Fall Regulatory Update: Developments RIAs should track

Regulatory seal

Key Points

  • Shifting regulatory landscape and interpretations force advisors to take action.

  • Schwab's legal expert provides insights on Regulation Best Interest and what it means for RIAs, what to include on Form CRS, and the new "standard of conduct" interpretations.

  • Below is a roundup of developments to monitor in the months ahead. We talked with Steve Johnson, Schwab vice president and associate general counsel for Schwab Advisor Services™ and Digital Services, about the new Securities and Exchange Commission (SEC) rules, Regulation Best Interest (Reg BI), and Form CRS (Client Relationship Summary), along with new interpretations under the Investment Advisers Act. Get up to speed on the details advisors should include on their Form CRS by the June 30, 2020, compliance date, as well as evolving disclosure expectations, recent enforcement actions, and new proxy voting guidance.

    1. Reg BI rules package

    On June 5, the SEC adopted a series of new rules and interpretations designed to enhance the quality and transparency of retail investors' relationships with investment advisors and broker-dealers (BDs).

    The two new rules include:

    1. Reg BI, which requires BDs and their representatives to act in the best interest of a retail customer when making recommendations.
    2. Form CRS, which requires BDs and investment advisors to provide retail investors with simple, easy-to-understand information about the nature of their relationship with their financial professional.

    The two new interpretations under the Investment Advisers Act focus on:

    1. Reaffirming and, in some cases, clarifying the standard of conduct for Registered Investment Advisors (RIAs).
    2. Clarifying the "solely incidental" brokerage advice exemption.

    Reg BI. Highlighted by Reg BI, the reform package seeks to raise the broker standard above suitability while preserving investor choice and access to services. According to Johnson, the SEC intentionally chose not to adopt uniform standards for BDs and investment advisors, but both BDs and investment advisors are now required to act in the client's best interest.

    What does that mean for advisors?

    Despite looking like a fiduciary duty, the new best-interest standard of conduct for BDs and their reps is described by the SEC as "similar but not the same." The key difference is a best-interest obligation that is transactional versus an overarching relationship. Reg BI requires BDs and their reps to act in a retail customer's best interest at the time of a recommendation and not place the BD's interest ahead of the customer's. Compare that with an investment advisor's fiduciary duty, which requires ongoing monitoring and is not limited to a transaction or recommendation.

    To demonstrate acting in a client's best interest, BDs must meet four distinct obligations:

    1. Disclosure. BDs must disclose the terms of the broker-dealer and client relationship and all material conflicts of interest before or when making a recommendation.
    2. Care. Reg BI creates a duty-of-care obligation that builds upon principles from the standard of care in the Department of Labor fiduciary rule and FINRA suitability standards.
    3. Conflicts of interest. The standard of conduct applies to specific buy, sell, and hold recommendations, as well as recommendations to follow a particular investment strategy or to roll over from a 401(k) to an Individual Retirement Account. It goes further here for BDs and includes recommendations about account types, opening an account, and transferring assets into an account.
    4. Compliance policies. BDs must establish and enforce policies and procedures to identify, disclose, and mitigate conflicts of interest.

    Form CRS. The new disclosure rule requires both BDs and RIAs to deliver a standardized two-page disclosure document (four pages for dually registered firms) to retail investors as Part 3 of their Form ADV. Delivery must be made at the point a relationship begins—at account opening. The summary must include information about services provided, fees and costs, conflicts of interest, legal standard of conduct, and any disciplinary history related to the firm or the advisor. While the SEC will not provide a standardized template, it did provide guidance on format, content, and delivery requirements.

    Standard of conduct for RIAs. To clarify its views on the fiduciary standard of conduct for RIAs, the SEC reaffirmed that a principles-based standard continues, while recognizing that the duty looks different for retail versus institutional investors. Johnson says that the SEC also acknowledged that while advisors do have some ability to shape the fiduciary duty by contract, their fiduciary duty cannot be waived. An example of shaping the fiduciary duty might be the business decision to provide ongoing portfolio management versus a one-time financial plan. The "consent to conflicts" is an objective standard and is not subjective to each individual investor. Advisors may want to review their own disclosures and best execution procedures to ensure accuracy and compliance. Look for and eliminate problematic uses of "may" or "potential conflict," as these statements are inadequate if a conflict does exist. According to the guidance, account recommendations are subject to fiduciary obligation, including rollover recommendations.

