer and would extend the application of
Regulation Best Interest to entities that are not themselves broker-
dealers, which are not our intended focus.
2. When Making a Recommendation, at Time Recommendation Is Made
The Commission proposes that Regulation Best Interest would apply
when a broker-dealer is making a recommendation about any securities
transaction or investment strategy to a retail customer (as defined and
discussed below). We believe that by applying Regulation Best Interest
to a ``recommendation,'' as that term is currently interpreted under
broker-dealer regulation, we would provide clarity to broker-dealers
and their retail customers as to when Regulation Best Interest applies
and maintain efficiencies for broker-dealers that have already
established infrastructures to comply with suitability obligations.
Moreover, we believe that taking an approach that is driven by each
recommendation would appropriately capture and reflect the various
types of advice broker-dealers provide to retail customers, whether on
an episodic, periodic, or more frequent basis and help ensure that
customers receive the protections that Regulation Best Interest is
intended to provide.
The proposed rule relies in part on the statutory authority
provided in Section 913(f) of the Dodd-Frank Act, which provides the
Commission rulemaking authority to address the standards of care ``for
providing personalized investment advice about securities to such
retail customers.'' \131\ As noted in the 913 Study, Section 913 of the
Dodd-Frank Act does not define ``personalized investment advice,'' and
the broker-dealer regulatory regime does not use the term ``investment
advice'' but instead focuses on whether a broker-dealer has made a
``recommendation.'' \132\ The 913 Study recommended that the definition
of ``personalized investment advice'' should at a minimum encompass the
making of a ``recommendation'' as developed under applicable broker-
dealer regulation.\133\ Given that proposed Regulation Best Interest is
focused on broker-dealer standards of conduct, and recognizing that the
term ``personalized investment advice'' is not used in the broker-
dealer regulatory regime, we propose that, consistent with
[[Page 21593]]
broker-dealer regulation and in recognition of the 913 Study
recommendation, proposed Regulation Best Interest would apply to a
``recommendation,'' as discussed below.\134\
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\131\ See Section 913(f) of the Dodd-Frank Act.
\132\ See 913 Study at 123-24.
\133\ Id. at 127. The 913 Study also indicated that beyond that,
``the term also could include any other actions or communications
that would be considered investment advice about securities under
the Advisers Act (such as comparisons of securities or asset
allocation strategies), except for `impersonal investment advice' as
developed under the Advisers Act.'' Id. (emphasis in original). As
noted below, we are seeking comment on alternative definitions and
the scope of the term ``recommendation.''
\134\ See ICI August 2017 Letter (``We note that because we are
suggesting a distinct best interest standard of conduct for broker-
dealers, and that the FINRA definition of `recommendation' should
apply, the term `personalized investment advice,' which the SEC used
in its 2013 request for data, would not be applicable, as that term
was intended to encompass both `recommendations' under the FINRA
rules and `investment advice' under the Advisers Act.'').
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a. Scope of Recommendation
The Commission believes that the determination of whether a
recommendation has been made to a retail customer that triggers the
best interest obligation should be interpreted consistent with existing
broker-dealer regulation under the federal securities laws and SRO
rules, which would provide clarity to broker-dealers and maintain
efficiencies for broker-dealers with established infrastructures that
already rely on this term.\135\ In addition, the Commission believes
that whether a recommendation has been made should, also consistent
with existing broker-dealer regulation, 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.\136\ We believe that the meaning of the term
``recommendation'' is well-established and familiar to broker-dealers,
and we believe that the same meaning should be ascribed to the term in
this context. We are concerned that even providing a principles-based
definition, which draws upon the principles underlying existing
Commission precedent and guidance, may create unnecessary confusion as
to whether the language intentionally or unintentionally diverges from
existing precedent. As we are not proposing to make any changes to this
existing precedent and guidance regarding when a recommendation is
made, we preliminarily believe that it is not necessary or appropriate
to define it for purposes of the proposed rule.
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\135\ See, e.g., FINRA Regulatory Notice 12-25 at Q2 and Q3
(regarding the scope of ``recommendation''); see also Michael F.
Siegel, Exchange Act Release No. 58737, at *21-27 (Oct. 6, 2008)
(Commission opinion, sustaining NASD findings) (applying FINRA's
guiding principles to determine that a recommendation was made),
aff'd in relevant part, Siegel v. SEC, 592 F.3d 147 (D.C. Cir.
2010), cert. denied, 560 U.S. 926 (2010); In re Application of Paul
C. Kettler, Exchange Act Release No. 31354 at 5, n.11 (Oct. 26,
1992). Some commenters agreed that the Commission should use FINRA's
definition and guidance of recommendation in establishing a standard
of conduct for broker-dealers. See AFL-CIO Letter (``Because DOL
relied on FINRA guidance with regard to what constitutes a
recommendation, the SEC could simply adopt that same definition for
its own rulemaking purposes''); Letter from Barbara Roper, Director
of Investor Protection, Consumer Federation of America (Sept. 14,
2017) (``CFA'') (``While the determination of whether a
recommendation has been made will always be based on the particular
facts and circumstances, FINRA guidelines provide a sound basis for
such a definition.''). See also Business Conduct Standards Adopting
Release.
\136\ This approach to whether a ``recommendation'' has occurred
is consistent with the approach the Commission has taken in other
contexts. See Business Conduct Standards Adopting Release at 156.
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In determining whether a broker-dealer has made a recommendation,
factors that have historically been considered in the context of
broker-dealer suitability obligations 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.'' \137\ 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.''
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\137\ See FINRA Notice to Members 01-23, Online Suitability
(Mar. 19, 2001), and Notice of Filing of Proposed Rule Change to
Adopt FINRA Rules 2090 (Know Your Customer) and 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. 62718A (Aug. 20, 2010), 75 FR 52562 (Aug. 26, 2010)
(discussing what it means to make a ``recommendation''); FINRA
Regulatory Notice 11-02, Know Your Customer and Suitability (Jan.
2011) (discussing how to determine the existence of a
recommendation), and FINRA Regulatory Notice 12-25 at n.24 (citing
FINRA Regulatory Notices discussing principles on determining
whether a communication is a ``recommendation''). See also Michael
F. Siegel, Exchange Act Release No. 58737, at *11 (Oct. 6, 2008)
(Commission opinion, sustaining NASD findings) (applying FINRA
principles to facts of case to find a recommendation), aff'd in
relevant part, Siegel v. SEC, 592 F.3d 147 (D.C. Cir. 2010), cert.
denied, 560 U.S. 926 (2010).
The DOL Fiduciary Rule follows a consistent approach in defining
a ``recommendation'' as a ``communication that, based on its
content, context, and presentation, would reasonably be viewed as a
suggestion that the [advice] recipient engage in or refrain from
taking a particular course of action.'' See DOL Fiduciary Rule
Release, 81 FR 20945, 20972 (``The Department, however, as described
both here and elsewhere in the preamble, has taken an approach to
defining ``recommendation'' that is consistent with and based on
FINRA's approach''); U.S. Department of Labor, Employee Benefits
Security Administration, Conflict of Interest FAQs, Part II--Rule
(Jan. 2017) Q1 (discussing what types of communication constitute a
``recommendation''), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-rules-and-exemptions-part-2.pdf (``DOL FAQs Part II'').
We understand concerns have been expressed that the DOL
Fiduciary Rule covers a broader range of communications as
``fiduciary investment advice.'' We are mindful of such concerns and
therefore, propose to interpret what is a recommendation consistent
with existing guidance under the federal securities laws and SRO
rules. See, e.g., Letter from Lisa Bleier, Managing Director &
Associate General Counsel, SIFMA in response to DOL's Request for
Information Regarding the Fiduciary Rule and Prohibited Transaction
Exemptions (Aug. 9, 2017); Letter from Lisa Bleier, Managing
Director & Associate General Counsel, SIFMA, in response to RIN
1210-AB79; Proposed Delay and Reconsideration of DOL Regulation
Redefining the Term ``Fiduciary'' (Apr. 17, 2017) (expressing
concerns regarding the breadth of what is considered fiduciary
investment advice under the DOL Fiduciary Rulemaking and advocating
for an approach that ``would build upon, and fit seamlessly within,
the existing and long-standing securities regulatory regime for
broker-dealers'').
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Consistent with existing broker-dealer suitability obligations,
certain communications under this approach would generally be excluded
from the meaning of ``recommendation'' as long as they do not include
(standing alone or in combination with other communications), a
recommendation of a particular security or securities. For example, as
recognized under existing broker-dealer regulation, excluded
communications would include providing general investor education
(e.g., a brochure discussing asset allocation strategies) or limited
investment analysis tools (e.g., a retirement savings calculator).\138\
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\138\ See 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)
an 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
takes 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 29 CFR 2510.3-21(b); DOL
Fiduciary Rule Release, 81 FR 20945, 20971; DOL FAQs Part II;
Definition of Recommendation.
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Consistent with existing interpretations and guidance of what
constitutes a recommendation, the obligation would apply to activity
that has been interpreted as ``implicit
[[Page 21594]]
recommendations.'' \139\ For example, certain transactions that a
broker-dealer executes on a retail customer's behalf, even if not
separately authorized, have been interpreted as implicit
recommendations that can trigger suitability obligations.\140\ We
propose that, consistent with existing interpretations and guidance of
what constitutes a recommendation, as well as Exchange Act and SRO
rules addressing broker-dealer regulation of discretionary
accounts,\141\ the obligation to act in the customer's best interest
should apply consistently to any recommendation, whether through the
execution of discretionary transactions (considered to be implicitly
recommended) or when making a recommendation to a brokerage customer in
a non-discretionary account.\142\
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\139\ See, e.g., FINRA Regulatory Notice 12-25 at Q3 (regarding
the scope of ``implicit recommendation''); see also infra Section
II. F for further discussion.
\140\ See, e.g., Rafael Pinchas, 54 SEC. 331, 341 n.22, 1999 SEC
LEXIS 1754, at *20 n.22 (1999) (``Transactions that were not
specifically authorized by a client but were executed on the
client's behalf are considered to have been implicitly recommended
within the meaning of [FINRA's suitability rule].'').
\141\ The Exchange Act addresses manipulative, deceptive, or
fraudulent practices with respect to discretionary accounts. See
Exchange Act Rule 15c1-7 (Discretionary Accounts); Exchange Act
Section 3(a)(35) (defining when a person exercises ``investment
discretion'' with respect to an account). See also NASD Rule 2510
(Discretionary Accounts) and Incorporated NYSE Rule 408
(Discretionary Power in Customers' Accounts). These rules address
the obligations that apply to members that have discretionary power
over a customer's account, such as the requirement to obtain
customer authorization prior to exercising discretion and to conduct
supervisory reviews of discretionary accounts. FINRA has adopted
additional rules governing discretionary account requirements for
specific products and scenarios. See, e.g., FINRA Rule 5121 (Public
Offerings of Securities With Conflicts of Interest) (subpart (c)
relating to discretionary accounts); FINRA Rule 4512 (Customer
Account Information) (subpart (a)(3) relating to discretionary
accounts). These rules are in addition to rules, such as FINRA Rule
2111, that apply to any recommendation. See also Section II.F. for a
discussion and request for comment regarding broker-dealer exercise
of discretion and the extent to which such exercise is ``solely
incidental'' to the conduct of its business as a broker-dealer.
\142\ See, e.g., Paul C. Kettler, 51 SEC. 30, 32 n.11, 1992 SEC
LEXIS 2750, at *5 n.11 (1992) (stating that transactions a broker
effects for a discretionary account are implicitly recommended). A
number of commenters focused on addressing the standard that applied
to ``non-discretionary'' recommendations. See, e.g., SIFMA 2017
Letter (noting that ``BDs, on the other hand, provide non-
discretionary recommendations. BDs generally cannot trade on their
client's behalf; clients must authorize any transactions'' and
suggesting that the definition of the term ``recommendation'' be
limited to ``non-discretionary recommendations''); T. Rowe Letter
(``Given the history, we believe that the SEC's best path forward
would be to focus specifically on updating the standard applicable
to non-discretionary broker-dealer recommendations, irrespective of
account type.''). But see Letter from Ronald P. Bernardi, President
and Chief Executive officer, Bernardi Securities, Inc. (Sept. 11,
2017) (``Bernardi Letter'') (suggesting consideration of a ``Best
Interest Standard'' that ``would apply to all non-discretionary
(self-directed) and discretionary transaction-based, broker-dealer
relationships.''). See also infra Section II.F.
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b. Duration of Obligation and Effect of Contractual Arrangements/Course
of Dealing
Regulation Best Interest would be triggered ``when making'' a
recommendation and a broker-dealer would be required to act in the best
interest ``at the time the recommendation is made.'' The proposed rule
is intended to focus the obligation to each particular instance when a
recommendation is made to a retail customer and whether the broker-
dealer satisfied its best interest obligation (i.e., was in compliance
with the specific Disclosure, Care, and Conflict of Interest
Obligations) at the time of the recommendation. The proposed rule is
not intended to change the varied advice relationships that currently
exist between a broker-dealer and its retail customers, ranging from
one-time, episodic or more frequent advice,\143\ consistent with the
goal of enhancing investor protection while preserving retail customer
access to and choice in advice relationships.
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\143\ To that end, the intent of the proposed rule is to impose
a best interest obligation on a broker-dealer when engaging in a
very specific activity--the making of a recommendation to a retail
customer (as defined below)--and to define the contours of that
obligation. The rule is not intended to supersede the 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, owe customers a fiduciary duty, or the scope
of obligations that attach by virtue of that duty. 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). Such broker-dealers would continue
to have such fiduciary duties, subject to liability under the
antifraud provisions of the federal securities laws, in addition to
the express requirements of the proposed rule.
See also infra Section II.F. for a discussion and request for
comment regarding broker-dealer exercise of discretion and the
extent to which such exercise is ``solely incidental'' to the
conduct of its business as a broker-dealer.
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Accordingly, the best interest obligation would not, for example:
(1) Extend beyond a particular recommendation or generally require a
broker-dealer to have a continuous duty to a retail customer or impose
a duty to monitor the performance of the account;\144\ (2) require the
broker-dealer to refuse to accept a customer's order that is contrary
to a broker-dealer's recommendations; or (3) apply to self-directed or
otherwise unsolicited transactions by a retail customer, who may also
receive other recommendations from the broker-dealer.\145\
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\144\ Regulation Best Interest would not alter or diminish
broker-dealers' current supervisory obligations under the Exchange
Act and detailed 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 Exchange Act
Section 15(b)(4)(E); FINRA Rule 3110.
\145\ Under existing broker-dealer regulatory obligations,
broker-dealers have an obligation to accurately record all
recommended transactions as ``solicited.'' See Exchange Act Rule
17a-3(a)(6)-(7); Exchange Act Rule 17a-25(a)(2). We are not
proposing any changes to these compliance requirements.
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We recognize, however, that a broker-dealer 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 hold itself to fiduciary duties, or to provide
periodic or ongoing services (such as ongoing monitoring of the retail
customer's investments for purposes of recommending changes in
investments).\146\ To the extent that the broker-dealer takes on such
obligations, 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.
However, the best interest obligation does not impose new obligations
with respect to the additional services, provided that they do not
involve a recommendation to retail customers. Importantly, as noted
above, Regulation Best Interest would not alter a broker-dealer's
existing obligations under the Exchange Act or any other applicable
provisions of the
[[Page 21595]]
federal securities laws and rules and regulations.\147\
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\146\ See infra Section II.D.1.
\147\ See supra Section I.B (discussing a broker-dealer's
existing obligations, including fiduciary obligations).
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In addition, under Section 29(a) of the Exchange Act, a broker-
dealer would not be able to waive compliance with the rule's obligation
to act in the best interest of the retail customer at the time a
recommendation is made and the specific obligations thereunder, nor can
a retail customer agree to waive her protection under Regulation Best
Interest. Thus, the scope of Regulation Best Interest cannot be reduced
by contract.
Furthermore, in addition to furthering our goal of enhancing
investor protection while preserving retail customer access to and
choice of advice relationships, we believe that applying the best
interest obligation to when a broker-dealer is making a recommendation
generally would be consistent with the DOL's approach under the DOL
Fiduciary Rule and the BIC Exemption. The DOL states that the BIC
Exemption ``does not mandate an ongoing or long-term advisory
relationship, but rather leaves the duration of the relationship to the
parties.'' \148\ Consistent with the DOL's interpretation of a
fiduciary's monitoring responsibility in the preamble to the DOL
Fiduciary Rule,\149\ the BIC Exemption requires broker-dealers, among
others, to disclose whether or not they will monitor an investor's
investments and alert the investor to any recommended changes to those
investments and, if so, the frequency with which the monitoring will
occur and the reasons for which the investor will be alerted.\150\ The
DOL does not require broker-dealers to provide advice on an ongoing,
rather than transactional, basis.\151\ Specifically, ``[t]he terms of
the contract or disclosure along with other representations,
agreements, or understandings between the Adviser, Financial
Institution and Retirement Investor, will govern whether the nature of
the relationship between the parties is ongoing or not.'' \152\
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\148\ BIC Exemption Release, 81 FR at 21032. See also DOL
Fiduciary Rule Release, 81 FR at 20987 (``[T]he final rule does not
impose on the person an automatic fiduciary obligation to continue
to monitor the investment or the advice recipient's activities to
ensure the recommendations remain prudent and appropriate for the
plan or IRA. Instead, the obligation to monitor the investment on an
ongoing basis would be a function of the reasonable expectations,
understandings, arrangements, or agreements of the parties'').
\149\ Id.
\150\ Id. at 21032.
\151\ Id.
\152\ Id.
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3. Any Securities Transaction or Investment Strategy
The Commission proposes to apply Regulation Best Interest to
recommendations of any securities transaction (sale, purchase, and
exchange) \153\ and investment strategy (including explicit
recommendations to hold a security or regarding the manner in which it
is to be purchased or sold) to retail customers.\154\ Securities
transactions may 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 in an ERISA account to an IRA.\155\
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\153\ This approach is consistent with existing broker-dealer
suitability obligations. Regulation Best Interest applies only to
recommendations, and not to the execution of a recommended
transaction, which as discussed below is addressed by existing
broker-dealer best execution obligations. See, e.g., FINRA Rule 5310
(Best Execution and Interpositioning). Regulation Best Interest is
separate from and does not alter these obligations. See generally
infra Section II.D.2, for discussion of a broker-dealer's best
execution obligations.
\154\ FINRA interprets what is an investment strategy broadly.
Examples of investment strategies are recommendations to purchase
the ``Dogs of the Dow,'' securities on margin, liquify home
mortgages, or explicit recommendations to hold securities. See FINRA
Regulatory Notice 12-25 at Q7. Similarly, under antifraud case law,
a recommendation can also encompass the manner for purchasing or
selling the security. A recommendation to purchase on margin, if
unsuitable, may violate antifraud provisions of the Exchange Act in
the absence of disclosure. See Troyer v. Karcagi, 476 F. Supp. 1142,
1152 (S.D.N.Y. 1979) (opening an unsuitable margin account, without
disclosure of the unsuitability to the customer, renders a broker-
dealer primarily liable under section 10(b) and Rule 10b-5 if it
acts with scienter); Steven E. Muth and Richard J. Rouse, Exchange
Act Release No. 52551, at *19, 58 SEC. 770, 797 (Oct. 3, 2005)
(Commission opinion) (finding registered representative's
recommendations of risky margin purchases to customers who had
relatively modest financial profiles and conservative investment
objectives, where he also misled customers regarding adverse impact
of margin trading, were unsuitable). See also William J. Murphy and
Carl M. Birkelbach, Exchange Act Release No. 69923, at *17 (July 2,
2013) (Commission opinion, sustaining FINRA findings) (``The large
margin debit balance in Lowry's account exacerbated the
unsuitability of Murphy's already risky trading.'').
\155\ A recommendation concerning the type of retirement account
in which a customer should hold his retirement investments typically
involves a recommended securities transaction, and thus is subject
to FINRA suitability obligations. For example, a firm may recommend
that an investor sell his plan assets and roll over the cash
proceeds into an IRA. Recommendations to sell securities in the plan
or to purchase securities for a newly- opened IRA are subject to
FINRA suitability obligations. See FINRA Regulatory Notice 13-45. As
previously noted, recommendations of unsuitable transactions may
also violate the antifraud provisions of Securities Act Section
17(a); Exchange Act Section 10(b) and Rule 10b-5 thereunder.
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We are not proposing at this time that the duty extend to
recommendations of account types generally, unless the recommendation
is tied to a securities transaction (e.g., to roll over or transfer
assets such as IRA rollovers). Evaluating the appropriateness of an
account is an issue that implicates both broker-dealers and investment
advisers that are making recommendations of a brokerage account or an
advisory account. Accordingly, we are requesting comment below about
the obligations that apply to both broker-dealers and investment
advisers relating to recommendations of accounts generally, and whether
and how we should address those obligations.
4. Retail Customer
The Commission proposes 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.''
\156\ The definition generally tracks the definition of ``retail
customer'' under Section 913(a) of the Dodd-Frank Act, except as
discussed below.
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\156\ We believe that, pursuant to existing regulations, broker-
dealers would generally be required to obtain sufficient facts
concerning a retail customer to determine an account's primary
purpose for purposes of Regulation Best Interest. For example, FINRA
members are required to use reasonable diligence, in regard to the
opening and maintenance of every account, to know (and retain) the
essential facts concerning every customer and concerning the
authority of each person acting on behalf of such customer. See
FINRA Rule 2090 (Know Your Customer). Additionally, FINRA members
are required to ascertain the customer's investment profile under
FINRA suitability obligations. See FINRA Rule 2111 (Suitability).
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The Commission preliminarily believes this proposed definition is
appropriate, and in particular, the limitation to recommendations that
are ``primarily for personal, family or household purposes,'' as we
believe it excludes recommendations that are related to business or
commercial purposes, but remains sufficiently broad and flexible to
capture recommendations related to the various reasons retail customers
may invest (including, for example, for retirement, education, and
other savings purposes). As discussed in more detail above, the
Commission and studies have historically been, and continue to be,
focused on the potential investor harm that conflicted advice can have
on investors investing for present and future financial goals.\157\ The
[[Page 21596]]
Commission continues to believe the focus of Regulation Best Interest
should remain on investors with these personal goals but we request
comment below on whether the definition of ``retail customer'' should
be expanded or harmonized with the proposed definition of ``retail
investor'' in the Relationship Summary Proposal, as defined and
described below.
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\157\ See, e.g., 913 Study (focusing on retail investors trying
to manage their investments to meet their own and their families'
financial goals); RAND Study; Siegel & Gale Study; CFA 2010 Survey.
See also IAC Recommendation; Section I.A.
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As noted, this definition differs from the definition of ``retail
customer'' under Section 913 in three relevant aspects. First, for the
reasons discussed above,\158\ the Commission proposes to substitute
``recommendation of any securities transaction or investment strategy
involving securities'' for ``personalized investment advice about
securities.''
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\158\ See supra Section II.C.2.
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Second, the Commission proposes to extend the Section 913
definition beyond natural persons to any persons, provided the
recommendation is primarily for personal, family, or household
purposes. This extension would cover non-natural persons that the
Commission believes would benefit from the protections of Regulation
Best Interest (such as trusts that represent the assets of a natural
person).\159\ As discussed in Section II.E below, in light of this
expansion from ``natural person'' to any person, we are proposing a
new, separate recordkeeping requirement, as, among other things, the
similar existing recordkeeping requirements refer only to ``natural
persons.''
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\159\ This differs from the approach taken under current FINRA
suitability obligations, which as discussed below, provide an
exemption to broker-dealers from the customer-specific suitability
obligation with respect to ``institutional accounts,'' including
very high net worth natural persons, if certain conditions are met.
Under the Commission's proposal, to the extent that the
recommendation is not primarily used for personal, family, or
household purposes, ``institutional accounts,'' as defined in FINRA
Rules, would fall outside the definition of retail customer and be
excluded from Regulation Best Interest, and as a consequence
recommendations to such accounts would be solely subject to FINRA's
suitability rule.
Under the FINRA rules, a broker-dealer's suitability obligations
are different for certain institutional customers than for non-
institutional customers. A broker-dealer is exempt from its
customer-specific suitability obligation for an institutional
account, if the broker-dealer: (1) Has a reasonable basis to believe
that the institutional customer is capable of evaluating the risks
independently, both in general and with regard to particular
transactions and investment strategies, and (2) the institutional
customer affirmatively indicates that it is exercising independent
judgment in evaluating the broker-dealer's recommendations. FINRA
2111(b).
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Third, the proposed definition would only apply to a person who
``receives a recommendation . . . from a broker or dealer or a natural
person who is an associated person of a broker or dealer,'' and does
not include a person who receives a recommendation from an investment
adviser acting as such. This definition is appropriate as Regulation
Best Interest only applies in the context of a brokerage relationship
with a brokerage customer, and in particular, when a broker-dealer is
making such a recommendation in the capacity of a broker-dealer.\160\
In other words, Regulation Best Interest would not apply to the
relationship between an investment adviser and its advisory client (or
any recommendations made by an investment adviser to an advisory
client).\161\ Accordingly, dual-registrants would be required to comply
with Regulation Best Interest only when making a recommendation in
their capacity as a broker-dealer.
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\160\ This approach will facilitate broker-dealers building upon
their current compliance infrastructure and will enhance investor
protections to retail customers seeking financial services. FINRA's
suitability rule applies to a person who is not a broker-dealer who
opens a brokerage account at a broker-dealer or who purchases a
security for which the broker-dealer receives or will receive,
directly or indirectly, compensation even though the security is
held at an issuer, the issuer's affiliate or custodial agent, or
using another similar arrangement. See FINRA Regulatory Notice 12-
55, Guidance on FINRA's Suitability Rule (Dec. 2012) at Q6(a). A
broker-dealer customer relationship could also arise if the
individual or entity has an informal business relationship related
to brokerage services, as long as the individual or entity is not a
broker-dealer. See FINRA Regulatory Notice 12-25 at Q6.
In some instances, a brokerage relationship with a brokerage
customer can exist without a formal brokerage account (e.g., as
established by an agreement with the broker-dealer). For example,
broker-dealers can assist retail customers in purchasing mutual
funds or variable insurance products to be held with the mutual fund
or variable insurance product issuer, by sending checks and
applications directly to the fund or issuer (this is sometimes
referred to as ``check and application,'' ``application-way,''
``subscription-way'' or ``direct application'' business; we use the
term ``check and application'' for simplicity) even if that retail
investor does not have an account with the broker-dealer. The
broker-dealer is typically listed as the broker-dealer of record on
the retail customer's account application, and generally receives
fees or commissions resulting from the retail customer's
transactions in the account. See, e.g., FINRA Notice to Members 04-
72, Transfers of Mutual Funds and Variable Annuities (Oct. 2004).
Regulation Best Interest would apply to recommendations of such
transactions even in the absence of a formal account.
\161\ In a concurrent release, we are proposing an
interpretation that would reaffirm--and in some cases clarify--
certain aspects of the fiduciary duty that an investment adviser
owes to its clients. See Fiduciary Duty Interpretive Release.
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Regulation Best Interest and its specific obligations, including
the Disclosure Obligation, Care Obligation, and Conflicts Obligations,
would not apply to advice provided by a dual-registrant when acting in
the capacity of an investment adviser, even if the person to whom the
recommendation is made also has a brokerage relationship with the dual-
registrant or even if the dual-registrant executes the transaction.
Similarly, when an investment adviser provides advice, the rule would
not apply to an affiliated broker-dealer or to a third-party broker-
dealer with which a natural associated person of the investment
advisers is associated if such broker-dealer executes the transaction
in the capacity of a broker or dealer. For example, in the case of a
dual-registrant that provides advice with respect to an advisory
account and subsequently executes the transaction, Regulation Best
Interest would not apply to the advice and transaction because the firm
acted in the capacity of a broker-dealer solely when executing the
transaction and not when providing advice about a securities
transaction. In this case, when the advice is provided in the capacity
of an investment adviser, the firm would be required to comply with the
obligations prescribed under an investment adviser's fiduciary duty, as
described in more detail in the Fiduciary Duty Interpretive Release.
The Commission recognizes that making the determination of whether
a dual-registrant is acting in the capacity of a broker-dealer or an
investment adviser is not free from doubt, and this issue has existed
for dual-registrants prior to the proposal of Regulation Best Interest.
Generally, determining whether a recommendation made by a dual-
registrant is in its capacity as broker-dealer requires a facts and
circumstances analysis, with no one factor being determinative. When
evaluating this issue, the Commission considers, among other factors,
the type of account (advisory or brokerage), how the account is
described, the type of compensation, and the extent to which the dual-
registrant made clear the capacity in which it was acting to the
customer or client. We also have held the view that a dual-registrant
is an investment adviser solely with respect to those accounts for
which it provides advice or receives compensation that subjects it to
the Advisers Act.\162\ This interpretation of the Advisers Act permits
a dual-registrant to distinguish its brokerage customers from its
advisory clients. We recognize that this determination can leave
interpretive and other challenges for dual-registrants with clients
that have both brokerage and advisory accounts with the dual-
registrant. Our Disclosure Obligation is designed to help address some
of these challenges as the Commission believes
[[Page 21597]]
it will help clarify the capacity in which a dual-registrant is acting.
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\162\ See Release 51523; 2007 Proposing Release.
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By proposing Regulation Best Interest, we are not intending to
change the analysis regarding whether an investor is a brokerage
customer or an advisory client, as we believe this issue is outside the
scope of this rulemaking.\163\ However, we seek comment below on this
historical approach and whether particular scenarios involving
investors with brokerage and advisory accounts need further
clarification.
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\163\ Id.
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The proposed definition of ``retail customer'' also differs from
the definition of ``retail investor'' proposed in the Relationship
Summary Proposal, which is a prospective or existing client or customer
who is a natural person (an individual), regardless of the individual's
net worth (thus including, e.g., accredited investors, qualified
clients or qualified purchasers).\164\ The relationship summary
contemplated in the Relationship Summary Proposal, as defined and
described below in Section II.D.1., is intended for a broader range of
investors, before or at the time they first engage the services of a
broker-dealer, to provide important information for them to consider
when choosing a firm and a financial professional.\165\ The Commission
does not believe it is inconsistent or inappropriate, but rather
beneficial, to require firms to provide a relationship summary to all
natural persons to facilitate their understanding of the account
choices, regardless of whether the retail customers will receive
recommendations primarily for personal, family, or household purposes.
Regulation Best Interest and its intended focus, however, is more
limited in scope, in order to cover recommendations to ``retail
customers'' who have chosen to engage the services of a broker-dealer
after receiving the Relationship Summary required by the Relationship
Summary Proposal.\166\
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\164\ The definition of ``retail investor'' would include a
trust or other similar entity that represents natural persons, even
if another person is a trustee or managing agent of the trust. See
Relationship Summary Proposal, supra Section II.D.1.
\165\ See Relationship Summary Proposal, supra note 8 and
accompanying text.
\166\ Id.
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Furthermore, consistent with the definition of ``retail customer''
in Section 913 of the Dodd-Frank Act, except as noted above, and the
913 Study recommendation, the Commission is proposing to limit the
application of Regulation Best Interest to any person, or the legal
representative of such person, receiving and using a recommendation
primarily for personal, family, or household purposes, such as trusts
that represent natural persons. Given that our proposed definition
applies to ``any person'' and not ``natural persons'' as used in the
Relationship Summary Proposal, we believe it is appropriate to limit
the definition to persons who receive recommendations primarily for
these specified purposes, consistent with the Commission's historical
focus,\167\ as we do not intend at this time for Regulation Best
Interest to apply to all recommendations to any person. Without such a
limitation, we are concerned that this rule would apply to
recommendations that are primarily for business purposes (such as any
recommendations to institutions), which is beyond the intended focus of
Regulation Best Interest, as discussed above.
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\167\ See supra notes 157 and 166 and accompanying text.
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5. Request for Comment on Key Terms and Scope of Best Interest
Obligation
The Commission requests comment generally on the key terms and
scope of the best interest obligation.
Do commenters agree with the general approach of the best
interest obligation of building on existing requirements?
Should retail customers be permitted to amend their
contracts with broker-dealers to modify the terms of Regulation Best
Interest?
The Commission also requests comment specifically on the proposed
definition of ``natural person who is an associated person.''
Do commenters agree that proposed Regulation Best Interest
should apply to natural persons that are associated persons of a
broker-dealer? Why or why not?
Are there alternative definitions that the Commission
should consider?
Is the proposed rule's limitation of applicability to ``a
natural person who is an associated person'' appropriate? Why or why
not?
Should the Commission broaden or limit the scope of
individuals to whom Regulation Best Interest applies? For example,
should it apply to small business entities such as a sole
proprietorship? Why or why not?
The Commission also requests comment specifically on the scope of
the term ``recommendation.''
Should the Commission define the term ``recommendation''?
If so, should we define ``recommendation'' as described above?
Does the term ``recommendation'' capture all of the
actions to which Regulation Best Interest should apply? Why or why not?
Should the Commission limit the application of Regulation
Best Interest to when a recommendation is made? Why or why not?
Is sufficient clarity provided regarding what ``at the
time the recommendation is made'' means? Should the Commission define
this phrase? Why or why not?
Should Regulation Best Interest also cover broker-dealers
that only offer a limited range of products, or that are engaging in
other activities, even when not making a ``recommendation'' as
discussed above? Why or why not?
Instead, should Regulation Best Interest apply when a
broker-dealer is providing ``personalized investment advice''? Why or
why not? If so, how should the Commission define ``personalized
investment advice''? Should the Commission definition follow the 913
Study, which recommended that such a definition should at a minimum
encompass the making of a ``recommendation,'' and should not include
``impersonal investment advice''? \168\ What broker-dealer activities
would be covered by using this definition that would not be currently
covered by limiting the rule to a ``recommendation''?
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\168\ See 913 Study at 123-27.
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As noted above, the term ``recommendation'' has been
interpreted in the context of Commission rules, the FINRA suitability
requirement, and the DOL Fiduciary Rule. Should the Commission define
or describe more fully what is a ``recommendation'' in this context?
Should the Commission interpret the term ``recommendation'' differently
than it has been interpreted by the Commission and FINRA to date? If
so, what should the interpretation be and why? In what specific
circumstances, if any, would additional guidance as to the meaning of
``recommendation'' be useful? Does the description of what would be a
recommendation provide sufficient clarity in this regard? Why or why
not?
Has the Commission appropriately distinguished a
recommendation from investor education? Why or why not? If not, what
communications should be considered a recommendation or alternatively,
investor education? How would these situations differ from the current
standards with respect to what is a recommendation versus investor
education?
Regulation Best Interest would apply to both discretionary
and non-discretionary recommendations made by a broker-dealer. Do
commenters agree
[[Page 21598]]
that Regulation Best Interest should apply to any discretionary
recommendation made by a broker-dealer? \169\ Courts have found broker-
dealers that exercise discretion or de facto control of an account to
be fiduciaries under state law. What additional protections do
brokerage customers receive, if any, when their broker-dealers are
considered fiduciaries under state law? Does Regulation Best Interest
adequately account for these additional protections?
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\169\ See also infra Section II.F. for a discussion and request
for comment regarding broker-dealer exercise of discretion and the
extent to which such exercise is ``solely incidental'' to the
conduct of its business as a broker-dealer.
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The Commission requests comment on the scope of ``any securities
transaction or investment strategy involving securities.''
Do commenters agree that proposed Regulation Best Interest
should apply to recommendations of ``any securities transaction or
investment strategy involving securities''? Do commenters agree with
our proposed interpretation of the scope of these terms? Why or why
not?
Do commenters have alternative suggestions on the types of
recommendations to which Regulation Best Interest would apply? Please
specifically identify any recommendations that should be covered by the
proposed rule and explain why they should be covered.
Are there other broker-dealer recommendations that are not
captured by these terms that should be covered by Regulation Best
Interest? Please specify any recommendations that would not be covered
by the proposed rule and why they should or should not be covered.
Should the Commission provide additional guidance as to
what is or is not an ``investment strategy involving securities''?
Please identify where further guidance is needed and why
recommendations should or should not be viewed as an ``investment
strategy involving securities.''
Should the Commission extend Regulation Best Interest to
recommendations of account types even if the recommendation is not tied
to a securities transaction? If so, what factors should a broker-dealer
consider in making a recommendation of an account type? Should the
factors differ if the account type recommended is discretionary versus
non-discretionary? Should they differ for dual-registrants versus
standalone broker-dealers?
Should the rule include an obligation to perform ongoing
or periodic evaluation of whether an account type initially recommended
remains appropriate? If so, how frequently and what factors should that
evaluation take into consideration?
What factors do firms consider in determining the
appropriateness of an account for a particular investor, if any, and
what weight is given to the factors considered (i.e., do certain
factors carry more weight than others)?
What policies and procedures do firms currently use, if
any, to supervise recommendations by their associated persons of
account types?
How do firms mitigate incentives for associated persons to
recommend inappropriate account types?
The Commission requests comment on the definition of ``retail
customer.''
Do commenters agree with the proposed definition of
``retail customer''? Why or why not? Should the definition be narrowed
or expanded in any way? For example, should it apply to small business
entities such as a sole proprietorship? Why or why not?
Are there are other definitions of ``retail customer''
that the Commission should consider? If so, please provide any
alternative definition and the reasons why it is being suggested. For
example, should the Commission instead use the definition of ``retail
investor'' that is being proposed in the Relationship Summary or that
is used in the 913 Study?
Regulation Best Interest would apply to recommendations to
retail customers, while FINRA's general suitability requirements apply
to recommendations to all customers (although a broker-dealer is exempt
from its customer-specific suitability obligation for an institutional
account, if certain conditions are met).\170\ Do commenters agree that
having differing standards of care for different broker-dealer
customers is appropriate? Why or why not? Would differing standards for
different customers of broker-dealers confuse retail or other
customers? Would differing standards for different customers make it
more difficult for broker-dealers to comply with their obligations?
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\170\ FINRA Rule 2111(b).
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Do commenters believe that the definition of ``retail
customer'' should instead only include all natural persons as under
Section 913? Why or why not?
Do commenters believe the limitation of the proposed
definition of ``retail customer'' to recommendations primarily for
``personal, family or household purposes'' is appropriate and clear?
Why or why not? As proposed, the definition of ``retail customer,''
including the limitation, would cover, for example, participants in
ERISA-covered plans and IRAs. Should participants in these types of
plans be covered? Why or why not? Do firms require more guidance
regarding the current application of the law to specific scenarios?
Should the limitation be omitted? Why or why not?
The Commission requests comment on the proposed approach
with respect to dual-registrants. How do firms currently make the
determination of what capacity a dual-registrant is acting in when
making a recommendation or otherwise? Do commenters require more
guidance regarding the current application of the law to specific
scenarios? Do commenters agree with the Commission's interpretations of
when a dual-registrant is acting as an investment adviser? Why or why
not? Do commenters agree with the Commission's interpretations of when
a dual-registrant is acting as a broker-dealer? Why or why not?
D. Components of Regulation Best Interest
As part of Regulation Best Interest, we are proposing specifying
that the 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'' shall be satisfied if
the broker-dealer complies with four component requirements: A
Disclosure Obligation, a Care Obligation, and two Conflict of Interest
Obligations. Each of these components is discussed below. Failure to
comply with any of these requirements when making a recommendation of
any securities transaction or investment strategy involving securities
to a retail customer would violate Regulation Best Interest.
In specifying by rule these obligations, we intend to provide
clarity to broker-dealers on the requirements of the best interest
obligation. To that end, the best interest obligation does not impose
any obligations other than those specified by the rule: Namely, 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's interest, by complying with each of the components as set
forth in paragraph (a)(2) of the rule.
We wish to reemphasize that we recognize that components of these
obligations draw from obligations that have been interpreted under the
antifraud provisions of the federal securities laws, or may be
specifically addressed by the Exchange Act or the rules thereunder or
SRO rules. In proposing these obligations, we are not
[[Page 21599]]
proposing to amend or eliminate existing broker-dealer obligations, and
compliance with Regulation Best Interest is not determinative of a
broker-dealer's compliance with obligations under the general antifraud
provisions of the federal securities laws.\171\
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\171\ Any transaction or series of transactions, whether or not
effected pursuant 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 [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)].
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1. Disclosure Obligation
The Commission is proposing the Disclosure Obligation, which would
require a broker-dealer, or natural person who is an associated person
of a broker or dealer ``to, 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 and all material conflicts of interest
associated with the recommendation.'' We believe that an important
aspect of the broker-dealer's best interest obligation is to facilitate
its retail customers' awareness of certain key information regarding
their relationship with the broker-dealer.\172\ Specifically, and as
discussed more below, to meet 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: (i) That
the broker-dealer is acting in a broker-dealer capacity with respect to
the recommendation; (ii) fees and charges that apply to the retail
customer's transactions, holdings, and accounts; and (iii) type and
scope of services provided by the broker-dealer, including, for
example, monitoring the performance of the retail customer's account.
While these examples are indicative of what the Commission believes
would generally be material facts regarding the scope and terms of the
relationship, brokers, dealers, and natural persons who are associated
persons of a broker or dealer would need to determine what other
material facts relate to the scope and terms of the relationship, and
reasonably disclose them in writing prior to or at the time of a
recommendation. Additionally, this Disclosure Obligation would
explicitly require the broker-dealer to, prior to or at the time of
such recommendation, reasonably disclose in writing all material
conflicts of interest \173\ associated with the recommendation.
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\172\ Several commenters maintained that a disclosure
requirement with such information would be an effective approach to
addressing consumer confusion. See, e.g., State Farm 2017 Letter
(recommending a simplified account opening disclosure that includes:
(1) The type of relationship being entered into and specific duties
owed to the consumer based on the services performed; (2) the
services available as part of the relationship, and information
about applicable direct and indirect investment-related fees; and
(3) information about material conflicts of interest that apply to
these relationships, including material conflicts arising from
compensation arrangements or proprietary products); Letter from Paul
S. Stevens, President and CEO, Investment Company Institute (Feb. 5,
2018) (``ICI February 2018 Letter'') (recommending a best interest
standard requiring broker-dealers to disclose to retail customers
certain aspects of their relationship with the retail customer,
``such as the type and scope of services provided, the applicable
standard of conduct, the types of compensation it or its associated
persons receive, and any material conflicts of interest''); Letter
from Michelle B. Oroschakoff, LPL Financial, (Feb. 22, 2018) (``LPL
Financial'') (recommending a standard of conduct that requires clear
and comprehensive disclosure to retail investors explaining material
information about their services, including the nature of the
services, investment products, compensation, and material conflicts
of interest).
\173\ Under Regulation Best Interest, as proposed, a broker-
dealer's obligation to disclose material conflicts of interest would
resemble the duty to disclose material conflicts that has been
imposed on broker-dealers found to be acting in a fiduciary
capacity. 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. & Exch. Comm'n, 174 F.2d
969, 976 (D.C. Cir. 1949) (broker acted in the capacity of a
fiduciary and, as such, broker was under a duty to make full
disclosure of the nature and extent of her adverse interest,
``including her cost of the securities and the best price at which
the security might be purchased in the open market'').
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We understand that broker-dealers typically provide information
about their services and accounts, which may include disclosure
concerning the broker-dealer's capacity, fees, services, and
conflicts,\174\ on their firm websites and in their account opening
agreements. While broker-dealers are subject to a number of specific
disclosure obligations when they effect certain customer
transactions,\175\ and are subject to additional disclosure obligations
under the antifraud provisions of the federal securities laws,\176\
broker-dealers are not currently subject to an explicit and broad
disclosure requirement under the Exchange Act.\177\ To promote broker-
[[Page 21600]]
dealer recommendations that are in the best interest of retail
customers, we believe it is necessary to impose a more explicit
disclosure obligation on broker-dealers than what currently exists
under the federal securities laws and SRO rules.
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\174\ The 913 Study noted that, in practice, required
disclosures of conflicts have been more limited with broker-dealers
than with investment advisers. See 913 Study at 106. In addition,
the Tully Report focused on the potential harm to investors due to
broker-dealer conflicts of interest and in particular those related
to compensation. As a best practice, the Tully Report suggested
increased disclosure. See also Tully Report at 16 (finding that full
disclosure of the broker-dealer compensation practices could reduce
the ``potential for conflict and abuse); discussion supra Section
I.A.
\175\ See, e.g., Exchange Act Rule 10b-10, which generally
requires a broker-dealer effecting customer transactions in
securities (other than U.S. savings bonds or municipal securities)
to provide written notification to the customer, at or before
completion of the transaction, disclosing information specific to
the transaction, including whether the broker-dealer is acting as
agent or principal and its compensation, as well as any third-party
remuneration it has received or will receive. 17 CFR 240.10b-10. See
also Exchange Act Rules 15c1-5 and 15c1-6, which require a broker-
dealer to disclose in writing to the customer if it has any control,
affiliation, or interest in a security it is offering or the issuer
of such security. 17 CFR 240.15c1-5 and 15c1-6. There are also
specific, additional obligations that apply, for example, to
recommendations by research analysts in research reports and to
public appearances under Regulation Analyst Certification (AC). See,
e.g., 17 CFR 242.500 et seq. Finally, SRO rules apply to specific
situations, 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).
\176\ See, e.g., supra note 87. 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 n.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 and the Commission 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, 1302 (2d
Cir. 2002); Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2d
Cir. 1970).
\177\ Broker-dealers may be subject to additional disclosure
requirements imposed by other regulators. For example, as noted, the
BIC Exemption and related PTEs impose detailed disclosure conditions
on broker-dealers that rely on those exemptions. Other DOL
regulations and exemptions also impose disclosure requirements
applicable to broker-dealers providing advisory and other services
to ERISA-covered plans and IRAs. See, e.g., 29 CFR 2550.408g-
1(b)(7)(G) (regulation under statutory exemption for participant
advice requires fiduciary advisers to plans and IRAs seeking relief
to deliver certain disclosures and acknowledge fiduciary status); 29
CFR 2550.408b-2(c)(iv)(B) (regulation under statutory exemption for
reasonable service arrangements requires certain ERISA plan service
providers to disclose certain information in writing including
(among other things) a description of the services to be provided,
the fees to be paid directly and indirectly by the plan and, if
applicable, a statement that the service provider will provide or
reasonably expects to provide services as a ``fiduciary'' as defined
by ERISA).
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This Disclosure Obligation also forms an important part of a
broader effort to address retail investor confusion, as further
discussed in a separate concurrent rulemaking.\178\ Studies have shown
that retail investors are confused about the differences among
financial service providers, such as broker-dealers, investment
advisers, and dual-registrants.\179\ We have carefully considered these
concerns regarding investor confusion, and are committed to
facilitating greater clarity for retail investors. In our concurrent
rulemaking, we propose to: \180\ (1) Require broker-dealers and
investment advisers to provide to retail investors \181\ a short (i.e.,
four page or equivalent limit if in electronic format) relationship
summary (``Relationship Summary''); \182\ (2) restrict broker-dealers
and associated natural persons of broker-dealers, when communicating
with a retail investor, from using the term ``adviser'' or ``advisor''
in specified circumstances; and (3) require broker-dealers and
investment advisers, and their associated natural persons and
supervised persons, respectively, to disclose, in retail investor
communications, the firm's registration status with the Commission and
an associated natural person's and/or supervised person's relationship
with the firm (``Regulatory Status Disclosure'').\183\
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\178\ See Relationship Summary Proposal.
\179\ See, e.g., Siegel & Gale Study; RAND Study. See also CFA
2010 Survey.
\180\ See Relationship Summary Proposal.
\181\ As described in more detail under the definition of
``retail customer'' in Section II.C.4, the definition used in this
proposed rulemaking differs from the definition of ``retail
investor'' used in the Relationship Summary Proposal.
\182\ The customer or client relationship summary is being
proposed as ``Form CRS.''
\183\ See Relationship Summary Proposal.
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These proposed obligations reflect common goals and touch on issues
that are also contemplated under the proposed Disclosure Obligation
under Regulation Best Interest, notably clarifying the capacity in
which a firm or financial professional is acting, minimizing investor
confusion, and facilitating greater awareness of key aspects of a
relationship with a firm or financial professional, such as the
applicable standard of conduct, fees, and material conflicts of
interest. We believe these obligations 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
that we preliminarily believe are appropriate at different points of
the relationship with a broker-dealer.
The Relationship Summary highlights certain features of an
investment advisory or brokerage relationship, which is designed to
alert retail investors to information for them to consider when
choosing a firm and a financial professional. This would be achieved by
requiring that the Relationship Summary be initially delivered to a
retail investor before or at the time a retail investor enters into an
investment advisory agreement or first engages a brokerage firm's
services.\184\
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\184\ We note that the Relationship Summary may be provided
after the retail investor has initially decided to meet with the
firm or its financial professional, a selection which may have been
based on such person's name or title. This highlights the importance
of facilitating clarity and accuracy in the use of names and titles,
as is intended by the proposed restrictions on titles and the
Regulatory Status Disclosure. See Relationship Summary Proposal.
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By virtue of the high level nature of the disclosures in the
Relationship Summary, constituting a mix of prescribed language and
more firm-specific disclosures, and the space constraints (no more than
four pages or equivalent limit if in electronic format), the
Relationship Summary would form just one part of a broker-dealer's
broader set of disclosures. Firms would include information retail
investors need to understand the services, fees, conflicts, and
disciplinary history of firms and financial professionals they are
considering, along with references and links to other disclosure where
interested investors can find more detailed information. In this way,
the Relationship Summary is intended to foster a layered approach to
disclosure, as described above. It is also designed to facilitate
comparisons across firms that offer the same or substantially similar
services.\185\
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\185\ For further discussion, see Relationship Summary Proposal.
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The Disclosure Obligation under Regulation Best Interest further
builds on and complements these obligations as it would require a
broker-dealer or natural person who is an associated person of a
broker-dealer to, prior to or at the time of the recommendation,
reasonably disclose, 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
Disclosure Obligation under Regulation Best Interest would apply
specifically to the broker-dealer or natural person who is an
associated person of the broker-dealer and the specific recommendation
triggering Regulation Best Interest.
For example, whereas the Relationship Summary would require a brief
and general description of the types of fees and expenses that retail
investors will pay, under the Disclosure Obligation we would generally
expect broker-dealers to build upon the Relationship Summary to provide
more specific fee disclosures relevant to the recommendation to the
retail customer and the particular brokerage account for which
recommendations are made. In addition, while the Relationship Summary
would require a high-level description of specified conflicts of
interest, the Disclosure Obligation would require more comprehensive
disclosure of all material conflicts of interest related to the
recommendation to the retail customer.
Thus, as a general matter, the Regulatory Status Disclosure and the
Relationship Summary reflect initial layers of disclosure, with the
Disclosure Obligation reflecting more specific and additional, detailed
layers of disclosure.\186\
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\186\ Nevertheless, as discussed below where relevant, in some
instances, disclosures made pursuant to the Regulatory Status
Disclosure or the Relationship Summary may be sufficient to satisfy
some aspects of this Disclosure Obligation.
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a. Disclosure of Material Facts Relating to the Scope and Terms of the
Relationship
As noted above, to meet this Disclosure Obligation, we would
generally 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 is acting in a broker-dealer
capacity with respect to the recommendation; (ii) fees and charges that
apply to the retail customer's transactions, holdings, and accounts;
and (iii) type and scope of services provided by the broker-dealer,
including, for example, monitoring the performance of the retail
customer's account. This Disclosure Obligation
[[Page 21601]]
would also require broker-dealers and natural persons who are
associated persons of the broker-dealer to determine, 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 would need to be disclosed. For example, this would
include considering whether it is necessary, and if so how, to build
upon the high-level summary disclosures pursuant to the Relationship
Summary.
(1) Capacity
We have identified the capacity in which a broker-dealer is acting
as a likely material fact relating to the scope and terms of the
relationship that would be subject to the Disclosure Obligation. In
doing so, we hope to achieve greater awareness among retail customers
of the capacity in which their financial professional or firm acts when
it makes recommendations \187\ so that the retail customer can more
easily identify and understand the relationship, scope of services, and
standard of conduct that applies to such recommendations. As noted
above, the broker-dealer's standard of conduct would be disclosed in
plain language in the Relationship Summary.
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\187\ See supra Section II.B.
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For a broker-dealer that is not a dual-registrant (a ``standalone
broker-dealer''), or a natural person that is an associated person of a
standalone broker-dealer (and that natural person is not also a
supervised person of a registered investment adviser), the broker-
dealer or associated person would disclose that it is acting in a
broker-dealer capacity by complying with the Relationship Summary and
the Regulatory Status Disclosure requirements of the Relationship
Summary Proposal, described above. Because the Disclosure Obligation
would require disclosure ``prior to, or at the time of'' the
recommendation, the broker-dealer generally would not be expected to
repeat the disclosure each time it makes a recommendation. Rather, we
would consider the broker-dealer to have reasonably disclosed the
capacity in which it is acting at the time of the recommendation, if
the broker-dealer had already--``prior to . . . the time of'' the
recommendation--delivered the Relationship Summary to the retail
customer in accordance with the requirements of proposed Exchange Act
Rule 17a-14 and had complied with the Regulatory Status Disclosure. We
believe that delivery of the Relationship Summary would clearly
articulate to the retail customer that he/she has a relationship with a
broker-dealer, and that the broker-dealer must act in his/her best
interest when providing advice in the form of a recommendation in the
capacity of a broker or dealer, in addition to other specified
information concerning the broker-dealer. Moreover, the Regulatory
Status Disclosure would help ensure that each written or electronic
investor communication clearly alerts the retail customer to the
capacity in which the firm or financial professional acts.
Retail customers of dual-registrants or of financial professionals
who are dually-registered may be more susceptible to confusion
regarding the capacity in which their firms or financial professionals
are acting with respect to any particular recommendation. For that
reason, delivery of the Relationship Summary and compliance with the
Regulatory Status Disclosure would not be considered reasonable
disclosure of the capacity in which a dually-registered broker-dealer
or dually-registered individual is acting at the time of the
recommendation. Pursuant to the Relationship Summary Proposal, a dual-
registrant would deliver to the retail customer a Relationship Summary
that describes both the brokerage and advisory services offered by the
firm, and as such, would not provide clarity regarding the capacity in
which the dual-registrant is acting in the context of any particular
recommendation. Similarly, the Regulatory Status Disclosure would
require disclosure of both capacities in which firms and financial
professionals act. Therefore, the Commission would expect a broker-
dealer that is a dual-registrant to do more to meet the Disclosure
Obligation.
As discussed below in our guidance on reasonable disclosure, we are
not proposing to mandate the form, specific timing, or method for
delivering disclosure pursuant to the Disclosure Obligation, other than
the general requirement that the disclosure be made ``prior to or at
the time of'' the recommendation. Instead, we aim to provide broker-
dealers flexibility in determining how to satisfy the Disclosure
Obligation. As part of that determination, the dual-registrant should
consider how best to assist its retail customers in understanding the
capacity in which it is acting. For example, dual-registrants could
disclose capacity through a variety of means, including, among others,
written disclosure at the beginning of a relationship (e.g., in an
account opening agreement or account disclosure) that clearly sets
forth when the broker-dealer would act in a broker-dealer capacity and
how it will provide notification of any changes in capacity (e.g.,
``All recommendations will be made in a broker-dealer capacity unless
otherwise expressly stated at the time of the recommendation.'' or
``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 which account we are
discussing and the capacity in which we are acting.''). So long as the
broker-dealer provides this type of disclosure in writing prior to the
recommendation, we preliminarily believe that the broker-dealer would
not need to provide written disclosure each time it changes capacity or
each time it makes a recommendation, provided it makes clear the
capacity in which the broker-dealer is acting in accordance with its
initial disclosure.\188\
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\188\ See infra note 216 and accompanying text.
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(2) Fees and Charges
A broker-dealer's fees and charges that apply to retail customers'
transactions, holdings, and accounts would also be examples of items we
would generally consider to be ``material facts relating to the scope
and terms of the relationship.'' As such, fees and charges would
generally fall under the requirement for written disclosure prior to,
or at the time of, the recommendation. Fees and charges are important
to retail investors,\189\ but many retail investors are uncertain about
the fees they will pay.\190\ Many commenters have stressed the
importance of clear fee disclosure to retail investors.\191\
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\189\ See Staff of the Securities and Exchange Commission, Study
Regarding Financial Literacy Among Investors as required by Section
917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Aug. 2012), at iv (``With respect to financial intermediaries,
investors consider information about fees, disciplinary history,
investment strategy, conflicts of interest to be absolutely
essential.''), available at https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf.
\190\ See Rand Study, supra note 28, at xix (``In fact, focus-
group participants with investments acknowledged uncertainty about
the fees they pay for their investments, and survey responses also
indicate confusion about the fees.'').
\191\ See, e.g., Wells Fargo 2017 Letter (recommending
disclosure of fees and the scope of activities, among other
information, as part of a recommended standard of conduct); ACLI
Letter (recommending, among other things, full and fair disclosure
of the recommended product's features, fees, and charges, and fairly
disclosing how and by whom the financial professional is
compensated); SIFMA 2017 Letter (recommending a new broker-dealer
standard of conduct being accompanied by enhanced up-front
disclosure, including information such as the type and scope of
services, and the types of compensation the broker-dealer may
receive and the customer may pay); UBS 2017 Letter (recommending, in
the context of variable compensation received based on a
recommendation, an exemption subject to meeting the new standards of
conduct and providing a disclosure document (similar to Form ADV)
that would include compensation that may be received from clients
and from third parties, material conflicts of interest, and the
types of compensation for the various products and services
available); ICI August 2017 Letter (recommending a best interest
standard including, among other provisions, a requirement to
disclose certain key aspects of a broker-dealer's relationship with
the customer, such as the type and scope of services provided, the
applicable standard of conduct, and the types of compensation it or
its associated persons receive); State Farm 2017 Letter
(recommending a standardized, plain-English disclosure requirement
as a part of a standard of conduct, which would include, among other
information, the services available and applicable fees); Bernardi
Letter (recommending a ``standardized, straightforward, and truthful
disclosure regime'' describing, among other things, all fees and
commissions earned (including direct/indirect fees, and pricing
discounts received)); Vanguard Letter (recommending a standard
including several components such as enhanced disclosure, which
would include the nature and scope of the duty owed to clients and
the types of direct and indirect compensation to be received, among
other things).
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[[Page 21602]]
As described more fully in the Relationship Summary Proposal, the
Relationship Summary is designed to provide investors greater clarity
concerning the principal fees and charges they should expect to pay and
how the types of fees and charges affect the incentives of the firm and
their financial professionals.\192\ However, the proposed Relationship
Summary would focus on general descriptions regarding types of fees and
charges, rather than offer a comprehensive or personalized schedule of
fees or other information about the amounts, percentages or ranges of
fees and charges. Although we are not proposing to mandate the form,
specific content or method for delivering fee disclosure, in
furtherance of the goal of layered disclosure, to meet the Disclosure
Obligation, we would generally expect broker-dealers to build upon the
Relationship Summary, by disclosing additional detail (including
quantitative information, such as amounts, percentages or ranges)
regarding the types of fees and charges described in the Relationship
Summary.\193\
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\192\ As discussed above, broker-dealers are also currently
subject to a number of specific disclosure obligations when they
effect certain customer transactions, and additional disclosure
obligations under the antifraud provisions of the federal securities
laws. See supra notes 175, 176, 177 and accompanying text. See also
Exchange Act Rules 15g-4 and 15g-5 (prior to effecting a penny stock
transaction, a broker-dealer generally is required to provide
certain disclosures, including the aggregate amount of any
compensation received by the broker-dealer in connection with such
transaction; and the aggregate amount of cash compensation that any
associated person of the broker-dealer has received or will receive
from any source in connection with the transaction). Additional fee
disclosure requirements are also addressed in SRO guidance. See,
e.g., FINRA Regulatory Notice 13-23, Brokerage and Individual
Retirement Account Fees (July 2013) (providing guidance on
disclosure of fees in communications concerning retail brokerage
accounts and IRAs).
\193\ Specifically, the Relationship Summary requires high level
disclosures (in part, through prescribed statements) concerning
broad categories, but not specific amounts, percentages or ranges of
transaction-based or other fees (including commissions, mark-ups and
mark-downs and sales ``loads''), other account fees and expenses
(including, for example, custodian, account maintenance and account
inactivity fees), and investment fees and expenses for certain
products such as mutual funds and variable annuities.
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(3) Type and Scope of Services
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 scope and terms of the relationship,''
and thus would likely need to be disclosed prior to, or at the time of
the recommendation, pursuant to this obligation. More specifically, we
believe broker-dealers should, consistent with the goal of layered
disclosure, 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.
In particular, in the Relationship Summary, 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 investments.\194\ A
broker-dealer that offers different account types, or that offers
varying additional services to retail customers may not be able, within
the content and space constraints of the Relationship Summary, to
provide the ``material facts relating to the scope and terms of the
relationship'' with the retail customer (which may include further
detail regarding the specific products and services offered in that
retail customer's account,\195\ any limitations on those products or
services, the frequency and duration of those services, and the
standards of conduct that apply to those services). Pursuant to the
Disclosure Obligation, we would generally expect broker-dealers to
disclose these types of material facts concerning the actual services
offered as part of the relationship with the retail customer (i.e.,
specific to the type of account held by the retail customer) in a
separate document or documents.\196\
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\194\ See Relationship Summary Proposal.
\195\ Broker-dealers may determine that other services, not
included as part of the Relationship Summary, are also ``material
facts relating to the scope and terms of the relationship,''
including, for example, margin, cash management, discretionary
authority (consistent with the discussion in Section II.F), access
to research, etc.
\196\ As noted above, we understand that broker-dealers already
typically provide some of these disclosures through various means.
See supra notes 175, 176, 177 and accompanying text.
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b. Material Conflicts of Interest
The Disclosure Obligation would also explicitly require the broker-
dealer to, prior to or at the time of such recommendation, reasonably
disclose all material conflicts of interest associated with the
recommendation. For purposes of Regulation Best Interest, we propose 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. In determining how to interpret what constitutes a
``material conflict of interest,'' we considered the definition of
``material conflict of interest'' as used in BIC Exemption and related
PTEs.\197\ However, we developed this proposed interpretation based on
the Advisers Act as we believe it is appropriate to interpret the term
in accordance with existing and well-established Commission precedent
regarding identification of conflicts of interest for which advisers
may face antifraud liability under the Advisers Act in the absence of
full and fair disclosure.\198\
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\197\ In the BIC Exemption, a Material Conflict of Interest
exists when an Adviser or Financial Institution has a ``financial
interest that a reasonable person would conclude could affect the
exercise of its best judgment as a fiduciary in rendering advice to
a Retirement Investor.'' See BIC Exemption.
\198\ See SEC v. Capital Gains Research Bureau, Inc., 375 U.S.
180, 191-92, 194 (1963), (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'').
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We believe that this obligation to disclose should only apply to
``material conflicts of interest,'' and not to ``any conflicts of
interest'' that a broker-dealer may have with the retail customer.
