appropriate, the explicit minimum standards of conduct relating to the
duty of care currently applicable to broker-dealers (e.g., suitability,
best execution, and fair pricing and compensation requirements).\281\
The 913 Study stated that the standards could also take into account
Advisers Act principles related to the duty of care.\282\
---------------------------------------------------------------------------

    \279\ See 913 Study at 112.
    \280\ Id. at 123.
    \281\ Id. at 122.
    \282\ Id. at 123. See also Fiduciary Duty Interpretive Release,
discussing, among other things, investment advisers' duty of care.
---------------------------------------------------------------------------

    As part of the proposed care obligation under Regulation Best
Interest, we are only proposing an obligation with respect to the basis
a broker-dealer must have in making a recommendation to a retail
customer, and are not proposing the other aspects of the duty of care
that are specified in the 913 Study--notably best execution and fair
pricing and compensation requirements--as the Commission does not
believe that it is necessary to do so at this time. As noted in the 913
Study,\283\ broker-dealers currently are subject to explicit standards
of conduct relating to best execution \284\ and fair and reasonable
compensation,\285\ and preliminarily we do not believe that
enhancements to these obligations are required in connection with this
proposal.
---------------------------------------------------------------------------

    \283\ See 913 Study at 121.
    \284\ Under the antifraud provisions of the federal securities
laws and SRO rules, broker-dealers also have a legal duty to seek to
obtain best execution of customer orders, which requires broker-
dealers to seek to execute customers' trades at the most favorable
terms reasonably available under the circumstances. See, e.g.,
Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d
266, 269-70 (3d Cir.), cert. denied, 525 U.S. 811 (1998); Certain
Market Making Activities on Nasdaq, Exchange Act Release No. 40900
(Jan. 11, 1999) (citing Sinclair v. SEC, 444 F.2d 399 (2d. Cir.
1971); Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18,
1948) (Commission Opinion), aff'd sub nom. Hughes v. SEC, 174 F.2d
969 (DC Cir. 1949). See also Order Execution Obligations, Exchange
Act Release No. 37619A (Sept. 6, 1996) (``Order Handling Rules
Release''). See also Regulation NMS, Exchange Act Release No. 51808
(June 9, 2005) (``Regulation NMS Release''); FINRA Rule 5310 (``Best
Execution and Interpositioning'').
    \285\ FINRA Rule 2121 (``Fair Prices and Commissions'').
---------------------------------------------------------------------------

    Moreover, the 913 Study noted that the staff's recommendation to
specify these aspects of the duty of care was partly based on the need
to provide guidance to both investment advisers and broker-dealers of
their obligations under the recommended uniform fiduciary duty.\286\ In
particular, the Study recognized that ``detailed guidance'' regarding
the duty of care, and particularly the duty to provide suitable
investment advice ``has not been a traditional focus of the investment
adviser regulatory regime.'' \287\ In a concurrent release, we are
providing interpretive guidance that reaffirms--and in some cases
clarifies--certain aspects of the fiduciary duty that an investment
adviser owes to its

clients.\288\ As the proposed Regulation Best Interest is not based on
the Advisers Act and would not apply to investment advisers, but rather
is a new standard that would be unique to broker-dealers, taking into
consideration the existing requirements of the broker-dealer regulatory
regime, the Commission preliminarily does not believe that the Study's
recommendations related to these other obligations are relevant here.
---------------------------------------------------------------------------

    \286\ See 913 Study at 122-23.
    \287\ Id. at 123.
    \288\ See Fiduciary Duty Interpretive Release.
---------------------------------------------------------------------------