    "Solely incidental" brokerage advice exclusion. The SEC issued guidance to clarify and confirm the 80-year-old "solely incidental" exception to the Investment Advisers Act, which allows BDs to provide some investment advice without having to register as investment advisors but does not allow them to be compensated. The new interpretation clarifies that advice about the "value and characteristics" of securities or about transacting them is allowed in the normal course of business.

    Effective dates: The Reg BI and Form CRS rules will become effective 60 days after their publication in the Federal Register, and firms must be prepared to comply with them by June 30, 2020. The standard of conduct for RIAs and the "solely incidental" brokerage advice exclusion interpretations are effective immediately.

    2. What's changed and who's impacted

    In general, the new rules package affects BDs and dual-registrants more than RIAs, says Johnson, and the independent BD model bears the most onerous load of the new compliance obligations. For RIAs, the most complex issue will be Form CRS—understanding the nuances of the SEC's requirements and guidance, and how that translates into a final form. Advisors must file a completed relationship summary with the SEC and begin delivery to their current and prospective retail clients by the June 30, 2020, deadline.

    3. Generally good news for the RIA business model

    Johnson says the rules package preserves the distinction between BDs and RIAs. The SEC did adopt a uniform standard of care. However, this distinction is now more difficult to determine solely based on standard of care. Because Form CRS requires BDs and RIAs to use the same best-interest language, Johnson says that firms may want to review and elaborate on any marketing materials that use the term "best interest" to differentiate their services.

    4. Schwab's advocacy for advisors

    Throughout the proposal period, Schwab's advocacy spanned several channels. These included meetings with senior staff and commissioners, participation in working groups from other industries, and submitting comment letters regarding Form CRS. One of Schwab's major advocacy arguments was that the SEC should not force RIAs to talk about BD services and vice versa. As initially proposed, an advisor would have had to provide disclosures about a brokerage account. "And that just didn't make sense to us," says Johnson. "We argued that investors care about their relationship—and the account type they are considering. As part of that, we argued against the proposed title of Form CRS for RIAs: ‘Is an Advisory Account Right for You?' because it undermines customer choice and is potentially confusing."

    Schwab also argued that more disclosure doesn't mean better disclosure. Schwab urged the SEC to streamline and simplify its Form CRS to one page that would highlight only key information and include hyperlinks to more detailed information—including Form ADV—for clients who want it. To give investors the clarity they need, Schwab presented an alternative version of the disclosure to the SEC that simplifies the information in an easier-to-read format.

    "In the end," says Johnson, "we were pleased to see that our advocacy helped to streamline and simplify some of the requirements and guidelines around Form CRS. A more critical win was the SEC dropping its considerations of new rules for RIAs from its initial proposal."

    Read our comment letter to the SEC to learn more about how Schwab advocates on your behalf.

    5. Deep dive: Form CRS and practical next steps

    Even after reading the 524 pages of the final rule, says Johnson, it may still be difficult to understand exactly what needs to be covered in the Client Relationship Summary, on top of the specific formatting guidelines outlined by the commission. Advisors should consult the Form CRS instructions, which can be found on the SEC's website in Appendix B of the published final rule document.

    At a high level, the key components are as follows:

    Introduction. Not much creativity is possible here—simply follow the instructions.

    Version date. You must include the date of the current version being distributed. For every updated version of the relationship summary, you'll need to update this notation.

    Five mandatory headings. The SEC set forth five mandatory headings, phrased as questions. Each of your disclosures must tie back to each question, in the correct order.

    Disclosures. With each of your disclosures that respond to the questions, you should be clear and concise and demonstrate your consideration of the retail investor's level of financial expertise. Use plain, jargon-free English, speak in absolutes, and consider using graphics or text features within your disclosure to provide additional explanations or supplemental information.