Limiting the obligation to ``material'' conflicts is consistent with
case law under the antifraud provisions, which limit disclosure
obligations to ``material facts,'' even when a broker-dealer is in
[[Page 21603]]
a relationship of trust and confidence with its customer.\199\ Limiting
disclosure to material conflicts is designed to provide retail
customers with full disclosure of key pieces of information regarding
those conflicts that may affect a recommendation to a retail
customer.\200\ We believe that expanding the scope of the obligation
more broadly to cover any conflicts a broker-dealer may have would
inappropriately require broker-dealers to provide information regarding
conflicts that would not ultimately affect a retail customer's decision
about a recommended transaction or strategy and might obscure the more
important disclosures.
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\199\ See, e.g., Chasins v. Smith, Barney & Co., 438 F.2d 1167,
1172 (2d Cir. 1970) (``[F]ailure to inform the customer fully of its
possible conflict of interest, in that it was a market maker in the
securities which it strongly recommended for purchase by
[plaintiff], was an omission of material fact in violation of Rule
10b-5.''); United States v. Laurienti, 611 F.3d 530, 541 (9th Cir.
2010) (emphasizing that ``even in a trust relationship, a broker is
required to disclose only material facts'' and that ``materiality is
defined by the nature of the trust relationship between the clients
and the brokers: `This relationship places an affirmative duty on
brokers to use reasonable efforts to give the customer information
relevant to the affairs that have been entrusted to them.''')
quoting United States v. Szur, 289 F.3d 200, 211 (2d Cir. 2002)).
\200\ This interpretation is consistent with the 913 Study
recommendation. See 913 Study at 112.
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The Disclosure Obligation applies to any ``material conflict of
interest,'' including those arising from financial incentives. As
discussed below, the proposed Conflict of Interest Obligations would
require a broker-dealer to establish, maintain and enforce written
policies and procedures reasonably designed to: (1) Identify and at a
minimum disclose, or eliminate, all material conflicts of interest
associated with the recommendation; and (2) identify and disclose and
mitigate, or eliminate, material conflicts of interest arising from
financial incentives associated with the recommendation. To the extent
a broker-dealer determines, pursuant to the Conflict of Interest
Obligations, not to eliminate, but to disclose a material conflict of
interest, or to disclose and mitigate a material conflict of interest
that is a financial incentive, this Disclosure Obligation would apply.
We preliminarily believe that a material conflict of interest that
generally should be disclosed would include material conflicts
associated with recommending: Proprietary products,\201\ products of
affiliates, or limited range of products; \202\ one share class versus
another share class of a mutual fund \203\; securities underwritten by
the firm or a broker-dealer affiliate; the rollover or transfer of
assets from one type of account to another (such as recommendations to
rollover or transfer assets in an ERISA account to an IRA, when the
recommendation involves a securities transaction) \204\; and allocation
of investment opportunities among retail customers (e.g., IPO
allocation). A broker-dealer should also consider whether these
conflicts arise from financial incentives that need to be mitigated, as
discussed in proposed paragraph (a)(2)(iv).
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\201\ See SIFMA 2017 Letter (``Likewise, consistent with our
prior written advocacy on this issue, the new standard would not
prohibit BDs from offering any of the following, if accompanied by
appropriate disclosure, and the product or service is in the best
interest of the customer: (1) Proprietary products or services
(including those from affiliates); (2) transaction charge-based
accounts (e.g., commissions); (3) complex products (e.g., structured
products, alternative investments such as hedge funds and private
equity funds, etc.); and . . .'').
\202\ Broker-dealers may offer a limited range of products, for
instance, products sponsored or managed by an affiliate or products
with third-party arrangements (e.g., revenue sharing).
\203\ See, e.g., IFG Network Sec., Inc., Exchange Act Release
No. 54127 (July 11, 2006) (Commission Decision).
\204\ For example, firms and their registered representatives
that recommend an investor roll over plan assets to an IRA may earn
commissions or other fees as a result, while a recommendation that a
retail customer leave his plan assets with his old employer or roll
the assets to a plan sponsored by a new employer likely results in
little or no compensation for a firm or a registered representative.
See FINRA Regulatory Notice 13-45.
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For the avoidance of doubt, the requirement under Regulation Best
Interest that a broker-dealer disclose information about material
conflicts of interest is not intended to limit or restrict a broker-
dealer's obligations under federal securities laws, including the
general antifraud provisions of the federal securities laws, relating
to disclosure of additional information to a customer at the time of
the customer's investment decision.\205\
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\205\ See Sections 10(b) and 15(c) of the Exchange Act. See,
e.g., Exchange Act Rule 10b-10 (Confirmation of Transactions)
Preliminary Note (requiring broker-dealers to disclose specified
information in writing to customers at or before completion of the
transactions). For example, a broker-dealer may be required to
disclose revenue sharing payments that it or its affiliates may
receive for distributing fund shares from a fund's investment
adviser or others. Those payments provide sales incentives that
create conflicts between broker-dealers' financial interests and
their agency duties to customers. Revenue sharing payments may lead
a broker-dealer to use ``preferred lists'' that explicitly favor the
distribution of certain funds. Revenue sharing payments also may
lead to favoritism that is less explicit but just as real, such as
through broker-dealer practices allowing funds that make revenue
sharing payments to have special access to broker-dealer sales
personnel, and through other incentives or instructions that a
broker-dealer may provide to managers or salespersons. See, e.g., In
re Edward D. Jones & Co, Securities Act Release No. 8520 (Dec. 22,
2004) (broker-dealer violated antifraud provisions of Securities Act
and Exchange Act by failing to disclose conflicts of interest
arising from receipt of revenue sharing, directed brokerage payments
and other payments from ``preferred'' families that were exclusively
promoted by broker-dealer); In re Morgan Stanley DW Inc., Securities
Act Release No. 8339 (Nov. 17, 2003) (broker-dealer violated
antifraud provisions of Securities Act by failing to disclose
special promotion of funds from families that paid revenue sharing
and portfolio brokerage).
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c. Guidance on Reasonable Disclosure
We are proposing that the Disclosure Obligation would require a
broker-dealer, or natural person who is an associated person of a
broker or dealer to ``reasonably'' disclose material facts, including
material conflicts. In lieu of setting explicit requirements by rule
for what constitutes effective disclosure, the Commission proposes to
provide broker-dealers with flexibility in determining the most
appropriate way to meet this Disclosure Obligation depending on each
broker-dealer's business practices, consistent with the principles set
forth below and in line with the suggestion of some commenters that
stressed the importance of allowing broker-dealers to select the form
and manner of delivery of disclosure.\206\ To facilitate compliance
with this Disclosure Obligation, the Commission is providing
preliminary guidance, as discussed below, on what it believes 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. While the Commission is providing flexibility with regard
to the form and manner of disclosure as well as timing and frequency,
the adequacy of disclosure will depend on the facts and
circumstances.\207\ In order to
[[Page 21604]]
``reasonably disclose'' in accordance with this Disclosure Obligation,
a broker-dealer would need to give sufficient information to enable a
retail customer to make an informed decision with regard to the
recommendation.\208\ Disclosures made pursuant to the Disclosure
Obligation must be true and may not omit any material facts necessary
to make the required disclosures not misleading.\209\
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\206\ See TIAA Letter; Bernardi Letter; ACLI Letter. But see UBS
Letter; Nationwide Letter; FSR Letter (suggesting the SEC require a
disclosure document similar to Form ADV).
\207\ For example, the Commission has indicated that failure to
disclose the nature and extent of a conflict of interest may violate
Securities Act Section 17(a)(2). See Edward D. Jones & Co., L.P.,
Exchange Act Release No. 50910 (Dec. 22, 2004); Morgan Stanley DW,
Inc., Exchange Act Release No. 48789 (Nov. 17, 2003). In the context
of scalping, it is misleading to disclose that the person making the
investment recommendation ``may'' trade the recommended securities
when in fact the person does so. In SEC v. Blavin, for example, the
Sixth Circuit held that a newsletter publisher could not avoid
liability for scalping under Section 10(b) and Rule 10b-5 of the
Exchange Act by disclosing that it ``may trade for its own
account.'' 760 F.2d at 709-11. The court found that this was a
material misstatement because in fact it did trade for its own
account. See id.; see also SEC v. Gane, 2005 WL 90154 at *14 (S.D.
Fla., Jan. 4, 2005) (``By stating that they, their affiliates,
officers, directors, or employees `may' buy or sell stock in their
Investment Opinions, Southern Financial and Strategic investors
failed to provide adequate disclosure'').
\208\ See, e.g., De Kwiatkowski, 306 F.3d 1293, supra notes 15
(``the broker . . . is obliged to give honest and complete
information when recommending a purchase or sale.'') and 176; see
also Arleen W. Hughes, Exchange Act Release No. 4048, supra note 143
(finding duty to disclose material facts ``in a manner which is
clear enough so that a client is fully apprised of the facts and is
in a position to give his informed consent'').
\209\ As noted, 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.
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 [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.
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In addition to providing firms flexibility, we further believe it
is important to require that broker-dealers or natural persons who are
associated persons of the broker-dealer to ``reasonably disclose'' so
that compliance with the Disclosure Obligation will be measured against
a negligence standard, not against a standard of strict liability.\210\
In taking this position, we are sensitive to the potential that, if we
instead proposed an express obligation that broker-dealers ``disclose
material facts relating to the scope and terms of the relationship with
the retail customer and material conflict of interest,'' broker-
dealers, in an effort to avoid any inadvertent failure to disclose this
information as required, could opt to disclose all facts and conflicts
(including those that do not meet the materiality threshold). This
could result in lengthy disclosures that do not meaningfully convey the
material facts and material conflicts of interest and may undermine the
Commission's goal of facilitating disclosure to assist retail customers
in making informed investment decisions.
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\210\ While we understand that pursuant to the fiduciary duty
under the Advisers Act Section 206(1) and (2), an investment adviser
must eliminate, or at least disclose, all conflicts of interest, as
this duty is derived from the antifraud provisions, it is not a
strict liability standard. See In the Matter of Cranshire Capital
Advisors LLC, Investment Advisers Act Release No. 4277 (Nov. 23,
2015); SEC v. Capital Gains Research Bureau, Inc. In particular,
scienter is required to establish violations of Section 206(1) of
the Advisers Act. SEC v. Steadman, 967 F.2d 636, 641 & n.3 (D.C.
Cir. 1992). However, scienter is not required to establish a
violation of Section 206(2) of the Advisers Act; 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 & n.5; Steadman v. SEC, 603 F.2d 1126, 1132-34 (5th Cir.
1979), aff'd on other grounds, 450 U.S. 91 (1981).
The DOL Fiduciary Rule also would avoid strict liability, albeit
through a ``good faith'' exemption in its BIC Exemption. Section
II(e)(8), BIC Exemption Release at 21046-21047.
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Given the unique structure and characteristics of the broker-dealer
relationship with retail customers--including the varying levels and
frequency of recommendations that may be provided, and the types of
conflicts that may be presented--we believe it is important to provide
broker-dealers flexibility in determining the most appropriate and
effective way to meet this Disclosure Obligation, consistent with the
principles set forth below. Accordingly, at this time we are not
proposing to require a standard written document akin to Form ADV Part
2A, as suggested by certain commenters. As discussed in more detail
below, we preliminarily believe that while some forms of disclosure may
be standardized, certain disclosures may need to be tailored to the
particular recommendation, and some disclosures may be addressed
through an initial more generalized disclosure about the material fact
or conflict, followed by specific disclosure at another point.
Accordingly, we have preliminarily determined to provide flexibility in
the form and manner, and timing and frequency, of the disclosure.
(1) Form and Manner of Disclosure
The Commission believes that disclosure should be concise, clear
and understandable to promote effective communication between a broker-
dealer and retail customer.\211\ Specifically, broker-dealers generally
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.\212\ Broker-dealers may also, for example, consider whether
the use of graphics could help investors better understand and evaluate
these disclosures. Additionally, we believe that any such disclosure
must be provided in writing in order to 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.\213\ As with other documents
broker-dealers must deliver, broker-dealers would be able to deliver
the disclosure required pursuant to Regulation Best Interest consistent
with the Commission's guidance regarding electronic delivery of
documents.\214\
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\211\ Exchange Act Section 15(l)(1) and Advisers Act Section
211(h)(1) provide that the Commission shall ``facilitate the
provision of simple and clear disclosures to investors regarding the
terms of their relationships with brokers, dealers and investment
advisers, including any material conflicts of interest.''
\212\ See Office of Investor Education and Assistance, U.S.
Securities and Exchange Commission, A Plain English Handbook: How to
Create Clear SEC Disclosure Documents (Aug. 1998). See also
Relationship Summary Proposal.
\213\ We recognize that broker-dealers may provide
recommendations by telephone. In such instances, we believe that a
broker-dealer could meet its obligation to reasonably disclose ``in
writing,'' ``prior to or at the time of such recommendation''
through a variety of approaches, as described infra in Section
II.D.1.c.(2). For example, the broker-dealer may have already
provided relevant disclosures prior to the telephone conversation
(e.g., in a relationship guide, an account opening agreement or
account disclosure). The broker-dealer may also be able to meet the
delivery obligation by sending the relevant disclosure
electronically (e.g., by email) to the retail customer during the
telephone conversation. See also, infra note 216 and accompanying
text, where we explain that we would not consider the disclosure of
capacity at the time of recommendation to also be subject to the
``in writing'' requirement (i.e., a broker-dealer could clarify it
orally, so long as it had previously provided an initial disclosure
setting forth when the broker-dealer is acting in a broker-dealer
capacity and the method it will use to clarify the capacity in which
it is acting at the time of the recommendation).
\214\ See generally Use of Electronic Media for Delivery
Purposes, Exchange Act Release No. 36345 (Oct. 6, 1995) (``1995
Release'') (providing Commission views on the use of electronic
media to deliver information to investors, with a focus on
electronic delivery of prospectuses, annual reports to security
holders and proxy solicitation materials under the federal
securities laws); Use of Electronic Media by Broker-Dealers,
Transfer Agents, and Investment Advisers for Delivery of
Information, Exchange Act Release No. 37182 (May 9, 1996) (``1996
Release'') (providing Commission views on electronic delivery of
required information by broker-dealers, transfer agents and
investment advisers); Use of Electronic Media, Exchange Act Release
No. 42728 (Apr. 28, 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).
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As described above, we are not proposing to specify by rule the
form (e.g., narrative v. graphical/tabular, number of pages, etc.) or
manner (e.g., relationship guide or other written communications) of
disclosure. Given the variety of ways retail customers may communicate
with their broker-dealer, as well as the type of compensation and other
conflicts presented and the variety in the frequency and level of
advice services provided (i.e., one-time,
[[Page 21605]]
episodic or on a more frequent basis), we believe that some disclosures
may be effectively provided in a standardized document at the beginning
of the relationship, whereas others may need to be tailored to a
particular recommendation. Accordingly, we preliminarily believe that
broker-dealers should have the flexibility to make disclosures by
various means (e.g., different types of disclosure documents), as
opposed to requiring a single standard written document. As noted,
however, whether there is sufficient disclosure will depend on the
facts and circumstances.
(2) Timing and Frequency of Disclosure
The Disclosure Obligation would apply ``prior to or at the time
of'' the recommendation. The timing of the disclosure is critically
important to whether it may achieve the effect contemplated by the
proposed rule. Investors should receive 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, but not 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). The timing of the required disclosure should also reflect the
various ways in which retail customers may receive recommendations and
convey orders.\215\
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\215\ See, e.g., note 160 supra, describing ``check and
application'' arrangements.
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In light of these goals, we would like to emphasize 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, but which may be achieved through a variety of
approaches: (1) At the beginning of a relationship (e.g., in a
relationship guide, such as or in addition to the Relationship Summary,
or in written communications with the retail customer, such as the
account opening agreement); (2) on a regular or periodic basis (e.g.,
on a quarterly or annual basis, when any previously disclosed
information becomes materially inaccurate, or when there is new
relevant material information); (3) at other points, such as before
making a particular recommendation or at the point of sale; and/or (4)
at multiple points in the relationship or through a layered approach to
disclosure. For example, a broker-dealer may determine that certain
disclosures may be most effective if they are made at multiple points
in the relationship, or, if pursuant to a layered approach to
disclosure, certain material facts are conveyed in a more general
manner in an initial written disclosure and followed by more specific
information in a subsequent disclosure, which may be at the time of the
recommendation \216\ or even after the recommendation (i.e., in the
trade confirmation). 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.''
However, a broker-dealer could satisfy the Disclosure Obligation,
depending on the facts and circumstances, if the initial disclosure, in
addition to conveying material facts relating to the scope and terms of
the relationship with the retail customer, explains when and how a
broker-dealer would provide additional more specific information
regarding the material fact or conflict in a subsequent disclosure
(e.g., disclosures in a trade confirmation concerning when the broker-
dealer effects recommended transactions in a principal capacity).We
believe that including in the general disclosure this additional
information of when and how more specific information will be provided
would help the retail customer understand the general nature of the
information provided and alert the retail customer that more detailed
information about the fact or conflict would be provided and the timing
of such disclosure.\217\ As noted above, whether there is sufficient
disclosure in both the initial disclosure and any subsequent
disclosure, will depend on the facts and circumstances.
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\216\ For example, as discussed above in the discussion of the
disclosure of the capacity in which the broker-dealer is acting, a
broker-dealer may take this type of approach with respect to meeting
its obligation regarding the capacity in which it is acting at the
time of the recommendation. As noted above, we preliminarily believe
that a broker-dealer would satisfy the Disclosure Obligation
expressly by providing written disclosure setting forth when the
broker-dealer is acting in a broker-dealer capacity versus an
advisory capacity and how the broker-dealer will clarify when it is
making a recommendation whether it is doing so in a broker-dealer
capacity versus an advisory capacity. However, one important
distinction is that the written disclosure requirement would apply
to the initial disclosure (i.e., setting forth when the broker-
dealer is acting in a broker-dealer capacity and the method it will
use to clarify the capacity in which it is acting at the time of the
recommendation), but we would not consider the subsequent disclosure
of capacity at the time of recommendation to also be subject to the
``in writing'' requirement (i.e., a broker-dealer could clarify it
orally).
\217\ 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, Investment Advisers Act Release No. 4596 (Dec.
28, 2016); In the matter of UBS Financial Services, Inc., Investment
Advisers Act Release No. 4597 (Dec. 28, 2016); In the matter of
Wells Fargo Advisors, LLC, Wells Fargo Advisors Financial Network,
LLC, Investment Advisers Act Release No. 4598 (Dec. 28, 2016).
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The Commission anticipates that broker-dealers may elect to make
certain required disclosures of information to their customers at the
beginning of a relationship, such as in a relationship guide, account
agreement, comprehensive fee schedule, or other written document
accompanying such documents. While certain forms of disclosure may be
standardized, certain disclosures may need to be tailored to a
particular recommendation, for example, if the standardized disclosure
does not sufficiently identify the material conflicts presented by the
particular recommendation. Furthermore, additional disclosure may be
needed beyond the standardized disclosure (such as an account
agreement) 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). Because the Disclosure Obligation would
apply ``prior to or at the time of'' the recommendation, if a broker-
dealer has previously made the relevant disclosure to the retail
customer (and there have been no material changes to the previously
disclosed information), it would not be expected to repeat such
disclosure at each subsequent recommendation, depending on the facts
and circumstances of the prior disclosure. As noted above, we would
like to emphasize the importance of determining the appropriate timing
and frequency of disclosure. For example, where a significant amount of
time passes between the disclosure and a recommendation, the broker-
dealer generally should determine whether the retail customer should
reasonably be
[[Page 21606]]
expected to be on notice of the prior disclosure; if not, the broker-
dealer generally should not rely on such disclosure.
The Commission preliminarily believes this flexible approach to
disclosure is consistent with the broker-dealers' liabilities or
obligations under the antifraud provisions of the federal securities
laws.\218\
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\218\ For example, generally, under the antifraud provisions,
whether a broker-dealer has a duty to disclose material information
to its customer depends 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.''). Where a
broker-dealer processes its customer's orders, but does not
recommend securities or solicit customers, then the material
information that the broker-dealer is required to disclose to its
customer is narrow, encompassing only the information related to the
consummation of the transaction. See Press v. Chemical Inv. Servs.
Corp., 166 F.3d 529, 536 (2d Cir. 1999). In such circumstances, the
broker-dealer generally does not have to provide information
regarding the security or the broker-dealer's economic self-interest
in the security. See, e.g., Carras v. Burns, 516 F.2d 251, 257 (4th
Cir. 1975) (broker-dealer not required to volunteer advice where
``acting only as a broker''); Canizaro v. Kohlmeyer & Co., 370 F.
Supp. 282, 289 (E.D. La. 1974), aff'd, 512 F.2d 484 (5th Cir. 1975)
(broker-dealer that ``merely received and executed a purchase order,
has a minimal duty, if any at all, to investigate the purchase and
disclose material facts to a customer''); Walston & Co. v. Miller,
410 P.2d 658, 661 (Ariz. 1966) (``The agency relationship between
customer and broker normally terminates with the execution of the
order because the broker's duties, unlike those of an investment
advisor or those of a manager of a discretionary account, are only
to fulfill the mechanical, ministerial requirements of the purchase
and sale of the security or future contract on the market.'').
See also Exchange Act Rule 10b-10 (``Rule 10b-10''). Rule 10b-10
requires a broker-dealer effecting customer transactions in
securities (other than U.S. savings bonds or municipal securities)
to provide written notification to the customer, at or before
completion of the transaction, disclosing information specific to
the transaction, including whether the broker-dealer is acting as
agent or principal and its compensation, as well as any third-party
remuneration it has received or will receive. Exchange Act Rules
15c1-5 and 15c1-6 also require a broker-dealer to disclose in
writing to the customer if it has any control, affiliation, or
interest in a security it is offering or the issuer of such
security. The Commission and the SROs have also adopted rules
designed to address conflicts of interest that can arise when
security analysts recommend equity securities in research reports
and public appearances. See Regulation Analyst Certification, or
Regulation AC. Regulation AC requires that broker-dealers include
certifications by the research analyst in research reports and
disclose whether or not the research analyst received compensation
or other payments in connection with his or her specific
recommendations or reviews. See also FINRA Rule 2241 (imposing
requirements on FINRA members to address conflicts of interest
relating to the publication and distribution of equity research
reports).
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d. Consistency With Other Approaches
We believe that the proposed Disclosure Obligation, in conjunction
with the Relationship Summary and Regulatory Status Disclosure noted
above is consistent with many of the principles underlying the
disclosure recommendation regarding disclosure in the 913 Study and
behind the disclosure obligations of the BIC Exemption--which we
believe is to facilitate disclosure and retail customer understanding
of the key information material to a retail customer's relationship
with a broker-dealer, including the scope and terms of the relationship
and material conflicts of interest --and provides much of the same
information, but in a less prescriptive manner that is designed to
provide firms flexibility in how to satisfy the obligation.
Specifically, broker-dealers relying on the BIC Exemption to
provide investment advice to retirement accounts would need to do so
pursuant to a written contract that includes specific language and
disclosures, including, among others, provisions: Acknowledging
fiduciary status; committing the firm and the adviser to adhere to
standards of impartial conduct; and warranting the adoption of policies
and procedures reasonably designed to ensure that advisers provide best
interest advice and minimize the harmful impact of conflicts of
interest. The firm would also need to disclose information on the
firm's and advisers' conflicts of interest and the cost of their advice
and provide certain ongoing web disclosures.\219\
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\219\ See BIC Exemption.
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As previously noted, the 913 Study recommended that the Commission
engage in rulemaking and/or issue interpretive guidance on the
components of the recommended uniform fiduciary standard: The duties of
loyalty and care.\220\ With respect to disclosure obligations under the
Duty of Loyalty, the 913 Study recommended the Commission facilitate
the provision of uniform, simple, and clear disclosures to retail
customers about the terms of the relationships with broker-dealers and
investment advisers, including any material conflicts of interest. The
913 Study also recommended that the Commission consider disclosures
that should be provided (a) in a general relationship guide akin to
Form ADV Part 2A and (b) more specific disclosures at the time of
providing investment advice, as well as consider the utility and
feasibility of a summary disclosure document containing key information
on a firm's services, fees, and conflicts and the scope of its
services. Finally, the 913 Study recommended the Commission 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.\221\
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\220\ See 913 Study at 112.
\221\ See 913 Study at 114-18.
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We believe that our proposed Disclosure Obligation, in conjunction
with the Relationship Summary and Regulatory Status Disclosure noted
above, would address many of the underlying concerns of and would
provide customers with substantially similar information as required
under the BIC Exemption and recommended in the 913 Study.
The Disclosure Obligation under Regulation Best Interest further
builds on and complements the Relationship Summary and Regulatory
Status Disclosure and together, these obligations would clarify the
capacity in which a firm or financial professional is acting, in an
effort to minimize investor confusion, and facilitate greater awareness
of key aspects of a relationship with a firm or financial professional
through a layered approach to disclosure.
e. Request for Comment on Proposed Disclosure Obligation
The Commission generally requests comment on the Disclosure
Obligation. In addition, the Commission requests comment on the
following specific issues:
Would the Disclosure Obligation cause a broker-dealer to
act in a manner that is consistent with what a retail customer would
reasonably expect from someone who is required to act in his or her
best interest? Why or why not?
Should the Commission require new disclosure, beyond that
which is currently required pursuant to common law, and Exchange Act
and SRO rules?
Should the Commission promulgate more specific disclosure
requirements such as written account disclosure akin to Form ADV Parts
2A and 2B?
Should the Commission require a specific type or amount of
disclosure? What criteria should determine or inform the type or amount
of disclosure?
Should the Commission explicitly require that the
disclosure be ``full and fair''? Why or why not?
Should the Commission require broker-dealers to
``reasonably disclose'' as proposed? Should the Commission provide
additional guidance as to how broker-dealers can meet that standard? If
so, what additional guidance would commenters recommend? Should the
[[Page 21607]]
Commission consider a different approach, such as a ``good faith''
exemption? Why or why not?
Do commenters believe that the Disclosure Obligation
requires disclosure of information that investors would not find
useful? If so, please specify what information and why.
Is there additional information that investors would find
useful? If so, please specify what information and why.
The Commission requests comment on existing broker-dealer
disclosure practices. Do broker-dealers currently provide disclosures
that could satisfy this requirement? If so, what types of disclosures
and when/how are they delivered? Do broker-dealers provide customer-
specific disclosures indicating what type of account is held and in
what capacity the firm is acting? If so, how are those disclosures made
(e.g., on account statements) and at what time(s)? How do broker-
dealers provide disclosures when making recommendations on the phone?
Do all broker-dealers provide such disclosures, or only some broker-
dealers? If only some, how many and under what circumstances? Are those
disclosures written and presented in a manner consistent with the
preliminary guidance on disclosure in this release? Please provide
examples.
Do broker-dealers currently provide more detailed
disclosures than contemplated to be required as part of the
Relationship Summary regarding the nature and scope of services
provided, as well as the legal obligations and duties that apply to
those services? If so, how and when is such disclosure provided (e.g.,
in the account agreement or other document)? Please provide examples.
To what extent do retail customers read and/or understand these
disclosures? How effective are these disclosures and how consistent are
they with the plain language and other principles of reasonable
disclosure described above? How would we ensure that any disclosures
are understood by retail investors?
Would the Relationship Summary achieve the goal of the
Disclosure Obligation of facilitating the retail customer's awareness
of 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 without the additional
Disclosure Obligation? Should the Commission consider permitting
broker-dealers to satisfy their obligations under this requirement
solely by delivering the proposed Relationship Summary? Do commenters
believe the Relationship Summary would ever fulfill the Disclosure
Obligation? When would it? When would it not?
The Commission has identified certain topics that would
generally be considered material facts relating to the scope and terms
of the relationships (i.e., capacity, fees and services). Do commenters
have examples of other information relating to scope and terms of the
relationship that should be highlighted by the Commission as likely to
be considered material facts that would need to be disclosed? If so,
please provide examples. Should the Commission provide further guidance
on such additional material facts? Should the Commission articulate
these specific material facts (e.g., capacity, fees and services) as
required disclosures in the rule text (e.g., by defining ``material
facts relating to the scope and terms of the relationship'')? Why or
why not?
Should the Commission require additional disclosures for
dual-registrants, as suggested above, because the Relationship Summary
and Regulatory Status Disclosure for dual-registrants would describe
both brokerage and advisory services/capacities?
Should the Commission articulate additional requirements
or guidance for a dual-registrant to satisfy the Disclosure Obligation?
If so, what additional requirements or guidance and why? Should dual-
registrants be required to disclose, in writing, each time they change
capacity?
The Commission proposes to provide flexibility to a
broker-dealer that is a dual-registrant to determine how to disclose
that it is acting in a broker-dealer capacity. How do commenters
anticipate that dual-registrants will meet this obligation?
Specifically, how do commenters expect dual-registrants to meet the
obligation to provide such disclosure ``prior to or at the time of'' a
recommendation in their capacity as a broker-dealer? Should a broker-
dealer be required to make a customer-specific or recommendation-
specific disclosure about the capacity in which it is acting? Should
that disclosure be made on a one-time or ongoing basis? Should the
Commission mandate the form or method of delivery of that disclosure?
For example, should the Commission require broker-dealers to include
the disclosure in account opening forms or periodic statements or in
other documents?
Does the guidance concerning additional more detailed
disclosures that broker-dealers should consider providing in
furtherance of layered disclosure cause confusion about the level of
disclosure firms are required to make in order to satisfy the
requirement to disclose the terms and scope of the relationship? If so,
how could the Commission clarify this guidance? Would the layered
disclosure approach cause confusion among retail customers?
The Commission requests comment on existing broker-dealer
practices concerning fee disclosures. What types of fee disclosures do
broker-dealers currently provide? Do broker-dealers currently provide
fee disclosures that could satisfy this requirement? If so, what types
of disclosures and when/how are they delivered? Do broker-dealers
provide customer-specific disclosures indicating what type of fees are
charged, how they are identified (e.g., on account statements?), and
when/if they change? Please provide examples.
Should the Commission mandate the form, specific content
or method for delivering fee disclosure? Why or why not? Do commenters
believe that disclosure of fees in a uniform manner would be beneficial
for investors? If so, what would be the preferred style of such
disclosure in order to facilitate investor comprehension of such fees?
The Commission preliminarily believes that broker-dealers
should be required to disclose, at a minimum, the types of fees that
are included in the Relationship Summary. Should the Commission provide
more clarity regarding what types of fees should be disclosed? Should
the Commission add a materiality threshold for fee disclosure?
Should the Commission mandate a comprehensive fee
schedule? Why or why not? If so, should the Commission mandate the
form, specific content or method of delivering the comprehensive fee
schedule?
Should broker-dealers be required to update fee
disclosures 30 days or another specified time period before they raise
fees or impose new fees? Should this requirement be limited to material
fees? How should such fees be defined?
Should broker-dealers be required to use specified terms
to describe certain material fees? If so, what should those specified
terms be?
As proposed, the rule only requires disclosure to retail
customers who receive recommendations. Should the Commission consider
requiring fee disclosure to all retail customers, including customers
in self-directed brokerage accounts? Why or why not?
Would self-directed customers benefit from more detailed
fee disclosure? If so, in what form should
[[Page 21608]]
the disclosure to self-directed customers be provided, and what should
be the scope of fee information provided?
Regarding timing of disclosure, the Commission
preliminarily believes that the disclosure should be made ``prior to or
at the time of'' the recommendation. Should the Commission consider a
different timing requirement? For example, should the Commission
require disclosure ``immediately prior to the recommendation''? Should
the Commission instead mandate the timing and frequency of certain
disclosures? If so, which disclosures should be subject to more
specific timing or updating requirements? For example, should the
Commission require annual delivery of certain disclosure, such as fee
disclosures? Why or why not?
Do commenters agree that in certain circumstances broker-
dealers should be permitted to provide an initial disclosure followed
by more specific disclosure after the recommendation? Why or why not?
Do commenters require more guidance on when this would be permitted? If
so, how could the Commission clarify this guidance?
Are there services, in addition to those provided as
examples, that should be considered material facts relating to the
scope of terms of the relationships? If so, please explain. Are there
specific types of services that broker-dealers provide that should be
required to be disclosed? If so, which ones?
Should the Commission require specific disclosures on
products and product limitations? Why or why not?
Should broker-dealers be subject to more specific
requirements concerning the method of disclosures? If so, what
additional requirements should the Commission consider, and why? If
not, why not? For example, should the Commission impose requirements
concerning prominence or method of delivery?
Do commenters believe that all disclosures should be made
in writing, as proposed? Should the Commission permit disclosures to be
made orally, so long as a written record of the oral disclosure is made
and retained?
Should the Commission require that certain disclosures be
made prior to the execution of a transaction? If so, which ones? Why or
why not?
Should broker-dealers be required to make certain
disclosures before the first recommendation or transaction effected for
a customer? If so, which ones? Why or why not?
Are there any specific interactions or relationships
between the disclosure requirements under the Disclosure Obligation and
the Relationship Summary that should be addressed?
Are there any specific interactions or relationships
between the disclosure requirements under the Disclosure Obligation and
the Conflict of Interest Obligations that should be addressed?
Are there any specific interactions or relationships
between the disclosure requirements in Regulation Best Interest and the
existing general antifraud provisions that should be addressed? Do
commenters believe the general antifraud provisions adequately address
other non-recommendation related conflicts or should Regulation Best
Interest also cover such conflicts?
The Commission requests comment on the proposed requirement to
disclose all material conflicts of interest associated with the
recommendation.
Should the Commission require such disclosures?
Should the Commission use a different interpretation for
what is a ``material conflict of interest''? If so, which one and why?
Should the Commission define ``material conflicts of
interest'' in terms of an incentive that causes a broker-dealer not to
act in the retail customer's best interest? Why or why not?
Are there any types of material conflicts that commenters
believe the Commission should require to be disclosed? If so, which
ones and why?
Are there any material conflicts of interest that
commenters believe cannot be disclosed sufficiently in writing? If so,
which conflicts and why?
Should the Commission require a specific type or amount of
disclosure? What criteria should determine or inform the type or amount
of disclosure?
Should the disclosure requirements include quantification
of conflicts of interest, the economic benefits from material conflicts
of interest to firms and their associated persons, or the costs of such
conflicts to retail customers or clients?
Given the number of dually-registered representatives,
would the existence of written disclosure in Form ADV Part 2B,
including disclosure about financial incentives such as conflicts from
compensation received in association with a broker-dealer, in the
absence of comparable written disclosure expressly relating to other
conflicts that may affect the same representative's recommendations in
a broker-dealer capacity, create a misleading impression about the
representative's conflicts or their potential impact on advice in a
broker-dealer rather than an adviser capacity?
Are there particular material conflicts arising from
financial incentives or other material conflicts that the Commission
should specifically require a broker-dealer to disclose to a retail
customer? If so, which ones and why? If not, why not? Are there any for
which the Commission should specifically require advance customer
written consent? If so, which and why?
2. Care Obligation
The Commission proposes to require, as part of Regulation Best
Interest, a Care Obligation that would 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. These
proposed obligations would require a broker-dealer making a
recommendation of a securities transaction or investment strategy
involving securities to a retail customer to have a reasonable basis
for believing that the recommended transaction or investment strategy
is in the best interest of the retail customer and does not put the
financial or other interest of the broker-dealer before that of the
retail customer.\222\ The Care Obligation is intended to incorporate
and enhance existing suitability requirements applicable to broker-
[[Page 21609]]
dealers under the federal securities laws by, among other things,
imposing a ``best interest'' requirement which we would interpret to
require the broker-dealer not put its own interest ahead of the retail
customer's interest, when making recommendations.\223\
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\222\ Under Regulation Best Interest, as proposed, a broker-
dealer's duty to exercise reasonable diligence, care, skill and
prudence is designed to be similar to the standard of conduct that
has been imposed on broker-dealers found to be acting in a fiduciary
capacity. See, e.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith,
Inc., 906 F.2d 1206, 1215 (8th Cir. 1990) (the district court did
not abuse its discretion in instructing the jury that licensed
securities brokers were fiduciaries that owed their customers a duty
of utmost good faith, integrity and loyalty); see also Paine,
Webber, Jackson & Curtis, Inc. v. Adams, 718 P.2d 508, 515-16 (Colo.
1986) (evidence ``that a customer has placed trust and confidence in
the broker'' by giving practical control of account can be
``indicative of the existence of a fiduciary relationship''); SEC v.
Ridenour, 913 F.2d. 515 (8th Cir. 1990) (bond dealer owed fiduciary
duty to customers with whom he had established a relationship of
trust and confidence).
\223\ In response to Chairman Clayton's Statement, several
commenters supporting a best interest standard for broker-dealers
suggested that the best interest standard be built upon existing
broker-dealer requirements, such as suitability, and include
enhancements to those standards as the Commission sees necessary.
See, e.g., SIFMA 2017 Letter, John Hancock Letter; Fidelity Letter;
Wells Fargo Letter; ICI August 2017 Letter. See also supra Section
II.B.
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Although the term ``prudence'' is not a term frequently used in the
federal securities laws,\224\ the Commission believes that this term
conveys the fundamental importance of conducting a proper evaluation of
any securities recommendation in accordance with an objective standard
of care. However, recognizing that the term ``prudence'' is generally
not used under the federal securities laws, we also seek comment below
on whether there is adequate clarity and understanding regarding its
usage, or whether other terms are more appropriate in the context of
broker-dealer regulation.
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\224\ But see SEC v. Glt Dain Rauscher, Inc., 254 F.3d 852, 853
(9th Cir. 2001) (where, in the context of an underwriter of
municipal offerings who allegedly violated several federal
securities laws, the court held ``that the industry standard of care
for an underwriter of municipal offerings is one of reasonable
prudence, for which the industry standard is one factor to be
considered, but is not the determinative factor''). In addition,
under Section 11(c) of the Securities Act [15 U.S.C. 77k(c)], the
adequacy of an underwriter's due diligence efforts and, in turn, its
ability to establish a due diligence defense is determined by ``the
standard of reasonableness [that] shall be that required of a
prudent man in the management of his own property'' (emphasis
added).
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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. 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.\225\ Nor does Regulation Best Interest
prohibit, among others, recommendations from a limited range of
products, or recommendations of proprietary products, products of
affiliates, or principal transactions, provided the Care Obligation is
satisfied and the associated conflicts are disclosed (and mitigated, as
applicable) or eliminated, as discussed in Sections II.B. and II.D.2.
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\225\ See supra Section II.B.
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a. Understand the Potential Risks and Rewards of the Recommended
Transaction or Strategy, and Have a Reasonable Basis To Believe That
the Recommendation Could Be in the Best Interest of at Least Some
Retail Customers
Broker-dealers must deal with their customers fairly \226\--and, as
part of that obligation, have a reasonable basis for any
recommendation.\227\ This obligation stems from the broker-dealer's
``special relationship'' to the retail customer, and from the fact that
in recommending a security or investment strategy, the broker-dealer
represents to the customer ``that a reasonable investigation has been
made and that [its] recommendation rests on the conclusions based on
such investigation.'' \228\
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\226\ See, e.g., Duker & Duker, Exchange Act Release No. 2350,
at *2, 6 SEC. 386, 388 (Dec. 19, 1939) (Commission opinion)
(``Inherent in the relationship between a dealer and his customer is
the vital representation that the customer be dealt with fairly, and
in accordance with the standards of the profession.''). See also
Report of the Special Study of Securities Markets of the Securities
and Exchange Commission, H. Doc. 95, 88th Cong., 1st Sess., at 238
(1963) (``An obligation of fair dealing, based upon the general
antifraud provisions of the Federal securities laws, rests upon the
theory that even a dealer at arm's length impliedly represents when
he hangs out his shingle that he will deal fairly with the
public.'').
\227\ See Mac Robbins & Co., Exchange Act Release No. 6846, at
*3 (``[T]he making of representations to prospective purchasers
without a reasonable basis, couched in terms of either opinion or
fact and designed to induce purchases, is contrary to the basic
obligation of fair dealing borne by those who engage in the sale of
securities to the public.''), aff'd sub nom., Berko v. SEC, 316 F.2d
137 (2d Cir. 1963).
\228\ See Hanly, 415 F.2d 596-97 (``A securities dealer occupies
a special relationship to a buyer of securities in that by his
position he implicitly represents that he has an adequate and
reasonable basis for the opinions he renders.''); In the Matter of
Lester Kuznetz, 1986 WL 625417 at *3, Exchange Act Rel. No. 23525
(Aug. 12, 1986) (Commission opinion) (``When a securities salesman
recommends securities, he is under a duty to ensure that his
representations have a reasonable basis.''); see also FINRA
Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct
Reasonable Investigations in Regulation D Offerings (Apr. 2010).
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Paragraph (a)(2)(ii)(A) of proposed Regulation Best Interest, which
is intended to incorporate a broker-dealer's existing obligations under
``reasonable-basis suitability,'' \229\ would require a broker-dealer
to ``exercise reasonable diligence, care, skill, and prudence to . . .
[u]nderstand 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.'' \230\ This obligation would relate to the particular
security or strategy recommended, rather than to any particular retail
customer.\231\ Without establishing such a threshold understanding of
its particular recommendation, we do not believe that a broker-dealer
could, as required by Regulation Best Interest, act in the best
interest of a retail customer when making a recommendation.
---------------------------------------------------------------------------
\229\ The courts, the Commission, and FINRA have interpreted the
broker-dealer's existing reasonable-basis suitability obligation to
impose a broad affirmative duty to have an ``adequate and reasonable
basis'' for any recommendation that they make. See, e.g., Hanly, 415
F.2d 597; see also SEC v. Hasho, 784 F. Supp. 1059, 1107 (S.D.N.Y.
1992) (``By making a recommendation, a securities dealer implicitly
represents to a buyer of securities that he has an adequate basis
for the recommendation.''); Michael Frederick Siegel, Exchange Act
Rel. No. 58737, at *12-13 (Oct. 6, 2008) (Commission opinion) (``The
suitability rule . . . requires that . . . a registered
representative must first have an `adequate and reasonable basis'
for believing that the recommendation could be suitable for at least
some customers.''); Terry Wayne White, Exchange Act Rel. No. 27895,
at *4, 50 SEC. 211, 212 & n.4 (1990) (Commission opinion) (``It is
well established that a broker cannot recommend any security to a
customer `unless there is an adequate and reasonable basis for such
recommendation. . . .'').
\230\ Reasonable-basis suitability ``requires that a
representative ensure that he or she has an `adequate and
reasonable' understanding of an investment before recommending it to
customers.'' Richard G. Cody, Exchange Act Release No. 64565, at *12
(May 27, 2011) (Commission opinion, sustaining FINRA findings)
(citing Hanly, 415 F.2d at 597).
This understanding must include the `` `potential risks and
rewards' and potential consequences of such recommendation.'' See
Richard G. Cody, Exchange Act Release No. 64565, at *12 (May 27,
2011) (Commission opinion, sustaining FINRA findings) (internal
citations omitted), aff'd, Cody v. SEC, 693 F.3d 251 (1st Cir.
2012); F.J. Kaufman and Co. of Virginia and Frederick J. Kaufman,
Jr., Exchange Act Release No. 27535, at *3, 50 SEC. 164 (Dec. 13,
1989) (Commission opinion, sustaining NASD findings) (``[A] broker
cannot determine whether a recommendation is suitable for a specific
customer unless the broker understands the potential risks and
rewards inherent in that recommendation.''). See also FINRA
Regulatory Notice 11-02 (Jan. 2011).
\231\ See Michael Frederick Siegel, Exchange Act Release No.
58737, at *12-13 (Oct. 6, 2008) (Commission opinion, sustaining NASD
findings), aff'd in relevant part, Siegel v. SEC, 592 F.3d 147 (D.C.
Cir. 2010), cert. denied, 560 U.S. 926 (2010).
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To meet this proposed requirement under paragraph (a)(2)(ii)(A), a
broker-dealer would need to: (1) Undertake reasonable diligence (i.e.,
reasonable investigation and inquiry) to understand the potential risks
and rewards of the recommended security or strategy (i.e., to
understand the security or strategy), and (2) have a reasonable basis
to believe that the recommendation could be in the best interest of at
least some retail customers based on that
[[Page 21610]]
understanding.\232\ A broker-dealer must adhere to both components to
meet its obligation under proposed paragraph (a)(2)(ii)(A).\233\ Thus,
a broker-dealer could violate the obligation if he or she did not
understand the potential risks and rewards of the recommended security
or investment strategy, even if the security or investment strategy
could have been in the best interest for at least some retail
customers.\234\ In addition, if a broker-dealer understands the
recommended security or investment strategy, he or she 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.\235\
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\232\ See paragraph (a)(2)(ii)(A) of Proposed Regulation Best
Interest; see also Cody v. SEC, 693 F.3d 251, 259 (1st Cir. 2012)
(finding that registered representative was responsible for
investigating security that he recommended and failed to have
sufficient understanding of security); F.J. Kaufman, Exchange Act
Release No. 27535, at *3 (``A broker-dealer in his dealings with
customers impliedly represents that his opinions and predictions
respecting a [security] which he has undertaken to recommend are
responsibly made on the basis of actual knowledge and careful
consideration . . . .''); see also FINRA Regulatory Notice 12-25 at
Q22.
\233\ See FINRA Rule 2110.05(a). See also FINRA Regulatory
Notice 12-25 at Q22 (the ``reasonable-basis obligation has two
components: A broker must (1) perform reasonable diligence to
understand the nature of the recommended security or investment
strategy involving a security or securities, as well as the
potential risks and rewards, and (2) determine whether the
recommendation is suitable for at least some investors based on that
understanding''). In discussing SRO suitability rules, the
Commission has noted that ``the `reasonable-basis' test is subsumed
within the [NASD's] suitability rule. A broker cannot conclude that
a recommendation is suitable for a particular customer unless he has
a reasonable basis for believing that the recommendation could be
suitable for at least some customers.'' Terry Wayne White, Exchange
Act Release No. 27895, at *2, 50 SEC. 211, 212-13 (Apr. 11, 1990)
(Commission opinion, sustaining NASD findings) (citing F.J. Kaufman,
Exchange Act Release No. 27535).
\234\ See FINRA Regulatory Notice 12-25 at Q22 (noting that 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. Brokers cannot
fulfill their suitability responsibilities to customers (including
both their reasonable-basis and customer-specific obligations) when
they fail to understand the securities and investment strategies
they recommend. . . .''). Broker-dealers also have additional
specific suitability obligations with respect to certain types of
products or transactions, such as variable insurance products and
non-traditional products, including structured products and security
futures. See, e.g., FINRA Rule 2330, ``Members' Responsibilities
Regarding Deferred Variable Annuities;'' FINRA Rule 2370, ``Security
Futures;'' see also 913 Study at 65-66.
\235\ See FINRA Regulatory Notice 12-25 at Q22.
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In general, what would constitute reasonable diligence under
proposed 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.\236\ For example,
the cost associated with a recommendation is ordinarily only one of
many factors to consider when evaluating the risks and rewards of a
subject security or investment strategy involving securities. Other
factors may include, but are not limited to, the investment objectives,
characteristics (including any special or unusual features), liquidity,
risks and potential benefits, volatility, and likely performance 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.
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\236\ See FINRA Rule 2111.05(a).
---------------------------------------------------------------------------
While every inquiry will be specific to the broker-dealer and the
investment or investment strategy, broker-dealers may wish to consider
questions such as:
Can less costly, complex, or risky products available at
the broker-dealer achieve the objectives of the product?
What assumptions underlie the product, and how sound are
they? What market or performance factors determine the investor's
return?
What are the risks specific to retail customers? If the
product was designed mainly to generate yield, does the yield justify
the risk to principal?
What costs and fees for the retail customer are associated
with this product? Why are they appropriate? Are all of the costs and
fees transparent? How do they compare with comparable products offered
by the firm?
What financial incentives are associated with the product,
and how will costs, fees, and compensation relating to the product
impact an investor's return?
Does the product present any novel legal, tax, market,
investment, or credit risks?
How liquid is the product? Is there a secondary market for
the product? \237\
---------------------------------------------------------------------------
\237\ See NASD Notice to Members 05-26, New Products--NASD
Recommends Best Practices for Reviewing New Products (Apr. 2005).
---------------------------------------------------------------------------
This list of questions is not meant to be comprehensive, nor should
it substitute for a broker-dealer's own assessment of what factors
should be considered to determine the risks and rewards of a particular
investment or investment strategy. However, it is meant to illustrate
the types of questions and considerations a broker-dealer generally
should consider when developing an understanding of the potential risks
and rewards associated with a recommendation, and when developing a
reasonable basis to believe that the recommended investment or
investment strategy could be in the best interest of at least some
retail customers.\238\ If a broker-dealer cannot establish such a
fundamental understanding of its recommendation (i.e., the risks and
rewards associated with the recommendation, or that the recommendation
could be in the best interest of at least some retail customers), we do
not believe that the broker-dealer could establish that it is acting in
a retail customer's best interest when making a recommendation in
accordance with proposed paragraph (a)(2)(ii)(B) of Regulation Best
Interest.
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\238\ See supra note 233.
---------------------------------------------------------------------------
b. Reasonable Basis To Believe the Recommendation Is in the Best
Interest of a Particular Retail Customer
Beyond establishing an understanding of the recommended securities
transaction or investment strategy, we believe that acting in the best
interest of the retail customer would require a broker-dealer 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 proposed
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)(B), the second 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.'' 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, as discussed in Section II.B.
For the reasons set forth below, this proposed obligation is
intended to incorporate a broker-dealer's existing well-established
obligations under ``customer-specific suitability,'' \239\ but
[[Page 21611]]
enhances 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. After
extensive consideration of these existing customer-specific suitability
requirements, we believe that it is appropriate to generally draw and
build upon this existing obligation, as noted below, as the contours of
the obligation are well-defined, and this approach would promote
consistency and clarity in the relevant obligations, and facilitate the
development of compliance policies and procedures for broker-dealers
while also promoting investor protection.
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\239\ See, e.g., J. Stephen Stout, Exchange Act Release No.
43410, at *11, 54 SEC. 888, 909 (Oct. 4, 2000) (Commission opinion)
(``As part of a broker's basic obligation to deal fairly with
customers, a broker's recommendation must be suitable for the client
in light of the client's investment objectives, as determined by the
client's financial situation and needs.''); Richard N. Cea, Exchange
Act Release No. 8662, at *7 (Aug. 6, 1969) (Commission opinion)
(``It was incumbent on the salesmen in these circumstances, as part
of their basic obligation to deal fairly with the investing public,
to make only such recommendations as they had reasonable grounds to
believe met the customers' expressed needs and objectives.''). Both
courts and the Commission have found broker-dealers or their
registered representatives liable for making unsuitable
recommendations based on violations of the antifraud provisions of
the federal securities laws. See Brown v. E.F. Hutton Group, 991
F.2d 1020, 1031 (2d Cir. 1993) (``[a]nalytically, an unsuitability
claim is a subset of the ordinary Section 10(b) fraud claim'');
O'Connor v. R.F. Lafferty & Co., 965 F.2d 893 (10th Cir. 1992);
Clark v. John Lamula Investors, Inc., 583 F.2d 594, 599-600 (2d Cir.
1978); Steven E. Louros v. Kreicas, 367 F. Supp. 2d 572, 585
(S.D.N.Y. 2005); Mauriber v. Shearson/American Express, Inc., 567 F.
Supp. 1231 (S.D.N.Y 1983); Steven E. Muth and Richard J. Rouse,
Exchange Act Release No. 52551, 58 SEC. 770 (Oct. 3, 2005)
(Commission opinion). FINRA's suitability rule also imposes a
customer-specific suitability obligation on broker-dealers. See
FINRA Rule 2111.05(b) (``The customer-specific obligation requires
that a member or associated person have a reasonable basis to
believe that the recommendation is suitable for a particular
customer based on that customer's investment profile, as delineated
in Rule 2111(a).'').
---------------------------------------------------------------------------
Thus, under proposed Regulation Best Interest, the broker-dealer
will be required to have a reasonable basis to believe, based on its
diligence and understanding of the risks and rewards of the
recommendation, and in light of the retail customer's investment
profile, that the recommendation is in the best interest of the retail
customer and does not place the broker-dealer's interest ahead of the
customer's interest. We believe this will enhance the quality of
recommendations, and will improve investor protection by minimizing the
potential harmful impacts that broker-dealer conflicts of interest may
have on recommendations provided to retail customers.
As described above, the broker-dealer's diligence and understanding
of the risks and rewards would generally involve consideration of
factors, such as the costs, the investment objectives and
characteristics associated with a product or strategy (including any
special or unusual features, liquidity, risks and potential benefits,
volatility and likely performance in a variety of market and economic
conditions), as well as the financial and other benefits to the broker-
dealer.\240\ Thus, in forming a reasonable basis to believe that the
recommended securities transaction or investment strategy is in the
best interest of a particular retail customer, and does not place the
financial or other interest of the broker-dealer ahead of the interest
of the retail customer, the broker-dealer would generally need to
consider these specific product or strategy related factors, as
relevant--and in particular the financial and other benefits to the
broker-dealer--along with the customer's investment profile (as
described below). While the Commission believes these are all important
considerations in analyzing any recommendation made by a broker-dealer,
they are critical considerations in analyzing whether a recommendation
with respect to a particular retail customer's ``best interest.''
---------------------------------------------------------------------------
\240\ See supra Section II.D.2.a (providing examples of various
factors that could be considered when evaluating the risks and
rewards of a recommended investment or investment strategy).
---------------------------------------------------------------------------
Under the existing ``customer specific suitability'' obligation, to
determine whether an investment recommendation is suitable for the
customer when evaluated in terms of the investor's financial situation,
tolerance for risk, and investment objectives, broker-dealers have a
duty to seek to obtain relevant information from customers relating to
their financial situations and to keep such information current.\241\
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\241\ See Gerald M. Greenberg, Exchange Act Release No. 6320, at
*3, 40 SEC. 133, 137-38 (July 21, 1960) (Commission opinion,
sustaining NASD findings) (holding that a broker-dealer cannot avoid
the duty to make suitable recommendations simply by avoiding
knowledge of the customer's financial situation). Under FINRA's
suitability rule, the broker-dealer has a duty to undertake
reasonable diligence to ascertain the customer's investment profile.
FINRA Rule 2111(a) (``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.''); FINRA Regulatory Notice 12-25 at Q15-Q21
(discussing broker-dealer's information-gathering requirements).
---------------------------------------------------------------------------
The Commission also proposes to include this concept of a
``customer's investment profile,'' consistent with FINRA's suitability
rule.\242\ Specifically, the proposed rule would provide that the
``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.'' \243\ A broker-dealer would be
required to exercise ``reasonable diligence'' to ascertain the retail
customer's investment profile as part of satisfying proposed paragraph
(a)(2)(i)(B).\244\ When retail customer information is unavailable
despite a broker-dealer's reasonable diligence to obtain such
information, a broker-dealer would have to consider whether it has
sufficient understanding of the retail customer to properly evaluate
whether the recommendation is in the retail customer's best
interest.\245\ A broker-dealer that makes 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 the retail customer's investment profile
would not meet its obligations under the proposed rule.\246\
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\242\ Id.
\243\ See paragraph (c)(2) of Proposed Regulation Best Interest.
\244\ See FINRA Regulatory Notice 12-25 at Q16 (outlining what
constitutes ``reasonable diligence'' in attempting to obtain
customer-specific information and that the reasonableness of the
effort also will depend on the facts and circumstances). See also
FINRA Regulatory Notice 11-25, Know Your Customer and Suitability
(May 2011) (``FINRA Regulatory Notice 11-25'').
\245\ See FINRA Regulatory Notice 11-25 at Q3. While ``neglect,
refusal, or inability of the retail customer to provide or update
any information'' would excuse the broker, dealer, or associated
person from obtaining the information under proposed Rule 17a-
3(a)(25) discussed in Section II.E., it would not relieve a broker-
dealer of its obligation to determine whether it has sufficient
information to properly evaluate whether a recommendation is in the
retail customer's best interest.
\246\ See FINRA Regulatory Notice 12-25 at Q16 (outlining what
constitutes ``reasonable diligence'' in attempting to obtain
customer-specific information and that the reasonableness of the
effort also will depend on the facts and circumstances).
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For clarification, in keeping with the requirement that a
securities-related recommendation must be in the best interest of the
customer at the time it is made, 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--i.e., where a broker-dealer knows or has
reason to believe that the customer's investment profile has
changed.\247\ The reasonableness of a
[[Page 21612]]
broker-dealer's effort 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.\248\
Generally, however, absent information that would cause a broker-dealer
to know or have reason to know that the information contained in a
customer's investment profile is inaccurate, a broker-dealer may
reasonably rely on the information in an existing customer's investment
profile.
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\247\ We note that, pursuant to Exchange Act rules, a broker-
dealer must submit to an existing customer his or her account record
or alternative document to explain any terms regarding investment
objectives for accounts in which the member, broker or dealer has
been required to make a suitability determination within the past 36
months. The account record or alternative document must include or
be accompanied by prominent statements on which the customer should
mark any corrections and return the account record or alternate
document to the broker-dealer, and the customer should notify the
broker-dealer of any future changes to information contained in the
account record--including the customer's investment objectives. See
CFR 240.17a-3(a)-17(i)(A), (B)(i), (B)(iii), (D). The accompanying
discussion in the text addresses circumstances where a broker-dealer
generally should make reasonable efforts to ascertain a customer's
investment profile information prior to this 36-month period.
\248\ See FINRA Regulatory Notice 12-25 at Q16.
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We believe our proposed definition of ``retail customer investment
profile'' identifies appropriate factors that should be considered as
part of evaluating a recommendation and whether it is in a retail
customer's best interest, because the factors generally are relevant to
a determination regarding whether a recommendation is in the best
interest of a particular customer (i.e., does the recommendation
comport with the retail customer's investment profile). Furthermore, by
applying a consistent definition across existing suitability
requirements and proposed Regulation Best Interest, we hope to provide
clarity to broker-dealers and maintain efficiencies for broker-dealers
that have already established infrastructures to comply with their
suitability obligations when making recommendations. Finally, we note
that this definition would be consistent with the factors the DOL
identified for consideration as part of a best interest recommendation
under the BIC Exemption: ``the investment objectives, risk tolerance,
financial circumstances and needs'' of a retirement investor.\249\
---------------------------------------------------------------------------
\249\ See Best Interest Contract Exemption, 81 FR 21002 (Apr. 8,
2016).
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We propose to interpret the customer-specific obligation in
paragraph (a)(2)(ii)(B) of proposed Regulation Best Interest consistent
with existing precedent, rules and guidance, but subject to the
enhanced ``best interest'' (rather than ``suitability'') standard.
Thus, as noted above, when considering the factors that comprise a
retail customer's investment profile, the broker-dealer would be
required to consider whether it has sufficient information regarding
the customer to properly evaluate whether a recommendation is in the
best interest of the retail customer without placing the financial or
other interest of the broker-dealer ahead of that particular retail
customer's interests.\250\ As such, the level of importance of each
factor would depend on the facts and circumstances of a particular
recommendation. 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 to believe that the factors are not relevant in light
of the facts and circumstances of a particular situation.\251\ For
example, a broker-dealer may conclude that liquidity needs are
irrelevant regarding all customers for whom only liquid securities will
be recommended.\252\
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\250\ See FINRA Rule 2111.04.
\251\ Id.
\252\ See FINRA Regulatory Notice 11-25 at Q3.
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We reiterate that we recognize that it may be consistent with a
retail customer's investment objectives--and in many cases, in a retail
customer's best interest--for a retail customer to allocate investments
across a variety of investment products, or to invest in riskier or
more costly products, such as some actively managed mutual funds,
variable annuities, and structured products. However, in recommending
such products, a broker-dealer must satisfy its obligations under
proposed Regulation Best Interest. Such recommendations would continue
to be evaluated under a fact specific analysis based on the security or
investment strategy recommended in connection with the retail
customer's investment profile, consistent with the proposed best
interest obligation.
In addition, as discussed above under the proposed obligation in
paragraph (a)(2)(ii)(A), we emphasize that the costs and financial
incentives associated with a recommendation would generally be one of
many important factors--including other factors such as 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--to consider when determining whether a recommended security
or investment strategy involving a security or securities is in the
best interest of the retail customer.\253\ Thus, where, for example, 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.\254\
Similarly, we believe it would be inconsistent with the Care Obligation
if the broker-dealer made the recommendation to a retail customer in
order to: Maximize the broker-dealer's compensation (e.g., commissions
or other fees); further the broker-dealer's business relationships;
satisfy firm sales quotas or other targets; or win a firm-sponsored
sales contest.
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\253\ See discussion supra Section II.D.
\254\ See supra note 106, and accompanying text.
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We preliminarily believe that, under this prong of 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. 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 above,
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--retail customer, in light of the retail customer's
investment profile.
Furthermore, we do not believe a broker-dealer could meet its Care
Obligation through disclosure alone. Thus, for example, where a broker-
dealer is choosing among identical securities with different cost
structures,
[[Page 21613]]
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 Obligations, as
the broker-dealer would not have complied with its Care
Obligation.\255\ 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.
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\255\ Id.
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c. Reasonable Basis To Believe a Series of Recommended Transactions Is
Not Excessive and Is in the Retail Customer's Best Interest
The third 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. The
proposed requirement is intended to incorporate and enhance a broker-
dealer's existing obligations under the federal securities laws and
incorporate and go beyond FINRA's concept of ``quantitative
suitability.'' We believe it is appropriate to incorporate this
existing, well-established obligation, which would similarly promote
consistency and clarity regarding this obligation. However, we believe
it is appropriate to expand the scope of this requirement by applying
it 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.'' Accordingly,
Regulation Best Interest would include the existing ``quantitative
suitability'' obligation, but without a ``control'' element.
Pursuant to the federal securities laws, broker-dealers can violate
the federal antifraud provisions by engaging in excessive trading \256\
that amounts to churning, switching, or unsuitable recommendations.
Churning occurs when a broker-dealer, exercising control over the
volume and frequency of trading in a customer account, abuses the
customer's confidence for the broker-dealer's personal gain by
initiating transactions that are excessive in view of the character of
the account and the customer's investment objectives.\257\ Switching
occurs when a broker-dealer induces a customer to liquidate his or her
shares in a mutual fund or annuity in order to purchase shares in
another mutual fund or annuity, for the purpose of increasing the
broker-dealer's compensation, where the benefit to the customer of the
switch is not justified by the cost of switching.\258\ The Commission
has also found excessive trading as a suitability violation on the
basis that ``the frequency of trading must also be suitable.'' \259\ As
noted above, FINRA's suitability rule also includes a similar concept
known as quantitative suitability.\260\
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\256\ Excessive trading is a level of trading unjustified in
light of the customer's investment objectives. See Mihara v. Dean
Witter & Co., Inc., 619 F.2d 814, 821 (9th Cir. 1980).
\257\ See Carras v. Burns, 516 F.2d 251, 258 (4th Cir. 1975).
The elements of a churning claim brought under the antifraud
provisions include: (1)Eexcessive trading in the account that was
unjustified in light of the customer's investment objectives; (2)
the broker-dealer exercised actual or de facto control over the
trading in the account; and (3) the broker-dealer acted with intent
to defraud or with willful or reckless disregard for the customer's
interests. See Rizek v. SEC, 215 F.3d 157, 162 (1st Cir. 2000). A
broker-dealer churning a customer account may be liable under both
Exchange Act Section 10(b) and Rule 10b-5 thereunder, and/or
Exchange Act Section 15(c), Rules 15c1-2 and/or 15cl-7. See, e.g.,
McNeal v. Paine, Webber, Jackson & Curtis, Inc., 598 F.2d 888, n.1
(2d Cir. 1979) (noting that churning is illegal under the Exchange
Act Sections 15(c)(1) and 10(b) and Rule 10b-5).