    Although we are not proposing a fiduciary duty that includes a duty
of care for broker-dealers, it is important to note that we believe
that the proposed care obligation under Regulation Best Interest, in
combination with existing broker-dealer obligations (such as best
execution), is generally consistent with the underlying principles of--
albeit more prescriptive than-- the duty of care enforced under the
Advisers Act. We believe any differences in the articulation of these
standards for broker-dealers, as compared to investment advisers, is
appropriate given differences in the structure and characteristics of
their relationships with retail customers, to preserve and incorporate
existing guidance and interpretations related to broker-dealer
suitability obligations, and to provide clarity to how Regulation Best
Interest would change existing obligations.
e. Request for Comment on Proposed Care Obligation
    The Commission requests comment generally on the proposed care
obligation. In addition, the Commission seeks comment on the following
specific issues:
     Would the Care Obligation cause a broker-dealer to act in
a manner that is consistent with what a retail customer would
reasonably expect from someone who is required to act in their best
interest? Why or why not?
     Under the Care Obligation, a broker-dealer must exercise
reasonable diligence, care, skill, and prudence when making a
recommendation, including assessing the potential risks and rewards
associated with the recommendation. Do commenters believe that
Regulation Best Interest is sufficiently clear that a broker-dealer and
its associated natural persons may make a recommendation which may
result in investor losses due to market or other risks inherent in
investing?
     Has the Commission provided sufficient guidance on how a
broker-dealer can satisfy each component of the Care Obligation?
     Do commenters believe the proposed Care Obligation
enhances broker-dealers' existing suitability obligations?
     Are there aspects of a broker-dealer's existing
suitability obligations that the Commission should not incorporate? Are
there additional obligations that the Commission should incorporate? If
so, which ones and why?
     As noted, the Commission is not proposing additional
aspects of the duty of care that are specified in the 913 Study--
notably best execution and fair pricing and compensation requirements,
as broker-dealers are currently subject to explicit standards of
conduct relating to best execution and fair and reasonable
compensation. Do commenters agree that enhancements to these
obligations are not required at this time? If not, please explain why.
     Is there sufficient clarity regarding how a broker-dealer
``exercises reasonable diligence, care, skill, and prudence''? In
addition, is ``prudence'' a sufficiently clear term when referring to
the broker-dealer's Care Obligation? Should the Commission consider
another formulation for this obligation? If so, what language would be
clearer?
     Is there sufficient clarity regarding how a broker-dealer
determines if it has a reasonable basis to believe that the
recommendation in the best interest of ``some'' retail customers in
paragraph (a)(2)(ii)(A)? Why or why not? Should the rule expressly
require a broker-dealer or associated person, in formulating this
belief, to take into account all benefits to the broker-dealer or
associated person from the recommendation and the costs to a
hypothetical retail customer? Should the Commission require that a
broker-dealer have a reasonable basis to believe that a recommendation
is appropriate for the category of retail customers to which the retail
customer belongs?
     Is there sufficient clarity regarding how a broker-dealer
determines if it has a ``reasonable basis to believe that that the
recommendation is the best interest of the retail customer based on the
retail customer's investment profile and the potential risks and
rewards associated with the recommendation'' in paragraph (a)(2)(i)(B)?
Why or why not? Should the rule expressly require a broker-dealer or
associated person, in formulating this belief, to take into account all
benefits to the broker-dealer or associated person from the
recommendation and the costs to the retail customer?
     Should the Commission take a different approach to
defining the Care Obligation? If so, what approach should the
Commission and take and why? For example, in lieu of establishing a
Care Obligation that requires recommendations in the ``best interest,''
as described, should the Care Obligation codify existing suitability
obligations and require certain additional obligations (such as not
placing the financial or other interest of the broker-dealer ahead of
the retail customer)? If so, what additional obligations should be
required and why?
     As noted above, the Commission preliminary believes it is
appropriate to incorporate the concept of a ``customer's investment
profile'' consistent with FINRA's suitability rule. Do commenters
agree? Why or why not? Should additional factors be considered?
     Should the Commission require broker-dealers to document
their efforts to collect investment profile information? Relatedly,
should broker-dealers be required to document why they believe one or
more factors in a customer's investment profile are not relevant to a
determination regarding whether a recommendation is in the best
interest for a particular customer? Why or why not?
     Should the interpretation of what it means to make a
recommendation in the ``best interest'' for purpose of paragraph
(a)(2)(i)(B) be different from the interpretation of the best interest
obligation under paragraph (a)(1)? Why or why not? Please be specific
regarding any alternative suggestions and what they would or would not
require. If the standard were different, should the Commission change
the provision in the proposed rule that the obligation under paragraph
(a)(1) is satisfied only by compliance with the elements of paragraph
(a)(2)? If so, should the obligation in paragraph (a)(1) be an
independent obligation, for violation of which a broker-dealer and
associated person could be liable even if they complied with the
elements of paragraph (a)(2)?
     Should a broker-dealer and its associated persons, when
considering similar investment options available through the broker-
dealer, have the obligation to recommend the least expensive and/or
least remunerative option, at least if all other relevant factors are
equal? Why or why not? What other factors should be relevant in such
consideration?
     Should a broker-dealer and its associated persons, when
considering investment options, only be required to consider options
available through the broker-dealer? Alternatively, if a broker-dealer
and its associated persons are required to consider additional options
outside the broker-dealer, how should the Commission articulate the
extent of this duty? Please be specific.

     Is the phrase ``reasonably available alternative''
sufficiently clear? Should the Commission specify certain factors to be
used in the determination? Is there an alternative phrase or term that
would be clearer? Please be specific.
     Is there sufficient clarity regarding what ``less
expensive'' or ``least remunerative'' means and under what
circumstances expense or remuneration should be a significant factor?
     Should the Commission define what ``best interest'' means
for purposes of paragraph (a)(2)(i)(B)?
     Do commenters agree that turnover rate, cost-to-equity
ratio and in-and-out-trading are relevant factors for determining that
a series of recommended transactions is excessive for purposes of
paragraph (a)(2)(i)(C)? If not, what factors should a broker-dealer
consider with respect to this proposed obligation? Should the
Commission expressly articulate the relevant factors as part of the
rule?
     The Commission is proposing to use the term ``series of
recommended transactions'' as part of the obligation in paragraph
(a)(2)(i)(C), which is based, in part, on FINRA's quantitative
suitability obligation. Is ``series of recommended transactions'' a
sufficiently clear term when referring to the quantity/frequency of
trades? Should the Commission consider another formulation for this
obligation? If so, what language would be clearer?
     As noted above, the best interest obligation would not
extend beyond a particular recommendation or generally require a
broker-dealer to have a continuing duty to a retail customer. Is there
sufficient clarity regarding how the obligation applies to a series of
recommended transactions? Why or why not?
     The Commission is proposing, as part of the obligation in
paragraph (a)(2)(i)(C), that a broker-dealer must have a reasonable
basis to believe that a series of recommended transactions is not
excessive and is in the retail customer's best interest. Should the
Commission consider requiring only a reasonable basis to believe that a
``series of recommended transactions'' (or such other term per the
preceding question) is not excessive, or in the alternative, only
requiring a reasonable basis to believe that a series of recommended
transactions (or such other term per the preceding question) is in the
retail customer's best interest? If so, why?
     As noted above, FINRA's quantitative suitability rule
requires a broker-dealer to have a reasonable basis for believing that
a series of recommended transactions, even if suitable when viewed in
isolation, are not excessive and unsuitable for the customer when taken
together in light of the customer's investment profile. The
Commission's proposed obligation, instead, would require a broker-
dealer to have a reasonable basis to believe that a series of
recommended transactions is not excessive and is in the retail
customer's best interest. Should the Commission consider different
language, for example, requiring a reasonable basis to believe that a
series of recommended transactions is not excessive and not contrary to
the retail customer's best interest? Why or why not?
     The Commission is not proposing to incorporate the element
of control or de facto control in the requirement that a broker-dealer
form a reasonable basis to believe that a series of recommended
transactions, even if in the best interest of the retail customer when
viewed in isolation, is not excessive and is in the retail customer's
best interest when taken together in light of the retail customer's
investment profile. Should the Commission require ``control'' or ``de
facto'' control? Why or why not?
3. Conflict of Interest Obligations
    The Commission is proposing two requirements under Regulation Best
Interest focused specifically on the treatment of conflicts of
interest. These Conflict of Interest Obligations would require a
broker-dealer entity \289\ to: (1) Establish, maintain, and enforce
written policies and procedures reasonably designed to identify, and
disclose, or eliminate, all material conflicts of interest that are
associated with recommendations covered by Regulation Best Interest;
and (2) establish, maintain, and enforce written policies and
procedures reasonably designed to identify, and disclose and mitigate,
or eliminate, material conflicts of interest arising from financial
incentives associated with such recommendations.
---------------------------------------------------------------------------

