Recent industry developments
A. SEC adopts regulation best interest, significantly increasing standards of care and disclosure obligations
A. Regulation Best Interest (Regulation BI)
- The US Securities and Exchange Commission on June 5, 2019 voted to adopt a package of rulemakings and interpretations designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access (in terms of choice and cost) to a variety of investment services and products. Specifically, these actions include new Regulation Best Interest, the new Form consumer relationship systems (CRS) Relationship Summary, and two separate interpretations under the Investment Advisers Act of 1940. Individually and collectively, these actions are designed to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made.
- Under Regulation BI, broker-dealers must act in the best interest of the retail customer at the time a recommendation is made, without placing the financial or other interest of the broker, dealer or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer. Obligations of Care and Disclosure are similar to the fiduciary standard imposed on investment advisers (IAs) in guiding what associated persons must consider when making a recommendation and what must be disclosed in writing to the customer.
- Regulation BI requires firms to adopt policies and procedures designed to mitigate or eliminate conflicts of interest. Regulation BI becomes effective on August 5, 2019 and will include a transition period until June 30, 2020 to give firms time to come into compliance.
B. Regulation Best Interest includes the following components
- Disclosure obligation: Broker-dealers must disclose material facts about the relationship and recommendations, including specific disclosures about the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services.
- Care obligation: A broker-dealer must exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards and costs associated with the recommendation. The broker-dealer must then consider these factors in light of the retail customer’s investment profile and make a recommendation in the retail customer’s best interest. The final regulation, which is an enhancement from the proposal, explicitly requires the broker-dealer to consider the costs of the recommendation.
- Conflict of Interest obligation: The broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to identify and at a minimum disclose or eliminate conflicts of interest. This obligation, which is an enhancement from the proposal, specifically requires policies and procedures to
- Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest
- Prevent material limitations on offerings, such as a limited product menu or offering only proprietary products, from causing the firm or its financial professional to place his or her interest or the interests of the firm ahead of the retail customer’s interest
- Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time
- Compliance obligation: In an enhancement from the proposal, broker-dealers must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.
C. Form CRS relationship summary
Investment advisers and broker-dealers will be required to deliver a relationship summary to retail investors at the beginning of their relationship. Firms will summarize information about services, fees and costs, conflicts of interest, legal standard of conduct, and whether or not the firm and its financial professionals have disciplinary history. The relationship summary will have a standardized question- and-answer format to promote comparison by retail investors in a way that is distinct from existing disclosures. The relationship summary will permit the use of layered disclosure so that investors can more easily access additional information from the firm about these topics. It also will highlight the Commission’s investor education website, lnvestor.gov, which offers the investing public educational information, including a series of educational videos designed to provide ordinary investors with some basic information about broker-dealers and investment advisers.
D. Investment adviser interpretation
An investment adviser owes a fiduciary duty to its clients under the Advisers Act – a duty that is established by and enforceable through the Advisers Act. This duty is principles-based and applies to the entire relationship between an investment adviser and its client. The final interpretation reaffirms, and in some cases clarifies, certain aspects of the federal fiduciary duty that an investment adviser owes to its clients.
E. Solely incidental interpretation
The broker-dealer exclusion under the Advisers Act excludes from the definition of investment adviser – and thus from the application of the Advisers Act – a broker or dealer whose performance of advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation for those services. The interpretation confirms and clarifies the Commission’s interpretation of the ‘solely incidental’ prong of the broker-dealer exclusion of the Advisers Act. Specifically, the final interpretation states that a broker-dealer’s advice as to the value and characteristics of securities or as to the advisability of transacting in securities falls within the ‘solely incidental’ prong of this exclusion if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.
B. SEC grants exemptive relief to Precidian for actively-managed, non-fully-transparent ETFs
On May 20, 2019, the SEC issued an order granting Precidian ETFs Trust et al (Precidian) exemptive relief that will permit Precidian to operate non-fully-transparent actively-managed exchange-traded funds (ETFs). This is the first exemptive relief of its kind, as all prior actively-managed ETF exemptive orders included a condition requiring the ETF to disclose its portfolio holdings daily. Precidian’s funds are called “ActiveShares ETFs”.
As background, shares of ETFs trade on an exchange and can be purchased and redeemed directly from the fund only in creation unit aggregations by authorized participants. Many (but not all) ETFs transact in kind, meaning authorized participants purchase creation units by exchanging a specified basket of securities and other instruments for ETF shares and receive a basket upon redemption of a creation unit. The market price of an ETF’s shares generally remains at or close to the net asset value of the shares as a result of the arbitrage opportunities that exist based on the ability of authorized participants to create and redeem shares with the ETF, as well as the availability of information about the ETF’s portfolio.
Cases and administrative proceedings
A. SEC announces results of Share Class Selection Disclosure Initiative
On March 11, 2019, the SEC announced that it had settled charges against 79 investment advisers in connection with its Share Class Selection Disclosure Initiative (SCSD Initiative). This initiative was an enforcement program offering settlement terms for investment advisers that self-report circumstances in which they did not adequately disclose certain conflicts of interest relating to the sale of more expensive mutual fund share classes when lower-cost share classes of the same fund were available. According to the SEC, the self-reporting advisers, some of whom were dually registered as broker-dealers, did not adequately disclose either their receipt of 12b-l fees or “additional compensation received for investing clients in a fund’s 12b-1 fee-paying share class when a lower-cost share class was available for the same fund.” Per the terms of settlements under the SCSD Initiative, self-reporting advisers were found to have violated Section 206(2) and, except for advisers registered with a state and not the SEC, Section 207 of the Investment Advisers Act of 1940.