\258\ See, e.g., Russell L. Irish, 42 SEC. 735, 736-40 (1965),
aff'd, Irish v. SEC, 367 F.2d 637 (9th Cir. 1966), cert. denied, 386
U.S. 911 (1967).
\259\ Edgar B. Alacan, Exchange Act Release No. 49970, at *20,
57 SEC. 715, 736 (July 6, 2004) (Commission opinion) (quoting Sandra
K. Simpson and Daphne Ann Pattee, Exchange Act Release No. 45923, at
*13, 55 SEC. 766, 793-794 (May 14, 2002) (Commission opinion)). See
J. Stephen Stout, Exchange Act Release No. 43410, at *13, 54 SEC.
888, 912 (Oct. 4, 2000) (Commission opinion) (finding turnover in
customer account was unsuitable given customers' investment goals
and needs).
\260\ See FINRA Rule 2111.05(c) (``Quantitative suitability
requires a member or associated person who has actual or de facto
control over a customer account to have a reasonable basis for
believing that a series of recommended transactions, even if
suitable when viewed in isolation, are not excessive and unsuitable
for the customer when taken together in light of the customer's
investment profile, as delineated in Rule 2111(a).''). Unlike
churning, a violation of quantitative suitability does not require a
showing of wrongful intent. See Cody v. SEC, 693 F.3d 251, 260 (1st
Cir. 2012) (``[W]hile subjective intent is relevant to churning
charges under the antifraud regulation of Rule 10b-5, . . . NASD's
suitability rule is violated when a representative engages in
excessive trading relative to a customer's financial needs . . .
regardless of motivation . . . .'').
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Under the proposed rule, a broker-dealer must have a reasonable
basis to believe that a series of recommended transactions is not
excessive. Although no single test defines excessiveness, the following
factors may provide a basis for determining that a series of
recommended transactions is excessive: turnover rate,\261\ cost-to-
equity ratio,\262\ and use of in-and-out trading \263\ in a customer's
account. Consideration of turnover rate, cost-to-equity ratio and use
of in-and-out trading is consistent with some of the ways the
Commission, the courts, and FINRA have historically
[[Page 21614]]
evaluated whether trading activity is excessive.\264\ These factors can
be indicative of the magnitude of investor harm caused by the
accumulation of high trading costs.
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\261\ The turnover rate, which is the number of times during a
given period that securities in an account are replaced by new
securities, is a frequently used measure of excessive trading.
Turnover rate is calculated by ``dividing the aggregate amount of
purchases in an account by the average monthly investment. The
average monthly investment is the cumulative total of the net
investment in the account at the end of each month, exclusive of
loans, divided by the number of months under consideration.''
Shearson Lehman Hutton Inc., 49 SEC. 1119, 1122 n.10 (1989). Annual
turnover rates as low as three may trigger liability for excessive
trading. See, e.g., Laurie Jones Canady, 54 SEC. 65, 74 (1999),
Exchange Act Release No. 41250 (Apr. 5, 1999) (annual turnover rates
ranging from 3.83 to 7.28 times held excessive), petition denied,
230 F.3d 362 (DC Cir. 2000); Donald A. Roche, 53 SEC. 16, 22 (1997)
(annual turnover rates of 3.3, 4.6, and 7.2 times held excessive);
Gerald E. Donnelly, 52 SEC. 600, Exchange Act Release No. 36690
(Jan. 5, 1996) (annual turnover rates ranging from 3.1 to 3.8 times
held excessive); John M. Reynolds, 50 SEC. 805 (1991) (annual
turnover rate of 4.81 times held excessive). See also Dep't of
Enforcement v. Cody, No. 2005003188901, 2010 FINRA Discip. LEXIS 8
(NAC May 10, 2010) (same), aff'd, Exchange Act Rel. No. 64565, 2011
SEC LEXIS 1862, at *48 (May 27, 2011) (finding turnover rate of
three provided support for excessive trading); Dep't of Enforcement
v. Stein, No. C07000003, 2001 NASD Discip. LEXIS 38, at *17 (NAC
Dec. 3, 2001) (``Turnover rates between three and five have
triggered liability for excessive trading''). The Commission has
stated that, ``[a]lthough no turnover rate is universally recognized
as determinative of churning, a rate in excess of 6 is generally
presumed to reflect excessive trading,'' especially if the
customer's objective is conservative. Al Rizek, 54 SEC. 261 (1999),
Exchange Act Release No. 41725 (Aug. 11, 1999), aff'd, Rizek v.
SEC., 215 F.3d 157 (1st Cir. 2000). See also Craighead v. E.F.
Hutton & Co., 899 F.2d 485, 490 (6th Cir. 1990); Arceneaux v.
Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502
(11th Cir. 1985).
\262\ The cost-to-equity ratio represents ``the percentage of
return on the customer's average net equity needed to pay broker-
dealer commissions and other expenses.'' Rafael Pinchas, 54 SEC.
331, 340 (1999), 1999 SEC LEXIS 1754, at *18 (Commission review of
NASD disciplinary proceeding). Cost-to-equity ratios as low as 8.7
have been considered indicative of excessive trading, and ratios
above 12 generally are viewed as very strong evidence of excessive
trading. See Cody, 2011 SEC LEXIS 1862, at *49 & *55 (finding cost-
to-equity ratio of 8.7 percent excessive); Thomas F. Bandyk,
Exchange Act Rel. No. 35415, 1995 SEC LEXIS 481, at *2-3 (Feb. 24,
1995) (``His excessive trading yielded an annualized commission to
equity ratio ranging between 12.1% and 18.0%.'').
\263\ In-and-out trading refers to the ``sale of all or part of
a customer's portfolio, with the money reinvested in other
securities, followed by the sale of the newly acquired securities.''
Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir.
1983). A broker's use of in-and-out trading ordinarily is a strong
indicator of excessive trading. Id.
\264\ See also supra notes 256, 257, 259, 261, 262, 263. See,
e.g., FINRA Regulatory Notice 12-25 at 14, 28-29.
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The proposed rule would enhance a broker-dealer's existing
obligations in two ways. First, the proposed rule would create a new,
explicit obligation under the Exchange Act that a broker-dealer have a
reasonable basis to believe that a series of recommended transactions
is not excessive and is in the retail customer's best interest when
taken together. As noted, the Commission has found unsuitable
recommendations of a series of transactions on the basis that the
``frequency of trading'' was not suitable.\265\ Similarly, FINRA's
quantitative suitability rule requires the broker-dealer to have a
reasonable basis for believing that a series of recommended
transactions is not excessive and unsuitable for the customer when
taken together in light of the customer's investment profile.\266\ The
proposed rule, instead, would require a broker-dealer to have a
reasonable basis to believe that a series of recommended transactions
is not excessive and is in the retail customer's best interest when
taken together in light of the retail customer's investment profile.
What would constitute a ``series'' of recommended transactions would
depend on the facts and circumstances. Notably, here this would mean a
reasonable basis to believe that the series of recommended transactions
is in the best interest of the retail customer based on factors other
than the broker-dealer's financial incentive to recommend a series of
transactions, as discussed above, and in light of the retail customer's
investment profile, consistent with (a)(1).\267\
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\265\ See supra note 259.
\266\ See supra note 260.
\267\ See discussion supra Section II.D.
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Second, the proposed rule would require a broker-dealer to have a
reasonable basis to believe that a series of recommended transactions
is not excessive and is in the retail customer's best interest,
regardless of whether the broker-dealer has actual or de facto control
over a retail customer account. Currently, to prove a churning claim
under the antifraud provisions of the Exchange Act, courts and the
Commission have interpreted the federal securities laws to require that
the broker-dealer exercise actual or de facto control over a customer's
account.\268\ Similarly, FINRA's quantitative suitability rule only
applies to a member or associated person who has actual or de facto
control over a customer account.\269\
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\268\ See supra note 257.
\269\ See supra note 260.
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The Commission believes that a broker-dealer should 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, consistent with subparagraph(a)(1). We believe that
imposing this requirement without a ``control'' element would provide
consistency in the investor protections provided to retail customers by
this proposed paragraph (a)(2)(ii)(C) 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. Moreover, it would also take a consistent
approach with the other aspects of the proposed Care Obligation, which
apply regardless of whether a broker-dealer ``controls'' or exercises
``de facto control'' over the retail customer's account. Finally, by
removing the control element, the Commission believes the enhanced
requirement generally should expand the scope of retail customers that
could benefit from the protections of this requirement: specifically,
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.\270\ Thus, the fact that
a customer may have some knowledge of financial markets or some
``control'' should not absolve the broker-dealer of its ultimate
responsibility to have a reasonable basis for any recommendations that
it makes.\271\ We believe that when a broker-dealer is recommending a
series of transactions to the retail customer the broker-dealer must,
consistent with paragraph (a)(1), evaluate whether the series of
recommendations is placing the broker-dealer's interests ahead of the
retail customer's. Thus, even in instances where a broker-dealer would
not be considered to ``control'' or exercise ``de facto control'' over
the retail customer's account, the broker-dealer should be required to
comply with proposed paragraph (a)(2)(ii)(C).
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\270\ See, e.g., In re Michael Bresner, et al., 2013 WL 5960690,
at *112-115, ID-Rel. No. 517 (Nov. 8, 2013) (finding, inter alia,
that some registered representatives did not churn certain
customers' accounts because they did not exercise de facto control
where one customer had declined recommendations ``a handful of
times'' and another customer had picked stocks ``based on
information he may have heard on the radio'' and made shadow trades
of the same stocks that the representative had recommended).
\271\ See id.
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d. Consistency With Other Approaches
(1) DOL Fiduciary Rulemaking
By requiring a broker-dealer that is making a recommendation to a
retail customer to act in the retail customer's best interest without
placing the broker-dealer's interests ahead of the retail customer's
interest, which is satisfied (in part) by the broker-dealer exercising
``reasonable diligence, care, skill, and prudence,'' we believe the
proposed Care Obligation generally reflects similar underlying
principles as the ``objective standards of care'' that are incorporated
in the best interest Impartial Conduct Standard as set forth by the DOL
in the BIC Exemption.\272\
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\272\ The BIC Exemption requires that advice be in a retirement
investor's best interest, and further defines advice to be in the
``best interest'' if the person providing the advice acts ``with the
care, skill, prudence, and diligence under the circumstances then
prevailing that a prudent person acting in a like capacity and
familiar with the such matters would use . . . without regard to the
financial or other interests'' of the person. BIC Exemption Section
II(c)(1); Section VIII (d). The DOL stated this standard is based on
longstanding concepts derived from ERISA and the law of trusts, and
to ``require[s] fiduciaries to put the interests of trust
beneficiaries first, without regard to the fiduciaries' own self-
interest.'' BIC Exemption Release, 81 FR 21007, 21027.
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As noted above, the DOL stated that the best interest Impartial
Conduct Standard is intended to ``incorporate the objective standards
of care and undivided loyalty,'' that require adherence to a
professional standard of care in making investment recommendations that
are in the investor's best interest, and not basing recommendations on
the advice-giver's own financial interest in the transaction, nor
recommending an investment unless it meets the objective prudent person
standard of care.\273\ Proof of fraud or misrepresentation is not
required, and full disclosure is not a defense to making an imprudent
recommendation or favoring one's own interest at the investor's
expense.\274\
---------------------------------------------------------------------------
\273\ Id. at 21028.
\274\ Id.
---------------------------------------------------------------------------
Focusing on the ``professional standard of care'' or ``duty of
prudence,'' the DOL explains that the ``prudence'' standard, as
incorporated in the ``best interest'' standard set forth in the BIC
Exemption, is ``an objective standard of care that requires investment
advice fiduciaries to investigate and evaluate
[[Page 21615]]
investments, make recommendations, and exercise sound judgment in the
same way that knowledgeable and impartial professionals would.'' \275\
The fiduciary must adhere to an objective professional standard and is
subject to a particularly stringent standard of prudence when they have
a conflict of interest.\276\
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\275\ BIC Exemption Release, 81 FR at 21028.
\276\ Id.
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Our proposed Care Obligation establishes an objective, professional
standard of conduct for broker-dealers that requires broker-dealers to
``exercise reasonable diligence, care, skill and prudence to''
understand the potential risks and rewards associated with their
recommendation and have a reasonable basis to believe that it could be
in the best interest of at least some retail customers, have a
reasonable basis to believe that the recommendation is in a particular
retail customer's best interest based on that retail customer's
investment profile and the risks and rewards associated with the
recommendation, and 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. Moreover, as noted above, this
Care Obligation cannot be satisfied through full disclosure, and proof
of fraud or misrepresentation would also not be required.
In addition, the Commission believes that the incorporation and
enhancement of existing broker-dealer suitability obligations as part
of the proposed care obligation would address many of the concerns that
were raised by the DOL as a rationale for not referring to the existing
FINRA suitability standard as the basis for the best interest
obligation under the Impartial Conduct Standards.\277\ The proposed
Care Obligation incorporates and builds upon existing broker-dealer
suitability obligations, as discussed above. Again, while not the only
factors or sole determinants, cost and the broker-dealer's financial
incentives would be important factors--of many, including the financial
and other benefits to the broker-dealer--in determining whether a
recommendation is in the best interest.\278\ We preliminarily believe
that, in order to meet its Care Obligation, when a broker-dealer
recommends a security or investment strategy over another reasonably
available alternative offered by the broker-dealer, the broker-dealer
would need to have a reasonable belief that the recommendation was in
the best interest of the retail customer based on such other factors,
in light of the retail customer's investment profile. Furthermore, as
discussed in the Conflict of Interest Obligations below, proposed
Regulation Best Interest requires broker-dealers to take steps to
eliminate or mitigate material conflicts of interest arising from
financial incentives.
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\277\ Although DOL did not specifically incorporate the
suitability obligation as an element of the ``best interest''
standard, as suggested by FINRA, the DOL stated ``that many aspects
of suitability are also elements of the Best Interest Standard'' and
that a ``recommendation that is not suitable under the securities
laws would not'' meet the standard. But, the DOL identified the
following concerns with the current FINRA suitability standard: That
it does not ``reference a best interest standard, clearly require
brokers to put their client's interest ahead of their own, expressly
prohibit the selection of the least suitable (but most remunerative)
of available investments, or require them to take the kind of
measures to avoid or mitigate conflicts of interest that are
required as conditions of this exemption.'' BIC Exemption Release,
81 FR 21007, 21027-28.
\278\ See discussion infra Section II.D.
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(2) 913 Study
Further, we believe that the proposed Care Obligation is also
similar to the recommended duty of care in the 913 Study. As previously
noted, the 913 Study recommended that the Commission engage in
rulemaking and/or issue interpretive guidance on the components of the
recommended uniform fiduciary standard: the duties of loyalty and
care.\279\ With respect to the duty of care, the 913 Study recommended
that the Commission should consider specifying uniform standards for
the duty of care owed to retail investors, through rulemaking and/or
interpretive guidance. The 913 Study noted that minimum baseline
professionalism standards could include, for example, specifying what
basis a broker-dealer or investment adviser should have in making a
recommendation to an investor (i.e., suitability requirements).\280\
Further, the 913 Study suggested that the Commission could articulate
and harmonize any such professionalism standards for broker-dealers and
investment advisers, by referring to and expanding upon, as
appropriate, the explicit minimum standards of conduct relating to the
duty of care currently applicable to broker-dealers (e.g., suitability,
best execution, and fair pricing and compensation requirements).\281\
The 913 Study stated that the standards could also take into account
Advisers Act principles related to the duty of care.\282\
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\279\ See 913 Study at 112.
\280\ Id. at 123.
\281\ Id. at 122.
\282\ Id. at 123. See also Fiduciary Duty Interpretive Release,
discussing, among other things, investment advisers' duty of care.
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As part of the proposed care obligation under Regulation Best
Interest, we are only proposing an obligation with respect to the basis
a broker-dealer must have in making a recommendation to a retail
customer, and are not proposing the other aspects of the duty of care
that are specified in the 913 Study--notably best execution and fair
pricing and compensation requirements--as the Commission does not
believe that it is necessary to do so at this time. As noted in the 913
Study,\283\ broker-dealers currently are subject to explicit standards
of conduct relating to best execution \284\ and fair and reasonable
compensation,\285\ and preliminarily we do not believe that
enhancements to these obligations are required in connection with this
proposal.
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\283\ See 913 Study at 121.
\284\ Under the antifraud provisions of the federal securities
laws and SRO rules, broker-dealers also have a legal duty to seek to
obtain best execution of customer orders, which requires broker-
dealers to seek to execute customers' trades at the most favorable
terms reasonably available under the circumstances. See, e.g.,
Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d
266, 269-70 (3d Cir.), cert. denied, 525 U.S. 811 (1998); Certain
Market Making Activities on Nasdaq, Exchange Act Release No. 40900
(Jan. 11, 1999) (citing Sinclair v. SEC, 444 F.2d 399 (2d. Cir.
1971); Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18,
1948) (Commission Opinion), aff'd sub nom. Hughes v. SEC, 174 F.2d
969 (DC Cir. 1949). See also Order Execution Obligations, Exchange
Act Release No. 37619A (Sept. 6, 1996) (``Order Handling Rules
Release''). See also Regulation NMS, Exchange Act Release No. 51808
(June 9, 2005) (``Regulation NMS Release''); FINRA Rule 5310 (``Best
Execution and Interpositioning'').
\285\ FINRA Rule 2121 (``Fair Prices and Commissions'').
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Moreover, the 913 Study noted that the staff's recommendation to
specify these aspects of the duty of care was partly based on the need
to provide guidance to both investment advisers and broker-dealers of
their obligations under the recommended uniform fiduciary duty.\286\ In
particular, the Study recognized that ``detailed guidance'' regarding
the duty of care, and particularly the duty to provide suitable
investment advice ``has not been a traditional focus of the investment
adviser regulatory regime.'' \287\ In a concurrent release, we are
providing interpretive guidance that reaffirms--and in some cases
clarifies--certain aspects of the fiduciary duty that an investment
adviser owes to its
[[Page 21616]]
clients.\288\ As the proposed Regulation Best Interest is not based on
the Advisers Act and would not apply to investment advisers, but rather
is a new standard that would be unique to broker-dealers, taking into
consideration the existing requirements of the broker-dealer regulatory
regime, the Commission preliminarily does not believe that the Study's
recommendations related to these other obligations are relevant here.
---------------------------------------------------------------------------
\286\ See 913 Study at 122-23.
\287\ Id. at 123.
\288\ See Fiduciary Duty Interpretive Release.
---------------------------------------------------------------------------
Although we are not proposing a fiduciary duty that includes a duty
of care for broker-dealers, it is important to note that we believe
that the proposed care obligation under Regulation Best Interest, in
combination with existing broker-dealer obligations (such as best
execution), is generally consistent with the underlying principles of--
albeit more prescriptive than-- the duty of care enforced under the
Advisers Act. We believe any differences in the articulation of these
standards for broker-dealers, as compared to investment advisers, is
appropriate given differences in the structure and characteristics of
their relationships with retail customers, to preserve and incorporate
existing guidance and interpretations related to broker-dealer
suitability obligations, and to provide clarity to how Regulation Best
Interest would change existing obligations.
e. Request for Comment on Proposed Care Obligation
The Commission requests comment generally on the proposed care
obligation. In addition, the Commission seeks comment on the following
specific issues:
Would the Care Obligation cause a broker-dealer to act in
a manner that is consistent with what a retail customer would
reasonably expect from someone who is required to act in their best
interest? Why or why not?
Under the Care Obligation, a broker-dealer must exercise
reasonable diligence, care, skill, and prudence when making a
recommendation, including assessing the potential risks and rewards
associated with the recommendation. Do commenters believe that
Regulation Best Interest is sufficiently clear that a broker-dealer and
its associated natural persons may make a recommendation which may
result in investor losses due to market or other risks inherent in
investing?
Has the Commission provided sufficient guidance on how a
broker-dealer can satisfy each component of the Care Obligation?
Do commenters believe the proposed Care Obligation
enhances broker-dealers' existing suitability obligations?
Are there aspects of a broker-dealer's existing
suitability obligations that the Commission should not incorporate? Are
there additional obligations that the Commission should incorporate? If
so, which ones and why?
As noted, the Commission is not proposing additional
aspects of the duty of care that are specified in the 913 Study--
notably best execution and fair pricing and compensation requirements,
as broker-dealers are currently subject to explicit standards of
conduct relating to best execution and fair and reasonable
compensation. Do commenters agree that enhancements to these
obligations are not required at this time? If not, please explain why.
Is there sufficient clarity regarding how a broker-dealer
``exercises reasonable diligence, care, skill, and prudence''? In
addition, is ``prudence'' a sufficiently clear term when referring to
the broker-dealer's Care Obligation? Should the Commission consider
another formulation for this obligation? If so, what language would be
clearer?
Is there sufficient clarity regarding how a broker-dealer
determines if it has a reasonable basis to believe that the
recommendation in the best interest of ``some'' retail customers in
paragraph (a)(2)(ii)(A)? Why or why not? Should the rule expressly
require a broker-dealer or associated person, in formulating this
belief, to take into account all benefits to the broker-dealer or
associated person from the recommendation and the costs to a
hypothetical retail customer? Should the Commission require that a
broker-dealer have a reasonable basis to believe that a recommendation
is appropriate for the category of retail customers to which the retail
customer belongs?
Is there sufficient clarity regarding how a broker-dealer
determines if it has a ``reasonable basis to believe that that the
recommendation is the best interest of the retail customer based on the
retail customer's investment profile and the potential risks and
rewards associated with the recommendation'' in paragraph (a)(2)(i)(B)?
Why or why not? Should the rule expressly require a broker-dealer or
associated person, in formulating this belief, to take into account all
benefits to the broker-dealer or associated person from the
recommendation and the costs to the retail customer?
Should the Commission take a different approach to
defining the Care Obligation? If so, what approach should the
Commission and take and why? For example, in lieu of establishing a
Care Obligation that requires recommendations in the ``best interest,''
as described, should the Care Obligation codify existing suitability
obligations and require certain additional obligations (such as not
placing the financial or other interest of the broker-dealer ahead of
the retail customer)? If so, what additional obligations should be
required and why?
As noted above, the Commission preliminary believes it is
appropriate to incorporate the concept of a ``customer's investment
profile'' consistent with FINRA's suitability rule. Do commenters
agree? Why or why not? Should additional factors be considered?
Should the Commission require broker-dealers to document
their efforts to collect investment profile information? Relatedly,
should broker-dealers be required to document why they believe one or
more factors in a customer's investment profile are not relevant to a
determination regarding whether a recommendation is in the best
interest for a particular customer? Why or why not?
Should the interpretation of what it means to make a
recommendation in the ``best interest'' for purpose of paragraph
(a)(2)(i)(B) be different from the interpretation of the best interest
obligation under paragraph (a)(1)? Why or why not? Please be specific
regarding any alternative suggestions and what they would or would not
require. If the standard were different, should the Commission change
the provision in the proposed rule that the obligation under paragraph
(a)(1) is satisfied only by compliance with the elements of paragraph
(a)(2)? If so, should the obligation in paragraph (a)(1) be an
independent obligation, for violation of which a broker-dealer and
associated person could be liable even if they complied with the
elements of paragraph (a)(2)?
Should a broker-dealer and its associated persons, when
considering similar investment options available through the broker-
dealer, have the obligation to recommend the least expensive and/or
least remunerative option, at least if all other relevant factors are
equal? Why or why not? What other factors should be relevant in such
consideration?
Should a broker-dealer and its associated persons, when
considering investment options, only be required to consider options
available through the broker-dealer? Alternatively, if a broker-dealer
and its associated persons are required to consider additional options
outside the broker-dealer, how should the Commission articulate the
extent of this duty? Please be specific.
[[Page 21617]]
Is the phrase ``reasonably available alternative''
sufficiently clear? Should the Commission specify certain factors to be
used in the determination? Is there an alternative phrase or term that
would be clearer? Please be specific.
Is there sufficient clarity regarding what ``less
expensive'' or ``least remunerative'' means and under what
circumstances expense or remuneration should be a significant factor?
Should the Commission define what ``best interest'' means
for purposes of paragraph (a)(2)(i)(B)?
Do commenters agree that turnover rate, cost-to-equity
ratio and in-and-out-trading are relevant factors for determining that
a series of recommended transactions is excessive for purposes of
paragraph (a)(2)(i)(C)? If not, what factors should a broker-dealer
consider with respect to this proposed obligation? Should the
Commission expressly articulate the relevant factors as part of the
rule?
The Commission is proposing to use the term ``series of
recommended transactions'' as part of the obligation in paragraph
(a)(2)(i)(C), which is based, in part, on FINRA's quantitative
suitability obligation. Is ``series of recommended transactions'' a
sufficiently clear term when referring to the quantity/frequency of
trades? Should the Commission consider another formulation for this
obligation? If so, what language would be clearer?
As noted above, the best interest obligation would not
extend beyond a particular recommendation or generally require a
broker-dealer to have a continuing duty to a retail customer. Is there
sufficient clarity regarding how the obligation applies to a series of
recommended transactions? Why or why not?
The Commission is proposing, as part of the obligation in
paragraph (a)(2)(i)(C), that a broker-dealer must have a reasonable
basis to believe that a series of recommended transactions is not
excessive and is in the retail customer's best interest. Should the
Commission consider requiring only a reasonable basis to believe that a
``series of recommended transactions'' (or such other term per the
preceding question) is not excessive, or in the alternative, only
requiring a reasonable basis to believe that a series of recommended
transactions (or such other term per the preceding question) is in the
retail customer's best interest? If so, why?
As noted above, FINRA's quantitative suitability rule
requires a broker-dealer to have a reasonable basis for believing that
a series of recommended transactions, even if suitable when viewed in
isolation, are not excessive and unsuitable for the customer when taken
together in light of the customer's investment profile. The
Commission's proposed obligation, instead, would require a broker-
dealer to have a reasonable basis to believe that a series of
recommended transactions is not excessive and is in the retail
customer's best interest. Should the Commission consider different
language, for example, requiring a reasonable basis to believe that a
series of recommended transactions is not excessive and not contrary to
the retail customer's best interest? Why or why not?
The Commission is not proposing to incorporate the element
of control or de facto control in the requirement that a broker-dealer
form a reasonable basis to believe that a series of recommended
transactions, even if in the best interest of the retail customer 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. Should the Commission require ``control'' or ``de
facto'' control? Why or why not?
3. Conflict of Interest Obligations
The Commission is proposing two requirements under Regulation Best
Interest focused specifically on the treatment of conflicts of
interest. These Conflict of Interest Obligations would require a
broker-dealer entity \289\ to: (1) 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;
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.
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\289\ 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 proposed Conflict of Interest Obligations
apply 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 Obligations, 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 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 (if the retail customer is indirectly impacted).
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We believe that requiring the establishment of such policies and
procedures is critical to identifying and addressing conflicts of
interest, whether through elimination or, at a minimum, disclosure (and
mitigation, in the case of financial incentives). We also believe that
policies and procedures help ensure compliance with the proposed
requirement to disclose any material conflicts of interest associated
with a broker-dealer's recommendations pursuant to the Disclosure
Obligation described above. We further believe that requiring the
establishment of such policies and procedures serves the Commission's
goal of facilitating the disclosure and mitigation of material
conflicts of interest, while minimizing additional compliance costs
that may be passed on to retail customers.
Under the proposed rule, broker-dealers would be permitted to
exercise their judgment as to whether, for example, the conflict can be
effectively disclosed (as discussed in Disclosure Obligation),
determine what conflict mitigation methods may be appropriate, and
determine whether or how to eliminate a conflict, if necessary, so long
as the broker-dealer's policies and procedures are reasonably designed.
Whether a broker-dealer's policies and procedures are reasonably
designed to meet its Conflict of Interest Obligations will depend on
the facts and circumstances of a given situation. The Commission also
believes requiring policies and procedures specifically aimed at
mitigating, in addition to disclosing, material conflicts of interest
arising from financial incentives provides enhanced protections not
available to retail customers through disclosure alone.
A broker-dealer would not comply with the Conflict of Interest
Obligations of Regulation Best Interest by simply creating policies and
procedures, if the broker-dealer does not maintain and enforce such
policies and procedures.\290\ Broker-dealers are already subject both
to liability for failure to supervise under Section 15(b)(4)(E) \291\
of the Exchange Act and to express supervision requirements under SRO
rules, including the establishment of policies
[[Page 21618]]
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.\292\ As such, we believe
that a broker-dealer could comply with the policies and procedures
requirement of Regulation Best Interest by adjusting its current
systems of supervision and compliance, as opposed to creating new
systems.
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\290\ In the 913 Study, the staff stated that policies and
procedures alone are not sufficient to discharge supervisory
responsibility; it is also necessary to implement measures to
monitor compliance with those policies and procedures. See 913 Study
at 74, (citing In re Application of Stuart K. Patrick, Exchange Act
Release No. 32314 (May 17, 1993); In re Application of Richard F.
Kresge, Exchange Act Release No. 55988 (June 29, 2007)
(demonstrating the Commission's approach over the years)).
\291\ See Section 15(b)(4)(E) of the Exchange Act (authorizing
the Commission to impose sanctions on a firm or any associated
person that fails reasonably to supervise another person subject to
its supervision that commits a violation of the federal securities
laws).
\292\ See FINRA Rule 3110 (Supervision) (requiring firms to
establish and maintain systems to supervise the activities of its
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations and FINRA
rules).
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a. Material Conflicts of Interest and Material Conflicts of Interest
Arising From Financial Incentives Associated With Such Recommendations
As noted in the discussion of the Disclosure Obligation in Section
II.D.1., we propose to interpret, for purposes of Regulation Best
Interest, 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.\293\
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\293\ See Section II.D.I.b.
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For purposes of the Conflict of Interest Obligation in paragraph
(a)(2)(iv), we preliminarily believe that material conflicts of
interest arising from ``financial incentives'' associated with a
recommendation generally would include, but are not limited to,
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 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.
While our interpretation of the types of material conflicts of
interest arising from financial incentives is broad, we do not intend
to require broker-dealers to mitigate every material conflict of
interest in order to satisfy their Conflict of Interest Obligations. We
request comment below on the scope of the term financial incentives,
whether we have appropriately identified the types of financial
incentives that should be eliminated or mitigated and disclosed,
whether there are other material conflicts of interest commenters
believe are more appropriately eliminated or mitigated and disclosed,
and whether there are certain financial incentives that are
appropriately addressed through disclosure and for which additional
mitigation is unnecessary or that the burden of mitigating the conflict
would not justify any associated benefit to retail customers.
The Commission's proposed Conflict of Interest Obligations are
limited to material conflicts of interest, and to material conflicts
arising from financial incentives, that are associated with a
recommendation. The Commission believes this limitation is appropriate
because broker-dealers often provide a range of services as part of any
relationship with a retail customer, many of which would not involve a
recommendation, and such services already are subject to general
antifraud liability and specific requirements to address associated
conflicts of interest.\294\ We are not proposing to change the
disclosure obligations associated with these services under the general
antifraud provisions of the federal securities laws.
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\294\ See supra notes 87, 175, 176, 177 and accompanying text.
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b. Reasonably Designed Policies and Procedures
In determining whether a broker-dealer ``establishes, maintains,
and enforces reasonably designed policies and procedures,'' to address
its material conflicts of interest, as required by the Conflict of
Interest Obligations, the Commission preliminarily believes it would
consider whether a broker-dealer has adequate compliance and
supervisory policies and procedures in place (as well as a system for
applying such procedures) to identify and at a minimum disclose (and
mitigate, in the case of financial incentives) or eliminate, material
conflicts of interest. We believe that there is no one-size-fits-all
framework, and broker-dealers should have flexibility to tailor the
policies and procedures to account for, among other things, business
practices, size and complexity of the broker-dealer, range of services
and products offered and associated conflicts presented.
We believe that it would be reasonable for broker-dealers to use a
risk-based compliance and supervisory system to promote compliance with
Regulation Best Interest, rather than conducting a detailed review of
each recommendation of a securities transaction or security-related
investment strategy to a retail customer.\295\ Use of a risk-based
compliance and supervisory system would grant broker-dealers the
flexibility to establish systems that are tailored to their business
models, and to focus on specific areas of their business that pose the
greatest risk of noncompliance with the Conflict of Interest
Obligations,\296\ as well as the greatest risk of potential harm to
retail customers through such noncompliance. We believe that this would
protect retail customers by focusing the broker-dealer's resources on
the areas of greatest risk to both the firm and the retail customer, as
opposed to focusing on every aspect of the broker-dealer's business,
regardless of the level of risk of noncompliance or harm.
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\295\ We propose to interpret the term ``risk-based'' consistent
with SRO rules so that broker-dealers can incorporate these new
obligations into their current compliance infrastructure. According
to FINRA, ``the term `risk based' describes the type of methodology
a firm may use to identify and prioritize for review those areas
that pose the greatest risk of potential securities law and self-
regulatory organization (SRO) rule violations. In this regard, a
firm is not required to conduct detailed reviews of each transaction
if the firm is using a reasonably designed risk-based review system
that provides the firm with sufficient information to enable the
firm to focus on the areas that pose the greatest numbers of and
risks of violation.'' See FINRA Regulatory Notice 14-10,
Consolidated Supervision Rules (Mar. 2014).
\296\ As previously noted, the Commission would expect smaller
investment advisers without conflicting business interests to
require much simpler policies and procedures than larger firms that,
for example, have multiple potential conflicts as a result of their
other lines of business or their affiliations with other financial
service firms. See, e.g., Compliance Programs of Investment
Companies and Investment Advisers, Advisers Act Release No. 2204
(Dec. 17, 2003) (``Advisers Act Release 2204'').
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Among the components that broker-dealers should consider including
in their programs are: Policies and procedures outlining how the firm
identifies its material conflicts (and material conflicts arising from
financial incentives), including such material conflicts of natural
persons associated with the broker-dealer, clearly identifying all such
material conflicts of interest and specifying how the broker-dealer
intends to address each conflict; robust compliance review and
monitoring systems; processes to escalate identified instances of
[[Page 21619]]
noncompliance to appropriate personnel for remediation; procedures that
clearly designate responsibility to business lines personnel for
supervision of functions and persons,\297\ including determination of
compensation; \298\ processes for escalating conflicts of interest;
processes for a periodic review and testing of the adequacy and
effectiveness of policies and procedures; \299\ and training on the
policies and procedures.\300\
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\297\ See Frequently Asked Questions about Liability of
Compliance and Legal Personnel at Broker-Dealers under Sections
15(b)(4) and 15(b)(6) of the Exchange Act, Division of Trading and
Markets (Sept. 30, 2013), available at https://www.sec.gov/divisions/marketreg/faq-cco-supervision-093013.htm (providing
guidance on the roles and duties of compliance and legal personnel
at broker-dealers).
\298\ The Commission believes that the ability to control the
compensation of registered representatives is a key mechanism by
which registered broker-dealers exercise supervisory controls.
\299\ See Advisers Act Release 2204; see also Staff 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.
\300\ Id.
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c. Identifying Material Conflicts of Interest
We believe that having a process to identify and appropriately
categorize such conflicts of interest is a critical first step in
helping to ensure that broker-dealers have reasonably designed policies
and procedures to eliminate, or at a minimum disclose (and mitigate, as
required) their material conflicts of interest. Reasonably designed
policies and procedures to identify material conflicts of interest
(including material conflicts arising from financial incentives)
generally should do the following:
(i) Define such material conflicts in a manner that is relevant to
a broker-dealer's business (i.e., material conflicts of both the
broker-dealer entity and natural persons who are 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 material
conflicts that the broker-dealer (and natural persons who are
associated persons of the broker-dealer) may face, and whether such
conflicts arise from financial incentives;
(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 \301\ or
services) and regular, periodic (e.g., annual) review for the
identification of conflicts associated with the broker-dealer's
business; and
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\301\ FINRA Conflicts Report at 3 (``Firms at the forefront of
financial innovation are in the best position, and are uniquely
obligated, to identify the conflicts of interest that may exist at a
product's inception or that develop over time. There are a number of
effective practices firms can adopt to address such conflicts.
First, firms can use a new product review process--typically through
new product review committees--that includes a mandate to identify
and mitigate conflicts that a product may present. Second, firms
should disclose those conflicts in plain English, with the objective
of helping ensure that customers comprehend the conflicts that a
firm or registered representative have in recommending a product.
These conflicts may be particularly acute where complex financial
products are sold to less knowledgeable investors, including retail
investors.'')
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(v) establish training procedures regarding the broker-dealer's
material conflicts of interest, including material conflicts of natural
persons who are associated persons of the broker-dealer, how to
identify such material conflicts of interest (and material conflicts
arising from financial incentives), as well as defining employees'
roles and responsibilities with respect to identifying such material
conflicts of interest.
d. Disclosure, or Elimination, of Material Conflicts of Interest and
Disclosure and Mitigation, or Elimination, of Material Conflicts of
Interest Arising From Financial Incentives Associated With a
Recommendation
In addition to identifying material conflicts of interest, the
Commission proposes to require that the policies and procedures be
reasonably designed to at a minimum disclose, or eliminate, all
material conflicts of interest associated with making recommendations
to retail customers. In addition to the general guidance regarding
reasonably designed policies and procedures outlined above, we believe
that reasonably designed policies and procedures generally 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.
If a broker-dealer determines to satisfy its obligation to address
material conflicts of interest through disclosure, the broker-dealer
should consider the preliminary guidance on aspects of effective
disclosure, as discussed above in the Disclosure Obligation.\302\
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\302\ See Section II.D.1.
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While the Conflict of Interest Obligations would require a broker-
dealer to have 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), it does not mandate the absolute elimination of any
particular conflicts, absent another requirement to do so. The absolute
elimination of some particular conflicts could mean a broker-dealer may
not receive compensation for its services, which is not the
Commission's intent.
A broker-dealer seeking to address its Conflict of Interest
Obligations through elimination of a material conflict of interest
could choose to eliminate the conflict of interest entirely, for
example, by removing incentives associated with a particular product or
practice or not offering products with special incentives.
Alternatively, a broker-dealer could satisfy this obligation by
negating the effect of the conflict by, for example, in the case of
conflicts related to affiliated mutual funds, crediting fund advisory
fees against other broker-dealer charges--thus effectively eliminating
the material conflict of interest.
Furthermore, although the Commission is not proposing to require a
broker-dealer to develop policies and procedures to both disclose and
mitigate all material conflicts of interest (outside of the material
conflicts arising from financial incentives, which would specifically
require mitigation), the proposed Conflict of Interest Obligations
would require that a broker-dealer develop policies and procedures
reasonably designed to ``at a minimum disclose, or eliminate'' all
material conflicts. As such, a broker-dealer may determine to design
its policies and procedures to address material conflicts of interest
by both disclosing a conflict and taking other additional steps to
mitigate the conflict (outside of the material conflicts arising from
financial incentives, which would specifically require mitigation).
However, in situations where the broker-dealer determines that
disclosure does not reasonably address the conflict, for example, where
the disclosure cannot be made in a simple or clear manner, or otherwise
does not help the retail customer's understanding of the conflict or
capacity for informed decision-making, or where the conflict is such
[[Page 21620]]
that it may be difficult for the broker-dealer to determine that it is
not putting its own interest ahead of the retail customer's interest,
under the proposed obligation to have reasonably designed policies and
procedures to ``at a minimum disclose, or eliminate'' all material
conflicts the broker-dealer would need to establish policies and
procedures reasonably designed to either eliminate the conflict or to
both disclose and mitigate the conflict.
e. Mitigation of Material Conflicts of Interest Arising From Financial
Incentives
Under the requirement relating to the treatment of conflicts of
interest arising from financial incentives, the Commission proposes to
require broker-dealers 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. This proposed requirement is intended to capture
the range of financial incentives that could pose a material conflict
of interest.
The Commission recognizes the importance of the brokerage model as
a potentially cost-effective (and sometimes, a less costly) option for
investors to pay for investment advice. As discussed above, the
Commission recognizes, however, that broker-dealer financial
incentives--including internal compensation structures and compensation
arrangements \303\ with third parties--create inherent conflicts that
may affect the impartiality of a recommendation.\304\ These financial
incentives can create conflicts of interest that may be difficult, if
not impossible, to effectively manage through disclosure alone, or to
eliminate.\305\ At the same time, the Commission, like other
regulators,\306\ recognizes that differential compensation may
appropriately recognize the time and expertise necessary to understand
an investment, and in doing so promote investor choice and access to a
range of products, and so elimination of the conflict may not be
appropriate or desirable.\307\
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\303\ Conflicts of interest may arise from compensation other
than sales compensation. For example, in the case of mutual funds,
compensation for account servicing, sub-transfer agency, sub-
accounting, recordkeeping or other administrative services provides
an incentive for a firm to offer the mutual funds from or for which
the firm receives such compensation and not offer other funds or
products from or for which it does not receive such compensation.
\304\ See Tully Report. The Commission has historically
expressed concerns about the financial incentives that commission-
based compensation provides to broker-dealers. In order to address
these concerns and preserve the broker-dealer model to promote
investor choice, Regulation Best Interest imposes the additional
requirement to mitigate conflicts related to financial incentives.
See supra Section I.A.
\305\ Several commenters in response to Chairman Clayton's
Statement expressed similar concerns regarding the limits of
disclosure to address broker-dealer conflicts, and supported
requiring both disclosure and mitigation of conflicts. See, e.g.,
Economic Policy Institute Letter; PIABA Letter; Financial Planning
Coalition Letter (``The Coalition believes that disclosures alone
are insufficient to remedy investor confusion and harm stemming from
conflicted advice. Although the Coalition agrees that disclosures
can be a useful and important tool for investors, relying solely on
disclosures is inconsistent with the SEC's mission of investor
protection and contradicts substantial prior research demonstrating
that disclosures alone are ineffective. The Coalition opposes a
disclosure-only regime and urges consideration of system based on
either conflict avoidance or disclosures coupled with proper
mitigation.''); Nationwide Letter (``. . . Nationwide is firmly
committed to supporting a new best interest standard of care for
broker-dealers that focuses on increased transparency and mitigation
of conflicts, while at the same time protecting consumers' access to
advice, choice, and affordable products.''); LPL Financial Letter
(recommending that the Commission consider adopting a standard of
conduct that preserves financial institutions' flexibility to avoid
or manage conflicts in which they have a competing financial
interest, provided they fully and fairly disclose the nature of such
conflicts to investors and take such additional steps as may be
necessary to ensure such conflicts do not adversely affect the
impartiality and prudence of the advice they provide to investors).
\306\ For example, the preamble to the BIC Exemption states
``The Department has not made the requirements more stringent, as
suggested by some commenters, so as to require completely level
compensation. Different payments for different classes of
investments may be appropriate based on differences in the time and
expertise necessary to recommend them'' and that under the BIC
Exemption ``differential compensation is permitted but only if the
Financial Institution's policies and procedures, as a whole are
reasonably designed to avoid a misalignment of interests between
Advisers and Retirement Investors'' and that ``the payment of
differential compensation should be based only on neutral factors.''
BIC Exemption Release, FR 21007, 21035-40.
\307\ See, e.g., Letter from James D. Gallagher, Executive Vice
President and General Counsel, John Hancock Life Insurance Company
(U.S.A.) (Aug. 25, 2017) (``John Hancock Letter'') (``Customer
choice should allow advisers and broker-dealers to direct clients to
products that suit their needs, whether or not those products are
proprietary.'').
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In addition, through the proposed requirement to develop policies
and procedures reasonably designed to mitigate conflicts of interest
arising from financial incentives, we are clarifying how the best
interest obligation would be fulfilled when a broker-dealer is engaging
in principal trading by requiring a broker-dealer to, through its
required policies and procedures, identify and address, the financial
incentives presented by principal trading.\308\
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\308\ This is in line with the 913 Study recommendation that the
Commission address how the uniform fiduciary standard of conduct
would be fulfilled when engaging in principal trading, which at a
minimum should require disclosure but not necessarily require the
specific procedures of Advisers Act Section 206(3). See Study at
113.
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Accordingly, to make sure that recommendations are in the best
interest of the retail customer, the Commission proposes requiring
broker-dealers to establish, maintain and enforce written policies and
procedures reasonably designed to identify and disclose and mitigate
material conflict of interests related to financial incentives, in
addition to the proposed requirement to establish, maintain and enforce
written policies and procedures reasonably designed to identify and
disclose or eliminate general material conflicts of interest in
paragraph (a)(2)(iii).
As noted above, in lieu of mandating specific mitigation measures
or a ``one-size fits all'' approach, the Commission's proposal would
leave broker-dealers with flexibility to develop and tailor reasonably
designed policies and procedures that include conflict mitigation
measures, based on each firm's circumstances.\309\ This principles-
based approach provides broker-dealers the flexibility to establish
their supervisory system in a manner that reflects their business
models, and based on those models, focus on areas where heightened
concern may be warranted.\310\ The Commission believes that reasonably
designed policies and procedures should include mitigation measures
that depend on a variety of factors related to a broker-dealer's
business model (such as the size of the broker-dealer, retail customer
base, the nature and significance of the compensation conflict, and the
complexity of the product), some of which may be weighed more heavily
than others.\311\ Depending on a broker-dealer's assessment of these
factors as a whole, more or less demanding mitigation measures included
in reasonably designed policies and procedures may be appropriate. For
example, heightened mitigation measures, including enhanced
supervision, may be appropriate in situations where the retail customer
displays a less sophisticated understanding of securities investing
[[Page 21621]]
generally \312\ or the conflicts associated with particular products
involved,\313\ where the compensation is less transparent (for example,
a payment received from a third-party or built into the price of the
product or a transaction versus a straight commission payment), or
depending on the complexity of the product.\314\ 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 product or type of compensation conflict across the
board; or in some instances a broker-dealer may reasonably determine
that some compensation conflicts may be more difficult to mitigate, and
are more appropriately avoided in their entirety or for certain
categories of retail customers. Policies and procedures may be
reasonably designed at the outset, but may later become unreasonable
based on subsequent events or information obtained, such that the
actual experience of a broker-dealer should be used to revise the
broker-dealer's measures as appropriate. Further, what are considered
reasonable mitigation measures for a small firm may be different than
that for a large firm.\315\ While many broker-dealers may have programs
currently in place to manage conflicts of interest, each broker-dealer
will need to carefully consider whether its existing framework complies
with the proposed obligations under Regulation Best Interest.
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\309\ FINRA observed that the appropriate framework for
developing a conflicts governance framework depends on the scope and
scale of a firm's business. See FINRA Conflicts Report. See also
Letter from David T. Bellaire, Esq., Executive Vice President and
General Counsel, Financial Services Institute (Oct. 30, 2017) (``FSI
Letter'') (recommending the Commission adopt a principles-based
approach to allow firms to tailor their policies and procedures
designed to identify, manage and mitigate conflicts to their unique
business models).
\310\ See FINRA Rule 3110(b)(1) (Supervision) and Section
15(b)(4)(E) of the Exchange Act.
\311\ See FINRA Conflicts Report.
\312\ We believe that broker-dealers would ordinarily obtain,
pursuant to the proposed Care Obligation, sufficient facts
concerning a retail customer to determine a retail investor's
understanding of securities investing. As part of evaluating a
recommendation and whether it is in a retail customer's best
interest, the Care Obligation requires a broker-dealer to make a
reasonable effort to ascertain information regarding an existing
customer's investment profile, including, 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. See paragraph (c)(2) of Proposed
Regulation Best Interest (defining ``Retail Customer Investment
Profile'').
\313\ Currently, 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). FINRA has encouraged
member firms to take a similar approach in recommending complex
products. FINRA has noted that certain heightened procedures firms
have taken include making approval of complex products contingent
upon specific limitations or conditions, and prohibiting their sales
force from recommending the purchase of some complex products to
certain retail investors. See FINRA Regulatory Notice 12-03,
Heightened Supervision of Complex Products (Jan. 2012).
\314\ In a recent FINRA examination report, FINRA noted that the
concerns that FINRA had during the course of examinations with
regard to the suitability of certain products and their supervision
did not vary materially by firm size, but did occur more frequently
in connection with certain product classes, specifically unit
investment trusts (``UITs'') and certain multi-share class and
complex products, such as leveraged and inverse exchange-traded
funds (``ETFs''). See Report on FINRA Examination Findings (Dec.
2017), available at http://www.finra.org/industry/2017-report-exam-findings (``FINRA Exam Report 2017'').
\315\ 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.
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For example, broker-dealers generally should consider incorporating
the following non-exhaustive list of potential practices \316\ as
relevant into their policies and procedures to promote compliance with
(a)(2)(iv) of proposed Regulation Best Interest \317\:
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\316\ See FINRA Conflicts Report at 26.
\317\ As noted above, while the Commission believes these
practices, if incorporated into written policies and procedures, may
reasonably mitigate conflicts of interest arising from financial
incentives, whether a recommended securities transaction or
investment strategy complies with proposed Regulation Best Interest
will turn on the facts and circumstances of the particular
recommendation and the particular retail customer, and whether the
broker-dealer has complied with the Disclosure Obligation and the
Care Obligation.
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Avoiding compensation thresholds that disproportionately
increase compensation through incremental increases in sales;
minimizing compensation incentives for employees to favor
one type of product over another, proprietary or preferred provider
products, or comparable products sold on a principal basis--for
example, establishing differential compensation criteria based on
neutral factors (e.g., the time and complexity of the work involved);
eliminating compensation incentives within comparable
product lines (e.g., one mutual fund over a comparable fund) by, for
example, capping the credit that a registered representative may
receive across comparable 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, proprietary
products or transactions in a principal capacity; or, involve the
rollover or transfer of assets from one type of account to another
(such as recommendations to rollover or transfer assets in an ERISA
account to an IRA, when the recommendation involves a securities
transaction) \318\ or from one product class to another \319\;
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\318\ Id.
\319\ See FINRA Exam Report 2017. FINRA observed a variety of
effective practices in recommending the purchase and sale of certain
products, including tailoring supervisory systems to products'
features and sources of risk to customers. With respect to UITs,
FINRA observed firms that alerted customers to the consequences of
selling and reinvesting in a new UIT prior to the initial UIT's
maturity using negative or positive consent letters. Some firms
implemented surveillance patterns to identify early UIT rollovers
under a variety of scenarios. In addition, some firms required
registered representatives to enter a rationale into firm systems
for each short-term UIT transaction and coupled the entry with
documented supervisory review.
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adjusting compensation for registered representatives who
fail to adequately manage conflicts of interest; and
limiting the types of retail customers to whom a product,
transaction or strategy may be recommended (e.g., certain products with
conflicts of interest associated with complex compensation structures).
In addition, we believe certain material conflicts of interest
arising from financial incentives may be more difficult to
mitigate,\320\ and may be more appropriately avoided in their entirety
for retail customers or for certain categories of retail customers
(e.g., less sophisticated retail customers). These practices may
include the payment or receipt of certain non-cash compensation that
presents conflicts of interest for broker-dealers, for example, sales
contests, trips, prizes, and other similar bonuses that are based on
sales of certain securities or accumulation of
[[Page 21622]]
assets under management.\321\ Broker-dealers that make recommendations
to retail customers that may involve such compensation practices should
carefully assess the broker-dealer's ability to mitigate these
financial incentives and whether they can satisfy their best interest
obligation.
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\320\ See Tully Report. The Tully Report found the payment of
up-front bonuses and accelerated payouts raised concerns not about
particular recommendations but about the registered representative-
client relationship because registered representatives are
incentivized to generate large commissions through churning accounts
or switching firms. The Tully Report suggested best practices to
encourage long-term relationships through methods including, but not
limited to, possible elimination of up-front bonuses or payment of
up-front bonuses in the form of forgivable loans over a period of
time.
\321\ For example, FINRA rules establish restrictions on the use
of non-cash compensation in connection with the sale and
distribution of mutual funds, variable annuities, direct
participation program securities, public offerings of debt and
equity securities, and real estate investment trust programs. These
rules generally limit the manner in which members can pay for or
accept non-cash compensation and detail the types of non-cash
compensation that are permissible. See FINRA Rules 2310, 2320, 2331,
and 5110. FINRA conducted a retrospective review of the gifts and
gratuities and non-cash compensation rules to assess their
effectiveness and efficiency. See FINRA Regulatory Notice 14-15,
FINRA Requests Comment on the Effectiveness and Efficiency of its
Gifts and Gratuities and Non-Cash Compensation Rules (Apr. 2014);
FINRA Retrospective Rule Report, Gifts, Gratuities and Non-Cash
Compensation (Dec. 2014). In response, SIFMA commented that it
supported ``restricting the use of sales targets and requiring that
eligibility for training events be determined on the basis of total
production, not the sale of specific securities'' and recommended
that ``FINRA also consider whether these rules should be applied
consistently to all securities products, rather than (as today) just
to investment company securities, variable products and public
offerings of securities.''). See Letter from Kevin A. Zambrowicz,
Associate General Counsel & Managing Director, SIFMA (May 23, 2014).
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f. Consistency With Other Approaches
The Commission believes that the proposed requirements relating to
the treatment of conflicts are designed to address, albeit in a less
prescriptive manner, the same concerns regarding broker-dealer
conflicts of interest as expressed by the DOL in adopting the DOL
Fiduciary Rule and related PTEs, including the conflicts associated
with financial incentives, underlying the BIC Exemption. Among other
things, the BIC Exemption includes provisions requiring: (1) Disclosure
of information on the firm's material conflicts of interest, including
web and transaction-based disclosure; and (2) adoption of policies and
procedures reasonably designed to: (i) Ensure that advisers (i.e.,
individual representatives) adhere to the Impartial Conduct Standards
(e.g., provide best interest advice); (ii) prevent material conflicts
of interest from causing violations of the Impartial Conduct Standards,
and (iii) prevent the use of compensation or other incentives (e.g.,
quotas, appraisals, bonuses, contests, special awards, differential
compensation or other actions or incentives) that are intended or would
reasonably be expected to cause advisers to make recommendations that
are not in the best interest of the retirement investor.\322\
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\322\ See BIC Exemption Release.
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The DOL has stated that the restriction on compensation incentives
under the conditions of the BIC Exemption does not prevent the
provision of differential compensation to individuals (whether in type
or amount, and including, but not limited to, commissions) based on
investment decisions to the extent that the policies and procedures and
incentive practices, when viewed as a whole, are reasonably and
prudently designed to avoid a misalignment of the interests of advisers
with the investors they serve as fiduciaries.\323\ However, the
differential payments must be based on neutral factors, such as the
time or complexity and the work involved (and not based on what is more
lucrative to the firm), and the DOL noted the importance of employing
supervisory oversight structures.\324\ As an example, the DOL described
a commission-based compensation schedule for representatives in which
all variation in commissions is eliminated for recommendations of
investments within reasonably designed categories, and the entity
establishes supervisory mechanisms to protect against conflicts of
interest created by the transaction-based model and takes special care
to ensure that any differentials that are retained are based on neutral
factors (e.g., time or complexity) and do not incentivize based on the
amount of compensation the entity would receive.\325\
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\323\ See BIC Exemption Release at 21033-34. See also U.S.
Department of Labor, Employee Benefits Security Administration,
Conflict of Interest FAQs, Part I-Exemptions (Oct. 2017), available
at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-rules-and-exemptions-part-1.pdf
(``DOL FAQs Part I'').
\324\ See BIC Exemption Release at 21035-40. For example, the
DOL notes that the touchstone is to always avoid structures that
misalign the financial interests of the adviser with the interests
of the retirement investor. See DOL FAQs Part I.
\325\ See BIC Exemption Release 21038-39. See also DOL FAQs at
7-8.
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Our proposed Conflict of Interest Obligations are designed to
address these same concerns, and support the objective that the
recommendations of broker-dealers will not be self-interested, with a
principles-based approach that is designed to provide flexibility to
broker-dealers as to how to disclose and mitigate such conflicts of
interest, depending on their business model, the level of conflicts
presented, and the retail customers they serve. While the Commission
recognizes that broker-dealers are subject to supervisory obligations
under Section 15(b)(4)(E) \326\ of the Exchange Act and detailed 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,\327\ for the reasons set forth above, the
Commission believes that broker-dealers should be expressly required to
establish, maintain, and enforce written policies and procedures to
identify and address (through elimination or disclosure, and mitigation
in the case of financial incentives) material conflicts of interest .
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\326\ See Section 15(b)(4)(E) of the Exchange Act (authorizing
the Commission to impose sanctions on a firm or any associated
person that fails reasonably to supervise another person subject to
their supervision that commits a violation of the federal securities
laws).
\327\ See FINRA Rule 3110 (Supervision) (requiring firms to
establish and maintain systems to supervise the activities of its
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations and FINRA
rules).
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Furthermore, our proposed rule subjects broker-dealers to
additional requirements when certain material conflicts are present.
Specifically, Regulation Best Interest requires written policies and
procedures reasonably designed to identify and address, through
disclosure or elimination, of any material conflicts of interest that
are associated with the recommendation, and imposes heightened
obligations requiring written policies and procedures reasonably
designed to identify and address, through disclosure and mitigation, or
elimination, of material conflicts of interest that are related to
financial incentives. We believe that these requirements address the
same concerns that the DOL sought to address regarding conflicts of
interest and the duty of loyalty that underlies the detailed
obligations of the BIC Exemption, and also help ensure investment
recommendations will be in the retail customer's best interest,
consistent with our understanding of the DOL's objectives in the BIC
exemption.
We also believe that the proposed Conflict of Interest Obligations,
in conjunction with our Disclosure Obligation, are consistent with the
principles underlying the recommendations of the 913 Study relating to
a duty of loyalty. In the uniform fiduciary standard recommended in the
Study, ``incorporating Advisers Act Section 206(1) and 206(2)'' would
require an investment adviser or broker-dealer to ``eliminate, or
provide full and fair
[[Page 21623]]
disclosure about its material conflicts of interest.'' \328\ In
addition, the Study recommended that the Commission 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.'' \329\ Further,
with respect to principal trading, the Study provided that the
Commission should address how broker-dealers should fulfill the uniform
fiduciary standard when engaging in principal trading.\330\ The Study
noted that under the standard a broker-dealer should be required at a
minimum, to disclose its conflicts of interest related to principal
transactions, including its capacity as principal, but it would not
necessarily be required to follow the specific notice and consent
procedures of Advisers Act Section 206(3).\331\
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\328\ 913 Study at 112-13.
\329\ See id. at 118.
\330\ See id. at 118-20.
\331\ Id.
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We believe that the proposed Conflict of Interest Obligations
reflect and build upon the principles underlying these 913 Study
recommendations. As recommended by the 913 Study, we are proposing to
require, through implementation of policies and procedures, broker-
dealers to, at a minimum disclose, or eliminate, all material conflicts
of interest, which draws from principles of an investment adviser's
duty of loyalty under the Advisers Act, which includes an investment
adviser's duty to disclose. One difference between the Conflict of
Interest Obligations under Regulation Best Interest and the principles
in the 913 Study is that the proposed obligation for broker-dealers is
limited to disclosure of material conflicts associated with a
recommendation. As discussed above, the Commission believes this
limitation is appropriate because broker-dealers often provide a range
of services as part of any retail customer relationship, many of which
would not involve a recommendation, and such services already are
subject to general and specific requirements to address associated
conflicts of interest.\332\ As such, we are not proposing to change or
to have any impact on the disclosure obligations associated with these
services under the general antifraud provisions of the federal
securities laws rather than this more specific obligation.
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\332\ See Section II.D.1.b.
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Further, in line with the 913 Study recommendations as discussed
above, the Commission considered and believes that it is appropriate to
also propose a requirement to establish and maintain reasonably
designed policies and procedures to disclose and mitigate, or
eliminate, material conflicts of interest related to financial
incentives, in light of the concerns regarding potential harm to retail
customers resulting particularly from broker-dealer conflicts of
interest associated with financial incentives, such as compensation
practices.\333\
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\333\ See supra Section I.A. See also Tully Report.
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The proposed Conflict of Interest Obligations differ from the 913
Study in that Regulation Best Interest, as proposed, expressly requires
a broker-dealer to establish, maintain, and enforce written policies
and procedures reasonably designed to identify and address material
conflicts, through elimination or disclosure (and mitigation in the
case of material conflicts of interest arising from financial
incentives), as opposed to expressly requiring that broker-dealers
eliminate or provide full disclosure of conflicts of interest.\334\ As
discussed above, the Disclosure Obligation separately requires that
broker-dealers disclose material conflicts of interest associated with
the recommendation prior to or at the time of a recommendation. For the
reasons set forth above, we believe that requiring broker-dealers to
develop reasonably designed policies and procedures to identify and
eliminate or disclose (and mitigate, as appropriate or required)
material conflicts of interest is critical to compliance with
management of conflicts of interest, and provides more flexibility to
broker-dealers, and better serves the Commission's goal of facilitating
the elimination or disclosure and mitigation (as appropriate or
required) of material conflicts of interest, and minimizing additional
compliance costs that may be passed on to retail customers.
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\334\ See 913 Study at 112-13.
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g. Request for Comment on the Conflict of Interest Obligations
The Commission generally requests comment on the best interest
obligation relating to the treatment of conflicts of interest.
Specifically, we request comment on the following issues:
Would the Conflict of Interest Obligations cause a broker-
dealer to act in a manner that is consistent with what a retail
customer would reasonably expect from someone who is required to act in
their best interest? Why or why not?
Should the Conflict of Interest Obligations apply to
natural persons who are associated persons of a broker or dealer? Why
or why not?
Are there any specific interactions or relationships
between the disclosure requirements under the Conflict of Interest
Obligations and the Relationship Summary that should be addressed? Are
there any specific interactions or relationships between the disclosure
requirements under the Conflict of Interest Obligations and the
Disclosure Obligation that should be addressed? If so, please explain.
Are there any specific interactions or relationships
between the disclosure requirements in Regulation Best Interest and the
existing general antifraud provisions that should be addressed? If so,
please explain.
Do commenters believe the general antifraud provisions
adequately address other non-recommendation related conflicts or should
Regulation Best Interest also cover such conflicts?
Do commenters agree with the requirement to create
policies and procedures to promote and demonstrate compliance with the
Conflict of Interest Obligations? Why or why not? If so, how should
those policies and procedures differ, if at all, from those currently
required by FINRA? If not, what other approaches do commenters suggest?
Instead of requiring policies and procedures, should the
Commission simply require broker-dealers to eliminate or mitigate and
disclose conflicts of interest?
Should the Conflict of Interest Obligations apply to
natural persons who are associated persons? Why or why not?
Do commenters agree with the Commission's approach to
provide flexibility to broker-dealers in meeting their Conflict of
Interest Obligations? Why or why not?
Is the guidance concerning policies and procedures clear?
Would this guidance assist broker-dealers in understanding how they can
demonstrate compliance with the Conflict of Interest Obligation? Is
there additional guidance that would provide additional clarity?