    \289\ Unlike the Disclosure and Care Obligations, which apply to
a broker or dealer and to natural persons who are associated persons
of a broker or dealer, the proposed Conflict of Interest Obligations
apply solely to the broker or dealer entity, and not to the natural
persons who are associated persons of a broker or dealer. For
purposes of discussing the Conflict of Interest Obligations, the
term ``broker-dealer'' refers only to the broker-dealer entity, and
not to such individuals. While the Conflict of Interest Obligation
applies only to the broker-dealer entity, the conflicts of interest
that the broker-dealer entity must analyze are between: (i) The
broker-dealer entity and the retail customer, (ii) the natural
persons who are associated persons and the retail customer, and
(iii) the broker-dealer entity and the natural persons who are
associated persons (if the retail customer is indirectly impacted).
---------------------------------------------------------------------------

    We believe that requiring the establishment of such policies and
procedures is critical to identifying and addressing conflicts of
interest, whether through elimination or, at a minimum, disclosure (and
mitigation, in the case of financial incentives). We also believe that
policies and procedures help ensure compliance with the proposed
requirement to disclose any material conflicts of interest associated
with a broker-dealer's recommendations pursuant to the Disclosure
Obligation described above. We further believe that requiring the
establishment of such policies and procedures serves the Commission's
goal of facilitating the disclosure and mitigation of material
conflicts of interest, while minimizing additional compliance costs
that may be passed on to retail customers.
    Under the proposed rule, broker-dealers would be permitted to
exercise their judgment as to whether, for example, the conflict can be
effectively disclosed (as discussed in Disclosure Obligation),
determine what conflict mitigation methods may be appropriate, and
determine whether or how to eliminate a conflict, if necessary, so long
as the broker-dealer's policies and procedures are reasonably designed.
Whether a broker-dealer's policies and procedures are reasonably
designed to meet its Conflict of Interest Obligations will depend on
the facts and circumstances of a given situation. The Commission also
believes requiring policies and procedures specifically aimed at
mitigating, in addition to disclosing, material conflicts of interest
arising from financial incentives provides enhanced protections not
available to retail customers through disclosure alone.
    A broker-dealer would not comply with the Conflict of Interest
Obligations of Regulation Best Interest by simply creating policies and
procedures, if the broker-dealer does not maintain and enforce such
policies and procedures.\290\ Broker-dealers are already subject both
to liability for failure to supervise under Section 15(b)(4)(E) \291\
of the Exchange Act and to express supervision requirements under SRO
rules, including the establishment of policies

and procedures reasonably designed to prevent and detect violations of,
and to achieve compliance with, the federal securities laws and
regulations, as well as applicable SRO rules.\292\ As such, we believe
that a broker-dealer could comply with the policies and procedures
requirement of Regulation Best Interest by adjusting its current
systems of supervision and compliance, as opposed to creating new
systems.
---------------------------------------------------------------------------

    \290\ In the 913 Study, the staff stated that policies and
procedures alone are not sufficient to discharge supervisory
responsibility; it is also necessary to implement measures to
monitor compliance with those policies and procedures. See 913 Study
at 74, (citing In re Application of Stuart K. Patrick, Exchange Act
Release No. 32314 (May 17, 1993); In re Application of Richard F.
Kresge, Exchange Act Release No. 55988 (June 29, 2007)
(demonstrating the Commission's approach over the years)).
    \291\ See Section 15(b)(4)(E) of the Exchange Act (authorizing
the Commission to impose sanctions on a firm or any associated
person that fails reasonably to supervise another person subject to
its supervision that commits a violation of the federal securities
laws).
    \292\ See FINRA Rule 3110 (Supervision) (requiring firms to
establish and maintain systems to supervise the activities of its
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations and FINRA
rules).
---------------------------------------------------------------------------

a. Material Conflicts of Interest and Material Conflicts of Interest
Arising From Financial Incentives Associated With Such Recommendations
    As noted in the discussion of the Disclosure Obligation in Section
II.D.1., we propose to interpret, for purposes of Regulation Best
Interest, a ``material conflict of interest'' as a conflict of interest
that a reasonable person would expect might incline a broker-dealer--
consciously or unconsciously--to make a recommendation that is not
disinterested.\293\
---------------------------------------------------------------------------