The SEC’s Division of Enforcement announced the SCSD Initiative in February 2018, citing a significant concern that advisers across the industry were not fully disclosing all material conflicts of interest relating to mutual fund share class selection practices in a manner consistent with their obligations as fiduciaries under the Advisers Act.
Led by the Enforcement Division’s Asset Management Unit, the SCSD Initiative sought to address the issue of undisclosed conflicts of interest on an industry-wide basis by offering to recommend standardized terms of settlement as an incentive for advisers to self-report. As part of the SCSD Initiative, the Enforcement Division indicated that it would recommend that the SEC accept settlements in which the self-reporting adviser would be required to disgorge ill-gotten gains and pay prejudgment interest but would face no additional civil monetary penalty.
As part of the settled charges, the self-reporting advisers agreed, without admitting or denying the SEC’s findings, to return, in the aggregate, more than US$125m to their respective affected advisory clients and to undertake certain remedial actions concerning their relevant disclosure documents. The terms of the actual settlements were consistent with the framework of standardized settlement terms set forth in the SCSD Initiative.
B. Supreme Court clarifies standard for liability under Rule 10b-5 for dissemination of false or misleading statements
On March 27, 2019, the US Supreme Court ruled 6-2 in Lorenzo v. SEC, a Rule 10b-5 case, that “dissemination of false or misleading statements with intent to defraud can fall within the scope of subsections (a) and (c) of Rule 10b-5, as well as the relevant statutory provisions … even if the disseminator did not ‘make’ the statements and consequently falls outside subsection (b) of the Rule.”
The Lorenzo case involved a director of investment banking at a registered broker-dealer who was alleged to have sent false and misleading emails to investors, at the direction of his superior, in connection with a convertible debenture offering for which the broker-dealer was serving as placement agent. According to the decision, the emails in question contained numerous false and misleading statements. Also according to the decision, the petitioner’s superior supplied the content of these false statements, which the petitioner copied and pasted into the body of the emails.
The Court of Appeals for the DC Circuit concluded that, under the Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders, the petitioner was not the maker of these misstatements for purposes of subsection (b)’s prohibition. However, the DC Circuit also concluded that the petitioner, having acted with scienter, could still be liable under subsections (a) and (c), which, respectively, prohibit “employ[ing] any device, scheme, or artifice to defraud,” and “engaging] in any act, practice, or course of business which operates or would operate as a fraud or deceit... in connection with the purchase or sale of any security.”
The Supreme Court affirmed this conclusion, distinguishing the case from Janus. As the Court noted, Janus interpreted subsection (b), finding that only the maker of a false statement may be held liable for it under subsection (b), but did not reach the question of how Rule 10b-5 applies to the dissemination of false or misleading information more generally. Characterizing petitioner’s conduct as a “paradigmatic example of securities fraud,” the Court determined that subsections (a) and (c) were “sufficiently broad to include within their scope the dissemination of false or misleading information with the intent to defraud.
The Court in Lorenzo therefore rejected petitioner’s argument that, under Janus, subsection (b) “exclusively regulated conduct involving false or misleading statements [emphasis in original]” and thus informed the scope of subsections (a) and (c), observing that such a standard would mean that ‘those who disseminate false statements with the intent to cheat investors might escape liability under the Rule altogether.” The Court did, however, emphasize that Janus “would remain relevant (and preclude liability) where an individual neither makes nor disseminates false information [emphasis in original]. The Court also maintained that its ruling would not erode the distinction between primary and secondary liability since “it is hardly unusual for the same conduct to be a primary violation with respect to one offense and aiding and abetting with respect to another.”
C. Dually-Registered broker-dealer and investment adviser settles SEC action pertaining to directed brokerage arrangements
On March 5, 2019, the SEC announced a settled cease-and-desist order against BB&T Securities, a dually-registered broker-dealer and investment adviser (BB&T), relating to alleged violations of Sections 206(2) and 207 of the Advisers Act that the SEC claimed had misled clients about their brokerage options. Without admitting or denying the SEC’s findings, the BB&T agreed to a censure and payment of a US$500,000 penalty, disgorgement of US$4,712,366 and prejudgment interest of US$497,387.
According to the order, Valley Forge Asset Management (the asset manager), a dually-registered broker- dealer and investment adviser that BB&T’s parent company acquired in 2015, made misleading statements and inadequate disclosures regarding the costs and benefits of its in-house brokerage services. The order further indicates that the asset manager promised a “high level of service at a low cost,” but did not actually provide additional services to advisory clients that used its in-house broker rather than other brokers with lower commission rates. Additionally, the order states that the asset manager claimed to give its clients a 70 percent discount on its “retail commission rate,” but clients paid approximately 4.5 times more than what they would have paid to a third-party broker-dealer, resulting in clients paying the asset manager more than US$4.7m in excess compensation.