Do commenters have additional examples of processes or
systems the Commission should suggest or require broker-dealers to
include in compliance and supervisory programs?
Should the Conflict of Interest Obligations specify
certain minimum policies and procedures? If so, what specific required
policies and procedures should we include?
Should the Commission require in Regulation Best Interest
that broker-dealers undergo supervisory and compliance reviews? If so,
how
[[Page 21624]]
frequently and what would be the proper scope?
Is it sufficiently clear to commenters that the Commission
does not require the policies and procedures required by the Conflict
of Interest Obligations be assessed on a transaction-by-transaction
basis, but rather that broker-dealers may use a risk-based compliance
and supervisory system? Why or why not?
Should the Commission provide additional guidance on
identification of material conflicts of interest? Why or why not? If
so, what type of guidance should the Commission provide?
Similar to the Care Obligation, should a broker-dealer be
required to ``exercise reasonable diligence, care, skill, and
prudence'' to comply with the Conflict of Interest Obligations? Why or
why not? Would this lower or raise the standard for the Conflict of
Interest Obligations?
How will the Conflict of Interest Obligations affect dual-
registrants? Do commenters believe dual-registrants can adequately
comply with such requirements? Why or why not?
Are the situations identified in this proposal those where
conflicts of interest are present, the most prevalent or have the
greatest potential for harm or both? To what extent are retail
customers harmed by these types of conflicts? \335\ For example, do
certain types of conflicts and/or recommendations result in
systematically lower net returns or greater degrees of risk in retail
customers' portfolios relative to other similarly situated investors in
different relationships (e.g., investment adviser, bank and trust
company, insurance company accounts)? Are there steps the Commission
should take to identify and address these conflicts? Can they be
appropriately addressed through disclosure or other means? How would
any such steps to address potential conflicts of interest benefit
retail customers currently and over time? What costs or other
consequences, if any, would retail customers experience as a result of
any such steps? For example, would broker-dealers be expected to
withdraw from or limit their offerings or services in certain markets
or certain products?
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\335\ See Definition of the Term ``Fiduciary;'' Conflict of
Interest Rule--Retirement Investment Advice, 81 FR 20945 (Apr. 8,
2016) (to be codified at 29 CFR pts. 2509, 2510 and 2550) (stating
that conflicts of interest with respect to transactions pose
``special dangers to the security of retirement, health, and other
benefit plans'').
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Has the Commission identified the types of conflicts of
interest that need to be addressed in connection with Regulation Best
Interest and are these appropriately addressed to meet the objective
that broker-dealers provide recommendations in the best interest of
retail customers? Are there new or different types of conflicts of
interest that the Commission should consider? If so, which ones?
Do commenters have other suggestions on how broker-dealers
can eliminate material conflicts of interest, including financial
incentives? If so, please provide examples.
Do commenters agree with the scope of the Commission's
proposed requirement related to disclosure and mitigation, or
elimination, of all material conflicts of interest arising from
financial incentives? Do commenters agree with the proposed
interpretation of such financial incentives? Why or why not? Please
explain. Do commenters believe any financial incentives could be
adequately addressed through disclosure or elimination (and do not
require mitigation)? If so, which ones? Why or why not? Which material
conflicts of interest do commenters believe must be mitigated? Why?
Do commenters believe that retail customers recognize and
understand material conflicts of interest presented by broker-dealer
compensation arrangements, including the incentive to seek to increase
broker-dealers' compensation at the expense of the retail customers
they are advising?
In lieu of or in addition to disclosure, should the
Commission explicitly require firms to mitigate conflicts generally and
not only those arising from financial incentives? Why or why not? Or
should we provide flexibility to firms to decide whether to disclose or
mitigate conflicts generally (e.g., to provide flexibility to firms on
how to address conflicts of interest)? Or are there certain conflicts
beyond financial incentives, that should be both disclosed and
mitigated (or eliminated)?
Are there circumstances in which the Commission should
explicitly require elimination of certain material conflicts of
interest because mitigation would not be sufficient? Why or why not? If
so, please specify which ones.
Should Regulation Best Interest expressly require broker-
dealers to regularly (e.g., at least annually) and rigorously review
their written policies and procedures to make sure that they have
supervisory and compliance systems to identify and address all of their
material conflicts of interest?
Commenters in the past have highlighted several activities
of broker-dealers that are most likely to be impacted by an enhanced
standard of care for the provision of investment advice to retail
customers, such as a fiduciary standard. The Commission requests data
and other information related to the nature and magnitude of conflicts
of interest when broker-dealers engage in these activities and how
Regulation Best Interest would serve to increase or decrease broker-
dealers' conflicts of interest:
[cir] Recommending proprietary products and products of affiliates;
[cir] Engaging in principal trades with respect to a recommended
security (e.g., fixed income products);
[cir] Recommending a limited range of products and/or services;
[cir] Recommending a security underwritten by the firm or a broker-
dealer affiliate, including initial public offerings;
[cir] Allocating investment opportunities among retail customers
(e.g., IPO allocation);
[cir] Receiving third-party compensation in connection with
securities transactions or distributions (e.g., sales loads, ongoing
asset-based fees, or revenue sharing); and
[cir] Providing ongoing, episodic or one-time advice.
The Commission also requests comment on reasonable conflict
mitigation measures, specifically:
What factors should broker-dealers weigh and evaluate in
establishing reasonable mitigation measures?
Should the Commission take a more prescriptive approach
with regard to conflict mitigation measures? Why or why not?
Do commenters have further examples of potential
mitigation measures beyond the non-exhaustive list provided above? Do
commenters believe that any of the examples provided on the list would
not be effective at mitigating conflicts related to financial
incentives? Why or why not?
What impact should the firm's size have on implementation
of reasonable mitigation measures?
Are there conflicts of interest that commenters believe
the Commission should prohibit? If so, which ones and why? For example,
do commenters believe the Commission should prohibit receipt of certain
non-cash compensation (e.g., sales contests, trips, prizes, and other
bonuses based on sales of certain securities, accumulation of assets
under management or any other factor)? Why or why not?
Should the Commission require affirmative retail customer
consent for certain types of conflicts of interest? Why or why not?
[[Page 21625]]
Would the guidance related to mitigating conflicts provide
clarity to firms? Why or why not? Is this guidance consistent with the
Commission's goal of improving the quality of recommendations that
retail customers receive? What are some areas in which commenters would
like more guidance?
Are there certain product classes that commenters believe
the Commission should outright prohibit? If so, which ones and why?
Do commenters believe neutral compensation across certain
products (e.g., equities, mutual funds, variable annuities, ETFs) is an
appropriate mitigation measure? Why or why not?
E. Recordkeeping and Retention
In connection with proposed Regulation Best Interest, we are
proposing new record-making and recordkeeping requirements for broker-
dealers with respect to certain information collected from or provided
to retail customers. Exchange Act Section 17(a)(1) requires registered
broker-dealers to make and keep for prescribed periods such records as
the Commission deems ``necessary or appropriate in the public interest,
for the protection of investors.'' \336\ Exchange Act Rules 17a-3 and
17a-4 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.
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\336\ See Exchange Act Section 17(a).
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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 customer account information.\337\ As
part of developing a ``retail customer's investment profile,'' proposed
Regulation Best Interest may require broker-dealers to seek to obtain
certain retail customer information that is currently not required
pursuant to Rule 17a-3(a)(17). In addition, proposed Regulation Best
Interest would require broker-dealers to reasonably disclose in writing
the material facts relating to the scope and terms of their
relationship with the retail customer and all material conflicts of
interest that are associated with the investment recommendations
provided to the retail customer.
---------------------------------------------------------------------------
\337\ See Exchange Act Rule 17a-3(a)(17).
---------------------------------------------------------------------------
Accordingly, we are proposing to amend Rule 17a-3 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, however,
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.\338\
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\338\ 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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Under Rule 17a-4(e)(5), broker-dealers are required to maintain and
preserve in an easily accessible place all account information required
pursuant to Rule 17a-3(a)(17) \339\ for six years.\340\ We are
proposing to amend Exchange Act Rule 17a-4(e)(5) to 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 Rule 17a-3(a)(25), 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 of the
information collected from or provided to each retail customer pursuant
to Regulation Best Interest for six years.
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\339\ 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, customer
account information. As part of developing a ``retail customer's
investment profile,'' proposed Regulation Best Interest would
require broker-dealers to seek to obtain certain retail customer
information that is currently not required to be created under Rule
17a-3(a)(17). Because broker-dealers are already required to seek to
obtain identical information pursuant to the FINRA suitability rule,
we believe that broker-dealers should already be attempting to
collect, pursuant to the FINRA suitability rule, or collecting under
existing Exchange Act books and records rules, the information that
would be required pursuant to Regulation Best Interest. Accordingly,
we do not believe that it is necessary to impose any new record-
making requirement upon broker-dealers.
\340\ See Exchange Act Rule 17a-4(e)(5) (account record
information required pursuant to Rule 17a-3(a)(17) must be
maintained and preserved in an easily accessible place until 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).
---------------------------------------------------------------------------
We are not proposing new record retention requirements regarding
the written policies and procedures that broker-dealers would be
required to create pursuant to Regulation Best Interest because such
information is already currently required to be retained pursuant to
Exchange Act Rule17a-4(e)(7).\341\ Rule 17a-4(e)(7) 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.
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\341\ FINRA Rule 3110 requires written supervisory procedures
that are reasonably designed to achieve compliance with applicable
securities laws and regulations, and with applicable FINRA rules.
See FINRA Rule 3110(b)(1) (Supervision).
---------------------------------------------------------------------------
The Commission requests comment on recordkeeping and retention
requirements related to Regulation Best Interest:
Should the Commission impose additional record-making
requirements related to Regulation Best Interest? Why or why not? If
the Commission were to adopt additional requirements, what records
should we specifically require broker-dealers to make?
Should the Commission impose additional record retention
requirements related to Regulation Best Interest? Why or why not? If
the Commission were to adopt additional requirements, what records
should we specifically require broker-dealers to retain?
F. Whether the Exercise of Investment Discretion Should Be Viewed as
Solely Incidental to the Business of a Broker or Dealer
The Advisers Act regulates the activities of certain ``investment
advisers,'' who are defined in section 202(a)(11) of the Advisers Act
as persons who, for compensation, engage in the business of advising
others about securities. Section 202(a)(11)(C) excludes from the
definition of investment adviser a broker or dealer whose performance
of such advisory services is solely incidental to the conduct of his
business as a broker or dealer and who receives no special compensation
for those services (the ``broker-dealer exclusion''). The broker-dealer
exclusion shows, on the one hand, that Congress recognized broker-
dealers may give a certain amount of advice to their customers in the
course of their regular business as broker-dealers and that it would be
inappropriate to bring them within the scope of the Advisers Act merely
because of this aspect of their
[[Page 21626]]
business.\342\ On the other hand, the limitations of the exclusion show
that Congress also recognized certain broker-dealer advisory services
belong within the scope of the Advisers Act--namely those for which
they receive special compensation and those that are not solely
incidental to their regular business as broker-dealers.\343\
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\342\ Opinion of General Counsel Relating to Section
202(a)(11)(C) of the Investment Advisers Act of 1940, Investment
Advisers Act Release No. 2 (Oct. 28, 1940) (``Advisers Act Release
No. 2'').
\343\ In 1940, when Congress enacted the Advisers Act, broker-
dealers were already regulated under the Exchange Act. In the
Advisers Act, Congress expressly acknowledged that the broker-
dealers it covered could also be subject to other regulation. 15
U.S.C. 80b-8(b). Judicial interpretation of the broker-dealer
exclusion also has noted that Congress passed the Advisers Act to
provide certain protections to the public when receiving investment
advice and that there is nothing in the legislative history of the
Advisers Act ``to suggest that Congress was particularly concerned
about the regulatory burdens on broker-dealers'' associated with
their being subject to the Advisers Act in addition to Exchange Act.
Financial Planning Association v. SEC, 482 F.3d 481(D.C. Cir. 2007)
(``Financial Planning Association v. SEC'') (noting additionally
that ``[j]ust as the text and structure of paragraph 202(a)(11) make
it evident that Congress intended to define `investment adviser'
broadly and create only a precise exemption for broker-dealers, so
does a consideration of the problems Congress sought to address in
enacting the IAA'' and stating that the Advisers Act sought to
address these problems ``by establishing a federal fiduciary
standard to govern the conduct of investment advisers, broadly
defined'' and ``by requiring full disclosure of all conflicts of
interest'').
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The Commission has on many occasions discussed the scope of the
broker-dealer exclusion. In particular, the Commission has for many
years considered issues related to a broker-dealer's exercise of
investment discretion over customer accounts and the extent to which
such practices could be considered solely incidental to the business of
a broker-dealer. Since at least 1978, the Commission has recognized
that the broker-dealer exclusion requires some limitations on a broker-
dealer's exercise of investment discretion. At that time, the
Commission solicited comment on the question of whether broker-dealers
who exercised discretionary authority over customers' accounts should,
per se, be considered investment advisers with respect to those
accounts.\344\ While the Commission declined to adopt such an
interpretation at that time, it noted that if the business of a broker-
dealer consisted almost exclusively of managing accounts on a
discretionary basis, the Commission staff would not consider the
broker-dealer to be providing investment advice that is solely
incidental to its business as a broker-dealer.\345\ In 2005, the
Commission adopted an interpretive rule \346\ that, among other things,
provided that broker-dealers are not excluded from the Advisers Act for
any accounts over which they exercise more than temporary or limited
investment discretion.\347\ The 2005 interpretation regarding
investment discretion was part of a rule whose principal purpose was to
permit broker-dealers to offer fee-based brokerage accounts (where a
customer pays an asset-based fee) without being subject to the Advisers
Act with respect to those accounts.\348\ In 2007, the rule was vacated
by the U.S. Court of Appeals for the District of Columbia Circuit on
the grounds that the Commission did not have the authority to except
broker-dealers offering fee-based brokerage accounts from the
definition of ``investment adviser.'' \349\ Though the Court did not
specifically address the validity of the provision regarding investment
discretion, it vacated the entire rule. After the rule was vacated, the
Commission proposed in 2007, though did not adopt, a similar
interpretive rule regarding investment discretion.\350\
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\344\ Final Extension of Temporary Rules, Advisers Act Release
No. 626 (Apr. 27, 1978) (``Advisers Act Release No. 626'').
\345\ Applicability of the Investment Advisers Act to Certain
Brokers and Dealers, Investment Advisers Act Release No. 640 (Oct.
5, 1978) [43 FR 47176 (Oct. 13, 1978)] (``Advisers Act Release No.
640'').
\346\ Original rule 202(a)(11)-1 under the Advisers Act.
\347\ See Certain Broker-Dealers Deemed Not to be Investment
Advisers, Advisers Act Release No. 2340 (Jan. 6, 2005) (``2005
Proposing Release''); Certain Broker-Dealers Deemed Not to be
Investment Advisers, Advisers Act Release No. 2376 (Apr. 12, 2005)
(``2005 Adopting Release'').
\348\ See 2005 Adopting Release, supra note 347. Fee-based
brokerage accounts are similar to traditional full-service brokerage
accounts, which provide a package of services, including execution,
incidental investment advice, and custody. The primary difference
between the two types of accounts is that a customer in a fee-based
brokerage account pays a fee based upon the amount of assets on
account (an asset-based fee) and a customer in a traditional full-
service brokerage account pays a commission (or a mark-up or mark-
down) for each transaction.
\349\ See Financial Planning Association v. SEC, supra note 343.
\350\ Interpretive Rule Under the Advisers Act Affecting Broker-
Dealers, Investment Advisers Act Release No. 2652 (Sept. 24, 2007)
(``2007 Proposing Release'').
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In considering why limitations on broker-dealers' exercise of
investment discretion are needed, the Commission has noted that
discretionary brokerage relationships ``have many of the
characteristics of the relationships to which the protection of the
Advisers Act are important.'' \351\ In particular, the Commission has
noted that the exercise of investment discretion is qualitatively
distinct from simply providing advice as part of a package of brokerage
services, because a broker-dealer with such discretion is not just a
source of advice, but has authority to make investment decisions
relating to the purchase or sale of securities on behalf of
customers.\352\ The Commission has stated that the quintessentially
supervisory or managerial character of investment discretion warrants
the protection of the Advisers Act and its attendant fiduciary
duty.\353\ This position aligns with the interpretations of the courts,
which have generally found that broker-dealers with investment
discretion owe customers a fiduciary duty under state law.\354\
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\351\ Advisers Act Release No. 626.
\352\ See 2005 Proposing Release; see also 2007 Proposing
Release.
\353\ See Amendment and Extension of Temporary Exemption From
the Investment Advisers Act for Certain Brokers and Dealers,
Investment Advisers Act Release No. 471 (Aug. 20, 1975)(``. . . it
is not appropriate to exempt from the Advisers Act for an extended
period those brokers and dealers who perform investment supervisory
services or other investment management services because of the
special trust and confidence inherent in the relationships between
such brokers and dealers and their advisory clients.''). See also
2005 Proposing Release; 2005 Adopting Release; and 2007 Proposing
Release.
\354\ See, e.g., United State v. Skelly, 442 F.3d 94 at 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 at 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, 953-54 (E.D. Mich. 1978), aff'd, 647 F.2d
165 (6th Cir. 1981) (stating that courts have held that a broker who
has de facto control over a 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). See
also Arthur B. Laby, Fiduciary Duty of Broker-Dealers and Investment
Advisers, 55 VILL. L. REV. 3 (2010) (``most courts and commentators
agree that when a broker has discretionary authority, the broker
owes fiduciary duties to its customer''); Barbara Black, Brokers and
Advisers--What's in a Name?, 11 FORDHAM J. CORP. & FIN. L. 31, 36
(2005) (stating that broker-dealers generally do not owe a fiduciary
duty unless operating with discretion).
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At the same time, the Commission has recognized that at least some
exercise of discretionary authority by broker-dealers could be
considered solely incidental to their business. Under a previous
interpretation, a broker-dealer's discretionary account was subject to
the Advisers Act only if the broker-dealer had enough other
discretionary accounts to trigger the Advisers Act.\355\ The
interpretive
[[Page 21627]]
provision that we adopted in 2005 and proposed in 2007 would have
required broker-dealers to be considered to be investment advisers
under the Advisers Act with respect to discretionary accounts, except
that broker-dealers would have been permitted to exercise investment
discretion on a temporary or limited basis.\356\
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\355\ A broker-dealer who exercised discretionary authority over
the accounts of some of its customers was generally regarded as
providing investment advice incidental to its business as a broker-
dealer but a broker-dealer whose business consisted almost
exclusively of managing accounts on a discretionary basis was not
regarded as providing advice solely incidental to his business as a
broker-dealer. See Advisers Act Release No. 626.
\356\ The Commission stated that it would view a broker-dealer's
discretion to be temporary or limited within the meaning of proposed
rule 202(a)(11)-1(d) when the broker-dealer was given discretion:
(i) As to the price at which or the time to execute an order given
by a customer for the purchase or sale of a definite amount or
quantity of a specified security; (ii) on an isolated or infrequent
basis, to purchase or sell a security or type of security when a
customer is unavailable for a limited period of time not to exceed a
few months; (iii) as to cash management, such as to exchange a
position in a money market fund for another money market fund or
cash equivalent; (iv) to purchase or sell securities to satisfy
margin requirements; (v) to sell specific bonds and purchase similar
bonds in order to permit a customer to take a tax loss on the
original position; (vi) to purchase a bond with a specified credit
rating and maturity; and (vii) to purchase or sell a security or
type of security limited by specific parameters established by the
customer. See 2005 Proposing Release; 2005 Adopting Release; 2007
Proposing Release. In the 2005 Adopting Release, we noted that
accounts in which broker-dealers exercised such investment
discretion would continue to be subject to the existing Exchange Act
and SRO rules concerning broker-dealer exercise of investment
discretion. See 2005 Adopting Release.
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Although we did not adopt our 2007 proposal, many commenters were
generally supportive of our approach.\357\ We believe that much of the
financial industry has treated broker-dealers as not excluded from the
Advisers Act for any accounts over which they exercise more than
temporary or limited investment discretion. Most commenters to the
Chairman's recent request for comment, including broker-dealers, have
indicated that financial firms generally treat discretionary accounts
as advisory accounts.\358\
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\357\ See, e.g., Letter of the Consumer Federation of America
and Fund Democracy (Nov. 2, 2007); Letter of the Investment Adviser
Association (Nov. 2, 2007); Letter of Charles McKeown (Oct. 30,
2007); and Letter of the Securities Industry and Financial Markets
Association (Nov. 2, 2007).
\358\ See T. Rowe Letter; Stifel Letter (``In simple terms,
Brokerage relationships are non-discretionary, commission-based
accounts, through which a financial professional provides episodic
investment advice incidental to each transaction. By contrast, in an
Advisory relationship, a financial professional generally provides
ongoing investment advice and monitoring and charges a level fee,
generally based on assets.); see ICI August 2017 Letter (``broker-
dealers typically do not exercise discretionary authority over
customer accounts''); Vanguard Letter (``The investment advisory
business model is significantly different from that of a broker-
dealer. Advisers generally provide ongoing advice for a fee, take
discretion over client accounts, and engage other entities to carry
client accounts and handle client trading.'').
---------------------------------------------------------------------------
Our staff acknowledged that broker-dealers may provide some
discretionary account services in the 913 Study.\359\ We have also long
recognized that a broker-dealer's ability to engage in discretionary
activity is circumscribed by existing rules under the federal
securities laws.\360\ In addition, broker-dealers that engage in any
discretionary activity are subject to SRO Rules that prohibit and
require specific conduct with respect to discretionary accounts.\361\
Further, broker-dealers vested with discretionary authority or that
exercise control over customer assets have been held to a fiduciary
standard under state law.\362\
---------------------------------------------------------------------------
\359\ See 913 Study at 9-10.
\360\ See, e.g., Exchange Act Section 3(a)(35) (defining
investment discretion). 17 CFR 240.15c1-7.
\361\ See NASD Rule 2510 (Discretionary Accounts) and
Incorporated NYSE Rule 408 (Discretionary Power in Customers'
Accounts). Drawing upon the requirements of these rules and SRO
suitability rules, the Commission has found the exercise of
discretion over a customer's account may constitute a
``recommendation'' that additionally subjects a broker-dealer's
discretionary activity to SRO suitability requirements. See, e.g.,
In re Application of Paul C. Kettler, Exchange Act Release No.
31354, 1992 WL 320802, *3, n.11 (1992). See also In re James Harman
McNeill, (Case No. 2012030927101, AWC, Mar. 12, 2013), available at
http://www.finra.org/sites/default/files/fda_documents/2012030927101_FDA_TP44051.pdf (associated person violated FINRA Rule
2510(b) by exercising discretion in five customers' brokerage
accounts without the written authorization of the customers). See
also supra note 139 and accompanying text.
\362\ See supra note 15.
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We believe that it is appropriate for the Commission to again
consider the scope of the broker-dealer exclusion with regard to a
broker-dealer's exercise of investment discretion in light of both
proposed Regulation Best Interest and the proposed Relationship
Summary. Additionally, some commenters to the Chairman's request asked
that we expressly affirm the interpretive provision we adopted in 2005
and proposed in 2007.\363\
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\363\ IAA Letter; CFA 2017 Letter.
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In light of the foregoing, we request comment on the following:
Should a broker-dealer's provision of unfettered
discretionary investment advice be considered solely incidental to the
conduct of its business as a broker-dealer?
Should a broker-dealer's provision of limited
discretionary investment advice be considered solely incidental to the
conduct of its business as a broker-dealer? If so, what limitations on
a broker-dealer's exercise of investment discretion would make it
solely incidental to the conduct of its business as a broker-dealer?
Should we propose an interpretive rule placing express
limits on investment discretion permissible under the solely incidental
exclusion as we did in 2007? What would be the consequences of such a
rule?
In 2007, we proposed to permit broker-dealers to exercise
investment discretion granted by a customer on a temporary or limited
basis. Is that appropriate? Would it provide the intended investor
protection? Would it provide the clarity regarding the applicable
business model and standard of care?
In 2007 we provided examples of when we would consider a
broker-dealer's investment discretion to be temporary or limited.\364\
Should we define situations in which investment discretion should be
viewed as being granted on a temporary or limited basis? For example,
should temporary investment discretion last no more than a very limited
time (i.e., not as long as two or more months)? Should we restrict a
broker-dealer's ability to exercise temporary investment discretion
repeatedly? Should limited discretion ``to purchase or sell a security
or type of security limited by specific parameters established by the
customer'' be restricted? \365\ What are some examples of specific
parameters that a customer could establish under this example? Should
we expand any of the situations in which investment discretion could be
viewed as being granted on a temporary or limited basis? For example,
should we explicitly allow brokers to exercise investment discretion
granted by the customer to rebalance the customer's account or to
invest a limited portion of the account in a particular sector?
---------------------------------------------------------------------------
\364\ See supra note 356.
\365\ Id.
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Do broker-dealers generally use the examples from the 2007
release to determine when to seek authorization to exercise temporary
or limited investment discretion from a customer? Are there other
circumstances that cause broker-dealers to seek authorization to
exercise investment discretion?
The Commission requests data and other information related
to the nature and magnitude of discretionary services offered by
broker-dealers. To what extent do broker-dealers offer a range of
discretionary brokerage accounts? What is the range of discretionary
services offered, and what types of limits do broker-dealers apply to
such services?
We understand that dually-registered firms generally treat
discretionary accounts as advisory accounts. Is this understanding
correct? To what extent and under what circumstances do broker-dealers
treat discretionary accounts as brokerage accounts? If broker-dealers
offer
[[Page 21628]]
discretionary management in brokerage accounts, who are the typical
investors in those accounts?
Section 3(a)(35) of the Exchange Act defines ``investment
discretion.'' \366\ Should we consider a different, narrower definition
of discretionary management that would be deemed solely incidental to
the brokerage business?
---------------------------------------------------------------------------
\366\ 15 U.S.C. 78c(a)(35). Under Exchange Act Section 3(a)(35),
a person exercises ``investment discretion'' with respect to an
account if, ``directly or indirectly, such person (A) is authorized
to determine what securities or other property shall be purchased or
sold by or for the account, (B) makes decisions as to what
securities or other property shall be purchased or sold by or for
the account even through some other person may have responsibility
for such investment decisions, or (C) otherwise exercises such
influence with respect to the purchase and sale of securities or
other property by or for the account as the Commission, by rule,
determines, in the public interest or for the protection of
investors, should be subject to the operation of the provisions of
this title and the rules and regulations thereunder.''
---------------------------------------------------------------------------
Do broker-dealers rely on the staff's 2005 statement that
it would not deem a broker-dealer to exercise investment discretion for
purposes of the then existing Advisers Act rule 202(a)(11)-1 as a
result of the exercise of investment discretion by one of its
associated persons over a ``related account''? \367\
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\367\ A ``related account'' is an account where the associated
person's discretionary authority stems from his or her serving as
executor, conservator, trustee, attorney-in-fact or other agent as a
result of a family or personal relationship, and not from employment
with the broker-dealer. No-Action Letter Under Investment Advisers
Act of 1940--Rule 202(a)(11)-1 (Nov. 17, 2005), available at https://www.sec.gov/divisions/investment/noaction/morganlewis111705.htm.
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We are concerned that any approach to the broker-dealer
exclusion in the Advisers Act that would permit broker-dealers
unlimited investment discretion could increase incentives for improper
conduct, particularly the incentive to churn accounts because broker-
dealers receive transactional compensation. To what extent would
permitting broker-dealers to exercise unlimited investment discretion
increase the risk of such conduct? Are there protections in addition to
those already in place, or limitations on the permissible use of
investment discretion, that we could take to reduce such risks? To what
extent would subparagraph (a)(2)(i)(C) of proposed Regulation Best
Interest reduce such risks?
To what extent does broker-dealers' exercise of investment
discretion for their customers increase investor choice in financial
services? What are the benefits and risks to investors? How could the
risks be addressed through regulation, including Regulation Best
Interest?
The Commission also requests commenters' views on
potential opportunities for broker-dealers to offer discretionary
brokerage services in the future. To what extent would broker-dealers
anticipate offering additional discretionary brokerage services?
As discussed in this release and the Relationship Summary
Proposal, investors are often confused by the differences between
advisory and brokerage accounts. Would drawing a specific distinction
between discretionary and non-discretionary accounts resolve some of
this confusion?
III. Request for Comment
The Commission requests comments on all aspects of Regulation Best
Interest. The Commission particularly requests comment on the general
impact the proposal would have on recommendations to retail customers
and on the behavior of broker-dealers, including the interaction of
Regulation Best Interest with the requirements of the Relationship
Summary Proposal. The Commission also seeks comment on the interaction
of Regulation Best Interest with FINRA and other SRO rules, the
antifraud provisions of the federal securities laws, the Advisers Act,
ERISA, and the Code. In addition, the Commission seeks comment on the
following specific issues:
A. Generally
Does Regulation Best Interest clearly define the
obligations to which broker-dealers would be subject? Are there
clarifications or instructions to the proposed requirements that would
aid broker-dealers' compliance with the proposed rule? If so, what are
they, and what would be the benefits of providing clarifications or
instructions?
As proposed, compliance with paragraph (a)(2) of
Regulation Best Interest is designed to satisfy the duty in (a)(1). Is
this the right relationship between these two pieces? Should paragraph
(a)(2) be expressed as a minimum standard? Or should the duty in
expressed in paragraph (a)(1) have residual force and effect apart from
the obligations in (a)(2)? Alternatively, should compliance with (a)(2)
be a safe harbor? Or should it create a legal presumption that the
broker-dealer has met the standard in (a)(1)? Should the Commission
create a compliance safe harbor for Regulation Best Interest? Why or
why not? If so, what conditions should a broker-dealer be required to
satisfy to claim the safe harbor? What impact would this have on the
recommendations that retail customers receive?
Should broker-dealers be subject to any additional
requirements with respect to the best interest obligation proposed
under Regulation Best Interest? If so, what requirements and why?
Should the Commission require policies and procedures to
assist with compliance with Regulation Best Interest? If so, how would
those policies and procedures differ, if at all, from those currently
required by FINRA?
Should the Commission consider making other adjustments to
the regulatory obligations of broker-dealers, and if so, which
obligations?
Should the Commission include in the rule text the
interpretations and recommendations included in the guidance provided
above? If so, which interpretations and recommendations and why or why
not?
Do commenters believe any of the proposed definitions
under Regulation Best Interest should be eliminated or modified? Are
there any additional terms that should be defined; if so, what are
those terms, how should such terms be defined, and why?
To what extent would Regulation Best Interest help address
any investor confusion about the standard of conduct that applies when
a broker-dealer provides advice in the form of recommendations? What,
if any, other steps should the Commission consider to attempt to
mitigate investor confusion?
What impact would Regulation Best Interest have on the
range of choice--both in terms of services related to advice and
products--that is available to brokerage retail customers today? Would
it preserve such choice? What, if any, additional or different steps
should the Commission consider to attempt to preserve choice or
mitigate any negative impact on the range of choice available to
brokerage customers to receive financial advice?
What impact would Regulation Best Interest have on the
ability of broker-dealers to compete with other financial
intermediaries to provide advice to investors in the future?
To what extent would Regulation Best Interest be
consistent with relevant SRO requirements? Would Regulation Best
Interest be stricter or less strict than SRO obligations? Would
Regulation Best Interest conflict with or be redundant of SRO
obligations; if so, please identify which SRO obligations and whether
and how the Commission should consider to address such conflicts or
redundancies.
Is it appropriate for Regulation Best Interest to be
designed to be generally consistent with DOL and SRO
[[Page 21629]]
regulations? Why or why not? Should we take a different approach?
Does proposed Regulation Best Interest address current
deficiencies in the current standard applicable to broker-dealers who
provide advice? Why or why not? Please explain.
Are there any recommendations in the 913 Study that should
be, but have not been, incorporated into the proposed rule? Please
elaborate.
To what extent is the proposed Regulation Best Interest
consistent or inconsistent with broker-dealers' existing obligations?
How? What impact would such consistency or inconsistency have on retail
customers and broker-dealers?
B. Interactions With Other Standards of Conduct
Are there any specific interactions or relationships
between the proposed rules and other federal securities laws that
should be addressed?
Are there any specific interactions between the proposed
rules and other regulatory requirements, such as SRO rules or state
securities laws that should be addressed?
Are there any specific interactions between the proposed
rules and any non-securities statutes and regulations (e.g., ERISA and
the Code) that should be addressed? If so, how should those
interactions or relationships be addressed or clarified?
Do any of the proposed requirements conflict with any
existing requirements, including any requirement currently imposed by
an SRO or by a state regulator, such that it would be impractical or
impossible for a broker-dealer to meet both obligations? If so, which
one(s) and why?
Do commenters agree that proposed Regulation Best Interest
is consistent with and similar to (if not the same as) related
obligations under the duties of loyalty and care as interpreted under
the Advisers Act? Why or why not? Please explain.
If the Commission were to adopt this proposal, there would
still be different standards of conduct for retail customer accounts
subject to the DOL Fiduciary Rule and those that are not, as well as
existing differences between standards of conduct applicable to broker-
dealers and those applicable to investment advisers when providing
investment advice. Should the Commission consider harmonizing
regulatory obligations related to the provision of advice that are
applicable to broker-dealers and investment advisers? Why or why not?
If so, how so? Please be specific with regard to the existing
obligations and how they should be changed.
To what extent would regulatory harmonization address
investors' confusion about the obligations owed to them by broker-
dealers and investment advisers? To what extent would regulatory
harmonization result in additional investor confusion or otherwise
negatively impact investors? What would be positive and negative
investor impacts of regulatory harmonization? To what extent would
regulatory harmonization affect investors' choice of financial firms
and options to pay for financial advice? Please explain.
Are there any specific interactions between Regulation
Best Interest and state standards that should be addressed? What have
commenters' experiences been with respect to current state fiduciary
standards (regulatory and common law) for broker-dealers that provide
investment advice? How are these standards similar or different than
this proposal? What are commenters' views regarding proposed state
fiduciary standards for broker-dealers?
IV. Economic Analysis
A. Introduction, Primary Goals of Proposed Regulations and Broad
Economic Considerations
1. Introduction and Primary Goals of Proposed Regulation
The Commission is mindful of the costs imposed by, and the benefits
obtained from, our rules. Whenever the Commission engages in rulemaking
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
requires the Commission to consider whether the action would promote
efficiency, competition, and capital formation, in addition to the
protection of investors.\368\ Further, when making rules under the
Exchange Act, Section 23(a)(2) of the Exchange Act requires the
Commission to consider the impact such rules would have on
competition.\369\ Section 23(a)(2) of the Exchange Act also prohibits
the Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.\370\ The following analysis considers, in detail,
the potential economic effects that may result from proposed Regulation
Best Interest, including the benefits and costs to retail customers and
broker-dealers as well as the broader implications of the proposal for
efficiency, competition, and capital formation.
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\368\ See 15 U.S.C. 77b(b) and 15 U.S.C. 78c(f).
\369\ See 15 U.S.C. 78w(a)(2).
\370\ Id.
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Where possible, the Commission quantifies the likely economic
effects of proposed Regulation Best Interest; however, as explained
further below, the Commission is unable to quantify certain economic
effects because it lacks the information necessary to provide
reasonable estimates. In some cases, quantification is particularly
challenging due to the difficulty of predicting how market participants
would act under the conditions of the proposed rule. Nevertheless, as
described more fully below, the Commission is providing both a
qualitative assessment and quantified estimate of the potential
effects, including the potential aggregate initial and aggregate
ongoing costs, where feasible. The Commission encourages commenters to
provide data and information to help quantify the benefits, costs, and
the potential impacts of the proposed rule on efficiency, competition,
and capital formation.
2. Broad Economic Considerations
a. The Principal-Agent Relationship
The relationship between a retail customer and a broker-dealer is
an example of what is referred to in economic theory as an ``agency''
relationship. In an agency relationship, one party, commonly referred
to as ``the principal,'' engages a second party, commonly referred to
as ``the agent,'' to perform some service on the principal's
behalf.\371\ Because the agent and the principal are likely to have
different preferences and goals, there is reason to believe that the
agent may not always take actions that are in the principal's
interest.\372\ This divergence in interests gives rise to agency
problems: Agents take actions that increase their well-being at the
expense of principals.\373\
[[Page 21630]]
Retail customers face agency problems when they seek advice from
financial professionals. For example, a retail customer may believe
that a broker-dealer will exert a high level of effort on a retail
customer's behalf to identify a security that helps the retail customer
meet her objectives. But to the extent that effort is costly to the
broker-dealer and the benefits of the recommendation accrue solely to
the retail customer, the broker-dealer has an incentive to exert a
lower level of effort than the retail customer expects.\374\ In this
section, we describe how principals (customers) and agents (broker-
dealers and associated persons) ameliorate agency problems in the
market for investment advice using contracts and discuss limits to the
efficiency of contracting in the market for financial advice.
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\371\ For example, James A. Brickley, Clifford W. Smith, Jr.,
Jerold L. Zimmerman, ``Managerial Economics and Organizational
Architecture'' (2004, p. 265), ``An agency relationship consists of
an agreement under which one party, the principal, engages another
party, the agent, to perform some service on the principal's
behalf.'' See also Michael C. Jensen and William H. Meckling,
``Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure,'' Journal of Financial Economics (1976, vol. 3,
pp. 305-60).
\372\ See Michael C. Jensen and William H. Meckling, ``Theory of
the Firm: Managerial Behavior, Agency Costs and Ownership
Structure,'' Journal of Financial Economics (1976, vol. 3, p. 308).
\373\ See James A. Brickley, Clifford W. Smith, Jr., Jerold L.
Zimmerman, ``Managerial Economics and Organizational Architecture''
(2004, p. 265).
\374\ Other manifestations of the agency conflict between
broker-dealers and customers include conflicts that arise when
broker-dealers act as principal (e.g., proprietary products,
principal trades) or when the broker-dealer opts to enter into
relationships with third parties (e.g., revenue sharing) that
creates their own conflicts.
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Contracts are a common mechanism used by principals and agents to
ameliorate agency problems. They do so by explicitly setting out the
responsibilities of both parties under the contract. Typically, in
return for compensation from the principal, an agent agrees to perform
certain actions that will benefit the principal. For example, in a
typical contract between a broker-dealer and a retail customer, the
broker-dealer agrees to provide execution services in return for
compensation in the form of either a commission or a markup. The
contract ameliorates the conflict between the two parties because the
broker-dealer is compensated only if it provides the contracted
service.
Explicit contracting is an efficient mechanism for ameliorating
agency costs when the principal can monitor the agent's performance at
low cost. For certain services, however, it may be difficult or costly
for principals to monitor agent performance. For example, in seeking
investment advice, retail customers may expect broker-dealers to
understand the potential risks and rewards associated with a
recommended transaction or strategy. While it might be possible, in
theory, to include such an explicit provision in the contract between
the customer and the broker-dealer to this effect, it would be
difficult for the customer to confirm the broker-dealer's actual
understanding. The inability of the customer to confirm the broker-
dealer's actual understanding limits the usefulness of such a provision
in ameliorating the agency conflict between the customer and the
broker-dealer.
Another factor that determines the effectiveness of explicit
contracting and monitoring by the principal is the ability of the
principal to accurately measure and assess the actions of the
agent.\375\ For example, customers may expect advice that is tailored
to their specific investment objectives, financial situation, and
needs. Contracts between customers and broker-dealers could include
explicit provisions to this effect. However, customers may lack the
knowledge required to assess whether a recommendation is appropriate
for their needs, given their particular situation. As a result, while
such an explicit provision could be included in a contract between a
retail customer and a broker-dealer, it would be of limited value in
ameliorating the agency conflict between the two.
---------------------------------------------------------------------------
\375\ See Frank H. Easterbrook and Daniel R. Fischel, ``Contract
and Fiduciary Duty,'' Journal of Law & Economics (1993, vol. 36, p.
426) (``Contract and Fiduciary Duty'').
---------------------------------------------------------------------------
Finally, we note that beyond the agency costs described above,
there are costs associated with specifying the contractual terms
themselves. Specifying contractual terms potentially involves
forecasting all future states of the world that are relevant to the
contractual relationship and specifying the parties' obligations in
each of those states. In environments as complex as financial markets,
the ability to forecast future states may be especially difficult.
Further, even if financial firms and retail customers were able to
forecast all future states of the world relevant to their relationship,
the process of contractually specifying each state and the financial
firm's obligation to a retail customer in each of those states could be
very costly.\376\
---------------------------------------------------------------------------
\376\ See Frank H. Easterbrook and Daniel R. Fischel, ``The
Economic Structure of Corporate Law'' (1991, p. 90). See also
``Contract and Fiduciary Duty.'' The authors note that parties to
the contract are likely not able to see future possibilities well
enough to specify all contingencies ahead of time.
---------------------------------------------------------------------------
As an alternative to explicit contracting and monitoring by
principals, agents can expend resources (i.e., ``bonding costs'') to
guarantee their fulfillment of contractual terms or to ensure that the
principal will be compensated if the agents fail to meet their
obligations.\377\ As we noted above, customers would like broker-
dealers to understand the potential risks and rewards associated with a
recommended transaction or strategy. For example, and if consistent
with applicable legal limitations, the contract between the customer
and broker-dealer could include a provision in which the broker-dealer
agrees to compensate the retail customer if the broker-dealer does not
have the level of understanding promised under the contract.
Unfortunately, factors that limit the effectiveness of explicit
contracting and monitoring by principals also tend to limit the
effectiveness of explicit contracting and bonding by agents. For
example, a broker-dealer's actual level of understanding is difficult
to confirm. The difficulty in confirming a broker-dealer's
understanding would cause any promise to compensate the customer if the
broker-dealer did not understand the potential risks and rewards
associated with a recommended transaction or strategy to be of limited
value.
---------------------------------------------------------------------------
\377\ For example, agents might bond themselves by purchasing
insurance policies that pay the principal in the case of theft. See
James A. Brickley, Clifford W. Smith, Jr., Jerold L. Zimmerman,
``Managerial Economics and Organizational Architecture'' (2004, p.
265). The agent is willing to incur bonding costs to increase the
amount paid to the agent by the principal for the agent's services.
---------------------------------------------------------------------------
In situations where the costs of explicit contracting and
monitoring and bonding are large, or where the cost of writing and
enforcing contracts is large, a legal or regulatory standard of conduct
can serve as an alternative mechanism for ameliorating agency
costs.\378\ Under a legal or regulatory standard of conduct, agents are
obligated to act in the principal's interest with the standard of
conduct defining how that obligation is to be met. For example, as
noted above, retail customers would like broker-dealers to understand
the potential risks and rewards associated with a recommended
transaction or strategy as well as for the broker-dealer to tailor
recommendations to the retail customer's specific investment
objectives, financial situation, and needs. It would be difficult to
stipulate those requirements in an explicit contract between a broker-
dealer and a retail customer because such contract would be difficult
to monitor and enforce. In particular, under private contracting,
deterring broker-dealers from not acting in the retail customer's
interest could be difficult. A standard of conduct that requires
broker-dealers to act in the retail customer's best interest provides
an alternative mechanism that is designed to result in the broker-
dealer providing services at a level of quality
[[Page 21631]]
that better matches the expectations of its retail customers. In
particular, broker-dealers would face regulatory liability if they
failed to meet their obligation to act in the retail customer's
interest under the standard of conduct. Relative to private
contracting, a standard of conduct may be more effective in deterring
broker-dealers from acting in their own interest rather than the retail
customer's interest.
---------------------------------------------------------------------------
\378\ In a world of scarce information and high transactions
costs, regulation can promote the efficiency of contracting between
parties by prescribing the outcomes the parties themselves would
have reached had information been plentiful and negotiations
costless. See ``Contract and Fiduciary Duty'' and R. H. Coase, ``The
Problem of Social Cost,'' Journal of Law & Economics (1960, vol. 3,
pp. 1-44).
---------------------------------------------------------------------------
Regulation Best Interest would create a minimum professional
standard of conduct for broker-dealers under the Exchange Act that is
designed to ameliorate the agency costs associated with conflicts
between broker-dealers and their retail customers. It would also
articulate the role of regulators in enforcing such standard of
conduct. As a result, the firm's legal and regulatory obligations would
be designed to result in the firm providing advice at a level of
quality that better matches the expectations of its retail customers.
In the absence of some form of amelioration, the agency conflicts
between broker-dealers and retail customers may influence the advice
that retail customers obtain in a number of ways. In the narrow context
of a choice between two products with similar expected returns and risk
profiles, but with different commissions, an agency conflict leaves the
retail customer no worse off in terms of investment outcomes except to
the extent that higher commissions result in total returns that are
lower on one product than on the other. Under other circumstances,
however, an agency conflict may impose greater or different costs on
retail customers and, more generally, on financial markets.
For example, a financial firm that is able to systematically choose
a higher fee product to recommend to its retail customers may
rationally respond by constructing a menu of offerings that permit it
to choose to recommend products that yield the firm higher expected
payoffs. However, such menus may restrict retail customer access to
financial products that are equally suitable but that could provide
retail customers with better risk-return profiles. Agency conflicts
that arise from material conflicts of interest may similarly cause
financial firms to limit the choices available to retail customers.
Financial firms may have incentives to prefer proprietary products or
products of affiliates over more conventional products that may be
equally suitable for the retail customers, but potentially more
beneficial for the firms.
Furthermore, the ability of financial firms to act on conflicts may
have repercussions for retail customer welfare if it erodes retail
customer trust in financial markets or the market for financial advice.
As noted in the Relationship Summary Proposal, evidence suggests a
relatively low level of financial literacy among retail customers.\379\
Retail customers who are aware that financial firms are likely to be
conflicted may choose not to seek advice even when conflicted advice
would make them better off than no advice at all. If the presence of
conflicts of interest reduces retail customer trust, retail customers,
out of abundance of caution may forgo valuable investment
opportunities.\380\ By contrast, disclosure of conflicts of interest
and disclosure of measures taken to mitigate conflicts of interest
could have the opposite effect by bolstering investor trust.
---------------------------------------------------------------------------
\379\ See Relationship Summary Proposal. See, e.g., Staff of the
Securities and Exchange Commission, Study Regarding Financial
Literacy Among Investors As Required by Section 917 of the Dodd-
Frank Wall Street Reform and Consumer Protection Act (Aug. 2012), at
iv, v, xiv, 37, 73, 121-23 and 131-32, available at https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf
(``917 Financial Literacy Study'')
\380\ See Ko, K. Jeremy, ``Economics Note: Investor
Confidence,'' Oct. 2017, available at https://www.sec.gov/files/investor_confidence_noteOct2017.pdf.
---------------------------------------------------------------------------
b. Effects of the Best Interest Standard on the Agency Relationship
As discussed above, there are significant investor protections
offered by a best interest standard of conduct approach to addressing
the principal-agent issue. However, it is important to note that both
parties potentially benefit from the reduction of agency costs. As an
initial matter, both retail customers and financial firms enter into an
agency relationship only when both sides expect the relationship will
make them better off. Generally, both parties enter into a contracting
relationship when the retail customer values the financial firm's
services at a value that is greater than the minimum price at which the
financial firm is willing to supply them (the financial professional's
``reservation price'').\381\ The difference between the retail
customer's willingness to pay and the financial firm's reservation
price represents the ``gains from trade'' associated with the
contracting relationship. How these gains from trade are shared between
the retail customer and the broker-dealer depends on a variety of
factors, including the competitiveness of the market for financial
advice, and the ability of broker-dealers to exploit their
informational advantage over retail customers.
---------------------------------------------------------------------------
\381\ See James A. Brickley, Clifford W. Smith, Jr., Jerold L.
Zimmerman, ``Managerial Economics and Organizational Architecture''
(2004, p. 45).
---------------------------------------------------------------------------
To make this concrete, consider a situation where a principal
values the agent's services at $10,000 and the minimum price at which
the agent is willing to provide the service is $5,000.\382\ The
difference between the principal's valuation of the agent's services
and the minimum price at which the agent is willing to supply the
services represents potential gains from trade to be shared between the
two parties. In this case, the gains from trade would be $5,000
(=$10,000-$5,000).\383\
---------------------------------------------------------------------------
\382\ These numbers are provided only as an illustrative example
and are not meant to convey the costs of financial services.
\383\ See supra note 380.
---------------------------------------------------------------------------
Suppose, however, that the principal recognizes that the agent's
preferences are not perfectly aligned with her own and that given the
difference in preferences the principal revises her expectation of the
agent's behavior, and therefore the valuation of the agent's services,
to $7,000. The potential gains from trade have been reduced from $5,000
to $2,000. The $3,000 reduction in gains from trade is a real cost of
the agency conflict between the two parties.\384\ If gains from trade
are shared between both parties, both parties have an incentive to
ameliorate the agency conflict so as to maximize the potential gains
from trade to be shared between the two.
---------------------------------------------------------------------------
\384\ From the example, it should be clear that agency costs
can, potentially, rise to such a level that the gains from trade are
completely wiped out and trade does not occur.
---------------------------------------------------------------------------
Suppose further that the two parties could agree to a contract with
explicit provisions that would ameliorate the agency conflict to such a
degree that the principal would believe the agent's services to be
worth $9,000. Further, suppose that the contract has associated costs
of $500.\385\ It would be in both parties' interests to use the
contract because it would increase the gains from trade to be shared
between the two from $2,000 to $3,500 (=$9,000-$5,000-$500).
---------------------------------------------------------------------------
\385\ That is, the sum of the monitoring, bonding, and contract
specifications costs is $500.
---------------------------------------------------------------------------
However, contracts may be inefficient under certain circumstances.
For example, suppose there existed additional contract provisions that
could further ameliorate the agency conflict to a degree that the
principal would believe that the agent's services to be worth an
additional $500, or $9,500 in total (=$9,000 + $500), but that those
provisions cost $750 to implement. In this case, it would not be in the
parties' interests to engage in those additional contracting provisions
[[Page 21632]]
because it would result in a reduction in gains from trade from $3,500
to $3,250 (=$9,500-$5,000-$500-$750).
Importantly, this example does not reflect the types of factors
that can impact how these gains from trade will be shared. For example,
broker-dealers may have an informational advantage that could allow
them to maintain a large share of the gains of trade that flow from
their relationship with retail customers. We understand that retail
customers generally do not know the structure of mutual fund fees or
how much is remitted back to broker-dealers recommending those funds.
The proposed rule would no longer make it possible for the broker-
dealer to make a recommendation solely based on the portion of fees
that flow back to the broker-dealer, thereby reducing the share of the
gains from trade that broker-dealers are currently able to retain. In
response, broker-dealers may try to recoup this loss by increasing the
fees for recommendations to retail customers. Fees that broker-dealers
charge to retail customers, unlike the compensation that broker-dealers
extract from product sponsors, are generally required to be disclosed.
To the extent that retail customers are sensitive to fee increases
(e.g., may switch to another, lower-cost broker-dealer) broker-dealers
may not be able to reverse the loss in gains from trade through a fee
increase. Thus, the degree of competition among broker-dealers may
limit the extent to which a broker-dealer can recoup these losses. As a
result, if the market for broker-dealer advice is sufficiently
competitive, the gains from trade that result from the proposed rule
would mostly flow to retail customers.
Therefore, a standard of conduct may be an efficient alternative to
the costly explicit contracting illustrated above. We acknowledge,
however, that standards also can be costly. In the analysis that
follows in Section C below, we characterize the benefits and costs
associated with the proposed best interest standard of conduct and
their resulting effect on the gains from trade to be shared between
broker-dealers and their retail customers.
B. Economic Baseline
1. Market for Advice Services \386\
---------------------------------------------------------------------------
\386\ 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 insurance companies, which also
provide financial advice services to retail customers. A number of
broker-dealers (see infra note 391) have non-securities businesses,
such as insurance or tax services; however, the Commission is unable
to estimate the number of other entities that are likely to provide
financial advice to retail customers. As of January 2018, there were
approximately 17,800 state-registered investment advisers, of which
145 are also registered with the Commission, as reported on Form ADV
Item 2.A. The Department of Labor in its Regulatory Impact Analysis
identifies approximately 398 life insurance companies that could
provide advice to retirement investors. See infra note 453.
---------------------------------------------------------------------------
a. Broker-Dealers
The Commission analyzed the effect of proposed Regulation Best
Interest on the market for broker-dealer services. For simplification,
the Commission presents its analysis as if the market for broker-dealer
services encompasses one broad market with multiple segments, even
though, in terms of competition, it may be more realistic to think of
it as numerous interrelated markets. The market for broker-dealer
services covers many different markets for a variety of services,
including, but not limited to, managing orders for customers and
routing them to various trading venues; providing advice to retail
customers on an episodic, periodic, or ongoing basis; holding retail
customers' funds and securities; handling clearance and settlement of
trades; intermediating between retail customers and carrying/clearing
brokers; dealing in government bonds; privately placing securities; and
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 others may provide a wide variety of
services.
As of December 2017, there were approximately 3,841 registered
broker-dealers with over 130 million customer accounts. In total, these
broker-dealers have close to $4 trillion in total assets, which are
total broker-dealer assets as reported on Form X-17a-5.\387\ More than
two-thirds of all brokerage assets and close to one-third of all
customer accounts are held by the 16 largest broker-dealers, as shown
in Table 1, Panel A.\388\ Of the broker-dealers registered with the
Commission as of December 2017, 366 broker-dealers were dually-
registered as investment advisers; \389\ however, these firms hold
nearly 90 million (68% of) customer accounts.\390\ Approximately 546
broker-dealers (14%) reported at least one type of non-brokerage
business, including insurance, retirement planning, mergers &
acquisitions, and real estate, among others.\391\ Approximately 74% of
registered broker-dealers report retail customer activity.\392\
---------------------------------------------------------------------------
\387\ 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.
\388\ Approximately $3.91 trillion of total assets of broker-
dealers (98%) are at firms with total assets in excess of $1
billion. Of the 30 dual registrants in the group of broker-dealers
with total assets in excess of $1 billion, total assets for these
dual registrants are $2.46 trillion (62%) of aggregate broker-dealer
assets. Of the remaining 88 firms, 81 have affiliated investment
advisers.
\389\ Because this number does not include the number of broker-
dealers who are also registered as state investment advisers, it
undercounts the full number of broker-dealers that operate in both
capacities. Further, 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 dual
registrants offer advisory accounts to retail investors but offer
brokerage services, such as underwriting services, only to
institutional customers. For purposes of the discussion of the
baseline in this economic analysis, a dual registrant is any firm
that is dually-registered with the Commission as an investment
adviser and a broker-dealer. For the purposes of proposed Regulation
Best Interest, however, we propose to define dual registrant as a
firm that is dually-registered as a broker-dealer and an investment
adviser and offers services to retail investors as both a broker-
dealer and investment adviser.
\390\ Some broker-dealers may be affiliated with investment
advisers without being dually-registered. From Question 10 on Form
BD, 2,145 broker-dealers (55.8%) report that directly or indirectly,
they either control, are controlled by, or under common control with
an entity that is engaged in the securities or investment advisory
business. Comparatively, 2,478 (19.57% of) SEC-registered investment
advisers report an affiliate that is a broker-dealer in Section 7A
of Schedule D of Form ADV, including 1,916 SEC-registered investment
advisers that report an affiliate that is a registered broker-
dealer. Approximately 75% of total assets under management of
investment advisers is managed by these 2,478 investment advisers.
\391\ We examined Form BD filings to identify broker-dealers
reporting non-securities business. For the 546 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 (208), management/financial/other
consulting (101), advisory/retirement planning (80), mergers &
acquisitions (71), foreign exchange/swaps/other derivatives (31),
real estate/property management (31), tax services (15), and other
(141). Note that a broker-dealer may have more than one line of non-
securities business.
\392\ 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. We request comment on whether
firms that intermediate both retail and institutional customer
activity generally market only ``sales'' on Form BR.
---------------------------------------------------------------------------
Panel B of Table 1 limits the broker-dealers to those that report
some retail customer activity. As of December 2017,
[[Page 21633]]
there were approximately 2,857 broker-dealers that served retail
customers, with over $3.6 trillion in assets (90 of total broker-dealer
assets) and almost 128 million (96 of) customer accounts.\393\ Of those
broker-dealers serving retail customers, 360 are dually-registered as
investment advisers.\394\
---------------------------------------------------------------------------
\393\ 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.
\394\ Of the 36 dual registrants in the group of retail broker-
dealers with total assets in excess of $500 million, total assets
for these dual registrants are $2.19 trillion (60%) of aggregate
retail broker-dealer assets. Of the remaining 72 retail broker-
dealers, 67 have affiliated investment advisers.
---------------------------------------------------------------------------
---------------------------------------------------------------------------
\395\ The data is obtained from FOCUS filings as of December
2017. 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.
\396\ In addition to the approximately 130 million individual
accounts at broker-dealers, there are approximately 293,000 omnibus
accounts (0.2% of total accounts at broker-dealers), with total
assets of $23.1 billion, across all 3,841 broker-dealers, of which
approximately 99% are held at broker-dealers with greater than $1
billion in total assets. See also supra note 388. 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 underinclusive of all customer accounts held at
broker-dealers.
\397\ ``Customer Accounts'' includes both broker-dealer and
investment adviser accounts for dual registrants.
Table 1, Panel A--Registered Broker-Dealers as of December 2017 \395\
Cumulative Broker-Dealer Total Assets and Customer Accounts \396\
----------------------------------------------------------------------------------------------------------------
Cumulative
Total number Number of dual- Cumulative number of
Size of broker-dealer (total assets) of BDs registered BDs total assets customer
(billion) accounts \397\
----------------------------------------------------------------------------------------------------------------
> $50 billion................................... 16 10 $2,717 40,969,187
$1 billion to $50 billion....................... 102 20 1,196 81,611,933
$500 million to $1 billion...................... 38 7 26 4,599,330
$100 million to $500 million.................... 118 26 26 1,957,981
$10 million to $100 million..................... 482 94 17 2,970,133
$1 million to $10 million....................... 1,035 141 4 233,946
< $1 million.................................... 2,055 68 1 5,588
---------------------------------------------------------------
Total....................................... 3,841 366 3,987 132,348,098
----------------------------------------------------------------------------------------------------------------
Table 1, Panel B--Registered Retail Broker-Dealers as of December 2017
Cumulative Broker-Dealer Total Assets and Customer Accounts
----------------------------------------------------------------------------------------------------------------
Cumulative
Total number Number of dual- Cumulative number of
Size of broker-dealer (total assets) of BDs registered BDs total assets customer
(billion) accounts
----------------------------------------------------------------------------------------------------------------
> $50 billion................................... 15 10 $2,647 40,964,945
$1 billion to $50 billion....................... 70 19 923 77,667,615
$500 million to $1 billion...................... 23 7 16 4,547,574
$100 million to $500 million.................... 93 25 20 1,957,981
$10 million to $100 million..................... 372 94 14 2,566,203
$1 million to $10 million....................... 815 139 3 216,158
< $1 million.................................... 1,469 66 .4 5,588
---------------------------------------------------------------
Total....................................... 2,857 360 3,624 127,926,064
----------------------------------------------------------------------------------------------------------------
As shown in the table below, based on responses to Form BD, broker-
dealers' most significant business lines include private placements of
securities (61.4 of broker-dealers), retail sales of mutual funds
(54.2), acting as a broker or dealer retailing corporate equity
securities over the counter (51.2), acting as a broker or dealer
retailing corporate debt securities (46.6), acting as a broker or
dealer selling variable contracts, such as life insurance or annuities
(39.5), acting as a broker of municipal debt/bonds or U.S. government
securities (39.0 and 36.7, respectively), acting as an underwriter or
selling group participant of corporate securities (30.0), investment
advisory services (24.2), among others.\398\
---------------------------------------------------------------------------
\398\ 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 2 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 2017.
Table 2--Retail Broker-Dealer Lines of Business as of December 2017
------------------------------------------------------------------------
Total
-------------------------------
Line of business Number of
broker-dealers Percent
------------------------------------------------------------------------
Private Placements of Securities........ 1,755 61.4
[[Page 21634]]
Mutual Fund Retailer.................... 1,549 54.2
Broker or Dealer Retailing:
Corporate Equity Securities OTC..... 1,462 51.2
Corporate Debt Securities........... 1,331 46.6
Variable Contracts.................. 1,129 39.5
Municipal Debt/Bonds--Broker............ 1,115 39.0
U.S. Government Securities Broker....... 1,049 36.7
Put and Call Broker or Dealer or Options 999 35.0
Writer.................................
Underwriter or Selling Group 857 30.0
Participant--Corporate Securities......
Non-Exchange Member Arranging for 797 27.9
Transactions in Listed Securities by
Exchange Member........................
Investment Advisory Services............ 691 24.2
Broker or Dealer Selling Tax Shelters or 626 21.9
Limited Partnerships--Primary Market...
Trading Securities for Own Account...... 613 21.5
Municipal Debt/Bonds--Dealer............ 489 17.1
U.S. Government Securities--Dealer...... 347 12.1
Solicitor of Time Deposits in a 317 11.1
Financial Institution..................
Underwriter--Mutual Funds............... 232 8.1
Broker or Dealer Selling Interests in 232 8.1
Mortgages or Other Receivables.........
Broker or Dealer Selling Oil and Gas 207 7.2
Interests..............................
Broker or Dealer Making Inter-Dealer 205 7.2
Markets in Corporate Securities OTC....
Broker or Dealer Involved in Networking, 202 7.1
Kiosk, or Similar Arrangements (Banks,
Savings Banks, Credit Unions)..........
Internet and Online Trading Accounts.... 200 7.0
Exchange Member Engaged in Exchange 175 6.1
Commission Business Other than Floor
Activities.............................
Broker or Dealer Selling Tax Shelters or 163 5.7
Limited Partnerships--Secondary Market.
Commodities............................. 159 5.6
Executing Broker........................ 111 3.9
Day Trading Accounts.................... 92 3.2
Broker or Dealer Involved in Networking, 90 3.2
Kiosk, or Similar Arrangements
(Insurance Company or Agency)..........
Real Estate Syndicator.................. 89 3.1
Broker or Dealer Selling Securities of 76 2.7
Non-Profit Organizations...............
Exchange Member Engaged in Floor 63 2.2
Activities.............................
Broker or Dealer Selling Securities of 47 1.6
Only One Issuer or Associate Issuers...
Prime Broker............................ 21 0.7
Crowdfunding FINRA Rule 4518(a)......... 18 0.6
Clearing Broker in a Prime Broker....... 14 0.5
Funding Portal.......................... 8 0.3
Crowdfunding FINRA Rule 4518(b)......... 3 0.1
Number of Retail-Facing Broker-Dealers.. 2,857 ..............
------------------------------------------------------------------------
b. Investment Advisers
Proposed Regulation Best Interest could affect, indirectly, other
providers of investment advice, such as investment advisers, because
the proposed rule could impact the competitive landscape in the market
for the provision of financial advice.\399\ This section first
discusses Commission-registered investment advisers, followed by a
discussion of state-registered investment advisers.
---------------------------------------------------------------------------
\399\ In addition to the Commission-registered and state-
registered investment advisers, which are the focus of this section,
the proposed rule could also affect banks, trust companies,
insurance companies, and other providers of investment advice.