    \293\ See Section II.D.I.b.
---------------------------------------------------------------------------

    For purposes of the Conflict of Interest Obligation in paragraph
(a)(2)(iv), we preliminarily believe that material conflicts of
interest arising from ``financial incentives'' associated with a
recommendation generally would include, but are not limited to,
compensation practices established by the broker-dealer, including fees
and other charges for the services provided and products sold; employee
compensation or employment incentives (e.g., quotas, bonuses, sales
contests, special awards, differential or variable compensation,
incentives tied to appraisals or performance reviews); compensation
practices involving third-parties, including both sales compensation
and compensation that does not result from sales activity, such as
compensation for services provided to third-parties (e.g., sub-
accounting or administrative services provided to a mutual fund);
receipt of commissions or sales charges, or other fees or financial
incentives, or differential or variable compensation, whether paid by
the retail customer or a third-party; sales of proprietary products or
services, or products of affiliates; and transactions that would be
effected by the broker-dealer (or an affiliate thereof) in a principal
capacity.
    While our interpretation of the types of material conflicts of
interest arising from financial incentives is broad, we do not intend
to require broker-dealers to mitigate every material conflict of
interest in order to satisfy their Conflict of Interest Obligations. We
request comment below on the scope of the term financial incentives,
whether we have appropriately identified the types of financial
incentives that should be eliminated or mitigated and disclosed,
whether there are other material conflicts of interest commenters
believe are more appropriately eliminated or mitigated and disclosed,
and whether there are certain financial incentives that are
appropriately addressed through disclosure and for which additional
mitigation is unnecessary or that the burden of mitigating the conflict
would not justify any associated benefit to retail customers.
    The Commission's proposed Conflict of Interest Obligations are
limited to material conflicts of interest, and to material conflicts
arising from financial incentives, that are associated with a
recommendation. The Commission believes this limitation is appropriate
because broker-dealers often provide a range of services as part of any
relationship with a retail customer, many of which would not involve a
recommendation, and such services already are subject to general
antifraud liability and specific requirements to address associated
conflicts of interest.\294\ We are not proposing to change the
disclosure obligations associated with these services under the general
antifraud provisions of the federal securities laws.
---------------------------------------------------------------------------

    \294\ See supra notes 87, 175, 176, 177 and accompanying text.
---------------------------------------------------------------------------

b. Reasonably Designed Policies and Procedures
    In determining whether a broker-dealer ``establishes, maintains,
and enforces reasonably designed policies and procedures,'' to address
its material conflicts of interest, as required by the Conflict of
Interest Obligations, the Commission preliminarily believes it would
consider whether a broker-dealer has adequate compliance and
supervisory policies and procedures in place (as well as a system for
applying such procedures) to identify and at a minimum disclose (and
mitigate, in the case of financial incentives) or eliminate, material
conflicts of interest. We believe that there is no one-size-fits-all
framework, and broker-dealers should have flexibility to tailor the
policies and procedures to account for, among other things, business
practices, size and complexity of the broker-dealer, range of services
and products offered and associated conflicts presented.
    We believe that it would be reasonable for broker-dealers to use a
risk-based compliance and supervisory system to promote compliance with
Regulation Best Interest, rather than conducting a detailed review of
each recommendation of a securities transaction or security-related
investment strategy to a retail customer.\295\ Use of a risk-based
compliance and supervisory system would grant broker-dealers the
flexibility to establish systems that are tailored to their business
models, and to focus on specific areas of their business that pose the
greatest risk of noncompliance with the Conflict of Interest
Obligations,\296\ as well as the greatest risk of potential harm to
retail customers through such noncompliance. We believe that this would
protect retail customers by focusing the broker-dealer's resources on
the areas of greatest risk to both the firm and the retail customer, as
opposed to focusing on every aspect of the broker-dealer's business,
regardless of the level of risk of noncompliance or harm.
---------------------------------------------------------------------------

    \295\ We propose to interpret the term ``risk-based'' consistent
with SRO rules so that broker-dealers can incorporate these new
obligations into their current compliance infrastructure. According
to FINRA, ``the term `risk based' describes the type of methodology
a firm may use to identify and prioritize for review those areas
that pose the greatest risk of potential securities law and self-
regulatory organization (SRO) rule violations. In this regard, a
firm is not required to conduct detailed reviews of each transaction
if the firm is using a reasonably designed risk-based review system
that provides the firm with sufficient information to enable the
firm to focus on the areas that pose the greatest numbers of and
risks of violation.'' See FINRA Regulatory Notice 14-10,
Consolidated Supervision Rules (Mar. 2014).
    \296\ As previously noted, the Commission would expect smaller
investment advisers without conflicting business interests to
require much simpler policies and procedures than larger firms that,
for example, have multiple potential conflicts as a result of their
other lines of business or their affiliations with other financial
service firms. See, e.g., Compliance Programs of Investment
Companies and Investment Advisers, Advisers Act Release No. 2204
(Dec. 17, 2003) (``Advisers Act Release 2204'').
---------------------------------------------------------------------------

    Among the components that broker-dealers should consider including
in their programs are: Policies and procedures outlining how the firm
identifies its material conflicts (and material conflicts arising from
financial incentives), including such material conflicts of natural
persons associated with the broker-dealer, clearly identifying all such
material conflicts of interest and specifying how the broker-dealer
intends to address each conflict; robust compliance review and
monitoring systems; processes to escalate identified instances of

noncompliance to appropriate personnel for remediation; procedures that
clearly designate responsibility to business lines personnel for
supervision of functions and persons,\297\ including determination of
compensation; \298\ processes for escalating conflicts of interest;
processes for a periodic review and testing of the adequacy and
effectiveness of policies and procedures; \299\ and training on the
policies and procedures.\300\
---------------------------------------------------------------------------

