Regulation Best Interest

Federal RegisterMay 9, 2018

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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.

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

rule-comments@sec.gov.

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

(

i.e.,

full-service brokerage).

Broker-dealers are typically considered to provide advice when they make recommendations of securities transactions or investment strategies involving securities to customers.

Broker-dealers also may offer a variety of dealer (

i.e.,

principal) services and investment products to retail customers,

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.

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.

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.

See

913 Study at 124.

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.

Id.

at 13.

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,

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.

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.

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.

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-

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.

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.

• 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.

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”).

• 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,

which, among other things, requires broker-dealers to make only suitable recommendations to customers

and to receive only fair and reasonable compensation.

Broker-dealers are also subject to general and specific requirements aimed at addressing certain conflicts of interest, including

requirements to eliminate,

mitigate,

or disclose certain conflicts of interest.

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).

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.

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).

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.

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

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).

A broker-dealer may be liable if it does not disclose “material adverse facts of which it is aware.”

See, e.g., Chasins

Smith, Barney & Co.,

438 F.2d 1167, 1172 (2d Cir. 1970);

SEC

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

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).

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.”

Like many principal-agent relationships, the relationship between a broker-dealer and a retail customer has certain inherent and unavoidable conflicts of interest.

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.

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

Skelly,

442 F.3d 94, 98 (2d Cir. 2006);

United States

Szur,

289 F.3d 200, 211 (2d Cir. 2002);

Associated Randall Bank

Griffin, Kubik, Stephens & Thompson, Inc.,

3 F.3d 208, 212 (7th Cir. 1993);

MidAmerica Fed. Savings & Loan Ass'n

Shearson/American Express Inc.,

886 F.2d 1249, 1257 (10th Cir. 1989);

Leib

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

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.

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).

See infra

Section II.D.3.

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.

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”).

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.

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.

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.”

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

SEC.,

482 F.3d 481 (D.C. Cir. 2007).

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

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.

Most notably, in 2013, FINRA published a report on conflicts of interest in the broker-dealer industry to highlight effective conflicts management practices.

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.”

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.”

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).

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).

See

FINRA Report on Conflicts of Interest (Oct. 2013),

available at https://www.finra.org/sites/default/files/Industry/p359971.pdf

(“FINRA Conflicts Report”).

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

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

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

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.

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.

Commenters assert

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.”

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.

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”)).

CFA 2017 Letter.

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”).

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.

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.

Moreover, the Commission is aware that certain conflicts of interest are inherent in other principal-agent relationships.

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.

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).

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.

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.

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.

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.

See

Release 51523;

see also

Request,

infra

note 40.

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.

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.”

See

913 Study,

supra

note 1.

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.

Id.

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.

See

913 Study at viii, x, 101, 109, 166.

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.

The Request

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.

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

The Commission received more than 250 comment letters from industry groups, individual market participants, and other interested persons in response to the Request.

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.

Comments submitted in response to the Request are

available at https://www.sec.gov/comments/4-606/4-606.shtml

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).

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).

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.

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.

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.”

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.

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.

Id.

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”).

Commission staff provided DOL staff with technical assistance and expertise on our regulatory regime as DOL developed its rulemaking.

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.

See id.

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”).

On March 15, 2018, the DOL Fiduciary Rule was vacated by the United States Court of Appeals for the Fifth Circuit.

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.

Chamber of Commerce of the U.S.A., et al.

U.S. Dep't of Labor, et. al.,

No. 17-10238 (5th Cir.) (Mar. 15, 2018).

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.

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.

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

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.

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.”

See

BIC Exemption Release at 21002.

See generally

BIC Exemption; Principal Transactions Exemption,

infra

note 55.

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”).

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.

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).

See generally

BIC Exemption; Principal Transactions Exemption.

Specifically, the BIC Exemption would provide conditional relief for an “adviser,” as that term is used in the context of the BIC Exemption,

and the adviser's firm, to receive common forms of “conflicted” compensation, such as commissions and third-party payments (such as revenue sharing), provided that the adviser's firm meets certain conditions.

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).

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.

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.

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.

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.

See

BIC Exemption Release.

See

BIC Exemption.

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)

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,

as well as a contract requirement and a policies and procedures warranty that mirror the requirements in the BIC Exemption.

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.

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.

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).

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

See

Principal Transactions Exemption; DOL November Extension.

The revised definition of “fiduciary,” as well as the Impartial Conduct Standards, became effective on June 9, 2017.

Compliance with the remaining

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.

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.

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.gpo.gov/fdsys/pkg/FR-2017-04-07/pdf/2017-06914.pdf. But see Chamber of Commerce of the U.S.A., et. al.

U.S. Dep't of Labor, et. al.,

No. 17-10238 (5th Cir.) Mar. 15, 2018).

See

DOL November Extension.

Id.

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.

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.

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.

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

See

Chairman Clayton Statement.

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

and offered other options,

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

or, alternatively, a standard of conduct that uniformly applies to investment advisers and broker-dealers.

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).

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).

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).

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).

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).

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,

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.

See, e.g.,

BlackRock Letter; ICI August 2017 Letter.

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.”).

See, e.g.,

AARP Letter.

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”).

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).

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.

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).

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).

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.

Id.

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.

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.

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,

and we believe that such investors may prefer a commission-based brokerage

relationship over a fee-based account.

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.

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.”)

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).

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.

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.”).

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.

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.

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.

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.

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.

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.

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

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.

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”).

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.

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”).

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”);

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.

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.

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.”).

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.

See supra

note 7.

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.

See, e.g.,

SIFMA 2017 Letter.

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

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

and the 913 Study recommendation,

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).

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),

and we believe that our proposed formulation appropriately reflects what we believe is the underlying intent of the “without regard to . . .” formulation.

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.

See infra

Section II.D.2.d.2 for a further discussion of how proposed Regulation Best Interest compares to the 913 Study recommendations.

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.

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.

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.

Among other things, Dodd-Frank Act Section 913(g) expressly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities shall not, in and of itself, violate any uniform fiduciary standard promulgated under that subsection's authority as applied to a broker-dealer.

Moreover, Section 913(g) does not itself require the imposition of the principal trade provisions of Advisers Act Section 206(3) on broker-dealers.

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

See

discussion

infra

Section II.D.2.d.2.

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.

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

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.

103

See

discussion

infra

Section II.D.

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

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

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.

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.

105

See

discussion

infra

Section II.D.1.

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.

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.”).

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-

See also

Exchange Act Sections 10(b) and 15(c).

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

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.

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

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.

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

See

Fiduciary Duty Interpretive Release.

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

See

913 Study at 112-13.

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

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.

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.

130

See infra

discussion in Section II.D.1 and 2 comparing the Care and Conflict recommendations of the 913 Study.

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

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 performin

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