---------------------------------------------------------------------------
As of December 2017, there were 12,659 investment advisers
registered with the Commission. The majority of Commission-registered
investment advisers report that they provide portfolio management
services for individuals and small businesses.\400\
---------------------------------------------------------------------------
\400\ Of the 12,659 SEC-registered investment advisers, 7,979
(64%) 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 17,800 state-registered investment
advisers, of which 145 are also registered with the Commission.
Approximately 13,800 state-registered investment advisers are retail
facing (see Item 5.D. of Form ADV).
---------------------------------------------------------------------------
Of all SEC-registered investment advisers, 366 identified
themselves as dually-registered broker-dealers.\401\ Further, 2,478
investment advisers (20%) reported an affiliate that is a broker-
dealer, including 1,916 investment advisers (15%) that reported an SEC-
registered broker-dealer affiliate.\402\ As shown in Panel A of Table 3
below, in aggregate, investment advisers have over $72 trillion in
assets under management (``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, although the dollar value of AUM for
investment advisers and of customer assets in broker-dealer accounts is
comparable, the total number of accounts for investment advisers is
only 27% of the number of customer accounts for broker-dealers.
---------------------------------------------------------------------------
\401\ See supra note 389.
\402\ Form ADV Item 7.A.1.
---------------------------------------------------------------------------
Based on staff analysis of Form ADV data, approximately 60% of
investment advisers (7,600) have some portion of their business
dedicated to individual clients, including both high net worth and non-
high net worth individual clients,\403\ as shown in Panel B of Table
[[Page 21635]]
3.\404\ In total, these firms have approximately $32 trillion of assets
under management.\405\ Approximately 6,600 registered investment
advisers (52%) serve 29 million non-high net worth individual clients
and have approximately $5.33 trillion in assets under management, while
nearly 7,400 registered investment advisers (58%) serve approximately
4.8 million high net worth individual clients with $6.56 trillion in
assets under management.\406\
---------------------------------------------------------------------------
\403\ 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 proposed Regulation Best Interest because
the data obtained from Form ADV is limited to individuals and does
not involve any test of use for personal, family, or household
purposes.
\404\ 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. Form ADV Part
1A.
\405\ 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.
\406\ Estimates are based on IARD system data as of December 31,
2017. The AUM reported here is specifically that of non-high net
worth individual clients. Of the 7,600 investment advisers serving
individual clients, 360 are also registered as broker-dealers.
Table 3, Panel A--Registered Investment Advisers (RIAs) as of December 2017
Cumulative RIA Assets Under Management (AUM) and Accounts
----------------------------------------------------------------------------------------------------------------
Number of dual- Cumulative
Size of investment adviser (AUM) Number of RIAs registered Cumulative AUM number of
RIAs (billion) accounts
----------------------------------------------------------------------------------------------------------------
> $50 billion................................... 246 15 $48,221 17,392,968
$1 billion to $50 billion....................... 3,238 115 21,766 11,560,805
$500 million to $1 billion...................... 1,554 53 1,090 2,678,084
$100 million to $500 million.................... 5,568 129 1,303 3,942,639
$10 million to $100 million..................... 1,103 24 59 198,659
$1 million to $10 million....................... 172 2 1 5,852
< $1 million.................................... 778 28 .02 31,291
---------------------------------------------------------------
Total....................................... 12,659 366 72,439 35,810,298
----------------------------------------------------------------------------------------------------------------
Table 3, Panel B--Retail Registered Investment Advisers (RIAs) as of December 2017
Cumulative RIA Assets Under Management (AUM) and Accounts
----------------------------------------------------------------------------------------------------------------
Number of dual- Cumulative
Size of investment adviser (AUM) Number of RIAs registered Cumulative AUM number of
RIAs (billion) accounts
----------------------------------------------------------------------------------------------------------------
> $50 billion................................... 106 15 $22,788 16,638,548
$1 billion to $50 billion....................... 1,427 114 8,472 10,822,275
$500 million to $1 billion...................... 934 52 652 2,602,220
$100 million to $500 million.................... 4,114 126 917 3,814,900
$10 million to $100 million..................... 711 24 40 231,663
$1 million to $10 million....................... 98 1 .4 5,804
< $1 million.................................... 198 29 .02 31,271
---------------------------------------------------------------
Total....................................... 7,588 361 32,870 34,146,681
----------------------------------------------------------------------------------------------------------------
As an alternative to registering with the Commission, smaller
investment advisers could register with state regulators.\407\ As of
December 2017, there were 17,635 state registered investment
advisers,\408\ of which 145 are also registered with the Commission. Of
the state-registered investment advisers, 236 are dually-registered as
broker-dealers, while 5% (920) report a broker-dealer affiliate. In
aggregate, state-registered investment advisers have approximately $341
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 just 64% for Commission-
registered investment advisers.
---------------------------------------------------------------------------
\407\ Pursuant to the Dodd-Frank Act, Item 2.A. of Part 1A of
Form ADV requires an investment adviser to register with the SEC if
it (i) is a large adviser that has $100 million or more of
regulatory assets under management (or $90 million or more if an
adviser is filing its most recent annual updating amendment and is
already registered with the SEC); (ii) is a mid-sized adviser that
does not meet the criteria for state registration or is not subject
to examination; (iii) meets the requirements for one or more of the
revised exemptive rules under section 203A discussed below; (iv) is
an adviser (or subadviser) to a registered investment company; (v)
is an adviser to a business development company and has at least $25
million of regulatory assets under management; or (vi) received 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 for those investment advisers that do not
already file with the SEC.
\408\ There are 79 investment advisers with latest reported
Regulatory Assets Under Management in excess of $110 million but are
not listed as registered with the SEC. For the purposes of this
rulemaking, these are considered erroneous submissions.
---------------------------------------------------------------------------
Approximately 77% of state-registered investment advisers (13,470)
have some portion of their business dedicated to retail investors,\409\
and in aggregate, these firms have approximately $308 billion in
AUM.\410\ Approximately 12,700 (72%) state-registered advisers serve
616,000 non-high net worth retail clients and have approximately $125
billion in AUM, while over 11,000 (63%) state-registered advisers serve
approximately 194,000 high net worth retail clients with $138 billion
in AUM.\411\
---------------------------------------------------------------------------
\409\ 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. Form ADV Part
1A.
\410\ 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.
\411\ Estimates are based on IARD system data as of December 31,
2017. The AUM reported here is specifically that of non-high net
worth investors. Of the 13,471 investment advisers serving retail
investors, 144 may also be dually-registered as broker-dealers.
---------------------------------------------------------------------------
[[Page 21636]]
c. Trends in the Relative Numbers of Providers of Financial Services
Over time, the relative numbers of broker-dealers and Commission-
registered investment advisers have changed. Figure 1 presented below
shows the time series trend in the relative numbers of broker-dealers
and Commission-registered investment advisers between 2005 and 2017.
Over the last 13 years, the number of broker-dealers has declined from
over 6,000 in 2005 to less than 4,000 in 2017, while the number of
investment advisers has increased from approximately 9,000 in 2005 to
over 12,000 in 2017. This change in the relative numbers of broker-
dealers and investment advisers over time likely affects the
competition for advice and potentially reduces the choices available to
retail customers on how to receive or pay for such advice, the nature
of the advice, and the attendant conflicts of interest.
[GRAPHIC] [TIFF OMITTED] TP09MY18.000
Increases in the number of investment advisers and decreases in the
number of broker-dealers could have occurred for a number of reasons,
including anticipation of possible regulatory changes to the industry,
other regulatory restrictions, technological innovation (i.e., robo-
advisers and online trading platforms), product proliferations (e.g.,
index mutual funds and exchange-traded products), and industry
consolidation driven by economic and market conditions, particularly
among broker-dealers.\412\ Commission staff has observed the transition
by broker-dealers from traditional brokerage services to providing also
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 than accounts that charge
commissions.\413\ Broker-dealers have indicated that the following
factors have contributed to this migration: Provision of stability or
increase in profitability,\414\ perceived lower
[[Page 21637]]
regulatory burden, and provisions of more or better services to retail
customers.
---------------------------------------------------------------------------
\412\ See Hester Peirce, ``Dwindling numbers in the financial
industry,'' Brookings Center on Markets and Regulation, May 15, 2017
(``Brookings Report''), available at https://www.brookings.edu/research/dwindling-numbers-in-the-financial-industry/ (noting 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, NFA, the MSRB, or other SROs.
\413\ The Brookings Report also discusses the shift from broker-
dealer to investment advisory business models for retail investors,
in part due to the Department of Labor's fiduciary rule (page 7).
See also the RAND Study, supra note 28, which documents a shift from
transaction-based to fee-based accounts prior to recent regulatory
changes. Declining transaction-based revenue due to declining
commission rates and competition from discount brokerage firms has
made offering fee-based products and services more attractive.
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.
\414\ 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 9/30/2017 Form 10-Q, available at https://www.sec.gov/Archives/edgar/data/815917/000156459017023050/ck0000815917-10q_20170929.htm; Raymond James 9/30/2017 Form 10-K,
available at https://www.sec.gov/Archives/edgar/data/720005/000072000517000089/rjf-20170930x10k.htm; Stifle 12/31/2016 Form 10-
K, available at https://www.sec.gov/Archives/edgar/data/720672/000156459017022758/sf-10q_20170930.htm; Wells Fargo 9/30/2017 10-Q,
available at https://www.sec.gov/Archives/edgar/data/72971/000007297117000466/wfc-09302017x10q.htm; and Ameriprise 12/31/2016
Form 10-K, available at https://www.sec.gov/Archives/edgar/data/820027/000082002717000007/ameriprisefinancial12312016.htm. We note
that discussions in Form 10-K and 10-Q filings of this sample of
broker-dealers may not be representative of other large broker-
dealers or of small to mid-size broker-dealers. Some firms have also
reported record profits as a result of moving clients into fee-based
accounts, and cite that it provides ``stability and high returns.''
See ``Morgan Stanley Wealth Management fees climb to all-time
high,'' Bloomberg, Jan. 18, 2018, available at 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 (Morgan
Stanley Strategic Update, Jan. 18, 2018, available at https://www.morganstanley.com/about-us-ir/shareholder/4q2017-strategic-update.pdf). See also Beilfuss, Lisa and Brian Hershberg, ``WSJ
Wealth Adviser Briefing: The Reinvention of Morgan and Merrill,
Adviser Profile,'' The Wall Street Journal, Jan. 25, 2018, available
at https://blogs.wsj.com/moneybeat/2018/01/25/wsj-wealth-adviser-briefing-the-reinvention-of-morgan-and-merrill-adviser-profile/.
---------------------------------------------------------------------------
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, since 2012, more than 12 million new non-high
net worth retail clients have been added. With respect to assets under
management, 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.
[GRAPHIC] [TIFF OMITTED] TP09MY18.001
[[Page 21638]]
d. 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'' or ``RR''s).\415\ 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.\416\
---------------------------------------------------------------------------
\415\ 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.
Therefore, using 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.
\416\ See Advisers Act Rule 203A-3. 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 on behalf on an investment adviser 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 who meet the definition of
``qualified client,'' all of which individuals would fall under the
definition of retail investor if they use the assets in advisory
accounts for personal, family, or household purposes. See id. In
addition, state securities authorities may impose additional
criteria for requiring registration as an IAR.
---------------------------------------------------------------------------
We estimate the number of registered representatives and registered
IARs (together ``dually-registered representatives'') 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 broker-dealer agent or investment
adviser representative.\417\ We consider only employees at firms who
have retail-facing business, as defined previously.\418\ We observe in
Table 5 that approximately 61% 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, 72% of all registered financial
professionals in that size category are employed by dually-registered
firms. Focusing on dually-registered firms only, approximately 59.7% of
total licensed representatives at these firms are dually-registered,
approximately 39.9% are only registered representatives; and less than
1% are only registered investment adviser representatives.
---------------------------------------------------------------------------
\417\ We calculate these numbers based on Form U4 filings.
Broker-dealers, investment advisers, and issuers of securities must
file this form when applying to register persons in certain
jurisdictions and with certain SROs. Such firms and representatives
generally have an obligation to amend and update information as
changes occur. Using the examination information contained in the
form, we consider an employee a financial professional if he has an
approved, pending, or temporary registration status for either
Series 6 or 7 (RR) or is registered as an investment adviser
representative in any state or U.S. territory (IAR), although there
are representatives that have passed exams other than the Series 7.
We limit the firms to only those that do business with retail
investors.
\418\ See supra notes 392 and 404.
Table 5--Total Licensed Representatives at Broker-Dealers, Investment Advisers, and Dually-Registered Firms With
Retail Customers \419\
----------------------------------------------------------------------------------------------------------------
Percentage of
Size of firm (total assets for Total number of representatives Percentage of Percentage
standalone BDs and dually-registered representatives in dually- representatives representatives
firms; AUM for standalone IAs) registered firms in standalone BD in standalone IA
----------------------------------------------------------------------------------------------------------------
>$50 billion........................ 82,668 75 8 18
$1 billion to $50 billion........... 150,662 72 10 18
$500 million to $1 billion.......... 31,673 67 16 16
$100 million to $500 million........ 62,539 58 24 18
$10 million to $100 million......... 116,047 52 47 1
$1 million to $10 million........... 37,247 34 63 2
<$1 million......................... 13,563 7 87 6
---------------------------------------------------------------------------
Total Licensed Representatives.. 494,399 61 27 12
----------------------------------------------------------------------------------------------------------------
In Table 6 below, we estimate the number of employees who are
registered representatives, investment adviser representatives, or
dually-registered representatives.\420\ 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.\421\
---------------------------------------------------------------------------
\419\ 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.
\420\ We calculated these numbers based on Form U4 filings.
\421\ See supra notes 392 and 404.
---------------------------------------------------------------------------
In Table 6, approximately 24% of registered employees at registered
broker-dealers or investment advisers are dually-registered
representatives. However, this proportion varies significantly across
size buckets. For example, for firms with total assets between $1
billion and $50 billion,\422\ approximately 36% of all registered
employees are dually-registered representatives. In contrast, for firms
with total assets below $1 million, 15% of all employees are dual-
hatted representatives.
---------------------------------------------------------------------------
\422\ Firm size is measured by total firm assets from the
balance sheet (source: FOCUS reports) for broker-dealers and dual
registrants, and by assets under management 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 assets under management,
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.
[[Page 21639]]
Table 6--Number of Employees at Retail-Facing Firms who Are Registered Representatives, Investment Adviser
Representatives, or Both \423\
----------------------------------------------------------------------------------------------------------------
Size of firm (total assets for Percentage of
standalone BDs and dually-registered Total number of dual-hatted Percentage of RRs Percentages of
firms; AUM for standalone IAs) employees representatives only IARs only
----------------------------------------------------------------------------------------------------------------
>$50 billion........................ 216,655 18 17 1
$1 billion to $50 billion........... 292,663 36 11 3
$500 million to $1 billion.......... 50,531 15 40 6
$100 million to $500 million........ 112,119 23 24 8
$10 million to $100 million......... 189,318 19 41 1
$1 million to $10 million........... 61,310 19 39 1
< $1 million........................ 19,619 15 46 3
----------------------------------------------------------------------------------------------------------------
Total Employees at Retail-Facing 942,215 24 24 3
Firms..........................
----------------------------------------------------------------------------------------------------------------
Approximately 88% of investment adviser representatives in Table 5
are dually-registered as 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.\424\ In contrast,
approximately 50% of registered representatives were dually-registered
as investment adviser representatives at the end of 2017.\425\
---------------------------------------------------------------------------
\423\ See supra notes 391, 403, 420, and 422. Note that all
percentages in the table have been rounded to the nearest whole
percentage point.
\424\ FINRA comment letter to File Number 4-606; Obligations of
Brokers, Dealers and Investment Advisers (Nov. 3, 2010), available
at https://www.sec.gov/comments/4-606/4606-2836.pdf.
\425\ 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. 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 representatives.\426\ While some firms
provided a base pay for their financial professionals ranging from
approximately $45,000 to $85,000 per year, many firms provided
compensation only through a percentage of commissions, plus
performance-based awards, such as individual or team bonus based on
production. Commission-based payouts to financial professionals ranged
from 30% to 95%, although these payouts were generally reduced by
various costs and expenses attributable to the financial professional
(e.g., clearing costs associated with some securities, SRO or SIPC-
related charges, and insurance, among others).
---------------------------------------------------------------------------
\426\ Information on compensation and financial incentives
generally relates to 2016 compensation arrangements for a sample of
approximately 20 firms, comprised of 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 products offered by standalone broker-
dealers and dually-registered firms.
---------------------------------------------------------------------------
Several firms had varying commission payout rates depending on the
product type being sold. For example, payouts ranged from 76.5% for
stocks, bonds, options, and commodities to 90% for open-ended mutual
funds, private placements, and unit investment trusts. Several firms
charged varying commissions on products depending on the amount of
product sold (e.g., rates on certain proprietary mutual funds ranged
from 0.75% to 5.75% depending on the share class), but did not provide
those payout rates to financial professionals based on product type.
Some firms also provided incentives for their financial professionals
to recommend proprietary products and services over third-party or non-
proprietary products. Commission rates for some firms, however,
declined as the dollar amount sold increased and such rates varied
across asset classes as well (e.g., within a given share class, rates
ranged from 1.50% to 5.75% depending on the dollar amount of the fund
sold). With respect to compensation to individual financial
professionals, if payout rates for mutual funds were approximately 90%
(as discussed above, for example), financial professionals could earn
between 0.68% and 5.18%, depending on the type and amount of product
sold.
For financial professionals who did not earn commission-based
compensation, some firms charged retail customers flat fees ranging
from $500 to $2,500, depending on the level of service required, such
as financial planning, while others charged hourly rates ranging from
$150 to $350 per hour. For dually-registered firms that charged clients
based on a percentage of assets under management, the average
percentage charged varied based on the size of the account: The larger
the assets under management, the lower the percentage fee charged.
Percentage-based fees for the sample firms ranged from approximately
1.5% for accounts below $250,000 to 0.5% for accounts in excess of $1
million.\427\ If payout rates range between 30% and 95%, a firm
charging a customer $500 could provide compensation to the financial
professional between $150 and $475 for each financial plan provided.
For fee-based accounts, assuming that a retail customer had an account
worth $250,000, the firm would charge fees of $3,750 ($250,000 x 1.5%),
and the financial professional could earn between $1,170 and $3,560
annually for each account.
---------------------------------------------------------------------------
\427\ We note that some firms could have higher or lower
commission payout 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 ``Average Financial Advisor
Fees & Costs, 2017 Report, Understanding Advisory & Investment
Management Fees,'' AdvisoryHQ, available at 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.
---------------------------------------------------------------------------
In addition to ``base'' compensation, most firms also provided
bonuses (based on either individual or team performance) or variable
compensation, ranging from approximately 10% to
[[Page 21640]]
83% of base compensation. While the majority of firms based at least
some portion of their bonuses on production, usually in the form of
total gross revenue, other forms of bonus compensation were derived
from customer retention, customer experience, and manager assessment of
performance. Moreover, some firms used a tiered system within their
compensation grids depending on firm experience and production levels.
Financial professionals' variable compensation could also increase when
they enrolled retail customers in advisory accounts versus other types
of accounts, such as brokerage accounts. Some firms also provided
transition bonuses for financial professionals with prior work
experience based on historical trailing production levels and AUM.
Although many firms did not provide any incentive-based contests or
programs, some firms awarded 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.
2. Regulatory Baseline
Regulation Best Interest would require broker-dealers and natural
persons associated with broker-dealers, 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 natural person
who is an associated person of the broker or dealer making the
recommendation, ahead of the interest of the retail customer.
Regulation Best Interest incorporates and goes beyond the existing
broker-dealer regulatory regime for advice. In this section, we
describe the existing regulatory baseline for broker-dealers, including
existing obligations under the federal securities laws and FINRA rules,
in particular those related to the suitability of recommendations and
disclosure of conflicts of interest, state regulation, existing
antifraud provisions, and state laws that impose fiduciary obligations,
and other obligations that would be imposed by the DOL Fiduciary Rule
and related PTEs, most notably the BIC Exemption.
a. Suitability Obligations
Under the antifraud provisions of the federal securities laws and
SRO rules, broker-dealers are required to deal fairly with their
customers. By virtue of engaging in the brokerage profession, a broker-
dealer makes an implicit representation to those persons with whom it
transacts business that it will deal fairly with them, consistent with
the standards of the profession.\428\ A central aspect of a broker-
dealer's duty of fair dealing is the suitability obligation, which has
been interpreted as requiring a broker-dealer to make recommendations
that are consistent with the best interest of his customer under SRO
rules.\429\ The concept of suitability has been interpreted as an
obligation under the antifraud provisions of the federal securities
laws and also under specific SRO rules.\430\ FINRA Rule 2111
(``Suitability'') requires that a broker-dealer or associated person
have a reasonable basis to believe that a recommendation or investment
strategy is ``suitable'' for the retail customer.\431\ The suitability
obligation is fundamental to fair dealing and is intended to promote
ethical sales practices and high standards of commercial conduct.\432\
---------------------------------------------------------------------------
\428\ See 913 Study at 51; see also Charles Hughes & Co. v. SEC,
139 F.2d 434 (2d Cir. 1943), cert. denied, 321 U.S. 786 (1944).
\429\ See, e.g., In re Application of Raghavan Sathianathan,
Exchange Act Release No. 54722 at 21 (Nov. 8, 2006). See also supra
note 15.
\430\ See Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969).
\431\ See FINRA Rule 2111.
\432\ See FINRA Rule 2111.01.
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Under FINRA Rule 2111, there are three primary suitability
requirements for broker-dealers and associated persons. First,
reasonable-basis suitability requires that, based on reasonable
diligence, a broker-dealer must have a reasonable basis that a
recommendation is suitable for at least some retail customers.\433\
Second, customer-specific suitability requires that, based on a given
customer's investment profile as detailed above, the broker-dealer has
a reasonable basis to believe that the recommendation or investment
strategy is suitable for that customer.\434\ Finally, quantitative
suitability requires that a broker-dealer must have a reasonable basis
to believe that a series of recommended transactions is not excessive
or unsuitable for a customer when taken together in light of the
customer's investment profile, even if each individual recommendation
is suitable in isolation.\435\ Broker-dealers also have additional
specific suitability obligations with respect to certain types of
products or transactions, such as variable insurance products and non-
traditional products, including structured products and leveraged and
exchange-traded funds.\436\
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\433\ According to FINRA Rule 2111, reasonable diligence
requires that the broker-dealer or the associated person understands
the potential risks and rewards of the recommendation or the
investment strategy.
\434\ Id.
\435\ Id.
\436\ See, e.g., FINRA Rule 2330, ``Members' Responsibilities
Regarding Deferred Variable Annuities;'' FINRA Rule 2370,
``Securities Futures;'' see also 913 Study at 65-66.
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b. Existing Broker-Dealer Disclosure Obligations
As described above, broker-dealers are subject to a number of
specific disclosure obligations when they effect certain customer
transactions, and are subject to additional disclosure obligations
under the antifraud provisions of the federal securities laws.\437\
Generally, under the antifraud provisions of the federal securities
laws, a broker-dealer's duty to disclose material information to its
customers depends on the scope of the relationship with the customer,
which is fact intensive.\438\ When making recommendations, broker-
dealers may be held liable if they do not provide honest and complete
information or do not disclose material conflicts of interest of which
they are aware.\439\ For example, in making recommendations, courts
have found broker-dealers 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.\440\
---------------------------------------------------------------------------
\437\ See supra notes 175-177 and 205 and accompanying text.
\438\ See supra note 176.
\439\ Id.
\440\ See 913 Study at notes 251-54.
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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. 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.\441\
As discussed above, in developing proposed Regulation Best Interest,
the Commission has drawn from state common law fiduciary principles,
among other things, in order to establish greater consistency in the
level of retail customer protections and to ease compliance with
Regulation Best Interest where other legal regimes--such as state
common law--might also apply. For instance, under proposed Regulation
Best Interest, a broker-
[[Page 21641]]
dealer's duty to exercise reasonable diligence, care, skill, and
prudence would resemble the standard of conduct that has been imposed
on broker-dealers found to be acting in a fiduciary capacity under
state common law.\442\ Similarly, a broker-dealer's Disclosure
Obligation (along with the Conflict of Interest Obligations) under
proposed Regulation Best Interest would resemble the duty to disclose
material conflicts imposed on broker-dealers found to be acting as
fiduciaries under state common law.\443\
---------------------------------------------------------------------------
\441\ See supra note 15.
\442\ See, e.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith,
Inc., 906 F.2d 1206, 1215 (8th Cir. 1990) (finding that the district
court did not abuse its discretion in instructing the jury that
licensed securities brokers were fiduciaries that owed their
customers a duty of utmost good faith, integrity, and loyalty).
\443\ 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, ``including her cost of
the securities and the best price at which the security might be
purchased in the open market'').
---------------------------------------------------------------------------
c. Department of Labor's Fiduciary Rule and Related Federal Securities
Laws
DOL amendments to its regulation defining investment advice in the
DOL Fiduciary Rule would broadly expand the types of broker-dealer
services that may trigger fiduciary status for the purposes of the
prohibited transaction provisions of ERISA and the Code as a result of
rendering investment advice to retirement accounts.\444\ As noted, in
connection with the DOL Fiduciary Rule, DOL amended certain existing
PTEs and adopted new PTEs, including in particular the BIC Exemption,
which generally permits certain financial institutions including
broker-dealers to recommend investment transactions and receive
commissions and other compensation resulting from the recommended
transactions under certain conditions.\445\ As discussed above, a
broker-dealer that wishes to rely on the BIC Exemption to engage in
transactions that would otherwise be prohibited (e.g., providing
investment recommendations and receiving ``conflicted compensation'')--
would have to adhere to the Impartial Conduct Standards (including
obligations to provide ``best interest'' recommendations, receive no
more than reasonable compensation, and avoid making statements that are
materially misleading at the time they are made). Broker-dealers that
seek to rely on the BIC Exemption would have to satisfy additional
conditions including (among other things) that, as described above,
require broker-dealers to (1) enter into a written contract with each
IRA owner enforceable against the broker-dealer that acknowledges
fiduciary status, commits to adhere to the Impartial Conduct Standards,
and warrants to the adoption of certain policies and procedures, (2)
implement policies and procedures reasonably designed to ensure that
the firm and its advisers provide best interest advice and minimize the
harmful impact of conflicts of interest in conflicts, including a
prohibition against differential compensation or other incentives that
were intended or expected to cause advisers to provide recommendations
that are not in the customer's best interest, and (3) disclose
information about fees, compensation and material conflicts of interest
associated with recommendations in initial and ongoing disclosures,
including website disclosures.\446\
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\444\ See BIC Exemption Release, 81 FR at 21007 (DOL states that
it ``anticipates that the [DOL Fiduciary Rule] will cover many
investment professionals who did not previously consider themselves
to be fiduciaries under ERISA or the Code.'').
\445\ See BIC Exemption Release. Broker-dealers and their
registered representatives are not, however, required to comply with
conditions under the BIC Exemption if they adopt a different
approach to avoid non-exempt prohibited transactions, including by
meeting the conditions of the statutory exemption for the provision
of investment advice to participants of individual account plans
under ERISA sections 408(b)(14) and 408(g), or by offsetting third-
party payments against level fees, see BIC Exemption Release, 81 FR
at 21013, at n. 23 and accompanying text.
\446\ See BIC Exemption Release, 81 FR at 21007. These
conditions are discussed in more detail below.
---------------------------------------------------------------------------
Existing broker-dealer obligations under the federal securities
laws and FINRA rules prohibit misleading statements and require fair
and reasonable compensation. The antifraud provisions of the federal
securities laws prohibit broker-dealers from making misleading
statements,\447\ while FINRA Rule 2210 specifically addresses
communications between broker-dealers and the public and requires that
these communications be based on principles of fair dealing and good
faith and be fair and balanced.\448\ Under FINRA rules, prices for
securities and broker-dealer compensation are required to be fair and
reasonable, taking into consideration all relevant circumstances.\449\
Although the existing standards and rules identified above prohibit
broker-dealers from making misleading statements, address their
communications with the public, and require fair and reasonable
compensation, the DOL also adopted the Impartial Conduct Standards to
address these issues in the BIC Exemption.\450\
---------------------------------------------------------------------------
\447\ See Exchange Act Sections 10(b) and 15(c).
\448\ See FINRA Rule 2210 (``Communications with the Public'').
\449\ 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'').
\450\ See BIC Exemption Release, 81 FR 21007, 21030-32.
---------------------------------------------------------------------------
As discussed above, as a practical matter, broker-dealers offering
IRA brokerage accounts would generally need to meet the conditions of
the BIC Exemption or one of the related PTEs to make recommendations to
brokerage customers with such accounts and receive commissions or other
compensation relating to recommended transactions. To determine the
universe of broker-dealers that offer IRA brokerage accounts and
generally would need to meet the conditions of the BIC Exemption for
purposes of this baseline, we assume that all broker-dealers that have
retail accounts are required to comply with the PTEs, including the BIC
Exemption, in providing services to at least some of their retail
accounts. The Commission does not currently have data on the number of
firms that would rely on these PTEs and that would be required to
provide these disclosures.\451\ However, the Commission can broadly
estimate the maximum number of broker-dealers that would be subject to
the requirements of the PTEs from the number of broker-dealers that
have retail customer accounts. Approximately 74.4% (2,857) of
registered broker-dealers report sales to retail customers.\452\
Similarly, approximately 7,600 (60% 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
overestimates the broker-dealers and investment advisers that provide
retirement account services.\453\
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\451\ In order to perform this analysis, the Commission would
need to know which financial firms have retirement-based assets as
part of their business model. 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-based accounts.
\452\ As of December 2017, 3,841 broker-dealers filed Form BD.
Retail sales by broker-dealers were obtained from Form BR. See supra
note 392.
\453\ The Department of Labor Regulatory Impact Analysis (``DOL
RIA'') identified approximately 4,000 broker-dealers (FINRA, 2016),
of which approximately 2,500 are estimated to have either ERISA
accounts or IRA associated with the 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 dual registered,
approximately 6,000 ERISA plan sponsors (2013 Form 5500 Schedule C),
and approximately 400 life insurance companies (2014 SNL Financial
Data). See The Department of Labor, Regulating Advice Markets:
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/conflict-of-interest-ria.pdf.
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[[Page 21642]]
A recent survey and study were conducted to provide information
about how the broker-dealer industry has begun to transition as a
result of the DOL Fiduciary Rule. In 2017, the Securities Industry and
Financial Markets Association (``SIFMA'') teamed with Deloitte and
conducted a study focusing on the impact of the DOL Fiduciary Rule on
retirement investors and financial institutions.\454\ 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,\455\ and 27% of qualified retirement savings assets ($4.6
trillion out of $16.9 trillion).
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\454\ See The DOL Fiduciary Rule: A study on how financial
institutions have responded and the resulting impacts on retirement
investors, SIFMA and Deloitte (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 (``SIMFA Study'').
\455\ The types of retirement accounts serviced by the
participants in the SIFMA Study were not defined.
---------------------------------------------------------------------------
Of the 21 SIFMA members that participated in the survey, 53%
eliminated or reduced access to brokerage advice services and 67% have
migrated away from open choice to fee-based or limited brokerage
services. For those retail customers faced with eliminated or reduced
brokerage advice services, 63% chose to move to self-directed accounts
rather than fee-based accounts and cited the 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.'' For those retail customers that migrated from brokerage to
fee-based models, the average change in all-in fees increased by 141%
from 46 basis points (bps) to 110 bps.
Further, 95% of survey participants altered their product
offerings, by reducing or eliminating certain asset or share classes.
For example, 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 product offerings.
Moreover, although the DOL Fiduciary Rule applies only in connection
with services for retirement accounts, many of the survey participants
have implemented the changes to both retirement and non-retirement
accounts.\456\
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\456\ In July 2017, the American Bankers Association (``ABA'')
conducted a survey of 57 banks about their understanding of the
Fiduciary Rule on products and the impact of the rule on products
and services available to retirement investors. None of the survey
respondents added to the retirement products or services available,
while 30% eliminated or reduced products or services available to
retirement investors in response to the Fiduciary Rule. Nearly 40%
of banks further believed that the relationship with their customers
has been altered as a result of the Fiduciary Rule applying only to
retirement assets ``since the bank is unable to provide holistic
financial advice to its customers.'' available at https://www.aba.com/Advocacy/Issues/Documents/dol-fiduciary-rule-survey-summary-report.pdf. See ``Department of Labor Fiduciary Rule:
National Survey of Financial Professionals'' Financial Services
Roundtable/Harper Polling (July 2017), available at http://www.fsroundtable.org/wp-content/uploads/2017/08/17.07-FSR-Presentation-1.pdf. We note that the developments 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.
---------------------------------------------------------------------------
To date, the survey participants have incurred compliance costs of
$600 million, although the costs vary by the size of the respondent.
For instance, large firms with net capital in excess of $1 billion are
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 are expected to have start-up and ongoing
compliance costs of $16 million and $3 million, respectively. The SIFMA
Study estimates that total start-up compliance costs for large and
medium-size firms combined will be approximately $4.7 billion, compared
to the DOL's estimate of between $2 billion and $3 billion, while
ongoing costs will be approximately $700 million per year (DOL's
estimates between $463 million and $679 million annually).
C. Benefits, Costs, and Effects on Efficiency, Competition, and Capital
Formation
In formulating Regulation Best Interest, the Commission has
considered the potential benefits of establishing a best interest
standard of conduct for broker-dealers and the potential costs to the
firms and retail customers of complying with the best interest
obligation.
The best interest standard of conduct for broker-dealers would
enhance the quality of investment advice that broker-dealers provide to
retail customers, help retail customers evaluate the advice received,
and improve retail customer protection when soliciting advice from
broker-dealers. By imposing a best interest obligation on broker-
dealers, Regulation Best Interest would achieve these benefits by
ameliorating the agency conflict between broker-dealers and retail
customers. The three components of the best interest obligation, namely
the Disclosure Obligation, the Care Obligation, and the Conflict of
Interest Obligations work together towards ameliorating this agency
conflict by addressing specific aspects of the conflict. In particular,
these obligations, taken together, are meant to provide assurances to
the retail customer that a broker-dealer provides a certain quality of
recommendation that is consistent with the customer's best interest.
The Disclosure Obligation, as discussed above, would reduce the
informational gap with respect to certain elements of the relationship
that are not currently fully disclosed. In particular, this obligation
would foster retail customer awareness and understanding of key broker-
dealer practices as well as material conflicts of interest associated
with broker-dealer recommendations that would ultimately improve a
retail customer's assessment of the recommendations received.
The Care Obligation, as discussed above, is designed to result in
the broker-dealer providing advice at a level of quality that better
matches the expectations of retail customers, and, as a result, should
enhance the quality of recommendations received.\457\
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\457\ See supra Section IV.D.2.
---------------------------------------------------------------------------
Proposed Regulation Best Interest would impose two concurrent
Conflict of Interest requirements, as described above. These Conflict
of Interest Obligations would enable broker-dealers to meet the
Disclosure Obligation with regard to material conflicts of interest
which would enhance customer understanding of broker-dealer conflicts
associated with a recommendation and the extent to which those
conflicts may influence a recommendation. This enhanced understanding
of broker-dealer conflicts would aid retail customers in assessing, and
deciding whether to act on, broker-dealer recommendations. Taken
together, the Disclosure Obligation, the Care Obligation and the
Conflict of Interest Obligations are designed to reduce the effects of
conflicted broker-dealer advice and thereby improve retail customer
protection.
[[Page 21643]]
The Commission acknowledges, however, that Regulation Best
Interest, through its component obligations, would potentially give
rise to direct costs to broker-dealers and indirect costs to retail
customers. For example, the requirement to act in the retail customer's
best interest of the Care Obligation may lead some broker-dealers to
determine that they no longer wish to make certain recommendations,
and, as a result, may forgo some of the revenue stream associated with
such recommendations. The disclosure requirements of the Disclosure
Obligation and the Conflict of Interest Obligations would go beyond
existing disclosure obligations, and, as a result, may impose direct
costs on broker-dealers. Certain aspects of the Conflict of Interest
Obligations may decrease the incentives of registered representatives
to expend effort in providing quality advice, and, therefore, may
impose a cost on retail customers if there is a decline in the quality
of recommendations. Finally, other aspects of the Conflict of Interest
Obligations may limit retail customer choice and, therefore, impose
costs on retail customers, because broker-dealers, for compliance or
business reasons, may determine to avoid certain products, despite the
fact that those products may be beneficial to certain retail customers
in certain circumstances.
Although, in establishing a best interest obligation for broker-
dealers, the Commission considers these and other potential benefits
and costs, the Commission notes that generally it is difficult to
quantify such benefits and costs. Several factors make the
quantification of the effects of the best interest obligation
difficult. 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. The proposed rule would also give broker-dealers
flexibility in complying with the best interest obligation, and, as a
result, there could be multiple ways in which broker-dealers could
satisfy this obligation, so long as it complies with its baseline
obligations. Finally, any estimate of the magnitude of such benefits
and costs would depend on assumptions about the extent to which broker-
dealers are currently engaging in disclosure and conflict mitigation
activities, how broker-dealers would choose to satisfy the best
interest obligation, and, potentially, how retail customers perceive
the risk and return of their portfolio, the likelihood of acting on a
recommendation that complies with the best interest obligation, and how
the risk and return of their portfolio change as a result of how they
act on the recommendation. Since the Commission lacks the data that
would help narrow the scope of these assumptions, the resulting range
of potential quantitative estimates would be wide and, therefore, not
informative about the magnitude of the benefits or costs associated
with the best interest obligation.
1. Benefits
In this section, we discuss the benefits of a best interest
standard of conduct, generally, and the benefits associated with the
components of Regulation Best Interest, specifically.
Proposed Regulation Best Interest would create an express best
interest obligation under the Exchange Act that consists of three
components: The Disclosure Obligation, the Care Obligation, and the
Conflict of Interest Obligations. These obligations, taken together,
are meant to provide assurances to retail customers that broker-dealers
provide a certain quality of recommendations that are consistent with
the customers' best interest and to enhance retail customer protection.
The best interest obligation, including the specific component
obligations, may not be reduced or narrowed through contract with a
retail customer.
As discussed in Section IV.2, explicit contracts may, in some
cases, be inefficient means of ameliorating agency costs. In such
cases, legal and regulatory obligations can provide alternative and
more efficient tools to ameliorate these costs. For example, FINRA
rules require broker-dealers making recommendations to: (i) Have a
reasonable basis to believe, based on reasonable diligence, that the
recommendation is suitable for at least some investors, and (ii) based
on a particular customer's investment profile, have a reasonable basis
to believe that the recommendation is suitable for that customer.
Moreover, under FINRA rules, 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 the absence of these rules, these requirements are all
provisions that could, at least theoretically, be included in broker-
dealer account agreements with retail customers. Including these
provisions would be meant to provide assurance to the retail customer
that a broker-dealer provides a certain quality of recommendations. But
inclusion of such provisions would likely have limited effectiveness
because the retail customer would have little, if any, ability to
confirm the broker-dealer's compliance with the provisions. If these
provisions regarding the quality of advice were left open to contract,
it is equally likely that the broker-dealer (as the more informed
party) would be able to offer less optimal terms regarding the quality
of advice to be provided to the retail customer.
Proposed Regulation Best Interest, through the Disclosure, the
Care, and the Conflict of Interest Obligations, would incorporate and
go beyond current broker-dealer obligations under federal securities
laws and SRO rules in ways that would ameliorate the agency conflict
between broker-dealers and retail customers and would create a number
of potentially significant benefits for retail customers.
As discussed in more detail below, the Disclosure Obligation would
foster retail customer awareness and understanding of certain specified
information regarding the retail customer's relationship with the
broker-dealer as well as material conflicts of interest associated with
broker-dealer recommendations. As a result, this obligation would
reduce the informational gap between a broker-dealer making a
recommendation and a retail customer receiving that recommendation,
which, in turn, may cause the retail customer to act differently with
regard to the recommendation. For example, the retail customer may
reject a broker-dealer recommendation that she would otherwise not
reject absent the new information made available by the Disclosure
Obligation. Anticipating a potential change in the behavior of the
retail customer with respect to acting on recommendations as a result
of the Disclosure Obligation, a broker-dealer may adjust its own
behavior by providing recommendations that are less likely to be
rejected by the retail customer. By virtue of being tailored to the
retail customer's anticipated behavior, these recommendations are more
likely to be in the retail customer's best interest, and therefore of
higher quality relative to the recommendations that the broker-dealer
would supply absent this obligation. Thus, the Disclosure Obligation
would enhance the quality of recommendations that broker-dealers
provide to retail customers. Furthermore, to the extent
[[Page 21644]]
that uncertainty about a broker-dealer's conflicts of interest
associated with a recommendation complicates a retail customer's
evaluation of the recommendation, the Disclosure Obligation would
reduce that uncertainty and, therefore, would help retail customers
better evaluate broker-dealer recommendations.
Similarly, the Care Obligation would allow broker-dealers to
provide recommendations at a level of quality that better matches the
expectations of its retail customers, and, therefore, would enhance the
quality of recommendations that broker-dealers provide to retail
customers.
Finally, the Conflict of Interest Obligations would require broker-
dealers to establish, maintain, and enforce policies and procedures
that are reasonably designed to identify and disclose or eliminate
material conflicts of interest and establish, maintain, and enforce
policies and procedures that are reasonably designed to identify and
eliminate, or disclose and mitigate, material conflicts of interest
arising from financial incentives associated with their
recommendations. Such policies and procedures would benefit retail
customers because they would be designed to reduce conflicts of
interest that may motivate the behavior of associated persons of
broker-dealers and thereby enhance the quality of the recommendations
that they provide to their retail customers. Furthermore, these
obligations work in conjunction with the Disclosure Obligation by
including requirements designed to reduce the uncertainty with respect
to whether a broker-dealer recommendation is subject to conflicts of
interest. In particular, the Conflict of Interest Obligations would
benefit retail customers by helping them better evaluate the
recommendations received from broker-dealers.
a. Disclosure Obligation
Proposed Regulation Best Interest would establish the Disclosure
Obligation, which would foster a retail customer's awareness and
understanding of specified information regarding the relationship with
the broker-dealer as well as material conflicts of interest associated
with broker-dealer recommendations. To meet the Disclosure Obligation,
the Commission would consider the following to be examples of material
facts relating to the scope and terms of the relationship with the
retail customer that a broker-dealer would be required to disclose in
writing: (1) That it is acting in a broker-dealer capacity with respect
to the recommendation; (2) fees and charges that apply to the retail
customer's transactions, holdings, and accounts; and (3) type and scope
of services provided by the broker-dealer. Additionally, a broker-
dealer would be required to disclose in writing all material conflicts
of interest that are associated with the recommendation.
Currently, broker-dealers are not subject to an explicit and broad
disclosure obligation under the Exchange Act. However, broker-dealers
may provide information about their services and accounts, which may
include disclosure about a broker-dealer's capacity, fees, and
conflicts on their firm websites and in their account opening
agreements. In addition, as noted above, broker-dealers are currently
subject to specific disclosure obligations when making recommendations.
Broker-dealers generally may be liable under federal securities laws'
antifraud provisions if they do not give ``honest and complete
information'' or disclose any material adverse facts or material
conflict of interest, including economic self-interest. Many of these
existing disclosure obligations depend on the facts and circumstances
around recommendations, and different broker-dealers may comply with
them differently. In addition, these disclosure obligations may not
always produce information that is sufficiently relevant to a
recommendation to assist a retail customer in meaningfully evaluating
the recommendation. For instance, retail customers may not be aware of
or understand the broker-dealer's conflicts of interest.\458\
---------------------------------------------------------------------------
\458\ See supra discussion in Section II.D.
---------------------------------------------------------------------------
The disclosure obligations for broker-dealers under Regulation Best
Interest are more express and more comprehensive compared to existing
disclosure requirements and liabilities. Namely, a broker-dealer that
makes recommendations to a retail customer would be required to provide
the retail customer with sufficiently specific facts about any material
conflicts of interest such that the retail customer would be able to
understand the conflict and make an informed decision about the broker-
dealer recommendations. The Commission has provided preliminary
guidance above on aspects of disclosure by a broker-dealer to a retail
customer; this disclosure would help the retail customer understand
specified information regarding the relationship with the broker-
dealer, including the broker-dealer's material conflicts of interest.
In the case of retail customers who have both brokerage and
advisory accounts with the same financial professional, such as dual-
registrants, it may not always be clear whether the financial
professional is acting in a capacity of broker-dealer or investment
adviser when providing advice.\459\ This information may be useful to
the retail customer when evaluating the advice received. For instance,
the cost to the retail customer of acting on such advice may depend on
whether the advice is tied to the retail customer's brokerage or
advisory account.
---------------------------------------------------------------------------
\459\ See supra discussion in Section II.C.4.
---------------------------------------------------------------------------
By articulating an explicit disclosure requirement under the
Exchange Act as part of the best interest obligation, the Disclosure
Obligation would facilitate improved disclosure practices among broker-
dealers. In addition, the Disclosure Obligation would facilitate retail
customer awareness and understanding of certain key facts concerning
their relationship with a broker-dealer, as well as conflicts of
interest, and would provide retail customers with sufficiently specific
facts to help them evaluate a broker-dealer recommendation. As a
result, the Disclosure Obligation ameliorates the agency conflict
between retail customers and broker-dealers, and therefore provides a
potentially important benefit to investors in the form of reduced
agency conflict between retail customers and broker-dealers.
The magnitude of the benefit from the reduced agency conflict would
depend on a number of determinants, such as how retail customers
perceive the risk and return of their portfolio, how they would act on
a recommendation given the new information made available by the
Disclosure Obligation, and, finally, how the risk and return of their
portfolio would change as a result of acting on a recommendation. Given
the number and complexity of assumptions, the Commission lacks the data
that would allow it to narrow the scope of the assumptions regarding
these determinants and estimate the magnitude of the benefit.
b. Exercise Reasonable Diligence, Care, Skill, and Prudence
As noted above, the Care Obligation of the proposed rule would go
beyond the existing broker-dealer obligations under FINRA's suitability
rule by requiring that broker-dealers act in the best interest of their
retail customers, 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. Furthermore, the Care
Obligation does not include an
[[Page 21645]]
element of control, unlike the quantitative suitability prong of
FINRA's suitability rule.
The new requirements of the Care Obligation of proposed Regulation
Best Interest may restrict broker-dealers from making certain
recommendations. For instance, broker-dealers would not be able to make
recommendations to retail customers that comply with FINRA's
suitability rule if they do not also comply with all the requirements
of the Care Obligation. While the impact of the Care Obligation
restrictions on broker-dealer recommendations to retail customers would
depend largely, as noted earlier, on the facts and circumstances
related to each recommendation and the investment profile of the retail
customer receiving that recommendation, the fact that the Care
Obligation incorporates and goes beyond existing broker-dealer
suitability obligations may yield certain benefits for retail
customers. For instance, to the extent that currently broker-dealers
comply at all times with FINRA's suitability requirements but do not
always account for the retail customer's best interest, as proposed
here, when choosing between securities with similar payoffs but
different cost structures, the Care Obligation would encourage broker-
dealers to recommend a security that would be more appropriately suited
to achieve the retail customer's objectives. Thus, by promoting
recommendations that are better aligned with the objectives of the
retail customer, the Care Obligation of proposed Regulation Best
Interest would provide an important benefit to retail customers,
ameliorating the agency conflict between broker-dealers and retail
customers and, in turn, improving the quality of recommendations that
broker-dealers provide to retail customers.
The Commission is unable to quantify the magnitude of these
benefits to retail customers for a number of reasons. First, broker-
dealer recommendations would depend largely on the facts and
circumstances related to each recommendation and the investment profile
of the retail customer receiving that recommendation. Second, broker-
dealers currently do not have an explicit obligation to act in their
customers' best interest when making recommendations. Finally, the
magnitude of these benefits to retail customers would depend on how
retail customers generally perceive the risk and return of their
portfolio, the likelihood of acting on a recommendation that complies
with the best interest obligation, and, ultimately, how the risk and
return of their portfolio change as a result of how they act on the
recommendation. Any estimate of the magnitude of such benefits would
depend on assumptions about the facts and circumstances surrounding a
recommendation, the investment profile of the retail customer, how
retail customers perceive the risk and return of their portfolio, the
determinants of the likelihood of acting on a recommendation that
complies with the best interest obligation, and, finally, how the risk
and return of their portfolio change as a result of how they act on the
recommendation. Because the Commission lacks the data that would help
narrow the scope of these assumptions, the resulting range of potential
estimates would be wide, and, therefore, would not be informative about
the magnitude of these benefits to retail customers.
Another way in which the proposed rules would incorporate and go
beyond existing standards is by requiring a broker-dealer 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, regardless of whether the broker-dealer has actual
or de facto control over a retail customer account. This represents a
heightened standard relative to obligations under federal securities
laws and under FINRA's concept of quantitative suitability in two ways.
First, this proposed requirement applies a best interest standard to a
series of recommendations, rather than requiring broker-dealers to
merely have a reasonable basis for believing that a series of
recommendations are not excessive or unsuitable. Second, by removing
the control element, the proposed requirement would expand the scope of
retail customers that could benefit from existing suitability
requirements to those retail customers who, while retaining control
over their own accounts, nevertheless accept a series of broker-dealer
recommendations.
The Commission is unable to quantify the magnitude of the benefits
that retail customers could receive as a result of the new obligations
for broker-dealers that provide a series of recommendations to retail
customers for largely the same reasons that make the quantification of
the other Care Obligation benefits, as discussed above, difficult.\460\
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\460\ The DOL RIA estimates that due to one source of adviser
conflicts, namely that conflict related to underperformance
associated with front-end load mutual funds, retirement investors
will underperform no-load mutual funds by approximately 0.50% to
1.00%, on average, which translates to aggregate losses of between
$95 billion to $189 billion over 10 years. See The Department of
Labor, Regulating Advice Markets: 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/conflict-of-interest-ria.pdf. The Department of Labor further estimates that its
Fiduciary Rule and the BIC Exemption will reduce those losses
attributed to underperformance of front-end load mutual funds by $33
billion to $36 billion over 10 years. But see Letter from Craig
Lewis (Aug. 31, 2017) (offering a critique of the DOL RIA).
Generally, although the DOL RIA provides potential estimates of
investor harm and gains to investors as a result of that agency's
rule, the Commission has not incorporated those estimates into its
own economic analysis because of the differences in scope of the
intended effects of Regulation Best Interest. Moreover, because of
the range of investor risk profiles and the diversity of products
offered by broker-dealers outside of the retirement account context,
the Commission is unable to apply the DOL's analytical framework--
which focuses primarily on the differences between load and no-load
mutual funds as well as analyses that compare broker-dealer advised
investments to unadvised direct investments--to its own analysis.
With respect to the analysis of costs and benefits associated with
proposed Regulation Best Interest, the relevant metric is the
differences between broker-dealer advised accounts subject to the
current legal framework and broker-dealer advised accounts subject
to the proposed rule overlaid on the existing legal framework. See
also Council of Economic Advisers, The Effects of Conflicted
Investment Advice on Retirement Savings, 2015, available at https://obamawhitehouse.archives.gov/sites/default/files/docs/cea_coi_report_final.pdf, (using the same approach as the DOL RIA,
estimates annual losses to retirement investors from conflicted
advice at $17 billion per year). See also Economic Policy Letter,
supra note 27. The Consumer Federation of American estimated annual
losses from conflicted investment advice between $20 billion and $40
billion per year, while PIABA estimated annual losses at
approximately $21 billion per year. See CFA 2017 Letter; PIABA
Letter.
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c. Obligation To Establish, Maintain, and Enforce Written Policies and
Procedures Reasonably Designed To Identify and at a Minimum Disclose,
or Eliminate, All Material Conflicts of Interest Associated With a
Recommendation
Regulation Best Interest would include two requirements relating to
the treatment of conflicts. The first requirement under the Conflict of
Interest Obligations would require a broker-dealer \461\ to establish,
maintain, and enforce written policies and procedures reasonably
designed to identify and at a minimum disclose, or
[[Page 21646]]
eliminate, all material conflicts of interest that are associated with
a recommendation. Conflicts of interest may arise for a number of
reasons. For example, a broker-dealer may be in a position to
recommend: Proprietary products, products of affiliates, or a limited
range of products; one share class versus another share class of a
mutual fund; securities underwritten by the firm or a broker-dealer
affiliate; the roll over or transfer of assets from one type of account
to another (such as recommendations to rollover or transfer assets in
an ERISA account to an IRA, when the recommendation involves a
securities transaction); and allocation of investment opportunities
among retail customers. This Conflict of Interest Obligation may
benefit retail customers to the extent that a broker-dealer
establishes, maintains and enforces policies and procedures to
disclose, or eliminate, a material conflict of interest that may have a
negative impact on its recommendations to retail customers.
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\461\ The proposed Conflict of Interest Obligations apply 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 Obligations, the term ``broker-
dealer'' refers only to the broker-dealer entity, and not to such
individuals. However, the policies and procedures a broker-dealer
establishes, maintains, and enforces, pursuant to the proposed
Conflict of Interest Obligation, would apply to a broker-dealer's
registered representative's conflicts of interest.
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As noted in our earlier discussion of the Disclosure Obligation, a
broker-dealer that determines to address a conflict of interest
identified through policies and procedures by disclosing it should
provide the retail customer, in writing, with sufficiently specific
facts so that the customer is able to understand the material conflicts
of interest and is able to make an informed decision about the broker-
dealer recommendations.
The benefits to retail customers of this disclosed information have
been discussed earlier under the Disclosure Obligation. These benefits
are difficult to quantify for the same reasons that the benefits of the
overall Disclosure Obligation in Section IV.D.1.a. are difficult to
quantify.
As noted earlier, as an alternative to addressing a conflict of
interest identified through policies and procedures by disclosing it, a
broker-dealer may choose, instead, to satisfy this Conflict of Interest
Obligation by eliminating it altogether. If a broker-dealer addresses
the material conflict of interest by eliminating it, a retail customer
benefits from receiving a recommendation that is free of that
particular conflict of interest.
Generally, we preliminarily believe that having express Conflict of
Interest Obligations would result in broker-dealers establishing
policies and procedures focusing specifically on identifying and
evaluating conflicts and determining whether each of the identified
conflicts is material and should be disclosed or eliminated. We also
preliminarily believe that broker-dealers may be more inclined to
evaluate and address material conflicts of interest and eliminate more
egregious conflicts of interest to the extent that disclosure of the
conflict would result in reputation risk. Further, having a clearly
defined obligation that would require, among other things, that a
broker-dealer establish written policies and procedures reasonably
designed to identify and disclose, or eliminate, all material conflicts
of interest associated with a recommendation may result in increased
retail customer confidence in the recommendation received. Finally, the
Conflict of Interest Obligation may improve retail customer welfare, to
the extent that the obligation permits retail customers to understand
better which recommendations, within a broader set of suitable
recommendations, are or are not conflicted and the extent and nature of
any such conflicts, while maintaining retail customer access to a broad
variety of recommendations.
d. Obligation 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 Associated With a Recommendation
The Conflict of Interest Obligations of proposed Regulation Best
Interest include the additional requirement that a broker or dealer,
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 a recommendation.
This Conflict of Interest Obligation would apply to material
conflicts of interest that arise from financial incentives. As
discussed in more detail above, we 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. Material conflicts of
interest that arise from financial incentives include, but are not
limited to, conflicts arising from compensation practices such as how a
broker-dealer compensates its employees, and how a broker-dealer is
compensated by third-parties for whom it may act as a distributor or
service provider.
As noted in our earlier discussion of the Disclosure Obligation, a
broker-dealer that determines to address a conflict of interest arising
from financial incentives identified through policies and procedures by
disclosing and mitigating it should provide the retail customer, in
writing, with sufficiently specific facts so that the retail customer
is able to understand the material conflicts of interest and is able to
make an informed decision about the broker-dealer's recommendations.
The benefits to retail customers of this disclosed information have
been discussed earlier under the Disclosure Obligation.
As noted earlier, as an alternative to addressing conflicts of
interest through disclosure and mitigation of a material conflict of
interest arising from financial incentives, a broker-dealer may choose,
instead, to satisfy this Conflict of Interest Obligation by eliminating
the conflict altogether. If a broker-dealer establishes policies and
procedures to address a conflict of interest through eliminating a
material conflict of interest arising from financial incentives
associated with a recommendation, a retail customer benefits from
receiving a recommendation that is free of that particular conflict of
interest. In other words, if a retail customer receives a broker-dealer
recommendation and written disclosure about certain material conflicts
of interest arising from financial incentives associated with the
recommendation, the retail customer can expect that the conflicts of
interest arising from financial incentives and that are omitted from
such disclosure are either not material or eliminated. This may benefit
retail customers to the extent that the absence of certain conflicts of
interest arising from financial incentives associated with a
recommendation may increase retail customers' trust in the advice they
obtain and in financial markets.\462\ Moreover, in those circumstances
where a broker-dealer chooses to address a conflict of interest through
elimination because disclosure and mitigation of those conflicts of
interest may be too challenging, the broker-dealer would simplify the
evaluation of the recommendation by the retail customer.
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\462\ See supra Section IV.B.1.
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However, unlike other material conflicts of interest, under
proposed Regulation Best Interest, developing policies and procedures
to address material conflicts of interest arising from financial
incentives through disclosure alone would not be sufficient. The
requirement to establish, maintain, and enforce policies and procedures
to mitigate conflicts of interest related to financial incentives is a
significant expansion of current broker-dealer requirements to address
conflicts. As discussed in Section II.D.3.b., the Commission has
provided preliminary guidance on reasonably designed policies and
procedures for identifying and disclosing and
[[Page 21647]]
mitigating, or eliminating, material conflicts of interest arising from
financial incentives that allow broker-dealers the flexibility to
comply with the Conflict of Interest Obligations based on each firm's
circumstances. This approach allows broker-dealers the flexibility to
establish policies and procedures reasonably designed to identify and
disclose and mitigate, potential conflicts of interest arising from
financial incentives and to develop supervisory systems that would help
them maintain and enforce their policies and procedures in a manner
that reflects their business practices and that focuses on areas of
their business practices where heightened concern may be warranted.
The Commission is unable to quantify the size of these benefits for
several reasons. First, Regulation Best Interest would provide broker-
dealers flexibility in choosing whether to address a conflict of
interest arising from financial incentives through disclosure and
mitigation, or elimination and flexibility in choosing among methods of
mitigation. Second, the size of these benefits would depend on how
retail customers generally perceive the risk and return of their
portfolio, the likelihood of acting on a recommendation that complies
with the best interest obligation, and, ultimately, how the risk and
return of their portfolio change as a result of how they act on the
recommendations. Any estimate of the size of such benefits would depend
on assumptions about how broker-dealers choose to comply with this
requirement of the Conflict of Interest Obligations, how retail
customers perceive the risk and return of their portfolio, the
determinants of the likelihood of acting on a recommendation that
complies with the best interest obligation, and, finally, how the risk
and return of their portfolio change as a result of how they act on the
recommendation. Since the Commission lacks the data that would help
narrow the scope of these assumptions, the resulting range of potential
estimates would be wide, and, therefore, not informative about the
magnitude of these benefits.
2. Costs
In this section, we discuss the costs of a best interest standard
of conduct, generally, and the costs associated with the components of
Regulation Best Interest, specifically.
As discussed in more detail below, proposed Regulation Best
Interest would entail direct costs for broker-dealers and indirect
costs for retail customers and other parties with a stake in the market
for investment advice (e.g., product sponsors). The magnitude of the
costs will depend on several factors: (1) How broker-dealers would
choose to comply with the best interest obligation, (2) whether broker-
dealers would pass on some of the costs of complying with the best
interest obligation to the retail customers, and (3) the extent to
which broker-dealers are currently acting in a retail customer's best
interest when providing advice, and complying with the existing
disclosure requirements and liabilities. Regulation Best Interest would
impose a best interest obligation on broker-dealers that would
incorporate and go beyond existing suitability obligations under the
federal securities laws and SRO rules. The overall cost of proposed
Regulation Best Interest would depend on the costs that each of its
component obligations, namely the Disclosure, the Care, and the
Conflict of Interest Obligations, would impose on broker-dealers,
retail customers, and other parties such as product sponsors with a
stake in the market for financial advice.
For instance, with respect to the Disclosure Obligation, the
disclosure requirements would incorporate and go beyond existing
disclosure obligations and liabilities, and, as a result, may impose
direct costs on broker-dealers.
With respect to the Care Obligation, the requirement to have a
reasonable basis to believe that a recommendation is in the best
interest of a particular retail customer based on that retail
customer's investment profile and the risks and rewards associated with
the recommendation may impose a cost on the broker-dealers that
determine that they no longer wish to make certain recommendations to
brokerage customers, and, as a result, forgo some of the revenue stream
associated with such recommendations. Other requirements of this
obligation may impose operational and legal costs on broker-dealers.
Finally, with respect to Conflict of Interest Obligations, the
requirement to establish, maintain, and enforce written policies and
procedures to eliminate material conflicts of interest as an
alternative to disclosing such conflicts may impose potential costs on
broker-dealers to the extent that they determine to satisfy this
requirement by no longer offering certain recommendations or services,
and, therefore, forgo some of the revenue stream associated with such
recommendations or services. The requirement to establish, maintain,
and enforce written policies and procedures to mitigate or eliminate
certain material conflicts of interest arising from financial
incentives may alter the incentives of registered representatives to
expend effort in providing quality advice, and, therefore, may impose a
cost on retail customers due to the potential decline in the quality of
recommendations. The same requirement may limit retail customer choice,
and therefore impose costs on retail customers, because broker-dealers,
for compliance or business reasons, may determine to avoid recommending
certain products to retail brokerage customers, despite the fact that
these products may be beneficial to certain retail customers in certain
circumstances.
The Commission acknowledges that, taken together, the proposed
rules may generate tension between broker-dealers' regulatory
requirements and their incentives to provide high quality
recommendations to retail customers, including by recommending costly
or complex products. Retail customers may have diverse and complex
investment needs and goals and may benefit from tailored trading
strategies and financial products that may entail higher costs (e.g.,
due to the effort that broker-dealers may have to expend to understand
the product and which products would best fit the needs of their retail
customers). While this proposal is designed to incorporate and go
beyond the existing broker-dealer regulatory regime and ameliorate
certain conflicts of interest between retail customers and financial
firms, it is not intended to restrict broker-dealers from recommending
higher cost products or services to retail customers when appropriate
to meet a retail customer's needs or goals, so long as these
recommendations meet proposed Regulation Best Interest.\463\
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\463\ The DOL RIA estimates that the aggregate costs associated
with the implementation and compliance with the DOL Fiduciary Rule
and the BIC Exemption would be between $10 billion and $31.5 billion
over 10 years, with an expected cost of $16.1 billion. But see
Letter from Craig Lewis (Aug. 31, 2017) (offering a critique of the
DOL RIA). As noted above, because of the differences in the scope of
Regulation Best Interest, the Commission is not incorporating these
estimates into its own analysis.