    \297\ See Frequently Asked Questions about Liability of
Compliance and Legal Personnel at Broker-Dealers under Sections
15(b)(4) and 15(b)(6) of the Exchange Act, Division of Trading and
Markets (Sept. 30, 2013), available at https://www.sec.gov/divisions/marketreg/faq-cco-supervision-093013.htm (providing
guidance on the roles and duties of compliance and legal personnel
at broker-dealers).
    \298\ The Commission believes that the ability to control the
compensation of registered representatives is a key mechanism by
which registered broker-dealers exercise supervisory controls.
    \299\ See Advisers Act Release 2204; see also Staff Questions
Advisers Should Ask While Establishing or Reviewing Their Compliance
Programs (May 2006), available at https://www.sec.gov/info/cco/adviser_compliance_questions.htm.
    \300\ Id.
---------------------------------------------------------------------------

c. Identifying Material Conflicts of Interest
    We believe that having a process to identify and appropriately
categorize such conflicts of interest is a critical first step in
helping to ensure that broker-dealers have reasonably designed policies
and procedures to eliminate, or at a minimum disclose (and mitigate, as
required) their material conflicts of interest. Reasonably designed
policies and procedures to identify material conflicts of interest
(including material conflicts arising from financial incentives)
generally should do the following:
    (i) Define such material conflicts in a manner that is relevant to
a broker-dealer's business (i.e., material conflicts of both the
broker-dealer entity and natural persons who are associated persons of
the broker-dealer), and in a way that enables employees to understand
and identify conflicts of interest;
    (ii) establish a structure for identifying the types of material
conflicts that the broker-dealer (and natural persons who are
associated persons of the broker-dealer) may face, and whether such
conflicts arise from financial incentives;
    (iii) establish a structure to identify conflicts in the broker-
dealer's business as it evolves;
    (iv) provide for an ongoing (e.g., based on changes in the broker-
dealer's business or organizational structure, changes in compensation
incentive structures, and introduction of new products \301\ or
services) and regular, periodic (e.g., annual) review for the
identification of conflicts associated with the broker-dealer's
business; and
---------------------------------------------------------------------------

    \301\ FINRA Conflicts Report at 3 (``Firms at the forefront of
financial innovation are in the best position, and are uniquely
obligated, to identify the conflicts of interest that may exist at a
product's inception or that develop over time. There are a number of
effective practices firms can adopt to address such conflicts.
First, firms can use a new product review process--typically through
new product review committees--that includes a mandate to identify
and mitigate conflicts that a product may present. Second, firms
should disclose those conflicts in plain English, with the objective
of helping ensure that customers comprehend the conflicts that a
firm or registered representative have in recommending a product.
These conflicts may be particularly acute where complex financial
products are sold to less knowledgeable investors, including retail
investors.'')
---------------------------------------------------------------------------

    (v) establish training procedures regarding the broker-dealer's
material conflicts of interest, including material conflicts of natural
persons who are associated persons of the broker-dealer, how to
identify such material conflicts of interest (and material conflicts
arising from financial incentives), as well as defining employees'
roles and responsibilities with respect to identifying such material
conflicts of interest.
d. Disclosure, or Elimination, of Material Conflicts of Interest and
Disclosure and Mitigation, or Elimination, of Material Conflicts of
Interest Arising From Financial Incentives Associated With a
Recommendation
    In addition to identifying material conflicts of interest, the
Commission proposes to require that the policies and procedures be
reasonably designed to at a minimum disclose, or eliminate, all
material conflicts of interest associated with making recommendations
to retail customers. In addition to the general guidance regarding
reasonably designed policies and procedures outlined above, we believe
that reasonably designed policies and procedures generally should
establish a clearly defined and articulated structure for: Determining
how to effectively address material conflicts of interest identified
(i.e., whether to eliminate or disclose (and mitigate, as required) the
material conflict); and setting forth a process to help ensure that
material conflicts are effectively addressed as required by the
policies and procedures.
    If a broker-dealer determines to satisfy its obligation to address
material conflicts of interest through disclosure, the broker-dealer
should consider the preliminary guidance on aspects of effective
disclosure, as discussed above in the Disclosure Obligation.\302\
---------------------------------------------------------------------------

    \302\ See Section II.D.1.
---------------------------------------------------------------------------

    While the Conflict of Interest Obligations would require a broker-
dealer to have policies and procedures reasonably designed to at a
minimum disclose or eliminate all material conflicts of interest
related to the recommendation (or to disclose and mitigate or eliminate
those material conflicts of interest arising from financial
incentives), it does not mandate the absolute elimination of any
particular conflicts, absent another requirement to do so. The absolute
elimination of some particular conflicts could mean a broker-dealer may
not receive compensation for its services, which is not the
Commission's intent.
    A broker-dealer seeking to address its Conflict of Interest
Obligations through elimination of a material conflict of interest
could choose to eliminate the conflict of interest entirely, for
example, by removing incentives associated with a particular product or
practice or not offering products with special incentives.
Alternatively, a broker-dealer could satisfy this obligation by
negating the effect of the conflict by, for example, in the case of
conflicts related to affiliated mutual funds, crediting fund advisory
fees against other broker-dealer charges--thus effectively eliminating
the material conflict of interest.
    Furthermore, although the Commission is not proposing to require a
broker-dealer to develop policies and procedures to both disclose and
mitigate all material conflicts of interest (outside of the material
conflicts arising from financial incentives, which would specifically
require mitigation), the proposed Conflict of Interest Obligations
would require that a broker-dealer develop policies and procedures
reasonably designed to ``at a minimum disclose, or eliminate'' all
material conflicts. As such, a broker-dealer may determine to design
its policies and procedures to address material conflicts of interest
by both disclosing a conflict and taking other additional steps to
mitigate the conflict (outside of the material conflicts arising from
financial incentives, which would specifically require mitigation).
However, in situations where the broker-dealer determines that
disclosure does not reasonably address the conflict, for example, where
the disclosure cannot be made in a simple or clear manner, or otherwise
does not help the retail customer's understanding of the conflict or
capacity for informed decision-making, or where the conflict is such