    Prescribed language. The SEC provided specific language that must be included in disclosures pertaining to costs and standard of conduct. Review these guidelines, and prepare your staff to talk about this language when clients bring up questions.

    Conversation starters. The form's seven conversation starters are specific questions intended to encourage retail investors to "initiate and engage in useful and informative conversations with their investment professionals" about their circumstances. Be prepared to engage in a dialogue covering each question, should clients ask.

    The filing period for Form CRS opens May 1 through June 30, 2020. And if you haven't already done so, Johnson says that you may want to begin preparing your Client Relationship Summary now or in conjunction with your annual ADV filing. Both electronic and paper delivery of Form CRS are permitted.

    Next steps. Advisors should consider taking action quickly, as the compliance deadline for Form CRS will come sooner than you think. Here are some measures you can take:

    • Identify the team responsible for disclosures.
    • Inventory all disclosures, and make sure they are consistent.
    • Create guidelines/stylebook.
      • Pay particular attention to the use of the words "may" and "potential conflict."
    • Plan for lead times.
    • Draft Form CRS.
      • Consider delivery requirements.
      • Consider filing and recordkeeping requirements.
    • Review agreements with clients to make sure the scope of the advisory relationship is defined accurately.

    6. Evolving disclosure expectations and recent enforcement actions

    In February 2018, the SEC launched the Share Class Disclosure Initiative. In March 2019 and again in September, the SEC released details on the settlements of enforcement actions against advisors who failed to disclose that they received 12b-1 fees paid by their customers.

    SEC scrutiny on compensation conflicts is evolving. Phase one focused on enforcement actions against advisors who self-reported that they failed to adequately disclose their receipt of 12b-1 fees. Phase two has focused on advisors who did not self-report under the initiative. On September 30, the SEC cited an additional 16 firms that self-reported and 1 firm that did not self-report, bringing the total to 96 firms cited by the SEC and over $135 million paid back to investors. And phase three, beginning in Q3 2019, focuses on disclosure of other financial incentives.

    Johnson says the SEC is not just focused on 12b-1 fees but on all revenue streams from custodians and fund companies that create conflicts of interest.

    7. New proxy voting guidance

    Effective immediately, the SEC's new guidance in this area is meant to clarify how an advisor's fiduciary duty and Rule 206(4)-6 of the Advisers Act relate to their proxy voting on behalf of their clients, particularly if the advisor retains a proxy advisory firm.

    For advisors who retain proxy advisory firms, the guidance outlines that there is an expectation that advisors are monitoring the advice they are receiving. In this case, it's critical that advisors have policies and procedures in place that ensure the recommendations are accurate, complete, and in the best interest of the client. "Even if you decide you will not be exercising voting authority on behalf of your clients, you should still have a written policy in place that outlines this practice," says Johnson.

    Here are a few key takeaways for advisors from the SEC's recent proxy voting guidance:

    Investment advisors

    • Fiduciary duty to vote in client's best interest.
    • To comply, advisors must:
      • Determine the scope of authority and responsibilities to vote proxies on behalf of clients.
      • Demonstrate that voting is done in the client's best interest and in accordance with policies and procedures.
      • Consider the capacity and competency to adequately analyze the applicable voting matters, when retaining a proxy advisory firm.
      • Ensure that voting is based on accurate and complete information.
      • Perform ongoing assessments of the proxy advisory firm.
      • Determine whether the advisor should refrain from voting.

    Proxy advisory firms

    • Advice constitutes a "solicitation" under the federal proxy rules.
    • Rule 14a-9 applies to the services and activities of proxy advisory firms.
    • To comply, proxy advisory firms must establish detailed policies and procedures to ensure that recommendations are accurate and complete in all material respects.

    Insights to help you stay informed and prepared

    As these and other regulatory issues continue to unfold, keep reaching out to your own compliance contacts and legal counsel for guidance. Schwab Advisor Services™ also provides access to current news, analysis, and an extensive library of resources on our Legislative & Regulatory Affairs page.

    We hope these tips help you guide your firm and clients as regulatory issues continue to evolve. 

    If you're thinking about becoming an independent advisor, consider a custodian that invests in your success. Contact us to learn more about the benefits of a custodial relationship with Schwab.