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a. Standard of Conduct Defined as Best Interest
As noted above, the proposed rule would establish a best interest
standard of conduct for broker-dealers when making recommendations to
retail customers. Below, we discuss the operational and programmatic
costs anticipated as a result of the proposed rule.
(1) Operational Costs
Broker-dealers typically provide training to their employees with
respect
[[Page 21648]]
to relevant legal and regulatory requirements.\464\ Firms generally
prefer face-to-face training where possible, but large firms tend to
use computer-based training to reach their dispersed employees.\465\
The proposed rule would create a best interest standard of conduct for
broker-dealers. While incorporating the existing standards of conduct
for broker-dealers established by the federal securities laws and SRO
rules, this rule would enhance existing standards. Consequently,
complying with the best interest standard may require additional
training for broker-dealer employees. The cost of this training may
depend on whether a broker-dealer and its associated persons are
already behaving in a way that is consistent with the best interest
standard, and whether broker-dealer employees are trained to behave in
this manner. In particular, broker-dealers that currently are not
behaving consistent with the best interest standard and that are not
training their employees to behave in this manner may incur higher
training costs. For example, firms already provide training with
respect to FINRA suitability rules. As a result, we believe that the
costs associated with providing training with respect to the Care
Obligation of the proposed rule would be incremental for broker-dealers
that are behaving consistent with the best interest standard, but
potentially substantial for those broker-dealers that are not.
Similarly, broker-dealers currently provide training on material
conflicts of interest.\466\ However, the Conflict of Interest
Obligations of the proposed rule would be different from the existing
requirements or liabilities to disclose, and as a result, we believe
that the costs associated with providing training with respect to the
Conflict of Interest Obligations of the proposed rule could be
potentially significant.
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\464\ See FINRA, ``Report on Conflicts of Interest,'' Oct. 2013.
\465\ Id. at 15.
\466\ Id. at 15.
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In addition to the potential costs described above, certain factors
might mitigate the potential costs of proposed Regulation Best
Interest. As discussed earlier in Section IV.C, in addition to
obligations imposed by the existing standard of conduct, broker-dealers
that are servicing retirement accounts would also be subject to
obligations imposed by the DOL Fiduciary Rule and the BIC
Exemption.\467\ Regulation Best Interest would apply consistent
regulation to recommendations involving retail customers' retirement
and non-retirement accounts. To the extent that there might be a
discrepancy between broker-dealer obligations that apply to retirement
accounts and those that apply to non-retirement accounts, the proposed
rule, through its consistent approach to regulating recommendations
involving retail customers' retirement and non-retirement accounts, may
reduce any costs associated with such discrepancy. Similarly, to the
extent that broker-dealers that do not necessarily service retirement
accounts might be subject to and comply with similar overlapping
regulations that impose costs on broker-dealers (e.g., state laws that
impose fiduciary obligations),\468\ proposed Regulation Best Interest
may reduce any such costs.
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\467\ As discussed above, the DOL Fiduciary Rule was vacated by
the United States Court of Appeals for the Fifth Circuit on March
15, 2018. See supra note 51.
\468\ See supra note 442.
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While all broker-dealers would have to comply with Regulation Best
Interest, broker-dealers that service retirement accounts would also
have to comply with the DOL Fiduciary Rule and the BIC Exemption. Since
the best interest obligation of the proposed rule does not incorporate
all the requirements that the DOL Fiduciary Rule and the BIC Exemption,
broker-dealers that service retirement accounts may incur additional
costs as a result of overlapping but not identical regulations. For
example, broker-dealers that implement the BIC Exemption would be
subject to the disclosure regime imposed by the proposed rule, as well
as the disclosure requirements mandated by the BIC Exemption.\469\
Similarly, broker-dealers that are not necessarily servicing retirement
accounts but could be subject to overlapping but not identical
regulation may incur additional costs of complying with such
regulation. However, since Regulation Best Interest would not change
how broker-dealers would comply with the DOL Fiduciary Rule and the BIC
Exemption or other current overlapping regulations, broker-dealers may
incur the costs of complying with such regulations even absent an
explicit best interest obligation.
---------------------------------------------------------------------------
\469\ The disclosure requirements for the BIC Exemption are
discussed in the baseline. See Section IV.C.2, and supra note 52.
---------------------------------------------------------------------------
(2) Programmatic Costs
The proposed rule may impose programmatic costs on broker-dealers
by limiting their ability to make certain recommendations or deterring
them from making certain recommendations. To the extent that broker-
dealers are currently able to generate revenues from securities
recommendations that are consistent with FINRA's suitability rule but
not consistent with this proposed best interest obligation, those
revenues would be eliminated under the proposed rule. Specifically, if
a broker-dealer determines to no longer recommend a product because
that product is inferior to another product with similar payoffs but
lower cost, the revenue loss would consist of the difference between
the cost of the former product and the cost of the latter product.
While the FINRA suitability standard does not explicitly prohibit a
broker-dealer from putting its interest ahead of the customer's, FINRA
interpretations suggest that a broker-dealer may not put its interest
ahead of the customer's.\470\ The Commission is unable to quantify the
magnitude of this potential revenue loss because of the difficulty in
identifying systematically recommendations that are consistent with
FINRA's suitability rule but not with the proposed rule. The reason why
such identification is difficult is because a broker-dealer
recommendation depends largely, as noted earlier, on the facts and
circumstances related to that recommendation and the investment profile
of the retail customer receiving that recommendation. Any estimate of
the magnitude of the potential revenue loss would depend on assumptions
about a recommendation's potential facts and circumstances and the
investment profile of the retail customer receiving the recommendation.
Since the Commission lacks the data that would help narrow the scope of
these assumptions, the resulting range of potential estimates would be
wide, and, therefore, not informative about the magnitude of the
potential revenue loss.
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\470\ See Rule 2111, FAQ--Q7.1, available at http://www.finra.org/industry/faq-finra-rule-2111-suitability-faq.
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Broker-dealers may also face increased costs due to enhanced legal
exposure as a result of a potential increase in retail customer
arbitrations.\471\ Such costs may also be incurred to the extent
broker-dealers believe that such an increase may occur and therefore
choose to expend
[[Page 21649]]
resources to prepare for additional arbitration claims. Most, if not
all, brokerage agreements contain clauses that require retail customers
to arbitrate disputes with a broker-dealer through FINRA's Office of
Dispute Resolution.\472\ In the event that a brokerage agreement
contains no such arbitration clause, Rule 12201 of FINRA's Code of
Arbitration Procedure for Customer Disputes (the ``FINRA Code'') allows
a customer to compel a broker-dealer or person associated with a
broker-dealer to arbitrate a dispute.\473\ The FINRA Code does not
require a customer to allege a cause of action when pursuing
arbitration against a broker-dealer; rather, a customer need only
specify ``relevant facts and remedies requested.'' \474\ Nevertheless,
it is unclear whether or to what extent the adoption of Regulation Best
Interest would affect the number of retail customer arbitrations, since
many retail customer arbitrations are already predicated on facts
alleging that a broker-dealer breached a fiduciary duty or breached its
suitability obligations.\475\
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\471\ Moreover, we note that the proposed rule creates an
enhanced standard of conduct for broker-dealers under the Exchange
Act. One key difference and enhancement resulting from the
obligations imposed by Regulation Best Interest as compared to a
broker-dealer's existing obligations under the antifraud provisions
of the federal securities laws, is that the antifraud provisions
require an element of fraud or deceit, which would not be required
under Regulation Best Interest. More specifically, the Care
Obligation could not be satisfied by disclosure. To the extent that
broker-dealers believe that they may face enhanced legal exposure,
they may choose to incur costs in anticipation of any enforcement
action.
\472\ See SEC Investor Bulletin: Broker-Dealer/Customer
Arbitration (Dec. 20, 2016), available at https://www.sec.gov/oiea/investor-alerts-bulletins/ib_arbitration.html (``[A]ccount opening
agreements will almost always contain a provision binding the
parties to arbitration in the event of a dispute . . . [FINRA]
handles almost all securities industry arbitrations and
mediations.'').
\473\ See FINRA Rule 12200 (``Parties must arbitrate a dispute
under the Code if: Arbitration under the Code is either: (1)
Required by a written agreement; or (2) Requested by the customer. .
. .''). See also SEC Investor Bulletin: Broker-Dealer/Customer
Arbitration (Dec. 20, 2016), available at https://www.sec.gov/oiea/investor-alerts-bulletins/ib_arbitration.html.
\474\ See FINRA Rule 12302.
\475\ See FINRA Dispute Resolution Statistics, Top 15
Controversy Types in Customer Arbitrations, available at https://www.finra.org/arbitration-and-mediation/dispute-resolution-statistics#top15controversycustomers (of cases served from January
through October 2017, 1,529 cases alleged a breach of fiduciary
duty; during that same period, 1,279 cases alleged a breach of
suitability obligations).
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b. Disclosure Obligation
Proposed Regulation Best Interest would impose a number of
obligations on broker-dealers, including the Disclosure Obligation.
As noted earlier, the Disclosure Obligation would incorporate and
go beyond the existing disclosure obligations and liabilities by
establishing an explicit disclosure requirement for broker-dealers
under the Exchange Act, by facilitating a more uniform level of
disclosure of the material scope and terms of the relationship between
broker-dealer and retail customer as well as broker-dealer material
conflicts of interest across broker-dealers and by providing retail
customers with sufficiently specific facts concerning their
relationship with broker-dealers.
As discussed earlier, certain requirements of the Disclosure
Obligation could be satisfied in part by complying with the
requirements of the concurrent proposed Relationship Summary and
Regulatory Status Disclosure. For instance, with respect to the
requirement to disclose a broker-dealer's capacity, a standalone
broker-dealer would be able to satisfy fully the requirement by
delivering the Relationship Summary to the retail customer and by
maintaining a reasonable basis to believe that a retail customer had
been delivered the Relationship Summary prior to or at the time when a
recommendation was made, and by complying with the Regulatory Status
Disclosure. In contrast, a dual-registrant would only be able to
satisfy partially the requirement to disclose a broker-dealer's
capacity by complying with the Relationship Summary rule and the
Regulatory Status Disclosure. Given that a dual-registrant may act in
broker-dealer capacity or investment adviser capacity when providing
advice to a retail customer, a dual-registrant would have to comply
with the Disclosure Obligation expressly.\476\ Thus, while standalone
broker-dealers that comply with the Relationship Summary rule would not
incur additional costs to comply with this requirement of the
Disclosure Obligation, dual-registrants would. However, dual-
registrants would be given flexibility with respect to the form,
timing, or method of satisfying this requirement of the Disclosure
Obligation when they make recommendations in the capacity of broker-
dealer.
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\476\ Financial professionals who are dually-registered, but who
are affiliated with different standalone broker-dealers and
investment advisers would have the same obligation.
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With respect to the requirement to disclose a broker-dealer's fees,
the Disclosure Obligation may enhance the informativeness of the
broker-dealer disclosure to retail customers over the existing
disclosure practices. Currently, disclosure practices with respect to a
broker-dealer's fees may not be sufficiently informative to remove a
retail customer's uncertainty about the fees that it would have to pay
by acting on a broker-dealer recommendation.\477\ The proposed
Relationship Summary rule would require broker-dealers to disclose
general information about the types of fees that retail customers would
be expected to pay when receiving services from broker-dealers, but not
quantitative fee information. However, in addition to the Relationship
Summary, the Disclosure Obligation would foster more detailed fee
disclosure, and would require broker-dealers to provide, at the
minimum, additional detail about the fees described in the Relationship
Summary, such as fee amounts, percentages and ranges. Thus, even for
those broker-dealers that comply with the Relationship Summary, the
Disclosure Obligation with respect to disclosure of a broker-dealer's
fees would impose additional costs on broker-dealers. However, broker-
dealers would have flexibility as to the form and timing of how to
satisfy this requirement of the Disclosure Obligation.
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\477\ See, e.g., supra note 192.
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Finally, broker-dealers would be able to satisfy the requirement to
disclose all material conflicts of interest by complying with the
requirements of the Conflict of Interest Obligations. Thus, for broker-
dealers that comply with the Conflict of Interest Obligations, the
Disclosure Obligation with respect to disclosure of material conflicts
of interest would impose no additional costs on broker-dealers. The
Conflict of Interest Obligations would impose costs on broker-dealers,
and those costs are discussed in more detail below.
As noted above, proposed Regulation Best Interest would give
broker-dealers flexibility with respect to the form, timing, or method
of complying with the disclosure requirements. While this flexibility
would help broker-dealers tailor their form, timing, or method of
complying with the disclosure requirements to their business practices,
it may also impose a cost on broker-dealers because, in the absence of
a mandated form, timing, or method of disclosure, broker-dealers would
have to expend resources to develop standardized methods of disclosure
that could be easily understood by their retail customers.
Finally, as discussed above, the requirement to create certain
written records of information collected from and provided to a retail
customer of the Disclosure Obligation may impose additional costs on
broker-dealers. This new record-making requirement would amend Exchange
Act Rule 17a-3 by adding new paragraph (a)(25) that would require that
a broker-dealer create a record of all information collected from and
provided to the retail customer pursuant to Regulation Best Interest.
In addition, the Commission is proposing to amend Exchange Act Rule
17a-4(e)(5) to require broker-dealers to retain the records required
pursuant to Rule 17a-3(a)(25) for at least six years.
[[Page 21650]]
The Commission is unable to fully quantify the costs of the
Disclosure Obligation due to a number of factors. First, the Commission
lacks data on the extent to which current disclosure practices are
different from the disclosure requirements of the Disclosure
Obligation. Second, given that the proposed rule would give broker-
dealers flexibility in complying with the requirements of the
Disclosure Obligation, there could be multiple ways in which broker-
dealers may satisfy these requirements. Finally, the portion of
compliance costs that broker-dealers may pass on to retail customers
may depend on the costs that a retail customer would incur to switch
from one broker-dealer to another or from a broker-dealer to an
investment adviser
While a range of estimates for the costs of the Disclosure
Obligation may be difficult to obtain due to the potentially wide range
of assumptions about these factors, preliminary estimates for the
portion of these costs borne by broker-dealers may be obtained under
specific assumptions. As discussed further in Section V.D, the
Commission preliminarily believes that the preparation and delivery of
standardized language, fee schedules, and standardized conflict
disclosures that broker-dealers are expected to provide to retail
customers to comply with the Disclosure Obligation would impose an
initial aggregate burden of 5,808,703 hours and an additional initial
aggregate cost of $40.79 million as well as an ongoing aggregate burden
of 1,965,564 hours on broker-dealers.\478\ Thus, the Disclosure
Obligation of proposed Regulation Best Interest would impose an initial
aggregate cost of at least $1,391.07 million and an ongoing aggregate
annual cost of at least $460.81 million on broker-dealers.\479\ In
addition, the Commission believes that the record-making obligation of
proposed Rule 17a-3(a)(25) and the recordkeeping obligation of the
proposed amendment to Rule 17a-4(e)(5) associated with the Disclosure
Obligation and the obligations of proposed Regulation Best Interest
would impose an initial aggregate burden of 19,678,777 hours and an
additional initial aggregate cost of $378,544 as well as an ongoing
aggregate annualized burden of 3,173,334 hours on broker-dealers.\480\
Thus, the record-making obligation of proposed Regulation Best Interest
would impose an initial aggregate cost of at least $4,516.56 million
and an ongoing aggregate annual cost of at least $1,141.81 million on
broker-dealers.\481\
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\478\ The estimate of the initial aggregate burden is based on
the following calculation: 3,600 hours + 8,020 hours + 41,100 hours
+ 1,904,000 hours + 4,010 hours + 20,550 hours + 1,904,000 hours +
4,010 hours + 15,413 hours + 1,904,000 hours = 5,808,703 hours. As
discussed in more detail in Section V.D., 3,600, 8,020, and 41,100
hours are preliminary estimates of the initial aggregate burden for
the preparation of disclosure of capacity, type and scope, for dual
registrants, small and large broker-dealers, respectively. 1,904,000
hours is the preliminary estimate of the initial aggregate burden
for the delivery of the disclosure of capacity, type and scope to
retail customers. 4,010 and 20,550 hours are preliminary estimates
of the initial aggregate burden for the preparation of disclosure of
fees for small and large broker-dealers, respectively. 1,904,000
hours is the preliminary estimate of the initial aggregate burden
for the delivery of the disclosure of fees to retail customers.
4,010 and 15,413 hours are preliminary estimates of the initial
aggregate burden for the preparation of disclosure of material
conflicts of interest for small and large broker-dealers,
respectively. 1,904,000 hours is the preliminary 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:
$1.70 million + $3.79 million + $14.55 million + $1.89 million +
$9.70 million + $1.89 million + $7.27 million = $40.79 million. As
discussed in more detail in Section V.D., $1.70 million, $3.79
million, and $14.55 million are preliminary estimates of the initial
aggregate cost for the preparation of disclosure of capacity, type
and scope, for dual registrants, small and large broker-dealers,
respectively. $1.89 million and $9.70 million are preliminary
estimates of the initial aggregate cost for the preparation of
disclosure of fees for small and large broker-dealers, respectively.
$1.89 million and $7.27 million are preliminary 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: 2,520 hours + 3,208 hours + 41,100
hours + 380,800 hours + 1,604 hours + 8,220 hours + 761,600 hours +
802 hours + 4,110 hours + 761,600 hours = 1,965,564 hours. As
discussed in more detail in Section V.D., 2,520, 3,208, and 41,100
hours are preliminary estimates of the ongoing aggregate burden for
the preparation of disclosure of capacity, type and scope, for dual
registrants, small and large broker-dealers, respectively. 380,800
hours is the preliminary estimate of the ongoing aggregate burden
for the delivery of the disclosure of capacity, type and scope to
retail customers. 1,604 and 8,220 hours are preliminary estimates of
the ongoing aggregate burden for the preparation of disclosure of
fees for small and large broker-dealers, respectively. 761,600 hours
is the preliminary estimate of the ongoing aggregate burden for the
delivery of the disclosure of fees to retail customers. 802 and
4,110 hours are preliminary estimates of the ongoing aggregate
burden for the preparation of disclosure of material conflicts of
interest for small and large broker-dealers, respectively. 761,600
hours is the preliminary estimate of the ongoing aggregate burden
for the delivery of the disclosure of material conflicts of interest
to retail customers.
\479\ These estimates are calculated as follows: (96,703 hours
of in-house legal counsel) x ($409.37/hour for in-house counsel) +
(5,712,000 hours for delivery for each customer account) x ($229.46/
hour for registered representative) + (86,428 hours for outside
legal counsel) x ($472/hour for outside legal counsel) = $1,391.07
million, and (35,555 hours of in-house legal counsel) x ($409.37/
hour for in-house counsel) + (1,904,000 hours for delivery for each
customer account) x ($229.46/hour for registered representative) +
(26,009 hours for in-house compliance counsel) x ($359.81/hour for
outside legal counsel) = $460.81 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 Section V.D.
\480\ These estimates are based on the Commission's preliminary
estimates, discussed in Section V.D, 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)(25) and the
recordkeeping obligation of the proposed amendment to Rule 17a-
4(e)(5) associated with all component obligations of the proposed
Regulation Best Interest. The estimate of the initial aggregate
burden is based on the following calculation: 4,110 hours +
3,808,000 hours + 15,866,667 hours = 19,678,777 hours, where, as
discussed in more detail in Section V.D, 4,110 hours is the
preliminary estimate of amending the account disclosure agreement by
large broker-dealers, 3,808,000 hours is the preliminary estimate of
the burden associated with filling out the information disclosed
pursuant to Regulation Best Interest in the account disclosure
agreement, and 15,866,667 hours is the preliminary estimate of the
burden to broker-dealers for adding new documents or modifying
existing documents to the broker-dealer's existing retention system.
$378,544 is the preliminary estimate of amending the account
disclosure agreement by small broker-dealers pursuant to the record-
making obligation of proposed Rule 17a-3(a)(25). 3,173,334 hours is
the preliminary estimate of the ongoing aggregate annual burden to
broker-dealers of complying with the recordkeeping obligation of the
proposed amendment to Rule 17a-4(e)(5).
\481\ These estimates are calculated as follows: (2,055 hours of
in-house legal counsel) x ($409.37/hour for in-house counsel) +
(19,674,667 hours for entering and adding new or modifying existing
documents in each customer account) x ($229.46/hour for registered
representative) + (2,055 hours for in-house compliance counsel) x
($359.81/hour for in-house compliance counsel) + (802 hours for
outside legal counsel) x ($472/hour for outside legal counsel) =
$4,516.56 million, and (3,173,334 hours for record keeping) x
($229.46/hour for registered representative) = $1,141.81 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 Section V.D.
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c. Obligation To Exercise Reasonable Diligence, Care, Skill, and
Prudence in Making a Recommendation
The Care Obligation of the proposed rule, as described above, would
incorporate and go beyond a broker-dealer's existing obligations in two
ways. First, the proposed obligation would draw on broker-dealers'
existing well-established obligations for ``customer-specific
suitability,'' but would go beyond those obligations by requiring that
the broker-dealer have a reasonable basis to believe that the
recommendation is in the best interest of the retail customer based on
the retail customer's investment profile. Second, the proposed rule
would require a broker-dealer to have a reasonable basis to believe
that a series of transactions is not excessive and is in the retail
customer's best interest, regardless of whether the broker-dealer has
actual or de facto control over a retail account. As described in
Section IV.B above,
[[Page 21651]]
existing suitability rules require that a broker-dealer or associated
person have a reasonable basis to believe that a recommendation or
investment strategy is ``suitable'' for the retail customer.\482\
Suitability depends, among other things, on information obtained by the
broker-dealer or associated person about the retail customer's
investment profile (e.g., age, other investments, financial situation
and needs, tax status, investment objectives, investment experience,
investment time horizon, need for liquidity, and risk tolerance).\483\
In particular, pursuant to the requirements of FINRA's suitability
rule, currently, broker-dealers are expected to make efforts to
ascertain the potential risk and rewards associated with a
recommendation, given a customer's investment profile, and to determine
whether the recommendation could be in suitable for at least some
retail customers. Furthermore, broker-dealers are expected to evaluate
the information in a retail customer's investment profile and other
relevant information when determining whether a recommendation is
suitable or whether a series of recommendations is suitable and not
excessive.
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\482\ See supra note 431.
\483\ See supra note 241.
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Under FINRA's suitability rule and other applicable legal
standards, broker-dealers are also expected to make an effort to
ascertain relevant information about a retail customer's investment
profile prior to making a recommendation on an ``as needed'' basis. In
general, the reasonableness of a broker-dealer's effort to collect
information regarding a customer's investment profile information
depends on the facts and circumstances of a given situation.\484\ We
understand that currently broker-dealers collect information relevant
to a customer's investment profile at the inception of the relationship
with the retail customer through the use of a questionnaire, such as in
an account opening agreement, and during the relationship on an ``as
needed'' basis.
---------------------------------------------------------------------------
\484\ See FINRA Regulatory Notice 12-25 at Q16.
---------------------------------------------------------------------------
The requirements of the Care Obligation of proposed Regulation Best
Interest mirror closely but are not identical to the current broker-
dealer practices pursuant to the requirements of FINRA's suitability
rule and other applicable legal standards. The first important
difference is the requirement that broker-dealers have a reasonable
basis to believe that a recommendation is in the best interest of a
retail customer and that a series of recommendations is not excessive
and in the best interest of the retail customer. The suitability
standard does not have an explicit best interest requirement and
therefore broker-dealers may be able to make recommendations today
that, while suitable, may not meet the Care Obligation proposed as part
of Regulation Best Interest. As noted above, to the extent that current
broker-dealer practices pursuant to the requirements of FINRA's
suitability rule do not reflect the proposed best interest standard of
conduct, the Care Obligation would impose a cost on broker-dealers. The
other important difference is the removal of the element of control
from the requirement to have a reasonable basis to believe that a
series of recommendations is not excessive and in the best interest of
the retail customer. As noted above, unlike the quantitative
suitability requirement of FINRA's suitability rule, this requirement
of the Care Obligation applies irrespective of whether a broker-dealer
has actual or de facto control over the account of the retail customer.
To the extent that the removal of the element of control may cause a
potential increase in retail customer arbitrations, the Care Obligation
would impose a cost on broker-dealers due to enhanced legal
exposure.\485\
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\485\ See infra note 511.
---------------------------------------------------------------------------
As noted earlier, the proposed rule would also amend Exchange Act
Rule 17a-4(e)(5) to require broker-dealers to retain any customer
information that the customer would provide to the broker-dealer
pursuant to Regulation Best Interest, as well as copies of any conflict
disclosures provided to the customer by the broker-dealer pursuant to
Regulation Best Interest, in addition to the existing requirement to
retain information obtained pursuant to Exchange Act Rule 17a-3(a)(17).
Furthermore, broker-dealers would be required to retain all of the
retail customer investment profile information that they would obtain
as well as copies of conflict disclosures they would provide for six
years. 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 ``customer investment
profile'' that broker-dealers may attempt to obtain to make a customer-
specific suitability determination under FINRA's suitability rule. To
the extent that a retail customer would provide a broker-dealer with
information about the customer's investment profile pursuant to either
FINRA's suitability rule or Regulation Best Interest, the proposed rule
would require that broker-dealers retain that information for six
years. However, since the Care Obligation of proposed Regulation Best
Interest has no record-making requirement with respect to information
that broker-dealers obtain from retail customers, the Commission
believes that the costs to the broker-dealers of the retention
requirement to be small.
The Care Obligation may also impose costs on retail customers, to
the extent that broker-dealers pass on costs to their retail customers.
The Commission is unable to fully quantify the size of these costs due
to a number of factors. First, while the FINRA suitability standard
does not explicitly prohibit a broker-dealer from putting its interest
ahead of the customer's, FINRA's interpretation suggests that a broker-
dealer may not put its interest ahead of the customer's.\486\ Second,
it is unclear whether or to what extent the adoption of Regulation Best
Interest would affect the number of retail customer arbitrations, since
many retail customer arbitrations are already predicated on facts
alleging that a broker-dealer breached a fiduciary duty or breached its
suitability obligations.\487\ Finally, the portion of the costs that
broker-dealers may pass on to retail customers may depend on the costs
that a retail customer would incur to switch from one broker-dealer to
another or from a broker-dealer to an investment adviser. While a range
of estimates for the costs of the Care Obligation may be difficult to
obtain due to the potentially wide range of assumptions about these
factors, preliminary estimates for the portion of these costs borne by
broker-dealers may be obtained under specific assumptions. For
instance, the Commission believes that, with respect to the Care
Obligation, the record-making obligation of proposed Rule 17a-3(a)(25)
and the recordkeeping obligation of the proposed amendment to Rule 17a-
4(e)(5) would involve creating new documents or modifying existing
documents to reflect standardized questionnaires seeking customer
investment profile information. The costs associated with the record-
making and recordkeeping obligations are discussed in Section IV.D.2.b
above, and in more detail in Section V.D below.
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\486\ See Rule 2111, FAQ--Q7.1, available at http://www.finra.org/industry/faq-finra-rule-2111-suitability-faq.
\487\ See supra note 475 and accompanying text.
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[[Page 21652]]
d. Obligation To Establish, Maintain, and Enforce Written Policies and
Procedures Reasonably Designed To Identify and at a Minimum Disclose,
or Eliminate, All Material Conflicts of Interest Associated With a
Recommendation
As noted above, proposed Regulation Best Interest would require
broker-dealers to comply with two Conflict of Interest Obligations. The
first of these obligations would require a broker-dealer to establish,
maintain, and enforce written policies and procedures reasonably
designed to identify and at a minimum disclose, or eliminate, all
material conflicts of interest that are associated with a
recommendation.\488\ These conflicts may arise for a number of reasons.
For example, a broker-dealer may be in a position to recommend:
Proprietary products, products of affiliates, or limited range of
products; one share class versus another share class of a mutual fund;
securities underwritten by the firm or a broker-dealer affiliate; the
rollover 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, when the recommendation involves a securities
transaction); and allocation of investment opportunities among retail
customers. Broker-dealers would also need to consider whether these
conflicts arise from financial incentives and therefore are subject to
the additional Conflict of Interest Obligation 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 associated with a
recommendation that is discussed in more detail below.
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\488\ As discussed in Section I.B above, one key difference and
enhancement resulting from the obligations imposed by Regulation
Best Interest, as compared to a broker-dealer's existing suitability
obligations under the antifraud provisions of the federal securities
laws, is that the antifraud provisions require an element of fraud
or deceit, which would not be required under Regulation Best
Interest. More specifically, the Care Obligation could not be
satisfied by disclosure.
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Before determining whether to satisfy this Conflict of Interest
Obligation by disclosing, or eliminating, all material conflicts of
interest associated with a recommendation, broker-dealers would have to
first identify such material conflicts. To this end, the obligation
would require that broker-dealers establish written policies and
procedures reasonably designed to identify material conflicts of
interest. In particular, these policies and procedures would be
expected to identify a conflict in a manner that is relevant to a
broker-dealer's business practice, identify which conflicts arises from
financial incentives, provide a structure for identifying new conflicts
as broker-dealers' business practices evolve, and provide a structure
for an ongoing review for the identification of conflicts relevant to
current business practices.
Once the broker-dealer identifies a material conflict of interest
associated with a recommendation, the obligation requires that broker-
dealers establish written policies and procedures reasonably designed
to at a minimum disclose, or eliminate, the identified material
conflict of interest. In addition, reasonably designed policies and
procedures would likely include a discussion regarding the delivery of
a Relationship Summary, Regulatory Status Disclosure, or other
standardized documentation developed to disclose material conflicts of
interest to the retail customer. The Commission preliminarily believes
that such policies and procedures would provide a structure for
effectively addressing new or existing material conflicts of interest
that are relevant to a recommendation.
If a broker-dealer determines to satisfy the obligation through
disclosure, the broker-dealer would be expected to provide the retail
customer, in writing, with sufficiently specific facts so that the
customer is able to understand the conflicts of interest a broker-
dealer has and can make an informed decision about a recommended
transaction or strategy. As noted above, proposed Regulation Best
Interest would provide broker-dealers with flexibility in determining
the most appropriate way to meet their disclosure obligation in a
manner consistent with their business practices.
If a broker-dealer determines to satisfy the obligation by
eliminating an identified material conflict of interest, the broker-
dealer would be expected to, for instance, remove any incentives
associated with recommending a particular product or service, not offer
products that come with associated incentives, or negate the effect of
the conflict. The effects of this obligation on broker-dealers and
their retail customers are discussed in more detail below.
In addition to the requirement that broker-dealers establish
written policies and procedures to identify and at a minimum disclose,
or eliminate, material conflicts of interest, the obligation would also
require that broker-dealers maintain and enforce such policies and
procedures. Toward that end, broker-dealers would be expected to
develop risk-based compliance and supervisory systems that promote
compliance with proposed Regulation Best Interest consistent with their
business practices and in a manner that focuses on areas of those
business practices that pose risks of violating the Conflict of
Interest Obligations. 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.\489\ Consequently, in order to comply with the
requirement to maintain and enforce the policies and procedures
pursuant to the requirement to establish such policies and procedures
of the Conflict of Interest Obligation, broker-dealers could adjust
their current systems of supervision and compliance, as opposed to
creating new systems.
---------------------------------------------------------------------------
\489\ See FINRA Rule 3110 (Supervision) (requiring firms to
establish and maintain systems to supervise the activities of their
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations and FINRA
rules).
---------------------------------------------------------------------------
The requirement to establish, maintain, and enforce written
policies and procedures to identify and at a minimum disclose, or
eliminate, material conflicts of interest would impose initial and
ongoing costs and burdens on broker-dealers. As discussed in more
detail in Section V.D., the Commission preliminarily believes that
broker-dealers would update their policies and procedures to comply
with this requirement and would incur an initial aggregate burden of
131,320 hours and an additional initial aggregate cost of approximately
$24.84 million, as well as an ongoing aggregate annualized burden of
28,670 hours, and an ongoing aggregate annualized cost of approximately
$3.08 million.\490\ Furthermore, the Commission preliminarily believes
that in order to identify conflicts of interest and determine whether
the conflicts are material, broker-dealers would incur an
[[Page 21653]]
initial aggregate burden of 28,570 hours and an additional initial
aggregate cost of approximately $15.43 million as well as an ongoing
aggregate annualized burden of 28,570 hours.\491\ Finally, the
Commission preliminarily believes that in order to maintain and enforce
written policies pursuant to the obligation to identify and at the
minimum disclose, or eliminate, material conflicts of interest broker-
dealers would incur an initial aggregate burden of 446,499 hours and an
additional initial aggregate cost of approximately $61.71 million as
well as an ongoing aggregate annualized burden of 435,071 hours.\492\
Thus, the Conflict of Interest Obligation of proposed Regulation Best
Interest would impose an initial aggregate cost of at least $273.01
million and an ongoing aggregate annual cost of at least $120.92
million on broker-dealers.\493\
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\490\ These estimates are based on the following calculations:
123,300 hours + 8,020 hours = 131,320 hours; $9.7 million + $15.1
million = $24.8 million; and 24,660 hours + 4,010 hours = 28,670
hours. As discussed in more detail in Section V.D, 123,300 hours and
8,020 hours are preliminary estimates for the initial aggregate
burdens for large and small broker-dealers, respectively, $9.7
million and $15.1 million are preliminary estimates for the initial
aggregate costs for large and small broker-dealers, respectively,
and 24,660 hours and 4,010 hours are preliminary estimates for the
ongoing aggregate burdens for large and small broker-dealers,
respectively.
\491\ The estimate of the initial aggregate burden is based on
the following calculations: 14,285 hours + 14,285 hours = 28,570
hours, where, as discussed in more detail in Section V.D, 14,285
hours and 14,285 hours are preliminary estimates for the initial
aggregate burdens for identifying conflicts of interest and
determining whether the conflicts are material for all broker-
dealers, respectively.
\492\ The estimate of the initial aggregate burden is based on
the following calculations: 11,428 hours + 435,071 hours = 446,499
hours, where, as discussed in more detail in Section V.D, 11,428
hours and 435,071 hours are preliminary estimates for the initial
aggregate burdens of approving training modules and training of
registered representatives for all broker-dealers, respectively.
\493\ These estimates are calculated as follows: (106,209 hours
of in-house legal counsel) x ($409.37/hour for in-house counsel) +
(435,071 hours for training) x ($229.46/hour for registered
representative) + (27,692.5 hours for in-house compliance counsel) x
($359.81/hour for in-house compliance counsel) + (7,142.5 hours for
determining if identified conflicts of interest are material) x
($270.40/hour for senior business analyst) + (30,274 hours for
review of policies and procedures) x ($522.49/hour for compliance
manager) + (52,630 hours for outside legal counsel) x ($472/hour for
outside legal counsel) + (57,140 hours for modifying existing
technology) x ($270/hour for outside senior programmer) + (228,560
hours for updating training module) x ($270/hour for systems analyst
or programmer) = $273.01 million, and (8,220 hours of in-house legal
counsel) x ($409.37/hour for in-house counsel) + (435,071 hours for
training) x ($229.46/hour for registered representative) + (26,515
hours for in-house compliance counsel) x ($359.81/hour for in-house
compliance counsel) + (25,505 hours for identifying conflicts of
interest) x ($226.23/hour for business-line personnel) + (30,274
hours for review of policies and procedures) x ($522.49/hour for
compliance manager) + (4,010 hours for outside legal counsel) x
($472/hour for outside legal counsel) + (4,010 hours for outside
compliance services) x ($298/hour for outside compliance services) =
$120.92 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 Section V.D.
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(1) Eliminate Material Conflicts of Interest Associated With a
Recommendation
Broker-dealers may offer a wide variety of dealer services and
products to retail customers. Under the Exchange Act, a ``dealer'' is
defined as ``any person engaged in the business of buying and selling
securities (not including security-based swaps, other than security-
based swaps with or for persons that are not eligible contract
participants) for such person's own account through a broker or
otherwise.'' \494\ Dealer activity may include, but is not limited to,
selling securities (such as bonds) out of inventory; buying securities
from customers; selling proprietary products (e.g., products such as
affiliated mutual funds, structured products, private equity and other
alternative investments); selling initial and follow-on public
offerings; selling other underwritten offerings; acting as principal in
Individual Retirement Accounts; acting as a market maker or specialist
on an organized exchange or trading system; acting as a de facto market
maker or liquidity provider; and otherwise holding oneself out as
buying or selling securities on a continuous basis at a regular place
of business.
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\494\ Section 3(a)(5)(A) of the Exchange Act.
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In all of these instances broker-dealers transact with their
customers as principals. As discussed above, when a broker-dealer makes
a recommendation to a retail customer that involves products or
services associated with its dealer activities, the recommendation
would be subject to a conflict of interest. The Conflict of Interest
Obligations would require that broker-dealers establish, maintain, and
enforce written policies and procedures reasonably designed to identify
and disclose (and mitigate when financial incentives are involved), or
eliminate such conflicts of interest that are material.
If a broker-dealer determines to comply with the Conflict of
Interest Obligations by eliminating material conflicts of interest
associated with recommendations on products or services on which the
broker-dealer acts as a dealer, the broker-dealer would be expected to,
for instance, remove any incentives associated with recommending such
products or services, not offer products that come with associated
incentives, or negate the effect of the conflict. For instance, the
broker-dealer may choose to no longer recommend such products or
services or continue to make such recommendations but effectuate the
transactions in a way that does not involve a principal trade.
Eliminating this type of conflict of interest may have an impact on
broker-dealers' revenue and may reduce the set of securities
transactions recommended by a broker-dealer; or it may alter the
specific securities transactions that a broker-dealer recommends or the
manner and cost and quality of execution (e.g., because a broker-dealer
places an order with a third-party market maker rather than its own
proprietary trading desk). Further, dealers act as important financial
market intermediaries by providing liquidity to retail customers and
helping to maintain continuous and smooth price transitions for
securities. If broker-dealers determine to eliminate material conflicts
of interest, the resulting change to how this critical role is
performed could impact market liquidity.
The costs of complying with the Conflict of Interest Obligation by
eliminating material conflicts of interest related to financial
incentives that arise from broker activity are discussed in a
subsequent section below.
(2) At a Minimum Disclose Material Conflicts of Interest Associated
With a Recommendation
A broker-dealer would have to establish, maintain, and enforce
written policies and procedures that are reasonably designed to at a
minimum disclose those material conflicts of interest that the broker-
dealer does not determine to eliminate.
As described in Section IV.B above, when making a recommendation,
broker-dealers are subject to a number of disclosure requirements under
current Commission antifraud obligations, Exchange Act rules, and FINRA
rules. Also, as described in Sections I.A and IV.B above, when engaging
in transactions directly with customers on a principal basis, a broker-
dealer violates Exchange Act Rule 10b-5 when it knowingly or recklessly
sells a security to a customer at a price not reasonably related to the
prevailing market price and charges excessive markups, without
disclosing the fact to the customer. Exchange Act Rule 10b-10 also
requires a broker-dealer effecting transactions in securities to
provide written notice to the customer of certain information specific
to the transaction at or before the completion of the transaction,
including the capacity in which the broker-dealer is acting (i.e.,
agent or principal).\495\
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\495\ See Rule 10b-10. Rule 10b-10 requires a broker-dealer
effecting customer transactions in securities (other than U.S.
savings bonds or municipal securities) to provide written
notification to the customer, at or before completion of the
transaction, disclosing information specific to the transaction,
including whether the broker-dealer is acting as agent or principal
and its compensation, as well as any third-party remuneration it has
received or will receive. See also NASD Rule 2340 (Customer Account
Statements) (broker-dealers must provide customer account statements
on at least a quarterly basis).
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[[Page 21654]]
The Commission believes that policies and procedures would likely
include instructions for a broker-dealer to determine whether a
material conflict of interest, once identified, would need to be
disclosed.
As noted above, Regulation Best Interest would not prescribe the
process by which broker-dealers should disclose all material conflicts
of interest to their retail customers. Instead, the proposed rule would
give broker-dealers flexibility in identifying the most efficient and
effective way of complying with the disclosure obligation that is
consistent with a broker-dealer's business practice. Furthermore,
although the obligation to disclose material conflicts of interest may
impose costs on broker-dealers, the Commission preliminarily believes
that permitting disclosure instead of outright elimination of material
conflicts may reduce the costs the overall best interest obligation
could impose on retail customers. This is because the disclosure
alternative may preserve access to any recommendations that retail
customers currently might find beneficial, even taking into account the
existence of material conflicts.
Broker-dealers that currently employ minimal disclosure practices
that comply with the current disclosure requirements under federal
securities laws and applicable SRO rules about material conflicts of
interest with respect to their recommendations may incur higher costs
of complying with this enhanced disclosure obligation.
The Commission is unable to fully quantify these costs due to a
number of factors. First, the Commission lacks data that quantifies how
different current disclosure practices are compared to where they
should be to comply with the disclosure obligation with respect to
conflicts of interest. Second, given that the proposed rule allows
broker-dealers flexibility in complying with the disclosure obligation,
there could be multiple ways in which broker-dealers could satisfy this
obligation. While a range of estimates for the costs of disclosure
obligation with respect to conflicts of interest may be difficult to
obtain due to the potentially wide range of assumptions about these
factors, preliminary estimates for the portion of these costs borne by
broker-dealers may be obtained under specific assumptions. These latter
costs are discussed in Section IV.D.2.b above and in more detail in
Section V.D. below.
e. Obligation 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 Associated With a Recommendation
Proposed Regulation Best Interest also includes the additional
requirement that a broker, dealer, or associated person 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
a recommendation.
As noted above, we would interpret a material conflict of interest
arising from financial incentives to include the structure of 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); and compensation
practices involving third-parties, such as sales compensation and
compensation for services provided to third-parties or to retail
customers on behalf of third parties (e.g., sub-accounting or
administrative services provided to a mutual fund). In particular,
financial incentives that create material conflicts of interest from
financial incentives may include, for example, differential or variable
compensation received by the broker-dealer itself (but not an
affiliate), whether paid by the retail customer or a third-party;
receipt of fees, commissions or other charges on sales of proprietary
products, and transactions on a principal basis.
Broker-dealers may consider establishing policies and procedures
like the following to fulfill the Conflict of Interest Obligation:
Policies and procedures outlining how the firm identifies its material
conflicts (and material conflicts arising from financial incentives),
including such material conflicts of natural persons associated with
the broker-dealer, clearly identifying all such material conflicts of
interest and specifying how the broker-dealer intends to address each
conflict; robust compliance review and monitoring systems; processes to
escalate identified instances of noncompliance to appropriate personnel
for remediation; procedures that clearly designate responsibility to
business lines personnel for supervision of functions and persons,
including determination of compensation; processes for escalating
conflicts of interest; processes for a periodic review and testing of
the adequacy and effectiveness of policies and procedures; and training
on the policies and procedures. Furthermore, as noted above, such
policies and procedures would be expected to provide a structure for
effectively addressing new or existing material conflicts of interest
that arise from financial incentives associated with a recommendation,
including whether to disclose and mitigate or eliminate such a
conflict. Finally, in order to enforce such policies and procedures,
and consistent with the discussion above, broker-dealers may determine
that it is necessary to modify their current supervisory systems or
develop new ones.
The requirement to establish, maintain, and enforce written polices
pursuant to the requirement to identify and disclose and mitigate, or
eliminate, material conflicts of interest arising from financial
incentives of the Conflict of Interest Obligations would impose costs
on broker-dealers. These costs are discussed in Section IV.D.2.d above
and in more detail in Section V.D below.
(1) Eliminate Material Conflicts Arising From Financial Incentives
Associated With a Recommendation
For some broker-dealers, compensation arrangements with product-
sponsoring third parties may be an important source of revenue. For
instance, as described in Section IV.B, sales of investment company
products range on average between 8 percent and 20 percent of broker-
dealer revenue, depending on the size of the broker-dealer. Some (but
not necessarily all) of these products are subject to compensation
arrangements between broker-dealers and third parties that are
sponsoring these products. As noted above, when making recommendations
to retail customers on products that are subject to compensation
arrangements, a broker-dealer has a financial incentive, and therefore
a conflict of interest. The Conflict of Interest Obligations would
require that the broker-dealer establish, maintain, and enforce written
policies that are reasonably designed to identify and disclose and
mitigate, or eliminate this type of conflict of interest. If a broker-
dealer were to determine to eliminate this conflict, the broker-dealer
would have to take actions that would negate the existence of the
conflict in the first place. For instance, the broker-dealer could
credit retail customers all
[[Page 21655]]
the compensation it receives from product sponsors when recommending
their products to retail customers. Alternatively, the broker-dealer
could stop providing recommendations to retail customers on products
that are subject to compensation arrangements. In both cases, the
broker-dealer would forgo all the revenues tied to compensation paid by
product sponsors for distributing their products to retail customers.
More generally, broker-dealers that determine to eliminate
conflicts of interest arising from financial incentives may lose up to
the entire revenue stream associated with recommending products that
are subject to compensation arrangements. However, to the extent that
eliminating the conflict of interest arising from financial incentives
causes broker-dealers to offer only products that are no longer subject
to this type of conflict, the revenue stream generated by these
products would offset some of the revenue loss associated with products
no longer recommended. Furthermore, to the extent that broker-dealers
that chose to eliminate this conflict would limit their recommendations
on products subject to compensation arrangements, retail customers
would no longer have access to the same advice. The Commission
preliminarily believes that the cost to broker-dealers of eliminating
conflicts of interest arising from financial incentives could be large.
As noted earlier, investment company products account currently for a
significant portion of broker-dealers' revenues. However, only a
portion of such revenues come from recommendations that broker-dealers
make on investment company products to retail customers. Since the
Commission lacks data at this level of granularity, the Commission is
unable to quantify the magnitude of the potential revenue loss from
eliminating conflicts of interest associated with financial incentives.
Similarly, for reasons that include the aforementioned data limitation
and the difficulty in quantifying how retail customers value broker-
dealer advice (e.g., as discussed earlier, the value of broker-dealer
advice to retail customers would depend on how retail customers
generally perceive the risk and return of their portfolio, the
likelihood of acting on a recommendation that complies with the best
interest obligation, and, ultimately, how the risk and return of their
portfolio change as a result of how they act on the recommendation),
the Commission is unable to quantify the magnitude of the cost to
retail customers of no longer having access to the advice.
In addition to conflicts of interest arising from financial
incentives, broker-dealers also may be subject to conflicts of interest
associated with internal compensation structures that may give rise to
financial incentives to registered representatives. Much as there is an
agency relationship between retail customers and broker-dealers, there
is an agency relationship between broker-dealers and registered
representatives. Broker-dealer and registered representative incentives
may not be perfectly aligned. Like any agency relationship, contracts
can be structured in such a way as to better align the incentives of
the broker-dealer and its registered representatives. For example,
broker-dealers may offer registered representatives compensation
structures that reward them based on the amount of revenues they bring
in from providing services, including advice. Such compensation
structures are designed to benefit both the broker-dealers and the
registered representatives by motivating greater effort by registered
representatives. If a broker-dealer were to eliminate the use of
compensation structures that motivate effort by registered
representatives, its revenues would likely decline unless offset by
replacement revenue streams. At the same time, the agency costs
associated with the relationship between a broker-dealer and its
registered representatives could increase to the point where such a
relationship may not be justified going forward. In particular, a
registered representative at a standalone broker-dealer may determine
to terminate his or her relationship with the broker-dealer, while a
registered representative at a dual-registrant may determine to offer
advice only in a capacity of investment adviser. Such dynamics would
have a negative impact on the supply of broker-dealer recommendations,
which, in turn, would limit retail customer access to broker-dealer
advice.
Given these considerations, we preliminarily believe that the costs
associated with eliminating material conflicts of interest associated
with compensation structures could be large for both broker-dealers and
retail customers. However, the Commission is unable to fully quantify
the magnitude of such costs due to a number of factors. First, the cost
to broker-dealers would depend on determinants such as the extent to
which internal compensation structures reward registered
representatives for generating revenues and the sensitivity of broker-
dealer revenues to elements of the registered representatives'
compensation contract that rewards them for generating revenue (e.g.,
the portion of commission that they can retain). Currently, the
Commission has data only on the former determinant--as described in
Section IV.C--and lacks data on the second determinant. Second, the
cost to retail customers would depend on determinants such as how
retail customers perceive the risks and returns of their portfolios,
the likelihood of acting on a recommendation that complies with the
best interest obligation, and how those risk and returns change as a
result of a decline or change in the supply of broker-dealer
recommendations. While a range of estimates for these costs may be
difficult to obtain due to the potentially wide range of assumptions
about these factors, preliminary estimates for the portion of these
costs borne by broker-dealers may be obtained under specific
assumptions. For instance, the Commission preliminarily believes that
reasonably designed policies and procedures should establish a clearly
defined process for determining how to address any identified material
conflict of interest, including whether and how to eliminate a material
conflict of interest arising from financial incentives. The costs
associated with establishing, maintaining and enforcing such policies
are discussed in Section IV.D.2.d above and in more detail in Section
V.D below.
(2) Disclose and Mitigate Material Conflicts of Interest Arising From
Financial Incentives Associated With a Recommendation
As noted earlier, when providing recommendations, broker-dealers
potentially are liable under the federal securities laws' antifraud
provisions if they do not give ``honest and complete information'' or
disclose all material adverse facts and material conflicts of interest,
including economic self-interest, in connection with a recommendation.
The disclosure obligations for broker-dealer material conflicts of
interest--including conflicts related to financial incentives--under
Regulation Best Interest would go beyond the existing disclosure
requirements and liabilities. Namely, a broker-dealer making a
recommendation to a retail customer would be expected to provide the
retail customer with sufficiently specific facts about any material
conflicts of interest arising from financial incentives associated with
the recommendation such that the retail customer would be able to
understand the conflict and make an
[[Page 21656]]
informed decision about the recommendation.
A broker-dealer would have to establish, maintain, and enforce
written policies and procedures that are reasonably designed to
disclose and mitigate those material conflicts of interest arising from
financial incentives that the broker-dealer does not determine to
eliminate. The Commission expects that such policies and procedures
would include instructions for a broker-dealer to determine whether a
material conflict of interest, once identified, would need to be
disclosed and mitigated.
The requirement to establish, maintain, and enforce written
policies and procedures that are reasonably designed to disclose and
mitigate, or eliminate, material conflicts of interest arising from
financial incentives of the Conflict of Interest Obligations would
impose costs on broker-dealers. Broker-dealers that currently engage in
disclosure practices that are closer to the disclosure obligation of
the proposed rule would likely incur lower costs of complying with this
obligation. However, as noted above, Regulation Best Interest would
provide broker-dealers with flexibility in determining the most
appropriate way to meet this disclosure obligation, consistent with
each broker-dealer's business practices.
Similar to the discussion above about the disclosure obligation
with respect to all conflicts of interest, the Commission is unable to
fully quantify the costs associated with this obligation due to two
factors. First, the Commission lacks data that quantifies how different
current disclosure practices are compared to where they should be to
comply with the disclosure obligation with respect to conflicts of
interest arising from financial incentives. Second, given that the
proposed rule allows broker-dealers flexibility in complying with this
disclosure obligation, there could be multiple ways in which broker-
dealers could satisfy this obligation. While a range of estimates for
the costs of disclosure obligation may be difficult to obtain due to
the potentially wide range of assumptions about these factors,
preliminary estimates for the portion of these costs borne by broker-
dealers may be obtained under specific assumptions. These latter costs
are discussed in Section IV.D.2.b above and in more detail in Section
V.D below.
In addition to the disclosure obligation, the Conflict of Interest
Obligations of Regulation Best Interest would also require that broker-
dealers to establish, maintain, and enforce policies and procedures to
mitigate conflicts of interest related to financial incentives--
including conflicts arising from internal compensation structures and
compensation arrangements with product sponsors. The costs that broker-
dealers would potentially incur to comply with this new requirement
depends on what may constitute reasonable mitigation. The proposed rule
does not stipulate specific conflict mitigation measures. Instead, the
Commission's proposal would give broker-dealers flexibility to develop
and tailor policies and procedures aimed at conflict mitigation
measures based on each firm's business practices (such as the size of
the firm, retail customer base, the nature and significance of the
compensation conflict, and the complexity of the product).
Some conflicts of interest related to financial incentives arise
from internal compensation structures. As discussed above, the
Commission preliminarily believes that the costs to broker-dealers from
eliminating material conflicts of interest associated with compensation
structures could be large. As an alternative, broker-dealers could
retain the compensation structures to address the incentive conflict
between the broker-dealers and registered representatives, while taking
actions to mitigate the material conflict of interest that those
structures may create between broker-dealers or registered
representatives and retail customers.
Certain aspects of the market for brokerage services may serve, on
their own, to mitigate, to some extent, conflicts of interest between
broker-dealers and retail customers that may arise from compensation
structures. Potential legal liability and reputational risk related to
unsuitable recommendations can serve as a motivation to ameliorate the
conflict between broker-dealer representatives and customers. Concerned
about their potential legal liability as well as their reputations,
many broker-dealers currently take actions to ameliorate
conflicts.\496\ For example, some broker-dealers may use ``product
agnostic'' compensation structures (also referred to as ``neutral
grids'') that reduce a registered representative's incentive to
recommend one type of product over another.\497\ Broker-dealers can
also cap the credit a registered representative receives for selling
comparable products, thereby reducing the registered representative's
incentive to prefer, for example, one mutual fund or variable annuity
over another.\498\ Further, broker-dealers can impose compensation
adjustments on registered representatives who do not properly manage
material conflicts of interest.\499\ Another mechanism for mitigating
the conflict between registered representatives and customers is for
broker-dealers to link surveillance of registered representatives'
recommendations, and potential compensation adjustments, to thresholds
in a firm's compensation structure to deter recommendations that may be
motivated by a desire to receive higher compensation.\500\ A number of
firms also perform specialized supervision and surveillance of
recommendations, which could result in compensation adjustments, as a
registered representative approaches the end of the period over which
performance is measured for receiving bonuses.\501\ Finally, a number
of firms perform additional surveillance which could result in
compensation adjustments when a registered representative approaches
the threshold necessary for admission to a firm recognition club.\502\
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\496\ See FINRA Report on Conflicts of Interest (Oct. 2013), at
6, available at http://www.finra.org/sites/default/files/Industry/p359971.pdf.
\497\ Id.
\498\ Id.
\499\ Id.
\500\ Id.
\501\ Id.
\502\ Id.
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As noted above, proposed Regulation Best Interest would give
broker-dealers the flexibility to develop and tailor individual
conflict mitigating measures based on their business practices. The
cost of mitigating material conflicts associated with financial
incentives will depend, among other things, upon the extent to which
broker-dealers are currently engaging in conflict mitigating
activities. As discussed above, FINRA's 2013 study of conflicts states
that a number of firms are already engaging to various degrees in some
of those activities.\503\ For those firms that currently engage to a
larger extent in conflict mitigating activities, we would expect that
the costs associated with the Conflict of Interest Obligations of the
proposed rule to be lower. However, the Commission is currently unable
to quantify the magnitude of the costs to broker-dealers for complying
with the Conflict of Interest Obligation to mitigate material conflicts
of interest related to financial incentives, as applied to internal
compensation structures, for a number of reasons.
[[Page 21657]]
First, the Commission lacks data that quantifies the costs of firms
engaging in conflict mitigating activities. Second, given that the
proposed rule allows broker-dealers to tailor their conflict mitigating
measures to their business practices, there could be multiple ways in
which broker-dealers could address the conflict mitigating aspect of
the Conflict of Interest Obligation. Finally, any estimate of the
magnitude of such costs would depend on assumptions about the extent to
which broker-dealers are currently engaging in conflict mitigating
activities and how broker-dealers would choose to satisfy the Conflict
of Interest Obligation with respect to conflicts of interest arising
from internal compensation structures. Because the Commission lacks the
data that would help narrow the scope of these assumptions, the
resulting range of potential estimates would be wide, and, therefore,
may not be informative (in a statistical sense) about the magnitude of
the costs associated with mitigating conflicts of interest arising from
internal compensation structures.
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\503\ Id. The FINRA study notes that its observations are drawn
from discussions with large firms. As a result, FINRA notes that the
findings of the study will not in all cases be directly applicable
to small firms. See FINRA Report on Conflicts of Interest at p. 2.
---------------------------------------------------------------------------
Conflicts of interest related to financial incentives may also
arise from financial arrangements between broker-dealers and product
sponsors. Furthermore, as discussed above, the Commission preliminarily
believes that the costs to broker-dealers from eliminating material
conflicts of interest associated with financial incentives could be
large. As an alternative, broker-dealers may determine not to eliminate
a conflict and instead to mitigate it. To comply with the Conflict of
Interest Obligations of the proposed rule, broker-dealers that offer
recommendations to retail customers based on products subject to
agreement with product sponsors would have to adopt conflict mitigation
measures that would reasonably meet these obligations. As noted
earlier, the proposed rule does not explicitly specify mandatory
conflict mitigation measures. Instead, the rule would give broker-
dealers flexibility to develop and tailor conflict mitigation measures
consistent with their business practices.
Some broker-dealers may determine to eliminate the most expensive
products. For instance, broker-dealers may perceive that the monitoring
costs of ensuring that their registered representatives act in the
retail customer's best interest when making recommendations based on
the full set of offered products (including the most and least
expensive products) may be too large. It is possible that such an
approach, which eliminates products based on cost alone, may result in
a broker-dealer not making available products that, while being more
expensive, may provide better performance than products that are still
offered. Thus, conflict mitigating measures that constrain the set of
products offered may limit retail customer choice and, therefore, may
impose a cost on retail customers. Furthermore, these conflict
mitigating measures may impact the way registered representatives get
compensated, and, therefore, may alter their incentives to expend
effort (e.g., to understand the product and the customer that would
best fit the product) in providing recommendations of higher quality.
The potential change in the level of effort that registered
representatives expend when making recommendations may alter the
quality of advice that retail customers receive, which, in turn, may
impose a cost on retail customers. Alternatively, some broker-dealers
may determine to reduce the set of offered products in each product
class by eliminating those products that are the least expensive, or by
eliminating both the most and the least expensive. This approach would
result in a set of products that would be more homogeneously priced, in
order to comply with the mitigation aspect of the Conflict of Interest
Obligations. However, like the approach above, this approach may also
limit retail customer choice, and, therefore, may impose a cost on
retail customers.
More generally, the use of tailored products by broker-dealers to
mitigate conflicts of interest arising from financial incentives may
introduce additional complexities that could ultimately increase the
costs borne by retail customers. Therefore, there may be circumstances
where broker-dealers determine that eliminating rather than mitigating
conflicts through the use of products would be more advantageous for
the retail customer.
The factors that would affect a broker-dealer's choice to either
eliminate or mitigate conflicts are likely to vary. One example
involving the range of considerations that would need to be taken into
account is the use of ``clean'' shares, launched recently by a number
of mutual fund families. Clean shares, unlike other types of mutual
fund share classes, do not involve typical sales and servicing fees.
Instead, broker-dealers would be able to set their own commissions
which could be structured to avoid the conflicts posed by existing
distribution and servicing fee structures. For instance, broker-dealers
could set the commissions for these products according to neutral
factors that have been discussed earlier.\504\
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\504\ Mutual fund sponsors may use different combinations of
sales and servicing fees to discriminate among investors with
different expected holding periods. Investors who redeem impose
costs on those who remain in a fund. As a result, long-term
investors may be unwilling to invest alongside investors with
shorter expected holding periods. Differing sales and servicing fees
can induce investors to self-select into different funds based on
their expected holding period, thereby solving the long-term
investors' problem of investing alongside investors with shorter
expected holding periods which may, in turn, induce more investment
by long-term investors. See Tarun Chordia, ``The structure of mutual
fund charges,'' Journal of Financial Economics (1996, vol. 41, pp.
3-39). If broker-dealers meet the conflict mitigation requirement of
the proposed rule by relying on a single commission schedule, funds
would not have the ability to induce investors to self-select into
different funds based on expected holding period.
---------------------------------------------------------------------------
While some broker-dealers may determine that clean shares are a
potential solution to mitigating conflicts of interest arising from
compensation arrangements for mutual funds, because broker-dealers
could set the fee schedules according to neutral factors, retail
customers purchasing clean shares could face higher costs compared to
other share classes depending on the investors' holding period for the
shares. For some retail customers with short time horizons, clean
shares may be more costly relative to other mutual fund share classes.
Moreover, due to the nature of clean shares, retail customers may not
receive other benefits associated with some mutual fund share classes,
such as rights of accumulation that allow investors to account for the
value of previous fund purchases with the value of the current
purchases. Investors also may not be able to use letters of intent for
further purchases to qualify for breakpoint discounts.
In addition, broker-dealers that use clean shares may incur costs
stemming from, among other things, back-office work, training of
employees, reprogramming of systems, changes to compliance and desk
policies and procedures, and changes to clearing procedures. In
addition, while some fund complexes currently offer clean shares, not
all of them do. While this trend may change in the future, broker-
dealers may not be able to offer products that rely on clean shares in
each product class. Further, broker-dealers may choose to incorporate
clean shares into compliance systems for other commission-based
products.
For broker-dealers that determine to rely on clean shares to
mitigate conflicts related to financial incentives, revenues may either
increase or decrease depending on the extent that the commissions
charged on the clean share products are different than the overall
[[Page 21658]]
compensation with other funds. Furthermore, to the extent that clean
shares would lead to significant changes in how broker-dealers and
their associated persons would get compensated, the incentives of
broker-dealers when providing advice may change. In particular, if the
new compensation arrangement reduces the incentives of broker-dealers
to exert effort in providing quality advice, broker-dealer
recommendations could end up being of lower quality.
As noted earlier, in general, complying with the Conflict of
Interest Obligations to mitigate certain material conflicts of interest
may reduce broker-dealers' incentives to provide recommendations of
high quality to their retail customers, and, therefore, may impose a
cost on retail customers who seek advice from broker-dealers.
Furthermore, certain conflict mitigation measures may be costly to
implement. These implementation costs would be borne by broker-dealers,
and, to the extent that they can pass on some of the costs to their
retail customers, by retail customers as well.
Another way in which a broker-dealer may determine to mitigate a
material conflict of interest arising from compensation arrangements
with product sponsors is by expanding the set of products that the
broker-dealer may recommend to a retail customer to include products
that are less prone to this type of conflict of interest. That is, a
broker-dealer could recommend several products that satisfy the best
interest obligation and achieve the same goal (as perceived by the
broker-dealer) but that differ along several dimensions, such as
expected performance and the amount of compensation that the broker-
dealer receives from product sponsors. Presumably, no choice in this
set of suitable recommendations is strictly dominated by any of the
other choices, or else some of the recommendations in this set would
not be consistent with the best interest obligation. To the extent that
the retail customer picks a choice in this set that happens to offer
less compensation to the broker-dealer compared to the choice that the
broker-dealer would have recommended under the baseline, the broker-
dealer may incur some revenue loss.
The discussion above suggests that the requirement to establish,
maintain, and enforce written policies and procedures to mitigate
material conflicts of interest arising from financial incentives may
impose costs on broker-dealers, such as potential revenue loss and
costs related to the implementation of conflict mitigating measures.