that it may be difficult for the broker-dealer to determine that it is
not putting its own interest ahead of the retail customer's interest,
under the proposed obligation to have reasonably designed policies and
procedures to ``at a minimum disclose, or eliminate'' all material
conflicts the broker-dealer would need to establish policies and
procedures reasonably designed to either eliminate the conflict or to
both disclose and mitigate the conflict.
e. Mitigation of Material Conflicts of Interest Arising From Financial
Incentives
    Under the requirement relating to the treatment of conflicts of
interest arising from financial incentives, the Commission proposes to
require broker-dealers to establish, maintain, and enforce written
policies and procedures reasonably designed to identify and disclose
and mitigate, or eliminate, material conflicts of interest arising from
financial incentives. This proposed requirement is intended to capture
the range of financial incentives that could pose a material conflict
of interest.
    The Commission recognizes the importance of the brokerage model as
a potentially cost-effective (and sometimes, a less costly) option for
investors to pay for investment advice. As discussed above, the
Commission recognizes, however, that broker-dealer financial
incentives--including internal compensation structures and compensation
arrangements \303\ with third parties--create inherent conflicts that
may affect the impartiality of a recommendation.\304\ These financial
incentives can create conflicts of interest that may be difficult, if
not impossible, to effectively manage through disclosure alone, or to
eliminate.\305\ At the same time, the Commission, like other
regulators,\306\ recognizes that differential compensation may
appropriately recognize the time and expertise necessary to understand
an investment, and in doing so promote investor choice and access to a
range of products, and so elimination of the conflict may not be
appropriate or desirable.\307\
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    \303\ Conflicts of interest may arise from compensation other
than sales compensation. For example, in the case of mutual funds,
compensation for account servicing, sub-transfer agency, sub-
accounting, recordkeeping or other administrative services provides
an incentive for a firm to offer the mutual funds from or for which
the firm receives such compensation and not offer other funds or
products from or for which it does not receive such compensation.
    \304\ See Tully Report. The Commission has historically
expressed concerns about the financial incentives that commission-
based compensation provides to broker-dealers. In order to address
these concerns and preserve the broker-dealer model to promote
investor choice, Regulation Best Interest imposes the additional
requirement to mitigate conflicts related to financial incentives.
See supra Section I.A.
    \305\ Several commenters in response to Chairman Clayton's
Statement expressed similar concerns regarding the limits of
disclosure to address broker-dealer conflicts, and supported
requiring both disclosure and mitigation of conflicts. See, e.g.,
Economic Policy Institute Letter; PIABA Letter; Financial Planning
Coalition Letter (``The Coalition believes that disclosures alone
are insufficient to remedy investor confusion and harm stemming from
conflicted advice. Although the Coalition agrees that disclosures
can be a useful and important tool for investors, relying solely on
disclosures is inconsistent with the SEC's mission of investor
protection and contradicts substantial prior research demonstrating
that disclosures alone are ineffective. The Coalition opposes a
disclosure-only regime and urges consideration of system based on
either conflict avoidance or disclosures coupled with proper
mitigation.''); Nationwide Letter (``. . . Nationwide is firmly
committed to supporting a new best interest standard of care for
broker-dealers that focuses on increased transparency and mitigation
of conflicts, while at the same time protecting consumers' access to
advice, choice, and affordable products.''); LPL Financial Letter
(recommending that the Commission consider adopting a standard of
conduct that preserves financial institutions' flexibility to avoid
or manage conflicts in which they have a competing financial
interest, provided they fully and fairly disclose the nature of such
conflicts to investors and take such additional steps as may be
necessary to ensure such conflicts do not adversely affect the
impartiality and prudence of the advice they provide to investors).
    \306\ For example, the preamble to the BIC Exemption states
``The Department has not made the requirements more stringent, as
suggested by some commenters, so as to require completely level
compensation. Different payments for different classes of
investments may be appropriate based on differences in the time and
expertise necessary to recommend them'' and that under the BIC
Exemption ``differential compensation is permitted but only if the
Financial Institution's policies and procedures, as a whole are
reasonably designed to avoid a misalignment of interests between
Advisers and Retirement Investors'' and that ``the payment of
differential compensation should be based only on neutral factors.''
BIC Exemption Release, FR 21007, 21035-40.
    \307\ See, e.g., Letter from James D. Gallagher, Executive Vice
President and General Counsel, John Hancock Life Insurance Company
(U.S.A.) (Aug. 25, 2017) (``John Hancock Letter'') (``Customer
choice should allow advisers and broker-dealers to direct clients to
products that suit their needs, whether or not those products are
proprietary.'').
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    In addition, through the proposed requirement to develop policies
and procedures reasonably designed to mitigate conflicts of interest
arising from financial incentives, we are clarifying how the best
interest obligation would be fulfilled when a broker-dealer is engaging
in principal trading by requiring a broker-dealer to, through its
required policies and procedures, identify and address, the financial
incentives presented by principal trading.\308\
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    \308\ This is in line with the 913 Study recommendation that the
Commission address how the uniform fiduciary standard of conduct
would be fulfilled when engaging in principal trading, which at a
minimum should require disclosure but not necessarily require the
specific procedures of Advisers Act Section 206(3). See Study at
113.
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    Accordingly, to make sure that recommendations are in the best
interest of the retail customer, the Commission proposes requiring
broker-dealers to establish, maintain and enforce written policies and
procedures reasonably designed to identify and disclose and mitigate
material conflict of interests related to financial incentives, in
addition to the proposed requirement to establish, maintain and enforce
written policies and procedures reasonably designed to identify and
disclose or eliminate general material conflicts of interest in
paragraph (a)(2)(iii).
    As noted above, in lieu of mandating specific mitigation measures
or a ``one-size fits all'' approach, the Commission's proposal would
leave broker-dealers with flexibility to develop and tailor reasonably
designed policies and procedures that include conflict mitigation
measures, based on each firm's circumstances.\309\ This principles-
based approach provides broker-dealers the flexibility to establish
their supervisory system in a manner that reflects their business
models, and based on those models, focus on areas where heightened
concern may be warranted.\310\ The Commission believes that reasonably
designed policies and procedures should include mitigation measures
that depend on a variety of factors related to a broker-dealer's
business model (such as the size of the broker-dealer, retail customer
base, the nature and significance of the compensation conflict, and the
complexity of the product), some of which may be weighed more heavily
than others.\311\ Depending on a broker-dealer's assessment of these
factors as a whole, more or less demanding mitigation measures included
in reasonably designed policies and procedures may be appropriate. For
example, heightened mitigation measures, including enhanced
supervision, may be appropriate in situations where the retail customer
displays a less sophisticated understanding of securities investing

