Presented by the Securities and Investment Professional Liability Practice Group

Legal Updates for Securities - June 5, 2019

SEC Adopts a New Standard for Broker-Dealer Conduct and Clarifies the Standard for Incidental Investment Advice

by John P. Quinn, Esq.

At today’s meeting of Commissioners, the Securities & Exchange Commission formally adopted a rule intended to heighten the business conduct standards for broker-dealers and an interpretation intended to clarify when broker-dealers and associated persons must register under the Investment Advisers Act of 1940  The rule and interpretation, which were initially proposed in April 2018, are part of the SEC’s initiative to enhance disclosure obligations and elevate retail customers’ interests above the financial interests of securities brokers.

Best Interest Rule for Broker-Dealers

Regulation Best Interest (“Reg BI”) establishes a new, enhanced standard of conduct for broker-dealers recommending securities transaction or investment strategies to retail investors. Reg BI also applies to account recommendations, such as recommendations to roll over or transfer assets in a workplace retirement account to an IRA, recommendations to open particular securities accounts (e.g., brokerage or advisory accounts), and recommendations for plan distributions. 

The regulation mandates that the broker-dealer, in making any such recommendation, act in the retail customer’s “best interest” by not placing the interests of the broker ahead of the interests of the retail customer.  In effect, Reg BI applies certain fiduciary principles to the brokerage industry, but does not necessarily establish a fiduciary relationship between the broker and the customer.  The regulation explicitly requires brokers to exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. This requires the broker to understand potential risks, rewards, and costs associated with a recommendation, and then consider those risks, rewards, and costs in light of the customer’s investment profile.  Considering all of the foregoing, the broker must have a reasonable basis to believe that the recommendation is in the customer’s best interest, and must not place the broker’s interest ahead of the retail customer’s interest.  Moreover, when recommending a series of transactions, the broker must have a reasonable basis to believe that the transactions taken together are not excessive, even if each separate transaction is in the customer’s best interest when viewed in isolation.

Additionally, Reg BI imposes certain disclosure obligations before or at the time of the recommendations.  Specifically, a broker-dealer must disclose, in writing, material facts about the scope and terms of its relationship with the customer, including disclosure of: (a) the broker-dealer relationship between the firm or representative and the customer; (b) the material fees and costs the customer will incur in the transaction(s); and the services to be provided, including any material limitations on the recommendations that could be made to the retail customer (e.g., whether account monitoring services are offered, or whether there are limitations to the securities offered to a retail customer). All conflicts of interest that may cause a broker-dealer to make a recommendation that is beneficial to the broker, such as sales of proprietary products, payments from third parties, and broker-dealer compensation arrangements, must also be disclosed before or at the time of any recommendation.

Broker-dealers must adopt written policies and procedures to achieve compliance with Regulation Best Interest in its entirety.  This includes policies and procedures necessary to identify, disclose and mitigate conflicts of interest that create incentives for associated persons to place the broker’s interests above the customer’s interest.

Interpretation of the Broker-Dealer Exclusion Under the Investment Advisers Act

Under the Investment Advisers Act, broker-dealers and their associated persons are exempt from registration if they provide investment advice that is “solely incidental” to their brokerage relationship with a client and they receive no special or additional compensation for the advisory services (known as the “broker-dealer exclusion”).  In Wednesday’s release, the SEC clarified the standard for “solely incidental.” 

For many years, the SEC permitted broker-dealers to exercise investment discretion over customer accounts without requiring such brokers to register as investment advisers.  In 2005, however, the SEC amended its interpretation of the broker-dealer exclusion, requiring brokers who exercise more than temporary or limited investment discretion over accounts to register as investment advisers. 

The new interpretation issued by the SEC clarifies the circumstances in which broker-dealers and associated persons will be required to register under the Investment Advisers Act.  The final interpretation concludes that advice as to the value and characteristics of securities or as to the advisability of transacting in securities falls within the “solely incidental” prong of the broker-dealer exclusion if such advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.  Ongoing and unlimited investment discretion over clients’ accounts, as well as general investment advice unrelated to securities brokerage services will be considered investment advice, and will subject the broker or associated person to registration.

Form CRS

In addition to the above rule and interpretation, the SEC also adopted a new form for broker-dealers and investment advisers called Form CRS (Client Relationship Summary).  For broker-dealers, Form CRS will be filed through the SEC’s EDGAR system in text-searchable format and must be provided to clients before or at the time the client engages the broker’s services.  Broker-dealers must update Form CRS within thirty (30) days of any material changes to the information, and must be delivered to clients within thirty (30) days after material changes to the form are filed through EDGAR. 

Form CRS will require brokers to provide narrative explanations of: (1) the nature of the firm (broker-dealer, investment adviser, dual-registered, etc.), (2) a graphic description of the relationship and services offered to the client, (3) the standard of conduct owed to the client (e.g., fiduciary duty), (4) a summary of fees and costs; (5) a chart comparing the firm’s services to other types of services (e.g., RIA services versus broker-dealer services), (6) conflicts of interest, and (7) additional information and sample key questions for clients to ask. 


The mandates of Reg BI and Form CRS will take effect 60 days after the publication of the rule in the Federal Register (which will usually be completed within a week to 10 days).  The interpretation of solely incidental investment advice will take effect immediately upon publication in the Federal Register.