The Commission is unable to quantify the magnitude of these costs for a
number of reasons. First, the Commission lacks data on the extent to
which current broker-dealer recommendations are subject to conflicts of
interest related to financial incentives. Second, given that the
proposed rule allows broker-dealers to tailor their conflict mitigating
measures to their business practices, there could be multiple ways in
which broker-dealers could address the conflict mitigating aspect of
the Conflict of Interest Obligation. Finally, any estimate of the
magnitude of such costs would depend on assumptions about the extent to
which broker-dealers are currently providing retail customers with
conflicted recommendations, how broker-dealers would choose to satisfy
the conflict mitigating aspect of the obligation, the costs associated
with implementing conflict mitigating measures, and, finally, how
retail customers would respond to recommendations that reflect a given
set of conflict mitigating measures. While a range of estimates for the
costs of the mitigation aspect of the Conflict of Interest Obligation
may be difficult to obtain due to the potentially wide range of
assumptions about these factors, preliminary estimates for the portion
of these costs borne by broker-dealers may be obtained under specific
assumptions. For instance, the Commission preliminarily believes that
reasonably designed policies and procedures should establish a clearly
defined process for determining how to address any identified material
conflict of interest, including whether and how to disclose and
mitigate a material conflict of interest arising from financial
incentives. The costs associated with establishing, maintaining, and
enforcing such policies are discussed in Section IV.D.2.d.
The discussion above also suggests that the way broker-dealers
choose to comply with the requirement to establish, maintain, and
enforce written policies and procedures to mitigate material conflicts
of interest arising from financial incentives may impose costs on
retail customers. If a broker-dealer errs on the side of caution and
pursues the most conservative rather than the optimal conflict
mitigating measures, retail customers may end up with fewer investment
choices,\505\ and lower quality advice. For instance, if the main
determinant of compensation differential across products is the level
of effort it takes a broker-dealer to understand the product and the
customer that would best fit the product, conflict mitigating measures
that either lead to the elimination of some of these products or that
render the compensation to be less sensitive to the effort exerted by
broker-dealer may reduce the investment choices available to the retail
brokerage customer, and, more generally, may reduce the quality of the
recommendations that a retail customer obtains from the broker-dealer.
In addition, retail customers may bear some of the costs associated
with broker-dealers' implementation of conflict mitigating measures.
---------------------------------------------------------------------------
\505\ See SIFMA Study.
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The Commission is unable to quantify the magnitude of the costs to
retail customers due to having access to potentially fewer investment
choices and a potential decline in the quality of recommendations
received, because such costs would depend on determinants such as how
retail customers generally perceive the risk and return of their
portfolio, the likelihood of acting on a recommendation that complies
with the best interest obligation, and, ultimately, how the risk and
return of their portfolio change as a result of how they act on the
recommendation. Since the Commission lacks the data that would help
narrow the scope of the assumptions regarding these determinants, the
resulting range of potential estimates would be wide, and, therefore,
not informative about the magnitude of the costs that the conflict
mitigating aspect of the Conflict of Interest Obligation would impose
on retail customers.
In addition to the potential costs imposed on broker-dealers and
retail customers, the conflict mitigating aspect of the Conflict of
Interest Obligations may also impose costs on product sponsors that
sell their products through broker-dealers. If product sponsors rely on
the broker-dealers' distribution channels to fund their products, and
use compensation arrangements that create financial incentives for
broker-dealers, the proposed best interest obligation may undermine
those incentives and may adversely impact the funding of these
products.
Specifically, broker-dealers may determine to mitigate conflicts of
interest arising from financial incentives tied to compensation from
product sponsors by no longer offering some of those products. These
conflict mitigating measures would affect the funding of the products
that are being eliminated, and therefore, the proposed rule may impose
funding costs on product sponsors. The Commission is unable to quantify
the magnitude of these funding costs for several reasons. First, it is
difficult to identify the
[[Page 21659]]
products that broker-dealers may no longer recommend to retail
customers. Second, as noted above, there could be multiple ways in
which broker-dealers could satisfy the Conflict of Interest Obligation
with respect to conflicts of interest due to compensation arrangements
with product sponsors. Finally, any estimate of the magnitude of such
funding costs would depend on assumptions about the distribution of
products across product sponsors that broker-dealers would no longer
recommend to retail customers and how broker-dealers would choose to
satisfy the Conflict of Interest Obligation with respect to conflicts
of interest due to compensation arrangements with product sponsors.
Since the Commission lacks the data that would help narrow the scope of
these assumptions, the resulting range of potential estimates would be
wide, and, therefore, not informative about the magnitude of the
funding costs to product sponsors.
D. Effects on Efficiency, Competition, and Capital Formation
In this section, we discuss the impact that proposed Regulation
Best Interest may have on efficiency, competition, and capital
formation. As discussed above, the proposed rule entails both benefits
and costs. The tradeoff between the benefits and costs, and the
resulting effect on the gains from trade to be shared between broker-
dealers and retail customers, is essential for evaluating the impact of
the proposed rule on efficiency, competition, and capital
formation.\506\
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\506\ ``Gains from trade'' is defined as the difference between
the highest price a consumer is willing to pay for a product or
service and the lowest price at which the producer is willing to
supply the product or service. See Section IV.B.b.
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Competition. By establishing a best interest standard of conduct
that would incorporate and expand the current broker-dealer
obligations, Regulation Best Interest would ameliorate the principal-
agent conflict between retail customers and broker-dealers. However,
the proposed rule would impose costs on broker-dealers, retail
customers and other parties with a stake in the market for financial
advice, and in particular, product sponsors.
To the extent that retail customers perceive that the amelioration
of the principal-agency conflict reinforces retail customers' beliefs
that broker-dealers will act in their best interest, retail customers'
demand for broker-dealer recommendations may increase. In turn, the
potential increase in the demand for broker-dealer recommendations
could lead to an increase in the number of broker-dealers in the
marketplace, and therefore to an increase in the competition among
broker-dealers. An increase in competition could manifest itself in
terms of better service, better pricing, or some combination of the
two, for retail customers.
However, Regulation Best Interest could also have negative effects
on competition. It is possible that in the process of ameliorating the
agency conflict between broker-dealer and retail customers, Regulation
Best Interest may impose costs on broker-dealers or retail customers
that would be large enough to reduce the gains from trade shared by
broker-dealers and retail customers. For instance, to the extent that
the cost of the rule to broker-dealers would cause some broker-dealers
to charge more for providing advice, the proposed rule may have
negative competitive effects for retail customers in the form of higher
pricing for advice. Similarly, to the extent that the reduction in the
gains from trade causes a significant reduction in the supply of
broker-dealer advice, the proposed rule may have negative competitive
effects for retail customers in the form of higher prices for advice.
The reduction in the gains from trade for broker-dealers may come
in the form of lower profits. In some cases, the reduction in profits
may be large enough to cause some broker-dealers or their associated
persons to no longer offer broker-dealer advice. In particular, the
potential reduction in the profits associated with broker-dealer advice
may create further incentives for some standalone broker-dealers and
their associated persons to join investment advisers and, in the
process, persuade their retail customers to become investment advisory
clients. Similarly, some dually-registered broker-dealers may decide to
only offer advice through the investment advisory side of the business
or to persuade their customers to switch to advisory accounts.
Regulation Best Interest may also have a differential impact on broker-
dealers depending on whether they are standalone or dual-registrants.
Unlike standalone broker-dealers, a dual-registrant would be able to
offer advice in its capacity as an investment adviser but execute the
transaction in its capacity as a broker-dealer. Because such a dual-
registrant acted as a broker-dealer solely when providing execution
services and not when providing advice, the dual-registrant would not
be subject to the requirements of the proposed rule for its advice.
Rather, the dual-registrant would be subject to the investment
advisers' fiduciary standard of care.\507\
---------------------------------------------------------------------------
\507\ See Fiduciary Duty Interpretive Release.
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If a dual-registrant would incur a larger cost of complying with
the new requirements of the best interest obligation compared to the
cost of complying with the requirements of the investment advisers'
fiduciary standard of care and the concurrent proposed interpretation
for investment advisers with respect to providing advice, the dual-
registrant may have an incentive to bypass the requirements of the
proposed rule by providing advice in the capacity of investment
adviser, while executing transactions in the capacity of broker-dealer.
To the extent that dual-registrants would engage in this practice, and
to the extent that retail customers would be willing to pay for this
type of advice, the magnitude of impacts from Regulation Best Interest
would be lower for dual-registrants than for standalone broker-dealers.
As a corollary, the proposed rule could give dual-registrants a
competitive advantage over standalone broker-dealers.
Beyond having an effect on competition among broker-dealers, it is
possible that the proposed rule could affect competition between
broker-dealers and investment advisers. Whether the proposed rule will
have an effect on competition between broker-dealers and investment
advisers will depend on how they market their services for advice and
how potential customers choose between the two. For certain retail
customers, fee structure or costs may be the primary driver of the
choice of whether to obtain advice from a broker-dealer or an
investment adviser. For example, a buy-and-hold retail customer or a
retail customer who does not trade often may find the one-time
commission charge commonly charged by a broker-dealer preferable to the
ongoing percent-of-assets under management fee of an investment
adviser. Because the proposed rules are not likely to change the way
broker-dealers and investment advisers charge for their services, the
proposed rules may not substantially alter the way in which retail
customers that are sensitive to differences in fee structures and costs
choose between the two.\508\
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\508\ A customer's relationship with an associated person of a
broker-dealer or investment adviser may also influence the proposed
rule's effect on how customers choose between the two. For example,
customers who have relationships with an associated person outside
of their professional relationship (e.g., they are members of the
same family, they are friends, they are members of the same or
similar organizations) may choose the associated person, at least in
part, based on those outside relationships. To the extent customers
and associated persons have relationships outside of their
professional relationships and to the extent those outside
relationships are determinative of the customer's choice between a
broker-dealer and an investment adviser, the proposed rule would not
substantially alter the way customers choose between the two.
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[[Page 21660]]
It may be the case, however, that certain retail customers base
their choice between a broker-dealer and an investment adviser, at
least in part, on their perception of the standards of conduct each
owes to their customers. For example, there may be retail customers who
prefer the commission structure of a broker-dealer, but who also prefer
the fiduciary standard of conduct applicable to investment advisers.
For certain of those retail customers, the preference for a fiduciary
standard of care may lead them to choose an investment adviser. Because
the proposed rule establishes a best interest standard of conduct that
incorporates and goes beyond the current broker-dealer standard of
conduct, broker-dealers may be better able to compete with investment
advisers for those customers. To the extent that there are customers
who prefer the commission structure of a broker-dealer, but who chose
to use an investment adviser because of their fiduciary standard of
conduct, we expect that the proposed rule will enhance competition
between broker-dealers and investment advisers.
The gains from trade that result from broker-dealers complying with
Regulation Best Interest may depend also on the type of products being
recommended. It may be the case that for certain products that broker-
dealers are currently offering, the best interest standard improves the
gains from trade to such an extent that retail customer demand for
broker-dealers' recommendations with respect to those products
increases. Similarly, the best interest standard may also have a
positive impact on retail customer demand for broker-dealer
recommendations in the case of products that are currently offered only
by a limited set of broker-dealers. The overall potential increase in
the demand for broker-dealer recommendations would encourage entry in
the broker-dealer sector, which would tend to lead to increased
competition among broker-dealers. An increase in competition could
manifest itself in terms of better service, better pricing, or some
combination of the two, for retail customers.
Conversely, it may be the case that for some products the best
interest standard reduces the gains from trade to such an extent that
broker-dealers determine to no longer make recommendations to retail
customers with respect to those products. The potential decline in the
number of broker-dealers willing to provide recommendations to their
brokerage customers for these products may have negative competitive
effects within the markets where these products are traded. For
instance, if a significant portion of the trading volume in these
products flows from retail customers acting on recommendations from
broker-dealers, then the possibility of broker-dealers no longer
offering recommendations on these products may adversely impact the
pricing and availability of these products.
The potentially negative impact of complying with the best interest
obligation of the proposed rule on the pricing of products that may no
longer be part of some broker-dealers' product offering would likely be
diminished for those products that are available to purchase outside a
broker-dealer distribution channel. Products that broker-dealers offer
advice on currently also may be offered through other non-broker-dealer
channels such as investment advisers and commercial banks. For example,
commercial banks can engage in broker-dealer activity, subject to
certain conditions, without having to register as broker-dealers.\509\
The decline in the supply of these products through broker-dealer
recommendations may cause product sponsors to increase the supply of
these products through non-broker-dealer entities that offer advice. In
turn, this potential increase in supply may offset some of the
potential negative effects of the proposed rule on the pricing of these
products.
---------------------------------------------------------------------------
\509\ 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).
---------------------------------------------------------------------------
In addition, the possibility that broker-dealers may determine to
no longer offer recommendations related to certain products that are
subject to compensation arrangements with product sponsors may have a
potential competitive impact on product sponsors. To the extent that
product sponsors compete over funding for their products based on
compensation arrangements with broker-dealers, the mitigation measures
that broker-dealers may implement to comply with the best interest
obligation, such as the potential elimination of some of these
products, may change how product sponsors compete with each other. For
instance, product sponsors may, under the proposed rules, choose to
compete based on product quality rather than compensation arrangements
with the broker-dealers that distribute the products.
Capital Formation and Efficiency. As noted above, to the extent
that the proposed rule improves the gains from trade for retail
customers, these enhanced gains from trade could, in turn, result in
current retail customers being willing to invest more of their savings
in securities markets and potential retail customers being willing to
invest through broker-dealers for the first time. To the extent that
the proposed rule leads to greater investment, it may promote capital
formation by supplying more capital to issuers at lower cost.
A portion of the enhanced gains from trade may be attributable to
the best interest standard enhancing the quality of recommendations
provided by broker-dealers to retail customers relative to the
baseline. Recommendations that broker-dealers make to retail customers
would be of higher quality if they were to promote investment
opportunities that better help customers achieve their investment
goals. These recommendations are not only consistent with the proposed
best interest standard but may also reflect the higher effort that
broker-dealers expend to understand the universe of investment
opportunities that would fit best with the retail customers' investment
profiles. Higher quality recommendations may also be a manifestation of
the proposed rules' impact on competition between broker-dealers that
may choose to compete more intensively on the quality of
recommendations. At the same time, however, the incentives of broker-
dealers to expend effort when providing quality recommendations would
depend on how broker-dealers choose to respond to this rule and, if
they continue to make recommendations to brokerage customers, how they
choose to mitigate certain material conflicts of interest. To the
extent that the tradeoff between enhancing the quality of advice and
mitigating material conflicts of interest results in facilitating
higher quality broker-dealer recommendations to retail customers,
Regulation Best Interest could improve the efficiency of retail
customers' portfolios that benefit from broker-dealer advice.
Among investment opportunities that better help customers achieve
their savings goals, there would be some that would finance valuable
projects in the corporate sector of the economy (as opposed to the
financial sector, e.g., expanding the production of a product that is
in high demand). To the extent that a retail customer acting on a high-
[[Page 21661]]
quality broker-dealer recommendation efficiently allocates new capital
to an investment opportunity that funds valuable corporate sector
projects, Regulation Best Interest, as proposed, could improve the
efficiency with which capital in the economy is allocated to the
corporate sector.
As noted above, the proposed rule also may have potentially
differential implications for recommendations related to different
products, leading to heterogeneous impacts on capital formation. In
markets for financial products where the best interest standard
improves the gains from trade, or where the benefits from ameliorating
conflicts exceed the costs of additional requirements, the proposed
rule could result in increased retail customer demand for broker-dealer
recommendations for these products from current retail customers, as
well as new retail customers. To the extent that increased demand for
broker-dealer recommendations for particular products leads retail
customers to allocate more capital to securities markets, and given the
role of broker-dealers in the capital formation process, we could
expect greater demand for such products which could, in turn, promote
capital formation. In contrast, for those products where the best
interest standard could erode the gains from trade, the supply of
broker-dealer recommendations may decline, producing the opposite
effect on capital formation. At the same time, the potential decline in
the supply of broker-dealer recommendations on these products may
negatively impact the efficiency of portfolio allocation of those
retail customers who might otherwise benefit from broker-dealer
recommendations with respect to these products. In addition, a
reduction in broker-dealers' propensity to recommend certain products
could impair the efficiency with which capital in the economy is
allocated to the corporate sector.
As discussed earlier, the mitigation measures that broker-dealers
may implement to comply with the best interest obligation with respect
to conflicts of interest arising from compensation arrangements with
product sponsors may result in product sponsors competing over funding
based on features other than compensation arrangements, such as product
quality. In turn, competition among product sponsors based on product
quality may result in more funding going to the higher quality
products, and hence may increase capital allocation efficiency.
E. Reasonable Alternatives
The proposed rule would require broker-dealers, when recommending
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 of the recommendation and would require that
broker-dealers act without placing the financial or other interest of
the broker, dealer, or natural person who is an associated person of
the broker or dealer making the recommendation, ahead of the retail
customer's interest. In this section, a number of alternatives to
proposed Regulation Best Interest are discussed, including: (1) A
disclosure-only alternative; (2) a principles-based standard of conduct
obligation; (3) a fiduciary standard for broker-dealers; and (4)
enhanced standards akin to conditions of the BIC Exemption.\510\
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\510\ See BIC Exemption.
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1. Disclosure-Only Alternative
As an alternative to proposed Regulation Best Interest, that
includes Disclosure, Care, and Conflict of Interest Obligations, the
Commission could have the Disclosure Obligation alone, whereby broker-
dealers would be obligated to disclose all material facts and
conflicts, rather than also requiring broker-dealers to establish,
maintain, and enforce policies and procedures to disclose (and
mitigate) or eliminate material conflicts of interest associated with
recommendations or financial incentives associated with
recommendations. Under a disclosure-only alternative, broker-dealers
would need to provide disclosure of material facts relating to the
scope and term of the relationship, disclosure of material conflicts of
interest with respect to the recommendation itself, and disclosures
pertaining to broker-dealer compensation arrangements with third
parties and their internal compensation structure. Relative to the
current baseline of disclosure required by broker-dealers, a
disclosure-only alternative would increase the amount of disclosure
provided to retail customers and would bring such disclosure under the
Exchange Act. Further, such enhanced disclosure could provide benefits
to retail customers through increased information about material facts
about the broker-dealer and customer relationship as well as potential
conflicts of interest that broker-dealers may have.
Under the disclosure-only alternative, the proposed Relationship
Summary and Regulatory Status Disclosure could serve as key components
of any additional disclosure that would be required under the
disclosure-only alternative. In our concurrent rulemaking, we propose
to: \511\ (1) Require broker-dealers and investment advisers to deliver
to retail investors a short (i.e., four page or equivalent limit if in
electronic format) relationship summary \512\ and (2) require broker-
dealers and investment advisers, and their associated natural persons
and supervised persons, respectively, to disclose in retail investor
communications the firm's registration status with the Commission and
an associated natural person's and supervised person's relationship
with the firm (``Regulatory Status Disclosure'').\513\
---------------------------------------------------------------------------
\511\ See Relationship Summary Proposal.
\512\ The customer or client relationship summary is being
proposed as ``Form CRS.''
\513\ See Relationship Summary Proposal.
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Under this alternative, the overall costs to broker-dealers to
comply with the requirements of the rule would be larger than those
associated with currently required disclosure for broker-dealers;
however, the costs to comply would likely be lower relative to proposed
Regulation Best Interest.
The Commission preliminarily believes that a rule that only
required the disclosure of conflicts of interest would be less
effective than the proposed rule because broker-dealers would not be
required to act in the best interest of their customers under the
Exchange Act.\514\ An alternative that only provides disclosure of
conflicts of interest could therefore be less effective in increasing
retail customer protection in the absence of the best interest
requirement, relative to the proposed rule. Further, a disclosure-only
alternative puts the burden on the retail customer to understand the
disclosure and evaluate the magnitude of the conflict, without the
benefit of a best interest standard of conduct of proposed Regulation
Best Interest.\515\ Therefore, the Commission preliminarily believes
that a disclosure-only rule would be less effective in providing retail
customer
[[Page 21662]]
protection and reducing potential investor harm than proposed
Regulation Best Interest.
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\514\ The disclosure-only alternative would not provide the Care
Obligation required by proposed Regulation Best Interest, as
discussed above. However, FINRA Rule 2111 would continue to set a
minimum requirement regarding the advice that broker-dealers provide
to their customers, and therefore, would continue to address the
competency of the advice provided by the broker-dealers.
\515\ Relative to the disclosure-only alternative, broker-
dealers under proposed Regulation Best Interest would have to act in
the best interest of their investors, comply with the Care
Obligation, and would have to take actions to eliminate or disclose,
and where applicable, mitigate and disclose conflicts of interest.
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2. Principles-Based Standard of Conduct Obligation
As an alternative, the Commission could rely on a principles-based
standard of conduct, which could be developed by each broker-dealer
based on its business model rather than directly requiring conduct
standards. Under this alternative, broker-dealers would be required to
comply with a principles-based approach to providing recommendations
that are in the best interest of their customers, without expressly
being subject to requirements to disclose, mitigate, or eliminate
conflicts of interest. This alternative would focus on the competence
of broker-dealers to provide advice and would continue to rely on SRO
rules and the antifraud provisions of the federal securities laws and
SRO rules to address broker-dealer conflicts. A principles-based
standard of conduct would provide increased flexibility for broker-
dealers to tailor their recommendations to retail customers, subject to
the current obligations under the existing regulatory baseline,
discussed above, to make suitable recommendations. This approach could
impose lower compliance costs on regulated entities relative to the
requirements of the proposed rule.
The Commission preliminarily believes that an approach that does
not include the express requirements of the Disclosure, Care, or the
requirements of the Conflict of Interest Obligations is likely to be
less effective at reducing harm to retail customers that arises from
conflicts of interest. Further, because each broker-dealer could have
its own principles-based approach to meeting its care obligation under
the Exchange Act, broker-dealers could interpret the standard
differently. Variations in retail customer protection could make it
difficult for retail customers to evaluate the standard of care offered
by a broker-dealer and compare these across broker-dealers.
By contrast, Regulation Best Interest is designed to set a standard
applicable to all broker-dealers. In the absence of a requirement to
disclose or eliminate conflicts of interest or a requirement to
mitigate financial conflicts,\516\ as in proposed Regulation Best
Interest, some firms may not undertake such mitigation techniques,
either as they pertain to material conflicts of interest or those
related to financial incentives. Therefore, the Commission
preliminarily believes that a principles-based standard of conduct
approach on its own, would be less effective from a retail customer
protection standpoint than the proposed Regulation Best Interest. A
principles-based standard of conduct that obligates broker-dealers to
act in the best interest of their retail customers, without guidance on
what a best interest standard entails, is only one element that is
needed to reduce potential investor harm and that investor protection
is likely to be enhanced with the Disclosure, Care, and Conflict of
Interest Obligations in proposed Regulation Best Interest.
---------------------------------------------------------------------------
\516\ As discussed above, under a principles-based care
obligation, broker-dealers would be required to continue to comply
with the existing regulatory baseline, including disclosure
obligations under the antifraud provisions of the federal securities
laws.
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3. A Fiduciary Standard for Broker-Dealers
As an alternative, the Commission could impose a fiduciary standard
on broker-dealers for retail customers.\517\ Fiduciary standards vary
among investment advisers, banks, acting as trustees or fiduciaries, or
ERISA plan providers, but fiduciaries are generally required to act
with a duty of care and duty of loyalty to their clients.
---------------------------------------------------------------------------
\517\ Retail customers would consist of the same set of
investors as in proposed Regulation Best Interest.
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As discussed above, any prescribed standard of conduct, such as a
fiduciary standard, can seek to address the principal-agent problem
between retail customers and firms and financial professionals, whereby
principals (retail customers) are concerned that their agents (firms
and financial professionals) will not act in the best interest of the
principal. In the context of investment advice, firms and financial
professionals may have incentives (financial or otherwise) to provide
advice to their retail customers that benefits the firm or the
financial professional but may be suboptimal from the retail customer's
perspective. For example, a financial professional might offer costly
products, when low(er) cost alternatives are reasonably available, may
offer affiliated or proprietary products, or may trade more or less
frequently than is beneficial to the retail customer. As discussed
above in the discussion of broad economic considerations, retail
customers may not be able to adequately monitor the firms or financial
professionals to ensure that their agents are working in the retail
customer's best interest. Therefore, regardless of the type of
investment professional providing the advice, that advice may be
conflicted and potentially harm retail customers.
Although conflicts of interest may exist in any type of
relationship, the nature of such conflicts vary depending on the type
of firm or financial professional that provides the advice. Broker-
dealers and registered representatives generally provide financial
advice at the transactional level, and the nature of the relationship
between customers and broker-dealers and the level of monitoring by
broker-dealers tends to be episodic, rather than ongoing. Investment
advisers and their representatives commonly provide ongoing monitoring
to their clients. Because of the differences in the nature of the
relationship, the conflicts that are likely to arise from broker-
dealers (e.g., offering mutual funds with large front-end loads or
churning retail customer accounts) would be different from those that
arise for many standalone investment advisers (e.g., so-called
``reverse churning'') but may be the same as the conflicts faced by
advisers when the advisers, affiliates, or third-party broker-dealers
with which advisory personnel are associated receive compensation in a
broker-dealer capacity.\518\
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\518\ As discussed above, nearly 80% of investment adviser
representatives are also registered representatives of broker-
dealers; thus, those representatives and their firms, depending on
the capacity in which the representatives provide advice, could face
similar conflicts. Further, nearly 75% of total investment adviser
assets under management are associated with investment advisers that
have a broker-dealer affiliate. See Section IV.C.1.
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Over time, different bodies of laws and standards have emerged that
are generally tailored to the different business models of broker-
dealers and investment advisers and that provide retail customer
protection specific to the relationship types and business models to
which they apply. While obligations for broker-dealers and investment
advisers that arose from common law may appear similar, each set of
laws and obligations has emerged independently. Moreover, such
differences between business models have provided retail customers with
choice about the type of investment advice that they seek and how they
pay for such advice.
A fiduciary standard for broker-dealers could produce greater
uniformity between broker-dealers' and investment advisers' standards.
A uniform fiduciary standard for broker-dealers and investment advisers
could bring more uniformity to the professional standards of conduct
regarding advice provided to retail customers. A uniform standard could
potentially reduce certain conflicts and increase disclosure of others,
thereby enhancing the quality of such advice,
[[Page 21663]]
lowering the possibility of harm to investors, and potentially reducing
retail customer confusion with respect to investment advice. The
Commission preliminarily believes such uniformity would likely affect
the market for investment advice provided by broker-dealers; retail
customer choice; costs of investment advice; and could lead to the
potential loss of differentiation between two important business
models, each of which can serve a valuable function for retail
customers. This alternative also could have economic effects on both
retail customers and the industry, particularly if payment choice,
account choice, or product choice diminishes as a result. Regardless of
the form of a new fiduciary standard for broker-dealers, legal
certainty would be an important factor for broker-dealers and other
providers of investment advice.
As discussed above, the broker-dealer and investment adviser models
have emerged to meet the investing and advice needs of particular
clienteles with varying needs for monitoring, advice, and services.
Given the different business models, different standards have emerged
to provide retail customer protection reflective of the business model.
We preliminarily believe that a uniform fiduciary standard that would
attempt to fit a single approach to retail customer protection to two
different business models is unlikely to provide a tailored solution to
the conflicts that uniquely arise for either broker-dealers or
investment advisers.\519\ Moreover, such an alternative would likely
undermine efforts to preserve the ability of broker-dealers to employ
business models that are distinct from investment advisers', and could
thereby limit retail customer choice with respect to investment advice.
This differentiated approach to customer protection is more likely to
provide more appropriate investor protection commensurate with the
risks inherent in each of those business models. The nature of retail
investors' relationships with providers of financial advice is likely
to differ between broker-dealers and investment advisers (e.g., broker-
dealers are more likely to provide advice on an episodic basis), which
has led to the emergence of different regulatory regimes, each designed
to address conflicts of interest that may arise as a result of a given
business model. Therefore, the Commission preliminarily believes that
it is appropriate to maintain separate regulatory standards for broker-
dealers and investment advisers, while proposing to incorporate and go
beyond existing levels of retail customer protection for broker-dealer
customers through Regulation Best Interest and Form CRS Relationship
Summary Disclosure.
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\519\ An example of a uniform fiduciary standard is the staff
recommendation in the 913 Study. See supra note 38 and accompanying
text.
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4. Enhanced Standards Akin to Conditions of the BIC Exemption
The Commission could alternatively propose a fiduciary standard
coupled with a series of disclosure and other requirements akin to the
full complement of conditions of the DOL's BIC Exemption adopted in
connection with the DOL Fiduciary Rule, which would apply to broker-
dealers when making investment recommendations for all types of retail
accounts rather than only in connection with services to retirement
accounts.\520\ The key conditions of the BIC Exemption are described in
some detail in Section I.A.2. Below, we consider the tradeoffs to
retail customers, broker-dealers, and other market participants of an
alternative that would mirror the key conditions of the BIC
Exemption.\521\
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\520\ As discussed supra Section I.A.2., broker-dealers and
their associated persons who provide fiduciary investment advice to
retirement accounts (including ERISA-covered plans and participants,
as well as IRAs) are not required to comply with the BIC Exemption
to the extent that they are able to adopt an alternate approach to
avoiding non-exempt prohibited transactions.
\521\ The DOL also adopted the Impartial Conduct Standards in
the Principal Transactions Exemption and certain other PTEs relating
to the DOL Fiduciary Rule, see DOL Fiduciary Rule Release, supra
note 49, 81 FR at 20991; these other PTEs operate with additional
and/or different conditions from the BIC Exemption. This discussion
only considers the conditions of the BIC Exemption, because it
provides an example of the types of information and detail required
under PTEs related to the DOL Fiduciary Rule, and we understand that
most broker-dealers providing services to retirement accounts
generally would rely on the BIC Exemption. As discussed above, the
DOL Fiduciary Rule was vacated by the United States Court of Appeals
for the Fifth Circuit on March 15, 2018. See supra note 51.
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The alternative of requiring broker-dealers to adopt a fiduciary
standard coupled with a series of disclosure and other requirements
akin to the full complement of conditions of the DOL's BIC Exemption
for all retail customer accounts and not solely with respect to
retirement assets could likely have economic effects for broker-
dealers. Given that some broker-dealers have already adopted some of
the conditions of the DOL's BIC Exemption for retirement accounts and
may have already implemented the conditions for non-retirement
accounts, the incremental costs could be low under such an alternative.
However, the incremental costs could be reduced only to the extent that
broker-dealers have already begun to implement the conditions of the
DOL's BIC Exemption. Further, as discussed above, some components of
the DOL's BIC Exemption are already part of the broker-dealer
regulatory framework; therefore, any potential economic effects
associated with such conditions would be reduced.
An alternative that would impose on broker-dealers a fiduciary
standard coupled with set of requirements akin to the full complement
of the BIC Exemption conditions could drive up costs to retail
customers of obtaining investment advice from broker-dealers, and could
cause some retail customers to forgo advisory services through broker-
dealers if they were priced out of the market.\522\ For example, if the
costs associated with complying with a set of requirements akin to the
full complement of conditions under BIC Exemption are large, broker-
dealers could transition away from commission-based brokerage accounts
to fee-based advisory accounts. \523\ To the extent that such an
outcome increases the costs associated with investment advice, some
retail customers may determine to exit the market for financial advice.
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\522\ See SIFMA Study. See also the ABA survey and the Financial
Services Roundtable survey, supra note 456.
\523\ As discussed in the baseline section, the average fees
associated with broker-dealers' commission-based accounts are
significantly lower than the average fees associated with fee-based
accounts of registered investment advisers.
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Alternatively, as costs of complying with a fiduciary standard
coupled with a set of requirements akin to the full complement of BIC
Exemption conditions increase, some broker-dealers may abandon certain
subsets of retail customer accounts, which would similarly deprive some
broker-dealer customers of investment advice. A set of requirements
that are akin to the conditions of the BIC Exemptions, were they to be
imposed upon broker-dealers for all retail customer accounts, would
also likely have competitive effects for both broker-dealers and
investment advisers,\524\ and could cause exit or consolidation among
both broker-dealers and investment advisers that provide investment
advice,\525\ which could further reduce the overall level of investment
advice available to retail
[[Page 21664]]
customers.\526\ Further, for those broker-dealers that do not fully
exit the market, implementing a set of requirements that are akin to
the conditions of the BIC Exemption could lead to some broker-dealers
transitioning from a broker-dealer business model to an investment
adviser business model. Although this alternative could increase the
competition between investment advisers and broker-dealers subject to a
fiduciary standard and BIC Exemption-like conditions, any reduction in
the costs of investment advice due to a potential increase in the
supply of providers would like to be mitigated as the costs to broker-
dealers to follow such standards would likely be large and could raise
the costs associated with the provision of investment advice.\527\
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\524\ Investment advisers, depending on how they are
compensated, generally would not have to comply with the full set of
obligations of the BIC Exemption, thereby reducing the costs to such
firms, and providing incentives for broker-dealers to switch
customers from transaction-based accounts to advisory accounts.
\525\ In addition to competitive effects for broker-dealers and
investment advisers, any change in the competitive environment is
likely to have an impact on other providers of financial advice,
including banks, and trust companies.
\526\ As discussed above in Section IV.D, proposed Regulation
Best Interest also could have competitive effects between broker-
dealers and investment advisers.
\527\ One of the main critiques of the BIC Exemption arises from
the increased legal uncertainty and associated increased litigation
risk for broker-dealers, as discussed above.
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The Commission preliminarily believes that requiring broker-dealers
to comply with a fiduciary standard coupled with a set of requirements
akin to the full complement of conditions under the BIC Exemption could
impose costs on broker-dealers and impact retail customers and the
market for investment advice; however, the Commission is unable to
quantify the costs and benefits associated with this alternative.
Moreover, the Department of Labor has a different regulatory focus than
the Commission; therefore, a wholesale incorporation of conditions
consistent with the BIC Exemption is not entirely consistent with the
regulatory approach of the Commission.
F. Request for Comment
The Commission requests comment on all aspects of this initial
economic analysis, including whether we have correctly identified the
problem, its magnitude, and the set of reasonably available solutions
and alternative approaches. We also request comment on whether the
analysis has: (i) Identified all benefits and costs, including all
effects on efficiency, competition, and capital formation; (ii) given
due consideration to each benefit and cost, including each effect on
efficiency, competition, and capital formation; and (iii) identified
and considered reasonable alternatives to the proposed regulations. We
request and encourage any interested person to submit comments
regarding the proposed regulations, our analysis of the potential
effects of the proposed regulations, and other matters that may have an
effect on the proposed regulations. We request that commenters identify
sources of data and information as well as provide data and information
to assist us in analyzing the economic consequences of the proposed
regulations. We also are interested in comments on the qualitative
benefits and costs we have identified and any benefits and costs we may
not have discussed. We also request comment on the assumptions
underlying our analysis and cost estimates.
In addition to our general request for comment on the economic
analysis associated with the proposed regulations, we request specific
comment on certain aspects of the proposal:
We request comment on our characterization of the
relationship between a broker-dealer and a retail customer. Do
commenters agree with our principal-agent characterization of this
relationship? Are there different ways of characterizing this
relationship that we should consider? Is the concept of ``gains from
trade'' appropriate for capturing the economic impact of the proposed
regulation on the broker-dealers and their retail customers? Are there
alternative economic concepts that we should consider? Is the example
that illustrates how the concept of ``gains for trade'' works useful
for understanding the economic impacts of the proposed regulation? Can
commenters suggest alternative examples?
We request comment on our assumptions related to
identifying broker-dealers that are likely to have retail customers. If
only ``sales'' activity is marked on Form BR, is it appropriate to
assume that a firm has both ``retail'' and ``institutional'' sales
activities?
We request comment on the financial incentives provided by
broker-dealers to registered representatives and other associated
persons of the broker-dealer. Are the ranges provided reasonable? Are
there other types of compensation arrangements or financial incentives
that are provided to associated persons of broker-dealers, particularly
registered representatives, which are not included in the baseline?
Please be specific and provide data and analysis to support your views.
We request comment on our characterization of the benefits
of proposed Regulation Best Interest. We believe that the proposed rule
achieves its main benefits by ameliorating the agency conflict between
broker-dealers and retail customers. Do commenters agree with our
characterization of the benefits? Are there other benefits of the
proposed rule that have not been identified in our discussion and that
warrant consideration? Are the assumptions that form the basis of our
analysis of the benefits appropriate? Can commenters provide data that
supports or opposes these assumptions? Can commenters provide data that
would help the Commission quantify the magnitude of the benefits
identified in our discussion or other benefits that we missed to
identify in our discussion and that warrant consideration?
We request comment on our characterization of the costs of
the proposed Regulation Best Interest. We believe that the best
interest obligation through its component obligations would impose
direct costs on broker-dealers. Furthermore, we believe that depending
on how broker-dealers chose to comply with the best interest
obligation, the proposed rule may impose costs on retail customers. Do
commenters agree with our characterization of the costs? Are there
other costs of the proposed rule that have not been identified in our
discussion and that warrant consideration? Are the assumptions that
form the basis of our analysis of the costs appropriate? Can commenters
provide data that supports or opposes these assumptions? Can commenters
provide data that would help the Commission quantify the magnitude of
the costs identified in our discussion or other costs that we missed to
identify in our discussion and that warrant consideration?
How do commenters anticipate that the benefits and costs
of the proposed rule will be shared between broker-dealers and their
retail customers? Please be specific and provide data and analysis to
support your views.
Are there any effects on efficiency, competition, and
capital formation that are not identified or are misidentified in our
economic analysis? Please be specific and provide data and analysis to
support your views.
What would the costs for broker-dealers be if the
provision of discretionary investment advice, whether or not limited in
scope, were not to be considered ''solely incidental'' to broker-
dealer's business under Advisers Act rule 202(a)(11)(C)? Would there be
any costs or benefits to retail customers? How would the market for the
provision of financial advice change? Would dually-registered firms
treat discretionary accounts as brokerage accounts?
Do commenters believe that the alternatives the Commission
considered are appropriate? Are there other reasonable alternatives
that the
[[Page 21665]]
Commission should consider? If so, please provide additional
alternatives and how their costs and benefits would compare to the
proposal.
V. Paperwork Reduction Act Analysis
Certain provisions of the proposed rules and rule amendments would
impose new ``collection of information'' requirements within the
meaning of the Paperwork Reduction Act of 1995 (``PRA'').\528\
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\528\ 44 U.S.C. 3501 et seq.
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The Commission is submitting the proposed rules and rule amendments
to the Office of Management and Budget (``OMB'') for review and
approval in accordance with the PRA.\529\ The titles for these
collections of information are: (1) ``Regulation Best Interest;'' (2)
Rule 17a-3--Records to be Made by Certain Exchange Members, Brokers and
Dealers (OMB control number 3235-0033); \530\ and (3) Rule 17a-4--
Records to be Preserved by Certain Brokers and Dealers (OMB control
number 3235-0279).\531\ OMB has not yet assigned a control number to
the collection of information for ``Regulation Best Interest.'' 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.
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\529\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
\530\ See 17 CFR 240.17a-3. The proposed addition of paragraph
(a)(25) to Rule 17a-3 would amend the existing PRA for Rule 17a-3.
\531\ See 17 CFR 240.17a-4. The Proposed Amendment to Rule 17a-
4(e)(5) would amend the existing PRA for Rule 17a-4.
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Proposed pursuant to the Commission's authority under the Dodd-
Frank Act and the Exchange Act, Regulation Best Interest would: (1)
Improve disclosure about the scope and terms of the broker-dealer's
relationship with the retail customer, which would foster retail
customers' understanding of their relationship with a broker-dealer;
(2) enhance the quality of recommendations provided by establishing an
express best interest obligation under the federal securities laws; (3)
enhance the disclosure of a broker-dealer's material conflicts of
interest; (4) and establish obligations that require mitigation, and
not just disclosure, of conflicts of interest arising from financial
incentives associated with broker-dealer recommendations. Generally, in
crafting proposed 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 proposed amendments to Rule
17a-3(a)(25) and Rule 17a-4(e)(5).
A. Respondents Subject to Proposed Regulation Best Interest and
Proposed Amendments to Rule 17a-3(a)(25), Rule 17a-4(e)(5)
1. Broker-Dealers
Proposed Regulation Best Interest would impose 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 Investment Advisers Act,
would be subject to new, distinct burdens under proposed Regulation
Best Interest.
As of December 31, 2017, 3,841 broker-dealers were registered with
the Commission--either as standalone broker-dealers or as dually-
registered entities. Based on data obtained from Form BR, the
Commission preliminarily believes that approximately 74.4% of this
population, or 2,857 broker-dealers have retail customers and therefore
would likely be subject to Regulation Best Interest and the proposed
amendments to Rules 17a-3(a)(25) and 17a-4(e)(5).\532\
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\532\ As of December 31, 2017, 3,841 broker-dealers filed Form
BD. Retail sales by broker-dealers were obtained from Form BR.
---------------------------------------------------------------------------
2. Natural Persons who are Associated Persons of Broker-Dealers
As with broker-dealers, proposed Regulation Best Interest would
impose 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 preliminarily believes that approximately 435,071
natural persons would qualify as retail-facing, licensed
representatives at standalone broker-dealers or dually-registered
firms,\533\ and would therefore likely be subject to proposed
Regulation Best Interest, and the proposed amendments to Rules 17a-
3(a)(25) and 17a-4(e)(5).\534\
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\533\ See Section IV.B.1, supra, at Table 5. This estimate is
based on the following calculation: (494,399 total licensed
representatives (including representatives of investment advisers))
x (12% (the percentage of total licensed representatives who are
standalone investment adviser representatives)) = 59,328
representatives at standalone investment advisers. To isolate the
number of representatives at standalone broker-dealers and dually-
registered firms, we have subtracted 59,328 from 494,399, for a
total of 435,071 retail-facing, licensed representatives at
standalone broker-dealers or dually-registered firms.
\534\ 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 would require broker-dealers to act in the
best interest of a retail customer when recommending any securities
transaction or investment strategy involving securities to a retail
customer. As discussed above, proposed Regulation Best Interest would
specifically provide that this best interest obligation shall be
satisfied if: (1) The broker, dealer or natural person who is an
associated person of a broker or dealer, prior to or at the time of a
recommendation, reasonably discloses to the retail customer, in
writing, the material facts relating to the scope and terms of the
relationship with the retail customer, including all material conflicts
of interest that are associated with the recommendation; (2) the
broker, dealer or natural person who is an associated person of a
broker or dealer, exercises reasonable diligence, care, skill, and
prudence in making a recommendation; (3) the broker or dealer
establishes, maintains, and enforces written policies and procedures
reasonably designed to identify and at a minimum disclose, or
eliminate, all material conflicts of interest that are associated with
such recommendations; and (4) the broker or dealer establishes,
maintains, and enforces 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.
Furthermore, the proposed addition of paragraph (a)(25) to Rule
17a-3 would impose new record-making obligations on broker-dealers
subject to Regulation Best Interest, while the Proposed Amendment to
Rule 17a-4(e)(5) would impose new record retention obligations on
broker-dealers subject to Regulation Best Interest.
The obligations arising under Regulation Best Interest, the
Proposed Amendment to Rule 17a-3(a)(25), and the Proposed Amendment to
Rule 17a-4(e)(5) would give rise to distinct collections of information
and
[[Page 21666]]
associated costs and burdens for broker-dealers subject to the proposed
rules.
The collections of information associated with these proposed rules
and proposed rule amendments are described below.
1. Conflict of Interest Obligations
Regulation Best Interest would require a broker-dealer entity \535\
to establish, maintain, and enforce written policies and procedures
reasonably designed to identify and at a minimum disclose, or
eliminate, all material conflicts of interest that are associated with
a recommendation. Second, Regulation Best Interest would require a
broker-dealer 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 associated with a recommendation.
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\535\ As discussed above in Section II.D.3, the proposed
Conflict of Interest 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
Conflict of Interest Obligation, the term ``broker-dealer'' refers
only to the broker-dealer entity, and not to such individuals.
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Written policies and procedures developed pursuant to the Conflict
of Interest Obligations of proposed Regulation Best Interest would help
a broker-dealer develop a process, relevant to its retail customers and
the nature of its business, for identifying material conflicts of
interest, and then determining whether to eliminate, or disclose and/or
mitigate, the material conflict and the appropriate means of
eliminating, disclosing, and/or mitigating the conflict. As a result of
a broker-dealer's eliminating, disclosing, and/or mitigating the
effects of conflicts of interest on broker-dealer recommendations,
retail customers would more likely receive recommendations in their
best interest. In addition, the retention of written policies and
procedures would generally: (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.\536\
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\536\ Any written policies and procedures developed pursuant to
proposed 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 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. The record retention requirements of
Rule 17a-4(e)(7) include any written policies and procedures that
broker-dealers may produce pursuant to Regulation Best Interest's
Conflict of Interest Obligations. The costs and burdens associated
with Rule 17a-4(e)(7) will be updated in connection with the next
renewal for the PRA.
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Following is a detailed discussion of the estimated costs and
burdens associated with broker-dealers' Conflict of Interest
Obligations.
a. Written Policies and Procedures
(1) Initial Costs and Burdens
We believe that most broker-dealers have policies and procedures in
place to address material conflicts, but they do not necessarily have
written policies and procedures regarding the identification and
management of conflicts as proposed in Regulation Best Interest. To
initially comply with this 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.\537\ 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.
Based on FOCUS Report data,\538\ we estimate that, as of December 31,
2017, approximately 802 broker-dealers are small entities under the
RFA. Therefore, we estimate that 2,055 broker-dealers would qualify as
large broker-dealers for purposes of this analysis.\539\
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\537\ 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.
\538\ 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.
\539\ This calculation was made as follows: (2,857 total retail
broker-dealers)-(802 small broker-dealers) = 2,055 large broker-
dealers.
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As an initial matter, we estimate that a large broker-dealer would
incur a one-time average internal burden of 50 hours for in-house legal
and in-house compliance counsel to update existing policies and
procedures to comply with Regulation Best Interest.\540\ We
additionally estimate a one-time burden of 5 hours for a general
counsel at a large broker-dealer and 5 hours for a Chief Compliance
Officer to review and approve the updated policies and procedures, for
a total of 60 burden hours.\541\ In addition, we estimate a cost of
$4,720 for outside counsel to review the updated policies and
procedures on behalf of a large broker-dealer.\542\ We therefore
estimate the aggregate burden for large broker-dealers to be 123,300
burden hours,\543\ and the aggregate cost for large broker-dealers to
be $9.70 million.\544\
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\540\ This estimate would be broken down as follows: 40 hours
for in-house legal counsel + 10 hours for in-house compliance
counsel to update existing policies and procedures = 50 burden
hours.
\541\ This estimate is based on the following calculation: (50
hours of review for in-house legal and in-house compliance counsel)
+ (5 hours of review for general counsel) + (5 hours of review for
Chief Compliance Officer) = 60 burden hours.
\542\ Based on industry sources, Commission staff preliminarily
estimates that the average hourly rate for legal services is $472/
hour. This cost estimate is therefore based on the following
calculation: (10 hours of review) x ($472/hour for outside counsel
services) = $4,720 in outside counsel costs.
\543\ This estimate is based on the following calculation: (60
burden hours of review per large broker-dealer) x (2,055 large
broker-dealers) = 123,300 aggregate burden hours.
\544\ This estimate is based on the following calculation:
($4,720 for outside counsel costs per large broker-dealer) x (2,055
large broker-dealers) = $9.70 million in outside counsel costs.
---------------------------------------------------------------------------
In contrast, we believe 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. Moreover, since small broker-dealers would typically have
fewer conflicts of interest, we estimate that only 40 hours of outside
legal counsel services would be required to update the policies and
procedures, for a total one-time cost of $18,880 \545\ per small
broker-dealer, and an aggregate cost of $15.1 million for all small
broker-dealers.\546\ We additionally believe 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.\547\
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\545\ This cost estimate is based on the following calculation:
(40 hours of review) x ($472/hour for outside counsel services) =
$18,880 in outside counsel costs.
\546\ This cost estimate is based on the following calculation:
($18,880 for outside attorney costs per small broker-dealer) x (802
small broker-dealers) = $15.1 million in outside counsel costs.
\547\ This estimate is based on the following calculation: (10
burden hours) x (802 small broker-dealers) = 8,020 aggregate burden
hours.
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We therefore estimate the total initial aggregate burden to be
131,320 hours,\548\ and the total initial aggregate cost to be $24.8
million.\549\
---------------------------------------------------------------------------
\548\ This estimate is based on the following calculation:
(123,300 aggregate burden hours for large broker-dealers) + (8,020
aggregate burden hours for small broker-dealers) = 131,320 total
aggregate burden hours.
\549\ This estimate is based on the following calculation:
($9.70 million in aggregate costs for large broker-dealers) + ($15.1
million in aggregate costs for small broker-dealers) = $24.80
million total aggregate costs.
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[[Page 21667]]
(2) Ongoing Costs and Burdens
For purposes of this analysis, we have assumed 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 that they would perform the review and update using in-house
personnel.
For large broker-dealers with more numerous, more complex products
and services, and 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 to identify new conflicts. We therefore
estimate an ongoing, aggregate burden for large broker-dealers of
approximately 24,660 hours.\550\ 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 costs.
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\550\ This estimate is based on the following calculation: (12
burden hours per large broker-dealer) x (2,055 large broker-dealers)
= 24,660 aggregate ongoing burden hours.
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We assume for purposes of this analysis that small broker-dealers,
with fewer and less complex products, and lower rates of hiring, would
mostly 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
preliminarily estimate that outside counsel would require approximately
five hours per year to update policies and procedures, for an annual
cost of $2,360 for each small broker-dealer.\551\ The projected
aggregate, annual ongoing cost for outside legal counsel to update
policies and procedures for small broker-dealers would be $1.89
million.\552\ 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 $1,490 per
year,\553\ and an aggregate ongoing cost of $1.19 million.\554\ The
total aggregate, ongoing cost for small broker-dealers is therefore
projected at $3.08 million per year.\555\
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\551\ This estimate is based on the following calculation: (5
hours per small broker-dealer) x ($472/hour for outside counsel
services) = $2,360 in outside counsel costs.
\552\ This estimate is based on the following calculation:
($2,360 in outside counsel costs per small broker-dealer) x (802
small broker-dealers) = $1.89 million in aggregate, ongoing outside
legal costs.
\553\ Based on industry sources, Commission staff preliminarily
estimates that the average hourly rate for compliance services in
the securities industry is $298/hour. This cost estimate is based on
the following calculation: (5 hours of review) x ($298/hour for
outside compliance services) = $1,490 in outside compliance service
costs.
\554\ This estimate is based on the following calculation:
($1,490 in outside compliance costs per small broker-dealer) x (802
small broker-dealers) = $1.19 million in aggregate, ongoing outside
compliance costs.
\555\ This estimate is based on the following calculation:
($1.89 million for outside legal counsel costs) + ($1.19 million for
outside compliance costs) = $3.08 million total aggregate ongoing
costs.
---------------------------------------------------------------------------
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 4,010 hours for in-house compliance
manager review.\556\
---------------------------------------------------------------------------
\556\ This estimate is based on the following calculation: (5
hours compliance manager review per small broker-dealer) x (802
small broker-dealers) = 4,010 aggregate ongoing burden hours.
---------------------------------------------------------------------------
We therefore estimate the total ongoing aggregate ongoing burden to
be 28,670 hours,\557\ and the total ongoing aggregate cost to be $3.08
million per year.\558\
---------------------------------------------------------------------------
\557\ This estimate is based on the following calculation:
(24,660 aggregate ongoing burden hours for large broker-dealers) +
(4,010 aggregate ongoing burden hours for small broker-dealers) =
28,670 total aggregate ongoing burden hours.
\558\ This estimate is based on the following calculation:
($3.08 million per year in total aggregate ongoing costs for small
broker-dealers) + ($0 projected ongoing costs for large broker-
dealers) = $3.08 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 would
expect that the need to update policies and procedures might also vary
greatly.
b. Identification of Material Conflicts of Interest
(1) Initial Costs and Burdens
With respect to identifying and determining whether a material
conflict of interest exists in connection with a recommendation, 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.\559\ For purposes of this analysis, we
understand that most broker-dealers already have an existing
technological infrastructure in place, and we assume that such
infrastructure would need to be modified to effect compliance with
Regulation Best Interest.
---------------------------------------------------------------------------
\559\ See supra Section II.D.3.c.
---------------------------------------------------------------------------
Acknowledging that costs and burdens may vary greatly according to
the size of the broker-dealer, we expect that the modification of a
broker-dealer's existing technology would initially require the
retention of an outside programmer, and that the modification of
existing technology would require, on average, an estimated 20 hours of
the programmer's labor, for an estimated cost per broker-dealer of
$5,400.\560\ We additionally project that coordination between the
programmer and the broker-dealer's compliance manager would involve
five burden hours. The aggregate costs and burdens for the modification
of existing technology to identify conflicts of interest would
therefore be $15.43 million,\561\ and 14,285 burden hours.\562\
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\560\ Based on industry sources, Commission staff preliminarily
estimates that the average hourly rate for technology services in
the securities industry is $270. This cost estimate is based on the
following calculation: (20 hours of review) x ($270/hour for
technology services) = $5,400 in outside programmer costs.
\561\ This cost estimate is based on the following calculation:
($5,400 in outside programmer costs per broker-dealer) x (2,857
retail broker-dealers) = $15.43 million in aggregate outside
programmer costs.
\562\ This burden estimate is based on the following
calculation: (5 burden hours) x (2,857 broker-dealers) = 14,285
aggregate burden hours.
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We additionally believe that the determination whether the
conflicts of interest, once identified, are material, would require
approximately five hours per broker-dealer,\563\ for an aggregate of
14,285 burden hours for all broker-dealers.\564\ The total aggregate
burden for the identification of material conflicts is 28,570
hours.\565\
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\563\ This burden estimate consists of 2.5 hours for review by a
senior business analyst, and 2.5 hours for review by in-house
compliance manager.
\564\ This burden estimate is based on the following
calculation: (5 burden hours) x (2,857 broker-dealers) = 14,285
aggregate burden hours.
\565\ This burden estimate is based on the following
calculation: (14,285 burden hours for modification of technology) +
(14,285 burden hours for evaluation of conflict materiality) =
28,570 total aggregate burden hours.
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(2) Ongoing Costs and Burdens
To maintain compliance with Regulation Best Interest, we assume for
purposes of this PRA analysis that a broker-dealer would seek to
identify additional conflicts as its business evolves. The Commission
recognizes that the types of services and product offerings vary
greatly by broker-dealer.
[[Page 21668]]
However, for purposes of this analysis, we assume that broker-dealers
would, at a minimum, engage in a material conflicts identification
process on an annual basis.\566\ We estimate that a broker-dealer's
business line and compliance personnel would jointly spend, on average,
10 hours \567\ to perform an annual conflicts review using the modified
technology infrastructure. Therefore the aggregate, ongoing burden for
an annual conflicts review, based on an estimated 2,857 retail broker-
dealers, would be approximately 28,570 burden hours.\568\ Because we
assume that broker-dealers would use in-house personnel to identify and
evaluate new, potential conflicts, we do not believe they would incur
additional ongoing costs.
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\566\ Analogously, 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).
\567\ This burden estimate consists of 5 hours for review by a
senior business analyst, and 5 hours for review by an in-house
compliance counsel or compliance manager.
\568\ This estimate is based on the following calculation: (10
hours of labor per retail broker-dealer) x (2,857 retail broker-
dealers) = 28,570 aggregate burden hours.
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c. Training
Pursuant to the obligation to ``maintain and enforce'' written
policies and procedures, we additionally expect broker-dealers to
develop training programs that promote compliance with Regulation Best
Interest among registered representatives. The initial and ongoing
costs and burdens associated with such a training program are estimated
below.
(1) Initial Costs and Burdens
We believe that broker-dealers would likely use a computerized
training module to train registered representatives on the policies and
procedures pertaining to Regulation Best Interest. We estimate that a
broker-dealer would retain an outside systems analyst, an outside
programmer, and an outside programmer analyst to create the training
module, at 20 hours, 40 hours, and 20 hours, respectively. The total
cost for a broker-dealer to develop the training module would be
approximately $21,600,\569\ for an aggregate initial cost of $61.7
million.\570\
---------------------------------------------------------------------------
\569\ This estimate is based on the following calculation: ((20
hours of labor for a systems analyst) x ($270/hour)) + ((40 hours of
labor for a programmer) x ($270/hour)) + ((20 hours of labor for a
programmer analyst) x ($270/hour)) = $21,600 in external technology
service costs per broker-dealer. As noted above, the $270 estimated
average hourly rate for technology services is based on industry
sources.
\570\ This estimate is based on the following calculation:
(2,857 broker-dealers) x ($21,600 cost per broker-dealer) = $61.7
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 legal
counsel, each of whom we expect would require approximately 2 hours to
review and approve the training module. The aggregate burden for
broker-dealers is therefore estimated at 11,428 burden hours.\571\
---------------------------------------------------------------------------
\571\ This estimate is based on the following calculation:
(2,857 broker-dealers) x (4 burden hours per broker-dealer) = 11,428
burden hours.
---------------------------------------------------------------------------
In addition, broker-dealers would incur an initial cost for
registered representatives to undergo training through the training
module. We estimate the training time at one hour per registered
representative, for an aggregate burden of 435,071 burden hours, or an
initial burden of 152.3 hours per broker-dealer.\572\ The total
aggregate burden to approve the training module and implement the
training program would be 446,699 burden hours.\573\
---------------------------------------------------------------------------
\572\ This estimate is based on the following calculation: (1
burden hour) x (435,071 registered representatives at standalone or
dually-registered broker-dealers) = 435,071 aggregate burden hours.
Conversely, (435,071 aggregate burden hours)/(2,857 retail broker-
dealers) = 152.3 initial burden hours per broker-dealer.
\573\ This estimate is based on the following calculation:
(435,071 burden hours for training of registered representatives) +
(11,428 burden hours to approve training program) = 446,699 total
aggregate burden hours.
---------------------------------------------------------------------------
(2) 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 435,071 burden hours per year,
or 152.3 burden hours per broker-dealer per year.\574\
---------------------------------------------------------------------------
\574\ This estimate is based on the following calculation: (1
burden hour) x (435,071 registered representatives at standalone or
dually-registered broker-dealers) = 435,071 burden hours.
Conversely, (435,071 aggregate burden hours)/(2,857 retail broker-
dealers) = 152.3 initial burden hours per broker-dealer.
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2. Disclosure Obligation
The Disclosure Obligation under proposed Regulation Best Interest
would require a broker-dealer, prior to or at the time of recommending
a securities transaction or strategy involving securities to a retail
customer, to: (1) 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 (2) reasonably disclose to
the retail customer, in writing, all material conflicts of interest
that are associated with the recommendation. The Commission believes
that requiring broker-dealers to reasonably disclose to the retail
customer, in writing, the material facts relating to the scope and
terms of the relationship with a retail customer would facilitate a
retail customer's understanding of the nature of his or her account,
the broker-dealer's fees and charges, as well as the nature of services
that the broker-dealer provides, as well as any limitations to those
services. It would also reduce retail customers' confusion about the
differences among certain financial service providers, such as broker-
dealers, investment advisers, and dual-registrants. In addition, the
obligation to disclose all material conflicts of interest 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.
The collections of information associated with these Disclosure
Obligations, as well as the associated record-making and recordkeeping
obligations are addressed below.
a. Obligation To Reasonably Disclose to the Retail Customer, in
Writing, the 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 their obligation to reasonably disclose to the
retail customer, in writing, the material facts relating to the scope
and terms of the relationship with the retail customer through a
combination of delivery of the Relationship Summary, creating account
disclosures to include standardized language related to capacity and
scope, and types of services and the development of comprehensive fee
schedules.
(1) Disclosure of Capacity
As discussed above, the Commission preliminarily 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
[[Page 21669]]
the retail customer with the Relationship Summary in the manner
prescribed by the rules and guidance in the Relationship Summary
Proposal.\575\
---------------------------------------------------------------------------
\575\ See Relationship Summary Proposal.
---------------------------------------------------------------------------
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 how the broker-dealer would notify the retail customer of
any changes in its capacity. We understand that many broker-dealers
already include such information in account disclosures.
(2) Disclosure of Fees, Charges, and Types/Scope of Services
While many broker-dealers do provide fee information to retail
customers in a fee schedule, the Commission believes that to comply
with proposed Regulation Best Interest broker-dealers would likely
either amend this schedule or develop a new fee schedule to disclose
the fees and charges applicable to retail customers' transactions,
holdings, and accounts through the use or development of a
comprehensive, standardized fee schedule. 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 of the particular recommendation, the broker-dealer
would need to deliver an amended fee schedule.
With respect to disclosure of the types and scope of services
provided by the broker-dealer, we assume for purposes of this PRA
analysis that broker-dealers 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.
b. Obligation To Reasonably Disclose in Writing All Material Conflicts
of Interest That Are Associated With the Recommendation
Proposed Regulation Best Interest would require a broker-dealer to
reasonably disclose in writing all material conflicts of interest that
are associated with a recommendation.
As discussed above, we preliminarily assume that broker-dealers
would satisfy the obligation to disclose material conflicts of interest
through the use of a standardized, written disclosure document provided
to all retail customers and supplemental disclosure provided to certain
retail customers for specific products.
We assume for purposes of this analysis that delivery of written
disclosure would occur at the beginning of a relationship, such as
together with the account opening agreement. For existing retail
customers, the disclosure would need to occur ``prior to or at the
time'' of a recommendation. Subsequent disclosures may be delivered 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.\576\
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\576\ The costs and burdens arising from the obligation to
identify all material conflicts of interest that are associated with
the recommendation are addressed above, in the context of the
Conflict of Interest Obligation, in Section V.B.1.
---------------------------------------------------------------------------
c. Estimated Costs and Burdens
(1) Disclosure of Capacity, Type and Scope of Services
Standalone broker-dealers would satisfy the obligation to disclose
capacity through the delivery to retail customers of the Relationship
Summary, in accordance with the rules and guidance set forth in the
Relationship Summary Proposal. Additionally, although we understand
that many dual-registrants and standalone broker-dealers, as a matter
of best practice, already disclose capacity and types and scope of
services to retail customers, for purposes of this analysis, we are
assuming that dual-registrants would create new account disclosure
related to capacity and all broker-dealers would create account
disclosure related to types 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 registered representatives,
we do not expect registered representatives to incur any initial or
ongoing burdens with respect to the capacity, 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. With regard to disclosure of capacity, the Commission
believes that dually-registered representatives of broker-dealers would
incur initial and ongoing burdens. Following is a discussion of the
estimated initial and ongoing burdens and costs.
i. Initial Burdens and Costs
We estimate that a dually-registered firm would incur an initial
internal burden of 10 hours for in-house counsel and in-house
compliance personnel \577\ to draft language regarding capacity for
inclusion in the standardized account disclosure that is delivered to
the retail customer.\578\
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\577\ 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 of compliance personnel.
\578\ As discussed above, the following estimates include the
burdens and costs that broker-dealers would incur in drafting
standardized account disclosure language related to capacity, scope
and terms of the relationship on behalf of their dually-registered
representatives. For purposes of this analysis, the Commission
assumes that broker-dealers would undertake these tasks on behalf of
their registered representatives.