generally \312\ or the conflicts associated with particular products
involved,\313\ where the compensation is less transparent (for example,
a payment received from a third-party or built into the price of the
product or a transaction versus a straight commission payment), or
depending on the complexity of the product.\314\ A broker-dealer could
reasonably determine through its policies and procedures that the same
mitigation measures could apply to a particular type of retail
customer, type of product or type of compensation conflict across the
board; or in some instances a broker-dealer may reasonably determine
that some compensation conflicts may be more difficult to mitigate, and
are more appropriately avoided in their entirety or for certain
categories of retail customers. Policies and procedures may be
reasonably designed at the outset, but may later become unreasonable
based on subsequent events or information obtained, such that the
actual experience of a broker-dealer should be used to revise the
broker-dealer's measures as appropriate. Further, what are considered
reasonable mitigation measures for a small firm may be different than
that for a large firm.\315\ While many broker-dealers may have programs
currently in place to manage conflicts of interest, each broker-dealer
will need to carefully consider whether its existing framework complies
with the proposed obligations under Regulation Best Interest.
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    \309\ FINRA observed that the appropriate framework for
developing a conflicts governance framework depends on the scope and
scale of a firm's business. See FINRA Conflicts Report. See also
Letter from David T. Bellaire, Esq., Executive Vice President and
General Counsel, Financial Services Institute (Oct. 30, 2017) (``FSI
Letter'') (recommending the Commission adopt a principles-based
approach to allow firms to tailor their policies and procedures
designed to identify, manage and mitigate conflicts to their unique
business models).
    \310\ See FINRA Rule 3110(b)(1) (Supervision) and Section
15(b)(4)(E) of the Exchange Act.
    \311\ See FINRA Conflicts Report.
    \312\ We believe that broker-dealers would ordinarily obtain,
pursuant to the proposed Care Obligation, sufficient facts
concerning a retail customer to determine a retail investor's
understanding of securities investing. As part of evaluating a
recommendation and whether it is in a retail customer's best
interest, the Care Obligation requires a broker-dealer to make a
reasonable effort to ascertain information regarding an existing
customer's investment profile, including, the retail customer's age,
other investments, financial situation and needs, tax status,
investment objectives, investment experience, investment time
horizon, liquidity needs, risk tolerance, and any other information
the retail customer may disclose to the broker, dealer, or a natural
person who is an associated person of a broker or dealer in
connection with a recommendation. See paragraph (c)(2) of Proposed
Regulation Best Interest (defining ``Retail Customer Investment
Profile'').
    \313\ Currently, FINRA's heightened suitability requirements for
options trading accounts require that a registered representative
have ``a reasonable basis for believing, at the time of making the
recommendation, that the customer has such knowledge and experience
in financial matters that he may reasonably be expected to be
capable of evaluating the risks of the recommended transaction, and
is financially able to bear the risks of the recommended position in
the complex product.'' FINRA Rule 2360(b)(19). FINRA has encouraged
member firms to take a similar approach in recommending complex
products. FINRA has noted that certain heightened procedures firms
have taken include making approval of complex products contingent
upon specific limitations or conditions, and prohibiting their sales
force from recommending the purchase of some complex products to
certain retail investors. See FINRA Regulatory Notice 12-03,
Heightened Supervision of Complex Products (Jan. 2012).
    \314\ In a recent FINRA examination report, FINRA noted that the
concerns that FINRA had during the course of examinations with
regard to the suitability of certain products and their supervision
did not vary materially by firm size, but did occur more frequently
in connection with certain product classes, specifically unit
investment trusts (``UITs'') and certain multi-share class and
complex products, such as leveraged and inverse exchange-traded
funds (``ETFs''). See Report on FINRA Examination Findings (Dec.
2017), available at http://www.finra.org/industry/2017-report-exam-findings (``FINRA Exam Report 2017'').
    \315\ Large firms may address conflicts of interest through
enterprise management or operational risk frameworks, and components
of such programs, for example, risk and control self-assessments,
may provide an opportunity to identify and evaluate possible
impacts. By contrast, small firms selling basic products may have a
conflicts management framework that relies largely on the tone set
by the firm owner coupled with required supervisory controls,
particularly related to suitability, and the firm's compensation
structure. See FINRA Conflicts Report. An effective practice FINRA
observed at a number of firms is implementation of a comprehensive
framework to identify and manage conflicts of interest across and
within firms' business lines that is scaled to the size and
complexity of their business. See FINRA Conflicts Report at 5.
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    For example, broker-dealers generally should consider incorporating
the following non-exhaustive list of potential practices \316\ as
relevant into their policies and procedures to promote compliance with
(a)(2)(iv) of proposed Regulation Best Interest \317\:
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    \316\ See FINRA Conflicts Report at 26.
    \317\ As noted above, while the Commission believes these
practices, if incorporated into written policies and procedures, may
reasonably mitigate conflicts of interest arising from financial
incentives, whether a recommended securities transaction or
investment strategy complies with proposed Regulation Best Interest
will turn on the facts and circumstances of the particular
recommendation and the particular retail customer, and whether the
broker-dealer has complied with the Disclosure Obligation and the
Care Obligation.
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     Avoiding compensation thresholds that disproportionately
increase compensation through incremental increases in sales;
     minimizing compensation incentives for employees to favor
one type of product over another, proprietary or preferred provider
products, or comparable products sold on a principal basis--for
example, establishing differential compensation criteria based on
neutral factors (e.g., the time and complexity of the work involved);
     eliminating compensation incentives within comparable
product lines (e.g., one mutual fund over a comparable fund) by, for
example, capping the credit that a registered representative may
receive across comparable mutual funds or other comparable products
across providers;
     implementing supervisory procedures to monitor
recommendations that are: Near compensation thresholds; near thresholds
for firm recognition; involve higher compensating products, proprietary
products or transactions in a principal capacity; or, involve the
rollover or transfer of assets from one type of account to another
(such as recommendations to rollover or transfer assets in an ERISA
account to an IRA, when the recommendation involves a securities
transaction) \318\ or from one product class to another \319\;
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    \318\ Id.
    \319\ See FINRA Exam Report 2017. FINRA observed a variety of
effective practices in recommending the purchase and sale of certain
products, including tailoring supervisory systems to products'
features and sources of risk to customers. With respect to UITs,
FINRA observed firms that alerted customers to the consequences of
selling and reinvesting in a new UIT prior to the initial UIT's
maturity using negative or positive consent letters. Some firms
implemented surveillance patterns to identify early UIT rollovers
under a variety of scenarios. In addition, some firms required
registered representatives to enter a rationale into firm systems
for each short-term UIT transaction and coupled the entry with
documented supervisory review.
---------------------------------------------------------------------------