---------------------------------------------------------------------------
In addition, we estimate that dual-registrants would incur an
estimated external cost of $4,720 for the assistance of outside counsel
in the preparation and review of standardized language regarding
capacity.\579\ For the estimated 360 dually-registered firms with
retail business,\580\ we project an aggregate initial burden of 3,600
hours,\581\ and $1.7 million in aggregate initial costs.\582\
---------------------------------------------------------------------------
\579\ This estimate is based on the following calculation: (10
hours for outside counsel review/drafting) x ($472/hour for outside
counsel services) = $4,720 in initial outside counsel costs.
\580\ See supra Section IV.B.1.a, at Table 1, Panel B.
\581\ This estimate is based on the following calculation: (360
dually-registered retail firms) x (10 hours) = 3,600 initial
aggregate burden hours.
\582\ This estimate is based on the following calculation: (360
dually-registered retail firms) x ($4,720 in external cost per firm)
= $1.7 million in aggregate initial costs.
---------------------------------------------------------------------------
Similarly, to comply with proposed Regulation Best Interest,
standalone broker-dealers would likely draft standardized language for
inclusion in the account disclosure to provide the retail customer with
more specific information regarding the types and scope of services
that they provide. We expect that the associated costs and burdens
would differ between small and large broker-dealers, as large broker-
dealers generally offer more products
[[Page 21670]]
and services and therefore would need to potentially evaluate a larger
number of products and services.
Given these assumptions, we estimate that a small broker-dealer
would incur an internal initial burden of 10 hours for in-house counsel
and in-house compliance personnel to draft this standardized
language.\583\ In addition, a small broker-dealer would incur an
estimated external cost of $4,720 for the assistance of outside counsel
in the preparation and review of this standardized language.\584\ For
the estimated 802 small broker-dealers,\585\ we project an aggregate
initial burden of 8,020 hours,\586\ and aggregate initial costs of
$3.79 million.\587\
---------------------------------------------------------------------------
\583\ 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 of compliance personnel.
\584\ This estimate is based on the following calculation: (10
hours for outside counsel review/drafting) x ($472/hour for outside
counsel services) = $4,720 in initial outside counsel costs.
\585\ See supra note 538 and accompanying text.
\586\ This estimate is based on the following calculation: (802
small broker-dealers) x (10 hours per small broker-dealer) = 8,020
aggregate burden hours.
\587\ This estimate is based on the following calculation: (802
small broker-dealers) x ($4,720 in external cost per small retail
firm) = $3.79 million in aggregate initial costs.
---------------------------------------------------------------------------
Given the broader array of products and services offered, we
estimate that a large broker-dealer would incur an internal burden of
20 hours to draft this standardized language.\588\ A large broker-
dealer would also incur an estimated cost of $7,080 for the assistance
of outside counsel in the preparation and review of this standardized
language.\589\ For the estimated 2,055 large retail broker-dealers, we
estimate an aggregate initial burden of 41,100 hours,\590\ and $14.55
million in aggregate initial costs.\591\
---------------------------------------------------------------------------
\588\ 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 of compliance personnel.
\589\ This estimate is based on the following calculation: (15
hours for outside counsel review/drafting) x ($472/hour for outside
counsel services) = $7,080 in initial outside counsel costs.
\590\ This estimate is based on the following calculation:
(2,055 large broker-dealers) x (20 burden hours) = 41,100 aggregate
initial burden hours.
\591\ This estimate is based on the following calculation:
(2,055 large broker-dealers) x ($7,080 initial outside counsel
costs) = $14.55 million in aggregate initial costs.
---------------------------------------------------------------------------
We estimate that all broker-dealers would each incur approximately
0.02 burden hour \592\ for delivery of the account disclosure
document.\593\ Based on FOCUS data, we estimate that the 2,857 broker-
dealers that report retail activity have approximately 128 million
customer accounts, and that approximately 74.4%, or 95.2 million, of
those accounts belong to retail customers.\594\ We therefore estimate
that broker-dealers would have an aggregate initial burden of 1,904,000
hours, or approximately 666 hours \595\ per broker-dealer for the first
year after the rule is in effect.\596\
---------------------------------------------------------------------------
\592\ This is the same estimate the Commission makes in the
Relationship Summary Proposing 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.
\593\ As noted above, for new retail customers, we expect
delivery to occur at the inception of the relationship; for existing
customers, we expect delivery to occur prior to or at the time of a
recommendation.
\594\ The 2,857 broker-dealers (including dual registrants) with
retail customers report 128 million customer accounts. See Section
IV.B.1.a, Table 1, Panel B. Assuming the amount of retail customer
accounts is proportionate to the percentage of broker-dealers that
have retail customers, or 74.4% of broker-dealers, then the number
of retail customer accounts would be 74.4% of 128 million accounts =
95.2 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.
\595\ These estimates are based on the following calculations:
(0.02 hours per customer account x (95.2 million retail customer
accounts) = 1,904,000 aggregate burden hours. Conversely, (1,904,000
hours)/(2,857 broker-dealers) = approximately 666 burden hours per
broker-dealer.
\596\ 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.
---------------------------------------------------------------------------
We estimate a total initial aggregate burden for dually-registered,
small and large broker-dealers to develop and deliver to retail
customers account disclosures relating to capacity and type and scope
of services of 1,956,620 burden hours.\597\ We estimate a total initial
aggregate cost of $20.04 million.\598\
---------------------------------------------------------------------------
\597\ This estimate is based on the following calculation:
(3,600 aggregate initial burden hours for dual registrants) + (8,020
aggregate initial burden hours for small broker-dealers) + (41,000
burden hours for large broker-dealers) + (1,904,000 aggregate
initial burden hours for all broker-dealers to deliver the account
disclosures) = 1,956,620 total aggregate initial burden hours.
\598\ This estimate is based on the following calculation: ($1.7
million in initial aggregate costs for dual registrants) + ($3.79 in
initial aggregate costs for small broker-dealers) + ($14.55 million
in initial aggregate costs for large broker-dealers) = $20.04
million in total initial aggregate costs.
---------------------------------------------------------------------------
ii. Ongoing Burdens
For purposes of this analysis, we assume that broker-dealers would
review and amend the standardized language in the account disclosure,
on average, once a year. Further, we assume that broker-dealers would
not incur outside costs in connection with updating account
disclosures, as in-house personnel would be more knowledgeable about
changes in capacity, and the types and scope of services offered by the
broker-dealer.
We estimate that each dually-registered broker-dealer would incur
approximately five burden hours annually for compliance and business
line personnel to review changes in the dual-registrant's capacity and
types and scope of services offered, 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 and types
and scope of services offered, for a total of seven burden hours. The
estimated ongoing aggregate burden to amend dual-registrants' account
disclosures to reflect changes in capacity and types and scope of
services would therefore be 2,520 hours.\599\
---------------------------------------------------------------------------
\599\ This estimate is based on the following calculation: (7
burden hours per dually-registered firm per year) x (360 dually-
registered broker-dealers) = 2,520 ongoing aggregate burden hours.
---------------------------------------------------------------------------
With respect to small standalone broker-dealers, we estimate an
internal burden of two hours for in-house compliance and business line
personnel to review and update changes in capacity and types or scope
of services offered, and another two burden hours annually for in-house
counsel to amend the account disclosure to disclose material changes to
capacity and types or 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 capacity and types
and scope of services would therefore be 3,208 hours for small broker-
dealers.\600\
---------------------------------------------------------------------------
\600\ This estimate is based on the following calculation: (4
burden hours per broker-dealer per year) x (802 small broker-
dealers) = 3,208 ongoing aggregate burden hours.
---------------------------------------------------------------------------
We estimate that large standalone broker-dealers would incur 10
burden hours annually for in-house compliance and business line
personnel to review and update changes in capacity and the types or
scope of services offered, and another 10 burden hours annually for in-
house counsel to amend the account disclosure to disclose material
changes to capacity and the types and scope of services, for a total of
20 burden hours. We therefore believe the ongoing, aggregate burden
would be 41,100 hours for large broker-dealers.\601\
---------------------------------------------------------------------------
\601\ This estimate is based on the following calculation: (20
burden hours per broker-dealer per year) x (2,055 large broker-
dealers) = 41,100 ongoing aggregate burden hours.
---------------------------------------------------------------------------
With respect to delivery of the amended account agreements in the
[[Page 21671]]
event of material changes to the capacity disclosure or disclosure
related to types 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 380,800 hours, or 133 hours per broker-dealer.\602\
---------------------------------------------------------------------------
\602\ (20%) x (95.2 million retail customer accounts) x (.02
hours for delivery to each customer account) = 380,800 aggregate
burden hours. Conversely, 380,800 aggregate burden hours/2,857
broker-dealers = 133 burden hours per broker-dealer.
---------------------------------------------------------------------------
The total ongoing aggregate burden for dually-registered, small and
large broker-dealers to review, amend, and delivery updated account
disclosures to reflect changes in capacity, types and scope of services
would be 427,700 burden hours per year.\603\
---------------------------------------------------------------------------
\603\ This estimate is based on the following calculation:
(2,520 ongoing aggregate burden hours for dually-registered broker-
dealers) + (3,280 ongoing aggregate burden hours for small broker-
dealers) + (41,100 ongoing aggregate burden hours for large broker-
dealers) + (380,800 ongoing aggregate burden hours for delivery of
amended account disclosures) = 427,700 total ongoing aggregate
burden hours.
---------------------------------------------------------------------------
The Commission acknowledges that the types of services and offering
of products vary greatly by broker-dealer, and therefore that the costs
or burdens associated with updating the account disclosure might
similarly vary.
(2) Disclosure of Fees
The Commission assumes for purposes of this analysis that a broker-
dealer would disclose its fees and charges through a standardized fee
schedule, delivered to the retail customer at the inception of the
relationship, or, for existing retail customers, prior to or at the
time of a recommendation and, as discussed below, would 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. While the Commission recognizes that the fee disclosure
included in Disclosure Obligation applies to the broker-dealer entity
and its natural associated persons, we do not expect any burdens or
costs on registered representatives related to the fees and charges as
this information would be addressed in the broker-dealer entity's fee
schedule.
i. Initial Costs/Burdens
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 potentially 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 would initially spend five hours and large broker-
dealers would spend ten 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 $2,360 for smaller
broker-dealers \604\ and $4,720 for larger broker-dealers for outside
counsel to review the fee schedule.\605\ We therefore estimate the
initial aggregate burden for small broker-dealers to be 4,010 burden
hours,\606\ and the initial aggregate cost to be $1.89 million.\607\ We
estimate the aggregate burden for large broker-dealers to be 20,550
burden hours,\608\ and the aggregate cost to be $9.7 million.\609\
---------------------------------------------------------------------------
\604\ This cost estimate is based on the following calculation:
(5 hours of review) x ($472/hour for outside counsel services) =
$2,360 outside counsel costs.
\605\ This cost estimate is based on the following calculation:
(10 hours of review) x ($472/hour for outside counsel services) =
$4,720 outside counsel costs.
\606\ This estimate is based on the following calculation: (5
burden hours of review per small broker-dealer) x (802 small broker-
dealers) = 4,010 aggregate initial burden hours.
\607\ This estimate is based on the following calculation:
($2,360 for outside counsel costs per small broker-dealer) x (802
small broker-dealers) = $1.89 million in aggregate initial outside
costs.
\608\ This estimate is based on the following calculation: (10
burden hours of review per large broker-dealer) x (2,055 large
broker-dealers) = 20,550 aggregate initial burden hours.
\609\ This estimate is based on the following calculation:
($4,720 for outside counsel costs per large broker-dealer) x (2,055
large broker-dealers) = $9.70 million in aggregate initial costs.
---------------------------------------------------------------------------
Similar to delivery of the account disclosure regarding capacity
and types 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 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.\610\ As
stated above, we estimate that the 2,857 broker-dealers that report
retail activity have approximately 128 million customer accounts, and
that approximately 74.4%, or 95.2 million, of those accounts belong to
retail customers.\611\ We therefore estimate that a broker-dealer will
have an aggregate initial burden of 380,800 hours, or approximately 133
hours per broker-dealer for the first year after the rule is in
effect.\612\
---------------------------------------------------------------------------
\610\ See supra note 592.
\611\ See supra note 593.
\612\ This estimate is based on the following calculation: (20%)
x (95.2 million retail customer accounts) x (.02 hours for delivery
to each customer account) = 380,800 aggregate burden hours.
Conversely, (380,800 aggregate burden hours)/(2,857 broker-dealers)
= 133 burden hours per broker-dealer.
---------------------------------------------------------------------------
The total aggregate initial burden for broker-dealers is therefore
estimated at 405,360 \613\ hours, and the total aggregate initial cost
is estimated at $11.59 million.\614\
---------------------------------------------------------------------------
\613\ This estimate is based on the following calculations:
(4,010 aggregate burden hours for small broker-dealers) + (20,550
burden hours for large broker-dealers) + (380,800 burden hours for
delivery) = 405,360 total aggregate initial burden hours.
\614\ This estimate is based on the following calculation:
($1.89 million for small broker-dealer costs) + ($9.7 million large
broker-dealer costs) = $11.59 million in total aggregate costs.
---------------------------------------------------------------------------
ii. Ongoing Costs/Burdens
For purposes of this PRA analysis, we assume that broker-dealers
would review and amend the fee schedule on average, once a year. With
respect to small broker-dealers, we estimate that it would require
approximately two hours per year to review and update the fee schedule,
and for large broker-dealers, we estimate that the recurring, annual
burden to review and update the fee schedule would be four hours for
each large broker-dealer. Based on these estimates, we estimate the
recurring, aggregate, annualized burden would be approximately 1,604
hours for small broker-dealers \615\ and 8,220 hours for large broker-
dealers.\616\ We do not anticipate that small or large broker-dealers
would 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.
---------------------------------------------------------------------------
\615\ This estimate is based on the following calculation: (2
burden hours per broker-dealer) x (802 small broker-dealers) = 1,604
aggregate burden hours.
\616\ This estimate is based on the following calculation: (4
burden hours per broker-dealer) x (2,055 large broker-dealers) =
8,220 aggregate burden hours.
---------------------------------------------------------------------------
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. We therefore
estimate broker-dealers would incur a total annual aggregate burden of
761,600 hours, or 267 hours per broker-dealer.\617\
---------------------------------------------------------------------------
\617\ This estimate is based on the following calculation: (40%
of 95.2 million retail customer accounts) x (.02 hours) = 761,600
aggregate burden hours. Conversely, (761,600 aggregate burden
hours)/(2,857 broker-dealers) = 267 burden hours per broker-dealer.
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[[Page 21672]]
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 Material Conflicts of Interest
Regulation Best Interest would require broker-dealers to reasonably
disclose all material conflicts that are associated with a
recommendation. Because the Disclosure Obligation applies to both
broker-dealers entity and registered representatives, the Commission
expects that the broker-dealer entity and its registered
representatives would incur initial and ongoing burdens. However, as
with the disclosure of capacity and types and scope of services, we
assume for purposes of this analysis that broker-dealers would incur
the burdens and costs of disclosing material conflicts of interest on
behalf of their registered representatives.
i. Initial Costs and Burdens
The Disclosure Obligation of proposed Regulation Best Interest
would provide broker-dealers with the flexibility to choose the form
and manner of conflict disclosure. However, we believe that many or
most broker-dealers would develop a standardized conflict disclosure
document and distribute it to retail customers.\618\ We also assume for
purposes of this PRA analysis that broker-dealers would update and
deliver the standardized conflict disclosure document yearly on an
ongoing basis, following the broker-dealer's annual conflicts review
process.\619\
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\618\ As noted above, we assume that delivery for new customers
would occur at the inception of the relationship, and that delivery
for existing customers would occur prior to or at the time a
recommendation is made.
\619\ However, as discussed above, we recognize that broker-
dealers might choose to disclose material conflicts of interest on
an as-needed basis, and might take a layered approach to disclosure,
as opposed to a standardized conflict disclosure document. We
request comment on whether broker-dealers may choose to take a
layered approach to disclosure and the associated costs of burdens.
---------------------------------------------------------------------------
For purposes of this PRA analysis, we assume that a standardized
conflict disclosure document would be developed by in-house counsel and
reviewed by outside counsel. For small broker-dealers, we estimate it
would 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. The initial aggregate burden for the
development of a standardized disclosure document, based on an
estimated 802 small broker-dealers, would be approximately 4,010 burden
hours.\620\ We additionally estimate an initial cost of $2,360 per
small broker-dealer,\621\ and an aggregate initial cost of $1.89
million for all small broker-dealers.\622\
---------------------------------------------------------------------------
\620\ This estimate is based on the following calculation: (5
hours) x (802 small broker-dealers) = 4,010 aggregate burden hours.
\621\ This estimate is based on the following calculation:
($472/hour) x (5 hours) = $2,360 in initial costs.
\622\ This estimate is based on the following calculation:
($472/hour x 5 hours) x (802 broker-dealers) = $1.89 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 would
need to potentially disclose a larger number of conflicts. We estimate
that for large broker-dealers, it would take 7.5 burden hours for in-
house counsel to create the standardized conflict disclosure document,
and outside counsel would 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 2,055 large broker-dealers, to be
approximately 15,413 burden hours.\623\ We additionally estimate
initial costs of $3,540 per broker-dealer,\624\ and an aggregate cost
for large broker-dealers of approximately $7.27 million.\625\
---------------------------------------------------------------------------
\623\ This estimate is based on the following calculation: (7.5
hours x 2,055 large broker-dealers) = 15,413 burden hours.
\624\ This estimate is based on the following calculation:
($472/hour) x (7.5 hours) = $3,540 in initial costs.
\625\ This estimate is based on the following calculation:
($472/hour) x (7.5 hours x 2,055 large broker-dealers) = $7.27
million in aggregate costs.
---------------------------------------------------------------------------
We assume that broker-dealers would 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 would
require approximately 0.02 hours to deliver the standardized conflict
disclosure document to each retail customer.\626\ We therefore estimate
that broker-dealers would incur an aggregate initial burden of
1,904,000 hours, or approximately 666 hours per broker-dealer for
delivery of the standardized conflict disclosure document the first
year after the rule is in effect.\627\
---------------------------------------------------------------------------
\626\ See supra note 592. For purposes of this PRA analysis, we
have assumed any initial disclosures made by the broker-dealer
related to material conflicts of interest would be delivered
together.
\627\ These estimates are based on the following calculations:
(0.02 hours per customer account x 95.2 million retail customer
accounts) = 1,904,000 aggregate burden hours. Conversely, (1,904,000
hours)/(2,857 broker-dealers) = 666 burden hours per broker-dealer.
---------------------------------------------------------------------------
ii. Ongoing Costs and Burdens
We believe that broker-dealers would incur ongoing annual burdens
and costs to update the disclosure document to include newly identified
conflicts. While Regulation Best Interest does not require broker-
dealers to provide disclosures at specific intervals or times, but
rather allows broker-dealers to provide disclosures on an as-needed
basis, we assume for purposes of this analysis that broker-dealers
would update their conflict disclosure document annually, after
conducting an annual conflicts review. We estimate that the conflict
disclosure form would be updated internally by both small and large
broker-dealers.
We estimate that in-house counsel at a small broker-dealer would
require approximately 1 hour per year to update the standardized
conflict disclosure document, for an ongoing aggregate burden of
approximately 802 hours.\628\ For large broker-dealers, we estimate
that the ongoing, annual burden would be 2 hours for each broker-
dealer: 1 hour for compliance personnel and 1 hour for legal personnel.
We therefore estimate the ongoing, aggregate burden for large broker-
dealers to be approximately 4,110 burden hours.\629\ We do not
anticipate that small or large broker-dealers would 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.
---------------------------------------------------------------------------
\628\ This estimate is based on the following calculation: (1
hour per broker-dealer) x (802 small broker-dealers) = 802 aggregate
burden hours.
\629\ This estimate is based on the following calculation: (2
hours per broker-dealer) x (2,055 large broker-dealers) = 4,110
aggregate burden hours.
---------------------------------------------------------------------------
With respect to ongoing delivery of the updated conflict disclosure
document, we estimate that this would take place among 40% of a broker-
dealer's retail customer accounts annually.\630\ We therefore estimate
that broker-dealers would incur an aggregate
[[Page 21673]]
ongoing burden of 761,600 hours, or 267 burden hours per broker-
dealer.\631\
---------------------------------------------------------------------------
\630\ The Commission estimates that broker-dealers would update
fees and material conflicts of interest disclosure more frequently
than disclosure related to capacity or type and scope of services.
\631\ This estimate is based on the following calculation: (40%
of 95.2 million retail customer accounts) x (.02 hours) = 761,600
aggregate burden hours. Conversely, (761,600 aggregate burden
hours)/(2,857 broker-dealers) = 267 hours per broker-dealer.
---------------------------------------------------------------------------
3. Care Obligation
Under proposed Regulation Best Interest, prior to or at the time of
making the recommendation, a broker-dealer would be required to make a
reasonable effort to ascertain the potential risks and rewards
associated with the recommendation, and to determine whether the
recommendation could be in the best interest of at least some retail
customers. However, any PRA burdens or costs associated with the Care
Obligation are discussed below with respect to proposed Rule 17a-
3(a)(25).
4. Record-Making and Recordkeeping Obligations
Records made and retained in accordance with the proposed
amendments to Rule 17a-3(a)(25) and 17a-4(e)(5) would (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.
The record-making and recordkeeping costs and burdens associated
with the proposed amendments to Rule 17a-3(a)(25) and Rule 17a-4(e)(5)
are addressed below.
a. Record-Making
Proposed Rule 17a-3(a)(25) would require a broker-dealer to make a
record of all information collected from and provided to the retail
customer pursuant to Proposed Regulation Best Interest. We understand
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.\632\
---------------------------------------------------------------------------
\632\ 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 proposed Regulation Best Interest and
the Relationship Summary Proposal. With respect to the requirement
that a record be made of all information from the retail customer,
we believe that proposed Rule 17a-3(a)(25) would not impose any new
substantive burdens on broker-dealers. As discussed above, we
believe that the obligation to exercise reasonable diligence, care,
skill and prudence would 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
recommendation would need to adhere to the enhanced best interest
standard of Regulation Best Interest. See supra Section II.D.2.
---------------------------------------------------------------------------
In addition, the proposed amendment to Rule 17a-3(a)(25) would
require a broker-dealer, ``for each retail customer to whom a
recommendation of any securities transaction or investment strategy
involving securities is or will be provided,'' to make a record of the
``identity of each natural person who is an associated person, if any,
responsible for the account.'' 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). However, we are assuming, for
purposes of compliance with proposed Rule 17a-3(a)(25), 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 proposed Regulation Best Interest.
(1) Initial Costs and Burdens
We assume 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 this information. We
believe that the inclusion of this information in an account disclosure
document would require, on average, approximately 1 hour per year for
outside counsel at small broker-dealers, at an average rate of $472/
hour, for an annual cost of $472 for each small broker-dealer to update
an account disclosure document. The projected initial, aggregate cost
for small broker-dealers would be $378,544.\633\ For broker-dealers
that are not small entities, we estimate that the initial burden would
be 2 hours for each broker-dealer: 1 hour for compliance personnel and
1 hour for legal personnel. We therefore believe the initial aggregate
burden for broker-dealers that are not small entities would be
approximately 4,110 burden hours.\634\ Finally, we estimate it would
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 3,808,000 hours, or
approximately 1,333 hours per broker-dealer for the first year after
the rule is in effect.\635\ Because we have already included the costs
and burdens associated with the delivery of the amended account
disclosure document above, we need not include them in this section of
the analysis.
---------------------------------------------------------------------------
\633\ This estimate is based on the following calculation: (1
hour per small broker-dealer) x (802 small broker-dealers) x ($472/
hour) = $378,544 in aggregate costs.
\634\ This estimate is based on the following calculation: (2
burden hours per broker-dealer) x (2,055 large broker-dealers) =
4,110 aggregate burden hours.
\635\ These estimates are 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
burden hours)/(2,857 broker-dealers) = 1,333 hours per broker-
dealer.
---------------------------------------------------------------------------
(2) Ongoing Costs and Burdens
We do not believe that the identity of the registered
representative responsible for the retail customer's account would
change. Accordingly, we believe that there are no ongoing costs and
burdens associated with this record-making requirement of the proposed
amendment to Rule 17a-3(a)(25).
b. Recordkeeping Obligations
For each record made pursuant to proposed Rule 17a-3(a)(25), the
proposed amendment to Rule 17a-4(e)(5) would require broker-dealers to
retain ``all account record information required pursuant to
[Regulation Best Interest] and all records required pursuant to
[Regulation Best Interest], 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.'' As
discussed above, the following records would likely need to be retained
pursuant to proposed Rule 17a-3(a)(25): (1) A standardized Relationship
Summary document, developed in accordance with the rules and guidance
contained in the Relationship Summary Proposal; (2) existing account
disclosure documents; (3) a comprehensive fee schedule; and (4)
disclosures identifying material conflicts.
(1) Initial Costs and Burdens
We believe that, to reduce costs and for ease of compliance,
broker-dealers would 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 Proposed 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,
[[Page 21674]]
broker-dealers are already required to maintain documents such as
account blotters and ledgers for six years.
We believe that broker-dealers would leverage their existing
recordkeeping systems to include any additional or amended records
required by Regulation Best Interest or pursuant to Proposed Amendment
to Rule 17a-4(e)(5), and would similarly leverage 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
would expect broker-dealers to maintain any additional documents
required by Regulation Best Interest or Proposed 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 the assumption that broker-dealers will rely on existing
infrastructures to satisfy the recordkeeping obligations of Regulation
Best Interest and Proposed Amendment to Rule 17-a(4)(e)(5), we believe
the burden for broker-dealers to add new documents or modify existing
documents to the broker-dealer's existing retention system would be
approximately 15.9 million burden hours for all broker-dealers,
assuming a broker-dealer would need to upload or file each of the five
account documents discussed above for each retail customer
account.\636\ We do not believe there would be additional internal or
external costs relating to the uploading or filing of the documents,
nevertheless, we request comment on this assumption and whether the new
requirements would pose additional costs, for example, relating to
storage space for paper or relating to additional electronic database
storage space. 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.
---------------------------------------------------------------------------
\636\ This estimate is based on the following calculation: (5
documents per customer account) x (95.2 million retail customer
accounts) x (2 minutes per document)/60 minutes = 15,866,667
aggregate burden hours.
---------------------------------------------------------------------------
(2) Ongoing Costs and Burdens
We estimate that the approximate ongoing burden associated with the
recordkeeping requirement of proposed amendment to Rule 17a-4(e)(5) is
3.17 million burden hours per year.\637\ 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. However, we request
comment regarding both the frequency with which a broker-dealer would
need to collect, provide, replace, or update the records made pursuant
to the proposed amendment to Rule 17a-3(a)(25), and also on whether
there would be additional costs relating to ensuring compliance with
record retention and retention schedules pursuant to Rule 17a-4.
---------------------------------------------------------------------------
\637\ This estimate is based on the percentage of account
records we expect would be updated each year as described in Section
V.B.2, supra, and the following calculation: (40% of fee schedules x
95.2 million retail customer accounts) x (2 minutes per document) +
(40% of conflict disclosure forms x 95.2 million retail customer
accounts) x (2 minutes per document) + (20% of account opening
documents x 95.2 million retail customer accounts) x (2 minutes per
document) = 3,173,334 aggregate ongoing burden hours.
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C. Collection of Information Is Mandatory
The collections of information relating to: (1) ``Regulation Best
Interest;'' (2) the Proposed Amendment to Rule 17a-3--Records to be
Made by Certain Exchange Members, Brokers and Dealers (OMB control
number 3235-0033); and (3) the Proposed Amendment to Rule 17a-4--
Records to be Preserved by Certain Brokers and Dealers (OMB control
number 3235-0279) are mandatory for all broker-dealers.
D. Confidentiality
With respect to written disclosure provided to the retail customer
as required by Regulation Best Interest, such disclosure would not be
kept confidential. Other information provided to the Commission in
connection with staff examinations or investigations would be kept
confidential, subject to the provisions of applicable law.
E. Request for Comment
The Commission is using the above estimates for the purposes of
calculating reporting burdens associated with Regulation Best Interest,
the Proposed Amendment to Rule 17a-3 and the Proposed Amendment to Rule
17a-4. We request comment on our estimates for the new and recurring
burdens and associated costs described above in connection with
Regulation Best Interest. In addition to the request for comments made
throughout this Section V, the Commission more generally seeks comment
on its 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 associated with Regulation Best Interest that have not been
identified in this release.
The Commission additionally invites comment on any other issues
related to the costs and burdens associated with Regulation Best
Interest. Pursuant to 44 U.S.C. 3506(c)(2)(B), we request comment in
order to:
Evaluate whether the proposed collection of information is
necessary for the performance of our functions, including whether the
information will have practical utility;
evaluate the accuracy of our estimates of the burdens of
the proposed collections of information;
determine whether there are ways to enhance the quality,
utility and clarity of the information to be collected; and
evaluate whether there are ways to minimize the burden of
the collection of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
Persons wishing to submit comments on the collection of information
requirements of Regulation Best Interest should direct them to (1) the
Office of Management and Budget, Attention: Desk Officer for the
Securities and Exchange Commission, Office of FOIA Services,
Washington, DC 20503; and (2) Brent J. Fields, Secretary, Securities
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090,
with reference to File No. S7-XX-XX. Requests for materials submitted
to OMB by the Commission with regard to this collection of information
should be in writing, with reference to File No. S7-XX-XX, and be
submitted to the Securities and Exchange Commission, Office of Investor
Education and Advocacy, 100 F Street NE, Washington, DC 20549-0213. OMB
is required to make a decision concerning the collections of
information between 30 and 60 days after publication, so a comment to
OMB is best assured of having its full effect if OMB receives it within
30 days of publication.
VI. Small Business Regulatory Enforcement Fairness Act
For purposes of the Small Business Regulatory Enforcement Fairness
Act of
[[Page 21675]]
1996, or ``SBREFA,'' \638\ the Commission must advise the OMB as to
whether the proposed regulation constitutes a ``major'' rule. Under
SBREFA, a rule is considered ``major'' where, if adopted, it results or
is likely to result in:
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\638\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
An annual effect on the economy of $100 million or more
(either in the form of an increase or a decrease);
a major increase in costs or prices for consumers or
individual industries; or
significant adverse effect on competition, investment or
innovation. If a rule is ``major,'' its effectiveness will generally be
delayed for 60 days pending Congressional review.
The Commission requests comment on the potential impact of
Regulation Best Interest and the Proposed Amendment to Rule 17a-4(e)(5)
on:
The U.S. economy on an annual basis,
Any potential increase in costs or prices for consumers or
individual industries, and
Any potential effect on competition, investment, or
innovation.
Commenters are requested to provide empirical data and other
factual support for their view to the extent possible.
VII. Initial Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (``RFA'') \639\ requires federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) \640\ of the Administrative Procedure
Act,\641\ as amended by the RFA, generally requires the Commission to
undertake a regulatory flexibility analysis of all proposed rules, or
proposed rule amendments, to determine the impact of such rulemaking on
``small entities.'' \642\ Under Section 605(b) of the RFA, a federal
agency need not undertake a regulatory flexibility analysis of proposed
rules where, if adopted, they would not have a significant economic
impact on a substantial number of small entities.\643\
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\639\ 5 U.S.C. 601 et seq.
\640\ 5 U.S.C. 603(a).
\641\ 5 U.S.C. 551 et seq.
\642\ Although Section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission has adopted definitions for the term
small entity for the purposes of Commission rulemaking in accordance
with the RFA. Those definitions, as relevant to this proposed
rulemaking, are set forth in Rule 0-10 under the Exchange Act, 17
CFR 240.0-10.
\643\ See 5 U.S.C. 605(b).
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A. Reasons for and Objectives of the Proposed Action
As discussed above in Section I, the Commission is proposing
Regulation Best Interest to establish a standard of conduct for broker-
dealers and natural persons who are associated persons of a broker-
dealer when making a recommendation of any securities transaction or
investment strategy involving securities to a retail customer. While
broker-dealers are subject to extensive existing obligations, there is
no specific obligation under the Exchange Act that broker-dealers make
recommendations that are in their customers' best interest. The
Commission believes it is appropriate to make enhancements to the
obligations that apply when broker-dealers make recommendations to
retail customers.
The proposed standard of conduct is to act in the best interest of
the retail customer at the time a recommendation is made without
placing the financial or other interest of the broker-dealer or natural
person who is an associated person making the recommendation ahead of
the interest of the retail customer. This obligation shall be satisfied
if: The broker-dealer or a natural person who is an associated person
of a broker-dealer, before or at the time of such recommendation
reasonably discloses to the retail customer, in writing, the material
facts relating to the scope and terms of the relationship, and all
material conflicts of interest associated with the recommendation; the
broker-dealer or a natural person who is an associated person of a
broker-dealer, in making the recommendation, exercises reasonable
diligence, care, skill, and prudence; the broker-dealer establishes,
maintains, and enforces written policies and procedures reasonably
designed to identify and at a minimum disclose, or eliminate, all
material conflicts of interest that are associated with such
recommendations; and the broker-dealer establishes, maintains, and
enforces 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.
The Commission's objectives in proposing Regulation Best Interest
are to: (1) Enhance the quality of recommendations provided by broker-
dealers to retail customers, by establishing under the Exchange Act a
``best interest'' care obligation that encompasses and goes beyond
existing broker-dealer suitability obligations under the federal
securities laws and that cannot be satisfied through disclosure
alone,\644\ and further establishing obligations under the Exchange Act
that require mitigation, and not just disclosure, of conflicts of
interest arising from financial incentives, and thus helps to reduce
the potential harm resulting from such conflicts; (2) help retail
customers evaluate recommendations received from broker-dealers, as
well as address confusion regarding the broker-dealer relationship
structure, by improving the disclosure of information regarding broker-
dealer conflicts of interest and the material facts relating to scope
and terms of the relationship with the retail customer; (3) facilitate
more consistent regulation of substantially similar activity,
particularly across retirement and non-retirement assets held at
broker-dealers, and in this manner help to reduce investor confusion;
(4) better align the legal obligations of broker-dealers with
investors' reasonable expectations; and (5) help preserve investor
choice and access to affordable investment advice and products that
investors currently use. Each of these objectives is discussed in more
detail in Section I.B., supra.
---------------------------------------------------------------------------
\644\ See supra note 7.
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Furthermore, the proposed addition of paragraph (a)(25) to Rule
17a-3 would impose new record-making obligations on broker-dealers
subject to Regulation Best Interest,\645\ while the Proposed Amendment
to Rule 17a-4(e)(5) would impose new record retention obligations on
broker-dealers subject to Regulation Best Interest.\646\
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\645\ As described in Section II.E. supra, the Commission is
proposing to amend Rule 17a-3 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.
\646\ As described in Section II.E. supra, the Commission is
proposing to amend Exchange Act Rule 17a-4(e)(5) to require broker-
dealers to retain a record of all information collected from and
provided to the retail customer pursuant to Rule 17a-3(a)(25), 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 of the information collected from or provided
to each retail customer pursuant to Regulation Best Interest for six
years.
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B. Legal Basis
Pursuant to the 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, 17, 23 and 36 thereof, 15
U.S.C. 78c, 78j, 78o, 78q, 78w and 78mm, the Commission is
[[Page 21676]]
proposing to adopt Sec. 240.15l-1, to amend 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.
C. Small Entities Subject to the Proposed Rule
For purposes of a Commission rulemaking in connection with the RFA,
a broker-dealer will be deemed a small entity if it: (1) 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,\647\ or, if not required to file such statements, had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the last day of the preceding fiscal year (or in the time that it
has been in business, if shorter); and (2) is not affiliated with any
person (other than a natural person) that is not a small business or
small organization.\648\
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\647\ See 17 CFR 240.17a-5(d).
\648\ See 17 CFR 240.0-10(c).
---------------------------------------------------------------------------
As discussed in Section V, supra, the Commission estimates that
approximately 2,857 retail broker-dealers would be subject to
Regulation Best Interest and the proposed amendment to Rules 17a-3 and
17a-4. Based on FOCUS Report data,\649\ the Commission estimates that
as of December 31, 2017, approximately 802 of those retail broker-
dealers might be deemed small entities for purposes of this
analysis.\650\ 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.\651\
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\649\ See note 538, supra.
\650\ According to the FOCUS data, there are 1,040 broker-
dealers that might be deemed small entities, but only 77% of those
small entities (802 firms) have retail business and would be subject
to Regulation Best Interest and the proposed amendments to Rules
17a-3 and 17a-4.
\651\ Consistent with the PRA, unless otherwise noted, we use
the terms ``registered representative'' and ``dually registered
representative of a broker-dealer'' herein. See supra note 534.
---------------------------------------------------------------------------
D. Projected Compliance Requirements of the Proposed Rule for Small
Entities
The RFA requires a description of the projected reporting,
recordkeeping, and other compliance requirements of proposed Regulation
Best Interest and the proposed rule and rule amendments to Rules 17a-
3(a)(25) and 17a-4(e)(5), including an estimate of the classes of small
entities that will be subject to the requirements and the type of
professional skill necessary to prepare required reports and records.
Following is a discussion of the associated costs and burdens of
compliance with proposed Regulation Best Interest, as incurred by small
entities.
1. Conflict of Interest Obligations
As described more fully above in Section V.D.1., the Conflict of
Interest Obligations would generally include the obligation to: (1)
Update written policies and procedures to comply with Regulation Best
Interest; (2) identify material conflicts of interest; and (3) develop
a training program to maintain and enforce the policies and procedures
that promote compliance with Regulation Best Interest.\652\
---------------------------------------------------------------------------
\652\ For a discussion of additional costs and burdens, as well
as monetized burdens, related to the Conflict of Interest
Obligation, see supra Section IV.C.2.d.
---------------------------------------------------------------------------
a. Written Policies and Procedures
To initially comply with this obligation, we believe that small
entities would primarily rely on outside counsel to update existing
policies and procedures. We believe that the initial costs associated
with this for small entities would be $18,880 per small entity
(reflecting an estimated 40 hours of outside legal counsel services),
and an aggregate cost of $15.1 million for all small entities.\653\ We
additionally believe in-house legal counsel would require 10 hours to
review and approve the updated policies and procedures, for an
aggregate burden of 8,020 hours.\654\ We preliminarily believe that the
related ongoing costs for small entities (relating to reviewing and
updating policies and procedures on a periodic basis outside) would be
$3,850 \655\ annually for each small entity, and the projected ongoing,
aggregate annualized cost for small entities (relating to outside legal
counsel and outside compliance consulting services) would be $3.08
million.\656\ In addition, we believe that small entities would incur
approximately five hours internal burden for in-house compliance
manager to review and approve the updated policies and procedures per
year, for an aggregate annual burden of 4,010 hours for all small
entities.\657\
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\653\ See supra notes 545 and 546.
\654\ See supra note 547.
\655\ This estimate is based on the following calculation:
($2,360 for five hours of outside legal counsel review) + ($1,490
for five hours of outside compliance consulting services) = $3,850.
See supra notes 551 and 553, and accompanying text.
\656\ See supra note 555.
\657\ See supra note 556.
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b. Identification of Material Conflicts of Interest
To identify whether a material conflict of interest exists in
connection with a recommendation, a small entity would need to
establish mechanisms to proactively and systematically identify
conflicts of interest in its business on an ongoing or periodic
basis.\658\ Acknowledging that costs and burdens may vary greatly
according to the size of the small entity, we expect that the
modification of a small entity's existing technology would initially
require the retention of an outside programmer, and that the
modification of existing technology would require, on average, an
estimated 20 hours of the programmer's labor, for an estimated cost per
small entity of $5,400.\659\ We additionally project that coordination
between the senior programmer and the small entity's compliance manager
would involve five burden hours. The aggregate costs and burdens on
small entities for the modification of existing technology to identify
conflicts of interest would therefore be $4.33 million,\660\ and 4,010
burden hours.\661\
---------------------------------------------------------------------------
\658\ See supra Section V.B.1.b.(1).
\659\ See supra note 560.
\660\ This cost estimate is based on the following calculation:
(20 hours of review) x ($270/hour for technology services) x (802
small entities) = $4.33 million.
\661\ This burden estimate is based on the following
calculation: (5 burden hours) x (802 small entities) = 4,010 burden
hours.
---------------------------------------------------------------------------
We additionally believe that the determination whether the
conflicts of interest, once identified, are material, would require
approximately five hours per small entity,\662\ for an aggregate total
of 4,010 burden hours for small entities.\663\
---------------------------------------------------------------------------
\662\ See supra note 563.
\663\ This burden estimate is based on the following
calculation: (5 burden hours) x (802 small entities) = 4,010 burden
hours.
---------------------------------------------------------------------------
To maintain compliance with Regulation Best Interest, we expect
that a broker-dealer should seek to identify additional conflicts as
its business evolves. We estimate that a small entity's business line
and compliance personnel would jointly spend, on average, 10 hours
\664\ to perform an annual conflicts review using the modified
technology infrastructure. Therefore the aggregate, ongoing burden for
an annual conflicts review, based on an estimated 802 small entities,
would be approximately 8,020 burden hours.\665\
---------------------------------------------------------------------------
\664\ See supra note 567.
\665\ This estimate is based on the following calculation: (10
hours of labor per retail broker-dealer) x 802 small entities =
8,020 burden hours. The Commission recognizes that the types of
services and product offerings vary greatly by broker-dealer. See
supra Section V.D.1.b(2).
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[[Page 21677]]
c. Training
Proposed Regulation Best Interest would also require a small entity
to maintain and enforce its written policies and procedures. Toward
this end, we expect small entities to develop training programs that
promote compliance with Regulation Best Interest among registered
representatives. We assume that small entities would likely use a
computerized training module to train registered representatives. We
estimate that a small entity would retain an outside systems analyst,
an outside programmer, and an outside programmer analyst to create the
training module, at 20 hours, 40 hours, and 20 hours,
respectively.\666\ The total cost for a small entity to develop the
training module would be approximately $21,600,\667\ for an aggregate
cost of $17.32 million.\668\
---------------------------------------------------------------------------
\666\ See supra Section V.B.1.c.(1).
\667\ See supra note 569.
\668\ This estimate is based on the following calculation: (802
small entities) x ($21,600 cost per broker-dealer) = $17.32 million.
---------------------------------------------------------------------------
Additionally, we expect that the training module would require the
approval of the Chief Compliance Officer, as well as in-house legal
counsel, each of whom we expect would require approximately 2 hours to
review and approve the training module.\669\ The aggregate burden for
small entities would be estimated at 3,208 burden hours.\670\
---------------------------------------------------------------------------
\669\ See supra Section V.B.1.c.(1).
\670\ This estimate is based on the following calculation: (802
small entities) x (4 burden hours per small entity) = 3,208 burden
hours.
---------------------------------------------------------------------------
In addition, small entities would incur an initial start-up cost
for registered representatives to undergo training through the training
module. We estimate the training time at one hour per registered
representative, for a total aggregate burden of 4,236 burden
hours.\671\
---------------------------------------------------------------------------
\671\ This estimate is based on the following calculation: (1
burden hour) x (4,236 registered representatives at small entities)
= 4,236 burden hours. See supra note 572.
---------------------------------------------------------------------------
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 4,236 burden hours per year.\672\
---------------------------------------------------------------------------
\672\ This estimate is based on the following calculation: (1
burden hour) x (4,236 registered representatives at small entities)
= 4,236 burden hours.
---------------------------------------------------------------------------
2. Disclosure Obligations
Pursuant to the Disclosure Obligations of proposed Regulation Best
Interest, a small entity would need to: (1) Reasonably disclose to the
retail customer, in writing, the material facts relating to the scope
and terms of the relationship with the retail customer (including, at a
minimum, disclosure of capacity, fees and charges, and types and scope
of services); and (2) reasonably disclose to the retail customer, in
writing, all material conflicts of interest that are associated with
the recommendation. The estimated costs and burdens incurred by small
entities in relation to these Disclosure Obligations are discussed in
detail below.\673\
---------------------------------------------------------------------------
\673\ For a discussion of additional costs and burdens, as well
as monetized burdens, related to the Disclosure Obligation, see
supra Section IV.C.2.b.
---------------------------------------------------------------------------
a. Disclosure of Capacity, Type and Scope of Services
We estimate that dually-registered small entities would incur an
initial internal burden of ten hours for in-house counsel and in-house
compliance personnel to draft language regarding capacity for inclusion
in the standardized account disclosure that is delivered to the retail
customer.\674\ In addition, dual-registrants would incur an estimated
external cost of $4,720 for the assistance of outside counsel in the
preparation and review of this standardized language.\675\ For the
estimated 41 dually-registered small entities with retail
business,\676\ we project an aggregate initial burden of 410
hours,\677\ and $193,520 in initial external costs.\678\
---------------------------------------------------------------------------
\674\ See supra note 577 and 578.
\675\ See supra note 579.
\676\ This estimate is based on FOCUS data. See supra note 538.
\677\ This estimate is based on the following calculation: (41
dually-registered small entities) x (10 burden hours) = 410
aggregate burden hours.
\678\ This estimate is based on the following calculation: (41
dually-registered small entities) x ($4,720 in costs per small
entity) = $193,520 in aggregate initial costs.
---------------------------------------------------------------------------
Similarly, we estimate that small entities would incur an initial
burden of ten hours for in-house counsel and in-house compliance
personnel to draft this standardized language.\679\ In addition, small
entities would incur an estimated external cost of $4,720 for the
assistance of outside counsel in the preparation and review of this
standardized language.\680\ For the estimated 802 small entities, we
project an aggregate initial burden of 8,020 hours,\681\ and an initial
aggregate $3.79 million in costs.\682\
---------------------------------------------------------------------------
\679\ See supra note 583.
\680\ See supra note 584.
\681\ See supra note 586.
\682\ See supra note 587.
---------------------------------------------------------------------------
We estimate that small entities would each incur approximately 0.02
burden hour for delivery of the account disclosure document.\683\ Based
on FOCUS data, we believe that the 802 small entities that report
retail activity have a total of 10,545 customer accounts, and that
approximately 74.4%, or 7,845, of those accounts belong to retail
customers.\684\ We therefore estimate that small entities would incur
an aggregate initial burden of 156.9 hours, \685\ with each small
entity incurring an initial burden of 0.2 hour for the first year after
the rule is in effect.
---------------------------------------------------------------------------
\683\ See supra note 593.
\684\ See supra note 594. Assuming the percentage of retail
customer accounts at small broker-dealers is consistent with the
percentage of retail customer accounts at all broker-dealers, then
the number of retail customer accounts would be 74.4% of 10,545
accounts = 7,845 accounts. This number might 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.
\685\ This estimate is based on the following calculation: (.02
hour) x (7,845 retail customer accounts) = 156.9 hours (aggregate)/
802 small entities = 0.2 hour per small entity. We estimate that
small entities 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 customers.
---------------------------------------------------------------------------
On an ongoing basis, we estimate that small entities would review
and amend the standardized language in the account disclosure, on
average, once a year. Further, we assume that such amendments would
likely be minimal.
We estimate that each dually-registered small entity would spend
approximately five hours annually for compliance and business line
personnel to review changes in its capacity and types and scope of
services offered, and another two hours annually for in-house counsel
to amend the account disclosure to disclose material changes to the
broker-dealer's capacity and types and scope of services offered, for a
total of seven hours. The estimated ongoing aggregate burden would
therefore 287 hours for small entity dual-registrants capacity.\686\
---------------------------------------------------------------------------
\686\ This estimate is based on the following calculation: (7
hours per small entity per year) x (41 dually-registered small
entities) = 287 hours.
---------------------------------------------------------------------------
With respect to small entity standalone broker-dealers, we estimate
they would spend two for in-house compliance and business personnel to
review and update changes in capacity or the types or scope of services
offered, and we estimate another two hours annually for in-house
counsel to amend the account disclosure to disclose material changes to
capacity or the types or scope of services for small entities--for a
total of four hours. The estimated ongoing aggregate burden would
therefore be 3,208 hours for small
[[Page 21678]]
entities for types and scope of services.\687\
---------------------------------------------------------------------------
\687\ See supra note 600.
---------------------------------------------------------------------------
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 that small entities would incur an aggregate
burden of 313.8 hours,\688\ or .39 hours per small entity.\689\
---------------------------------------------------------------------------
\688\ This estimate is based on the following calculation: (20%)
x (7,845 total small entity retail customer accounts) x (.02 hours)
= 313.8 hours.
\689\ This estimate is based on the following calculation:
(313.8 hours aggregate)/802 small entity broker-dealers = 0.39 hour.
---------------------------------------------------------------------------
b. Disclosure of Fees
As stated above, we believe that small entities would initially
spend five 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 $2,360 for small
entities for outside counsel to review the fee schedule.\690\ We
therefore estimate the initial aggregate burden for small entities to
be 4,010 burden hours,\691\ and the aggregate cost to be $1.89
million.\692\
---------------------------------------------------------------------------
\690\ See supra note 604.
\691\ See supra note 606.
\692\ See supra note 607.
---------------------------------------------------------------------------
Similar to delivery of the account disclosure document related to
capacity and types 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 hour to deliver to each retail
customer.\693\ As stated above, we estimate that the 802 small entities
that report retail activity have approximately 7,845 retail customer
accounts. We estimate that small entities will have an aggregate
initial burden of 156.9 hours,\694\ or a burden of approximately 0.19
hour per small entity for the first year after the rule is in
effect.\695\
---------------------------------------------------------------------------
\693\ See supra note 592.
\694\ This estimate is based on the following calculation: (.02
hour per account) x (7,845 total small entity retail customer
accounts) = 156.9 hours.
\695\ These estimates are based on the following calculations:
(156.9 aggregate hours)/802 small broker-dealers = 0.19 hours per
small broker-dealer.
---------------------------------------------------------------------------
We also assume that small entities would review and amend the fee
schedule, on average, once a year. We estimate that each small entity
would require approximately two hours per year to review and update the
fee schedule. Based on this estimate, we project the recurring,
aggregate, annualized burden to be approximately 1,604 hours for small
entities.\696\ We do not anticipate that small entities would 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 therefore do not expect
external costs associated with updating the fee schedule.
---------------------------------------------------------------------------
\696\ See supra note 615.
---------------------------------------------------------------------------
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. We therefore
estimate that small entities would incur a total annual aggregate
burden of 62.76 hours, or 0.07 hour per small entity.\697\
---------------------------------------------------------------------------
\697\ 40% of 7,845 retail customer accounts x .02 hours = 62.76
aggregate hours. (62.76 hours)/(802 broker-dealers) = 0.07 hour per
broker-dealer.
---------------------------------------------------------------------------
c. Disclosure of Material Conflicts of Interest
For purposes of this analysis, we assume that small entities would
use in-house counsel and outside counsel to develop a standardized
conflict disclosure a document for delivery to retail customers. We
estimate it would take in-house counsel for small entities, on average,
5 burden hours to create the standardized disclosure document, and that
outside counsel would require 5 hours to review and revise the
standardized disclosure document. The initial aggregate burden for the
development of a standardized disclosure document, based on an
estimated 802 small entities, would be approximately 4,010 burden
hours.\698\ The initial external cost for a small entity is estimated
at $2,360 per small entity.\699\ The aggregate, initial external cost
for the development of a standardized conflict disclosure document,
based on an estimated 802 small entities, would be approximately $1.89
million.\700\
---------------------------------------------------------------------------
\698\ This estimate is based on the following calculation: (5
hours) x (802 small entities) = 4,010 aggregate burden hours.
\699\ This estimate is based on the following calculation:
($472/hour) x (5 hours) = $2,360 in costs.
\700\ This estimate is based on the following calculation:
($472/hour x 5 hours) x (802 small entities) = $1.89 million in
aggregate costs.
---------------------------------------------------------------------------
We assume that small entities would initially 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 would require approximately 0.02 hours to deliver the
standardized conflict disclosure document to each retail customer.\701\
We therefore estimate that small entities would incur an aggregate
initial burden of 156.9 hours \702\ for delivery of the standardized
conflict disclosure document, or 0.19 hour per small entity.
---------------------------------------------------------------------------
\701\ See supra note 592. We have assumed any initial
disclosures made by the small entity related to material conflicts
of interest would be delivered together, and therefore have not
included delivery costs for initial delivery.
\702\ This estimate is based on the following calculation: (0.02
hour) x (7,845 retail customer accounts at small entities) = 156.9
aggregate burden hours. Conversely, (156.9 burden hours)/(802 small
entities) = 0.19 burden hour per small entity.
---------------------------------------------------------------------------
On an ongoing basis, we believe that small entities would incur
burdens and costs to update the standardized conflict disclosure
document to include newly identified conflicts annually. We assume
small entities would rely on in-house counsel and in-house compliance
personnel to update the disclosure document. We do not anticipate that
small entities would incur outside legal, compliance, or consulting
costs in connection with updating the disclosure document, since in-
house personnel would presumably be more knowledgeable about material
conflicts of interest.
We estimate that small entities would require approximately 1 hour
per year, for a recurring, aggregate burden of approximately 802 hours
per year \703\ to update the standardized conflict disclosure document.
---------------------------------------------------------------------------
\703\ This estimate is based on the following calculation: (1
hour per small entity) x (802 small entities) = 802 aggregate burden
hours.
---------------------------------------------------------------------------
With respect to the ongoing costs and burdens of delivering the
amended conflict disclosure document, we estimate that this would take
place among 40% of a small entity's retail customer accounts
annually.\704\ We therefore estimate that small entities would incur an
annual aggregate burden of 62.76 burden hours, or 0.07 burden hour per
small entity.\705\
---------------------------------------------------------------------------
\704\ The Commission estimates that small entities would update
disclosures regarding fees and material conflicts of interest more
frequently than the disclosure related to capacity or type and scope
of services.
\705\ This estimate is based on the following calculation: (40%
of 7,845 retail customer accounts at small entities) x (0.02 hours)
= 62.76 burden hours. Conversely, (62.76 burden hours)/(802 small
entities) = 0.07 hour per small entity.
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3. Obligation To Exercise Reasonable Diligence, Care, Skill and
Prudence
As discussed above in Section V.B.3., we believe that the
obligation to exercise reasonable diligence, care, skill and prudence
in making a
[[Page 21679]]
recommendation would not impose additional costs or burdens on small
entities.\706\
---------------------------------------------------------------------------
\706\ For a discussion of additional costs and burdens, as well
as monetized burdens, related to the Care Obligation, see supra
Section IV.C.2.c.
---------------------------------------------------------------------------
4. Record-Making and Recordkeeping Obligations
Small entities' record-making and recordkeeping costs and burdens
associated with the proposed amendments to Rule 17a-3(a)(25) and Rule
17a-4(e)(5) are addressed below.\707\
---------------------------------------------------------------------------
\707\ For a discussion of additional costs and burdens, as well
as monetized burdens, related to Record-making and Recordkeeping,
see supra Section IV.C.2.c.
---------------------------------------------------------------------------
a. Record-Making Obligations
Proposed Rule 17a-3(a)(25) would require a broker-dealer (including
small entities) to make a record of all information collected from and
provided to the retail customer pursuant to Proposed Regulation Best
Interest. We understand that small entities 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 small entities' collection of information from retail
customers.\708\
---------------------------------------------------------------------------
\708\ As discussed above, we believe that the obligation to
exercise reasonable diligence, care, skill and prudence would not
require a small entity to collect additional information from the
retail customer beyond that currently collected in the ordinary
course of business, although a small entity's analysis of that
information and any resulting recommendation would need to adhere to
the enhanced best interest standard of Regulation Best Interest. See
supra Section II.D.2.
---------------------------------------------------------------------------
In addition, the proposed amendment to Rule 17a-3(a)(25) would
require a small entity, ``for each retail customer to whom a
recommendation of any securities transaction or investment strategy
involving securities is or will be provided,'' to make a record of the
``identity of each natural person who is an associated person, if any,
responsible for the account.'' We understand that small entities likely
make such records in the ordinary course of their business pursuant to
Exchange Act Rules 17a-3(a)(6) and (7). However, we are assuming, for
purposes of compliance with proposed Rule 17a-3(a)(25), 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 proposed Regulation Best Interest.
We believe that small entities 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 this information. We
believe that the inclusion of this information in the account
disclosure document would require, on average, approximately 1 hour per
year for outside counsel at small entities, at an average rate of $472/
hour, for an annual cost of $472 for each small entity. The projected
initial aggregate cost for small entities would be $378,544.\709\
Finally, we estimate it would require an additional 0.04 hour for the
registered representative responsible for the account (or other
clerical personnel) to fill out that information in the account
disclosure document, for an estimated total aggregate initial burden of
313.8 hours, or approximately 0.39 hour per small entity for the first
year after the rule is in effect.\710\ Because we have already included
the costs and burdens associated with the delivery of the account
disclosure document above, we need not include them in this section of
the analysis.
---------------------------------------------------------------------------
\709\ This estimate is based on the following calculation: (1
hour per small entity) x (802 small entities) x ($472/hour) =
$378,544 in aggregate costs.
\710\ These estimates are based on the following calculations:
(0.04 hour per customer account) x (7,845 customer accounts) = 313.8
aggregate burden hours. Conversely, (313.8 aggregate burden hours)/
(802 small entities) = approximately 0.39 hour per small entity.
---------------------------------------------------------------------------
We do not believe that the identity of the associated person
responsible for the retail customer's account would change.
Accordingly, there are no ongoing costs and burdens associated with
this record-making requirement of the proposed amendment to Rule 17a-
3(a)(25).
b. Recordkeeping Obligations
As described in more detail in Section V.B.4., the following
records would likely need to be retained for ``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'' pursuant to
proposed Rule 17a-3(a)(25): (1) A standardized Relationship Summary
document, developed in accordance with the rules and guidance contained
in the Relationship Summary Proposal; (2) account disclosure documents;
(3) comprehensive fee schedule; and (4) disclosures identifying
material conflicts.
We believe that small entities would utilize existing recordkeeping
systems in order to retain the records made pursuant to Regulation Best
Interest, as required under the Proposed Amendment to Rule 17a-4(e)(5).
We believe the initial burden for small entities to add new documents
or modified documents to their existing retention systems would be
approximately 1,307.5 hours.\711\ We do not believe there would be
initial costs relating to the uploading or filing of the
documents.\712\
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\711\ This estimate is based on the following calculation: (5
documents per retail customer account) x (7,845 retail customer
accounts at small entities) x (2 minute per document) = 78,450
minutes/60 minutes = 1,307.5 burden hours. See supra note 636.
\712\ As noted above, we request comment on this assumption and
whether the new requirements would pose additional costs.
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We estimate that the approximate ongoing burden associated with the
proposed amendment to Rule 17a-4(e)(5) would be 261.5 burden hours per
year for small entities.\713\ As explained above, we do not believe the
ongoing costs associated with the proposed amendment to Rule 17a-
4(e)(5) would change from small entities' current costs of compliance
with existing Rule 17a-4.\714\
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\713\ This estimate is derived from the percentage of records
that we expect to be updated annually, as described in Section
V.B.2. above, and based on the following calculation: (40% of fee
schedules x 7,845 retail customer accounts) x (2 minutes per
document) + (40% of conflict disclosures x 7,845 retail customer
accounts) x (2 minutes per document) + (20% of account opening
documents x 7,845 retail customer accounts) x (2 minutes per
document) = 7,845 minutes/60 minutes = 261.5 burden hours.
\714\ As noted above, we request comment regarding both the
frequency with which a broker-dealer would need to collect, provide,
replace or update the records made pursuant to the proposed
amendment to Rule 17a-3(a)(25), and also whether there would be
additional costs relating to ensuring compliance with the record
retention and retention schedules pursuant to Rule 17a-4.
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E. Duplicative, Overlapping, or Conflicting Federal Rules
An analysis under the RFA requires a federal agency to identify, to
the extent practicable, all relevant federal rules that may duplicate,
overlap or conflict with the proposed rule. As discussed above, the
existing regulatory regime for broker-dealers includes the DOL
Fiduciary Rule and related PTEs, in particular, the obligations that
the BIC Exemption and the Principal Transactions Exemption would
impose.\715\ However, we believe that the principles underlying
Regulation Best Interest would not conflict with and are generally
consistent with the principles underlying the DOL's approach under the
DOL Fiduciary Rule and the related PTEs, specifically the BIC Exemption
and the Principal Transactions Exemption.
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\715\ See, e.g., supra Sections I.A.2, II.B.1.a.
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F. Significant Alternatives
An RFA analysis requires a discussion of alternatives to the
proposed rule that would minimize the impact on small entities while
accomplishing the stated
[[Page 21680]]
objectives of the applicable statutes. The analysis should include: (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 under the rule for such small
entities; (3) the use of performance rather than design standards; and
(4) an exemption from coverage of the rule, or any part thereof, for
such small entities.
The Commission preliminarily does not believe that exempting any
subset of broker-dealers, including broker-dealers that are small
entities, from proposed Regulation Best Interest and the proposed
amendments to Rules 17a-3 and 17a-4(e)(5) would permit us to achieve
our stated objectives. We also do not believe it would be desirable to
establish different requirements applicable to broker-dealers of
different sizes to account for resources available to small entities.
As discussed above, we believe that the proposal would 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. For example, a primary objective of this proposal
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 exempting broker-dealers
that are small entities from proposed Regulation Best Interest and the
proposed amendments to Rules 17a-3 and 17a-4(e)(5) or subjecting these
broker-dealers to different requirements than larger broker-
dealers.\716\
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\716\ See, e.g., PIABA Letter (``Firms overcharge investors,
recommend higher fee share classes, recommend replacements of
existing mutual funds and annuities, and recommend complex products
with opaque fee structures. This conduct is not limited to one
sector of the brokerage industry--it occurs in firms both large and
small. Note further that the violations carry across the broad
spectrum of investment types.'').
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Moreover, 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).\717\ 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.
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\717\ See supra note 80 and accompanying text.
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For the same reasons, we do not believe that the clarification,
consolidation, or simplification of compliance and reporting
requirements would be appropriate for small entities. We note, however,
in crafting proposed Regulation Best Interest, we generally aimed to
provide broker-dealers flexibility in determining how to satisfy the
component obligations. For example, under proposed Regulation Best
Interest, broker-dealers would have the flexibility to establish
systems that are tailored to their business models, and to focus on
specific areas of their business that pose the greatest risk of
violating the Conflict of Interest Obligations. For instance, small
entities without conflicting business interests would require much
simpler policies and procedures than large broker-dealers that, for
example, have multiple potential conflicts as a result of their other
lines of business or their affiliations with other financial service
firms.\718\ Similarly, by not mandating the form, specific timing, or
method for delivering disclosure pursuant to the Disclosure Obligation,
we aim to provide broker-dealers flexibility in determining how to
satisfy the Disclosure Obligation depending on each broker-dealer's
business practices, consistent with the principles set forth supra
Section II.D.1.c, and in line with the suggestion of some commenters
that stressed the importance of allowing broker-dealers to select the
form and manner of delivery of disclosure.\719\ We believe that this
flexibility reflects a general performance-based approach, rather than
design-based approach in the proposal.
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\718\ See Compliance Programs of Investment Companies and
Investment Advisers, Advisers Act Release No. 2204 (Dec. 17, 2003),
available at