     adjusting compensation for registered representatives who
fail to adequately manage conflicts of interest; and
     limiting the types of retail customers to whom a product,
transaction or strategy may be recommended (e.g., certain products with
conflicts of interest associated with complex compensation structures).
    In addition, we believe certain material conflicts of interest
arising from financial incentives may be more difficult to
mitigate,\320\ and may be more appropriately avoided in their entirety
for retail customers or for certain categories of retail customers
(e.g., less sophisticated retail customers). These practices may
include the payment or receipt of certain non-cash compensation that
presents conflicts of interest for broker-dealers, for example, sales
contests, trips, prizes, and other similar bonuses that are based on
sales of certain securities or accumulation of

assets under management.\321\ Broker-dealers that make recommendations
to retail customers that may involve such compensation practices should
carefully assess the broker-dealer's ability to mitigate these
financial incentives and whether they can satisfy their best interest
obligation.
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    \320\ See Tully Report. The Tully Report found the payment of
up-front bonuses and accelerated payouts raised concerns not about
particular recommendations but about the registered representative-
client relationship because registered representatives are
incentivized to generate large commissions through churning accounts
or switching firms. The Tully Report suggested best practices to
encourage long-term relationships through methods including, but not
limited to, possible elimination of up-front bonuses or payment of
up-front bonuses in the form of forgivable loans over a period of
time.
    \321\ For example, FINRA rules establish restrictions on the use
of non-cash compensation in connection with the sale and
distribution of mutual funds, variable annuities, direct
participation program securities, public offerings of debt and
equity securities, and real estate investment trust programs. These
rules generally limit the manner in which members can pay for or
accept non-cash compensation and detail the types of non-cash
compensation that are permissible. See FINRA Rules 2310, 2320, 2331,
and 5110. FINRA conducted a retrospective review of the gifts and
gratuities and non-cash compensation rules to assess their
effectiveness and efficiency. See FINRA Regulatory Notice 14-15,
FINRA Requests Comment on the Effectiveness and Efficiency of its
Gifts and Gratuities and Non-Cash Compensation Rules (Apr. 2014);
FINRA Retrospective Rule Report, Gifts, Gratuities and Non-Cash
Compensation (Dec. 2014). In response, SIFMA commented that it
supported ``restricting the use of sales targets and requiring that
eligibility for training events be determined on the basis of total
production, not the sale of specific securities'' and recommended
that ``FINRA also consider whether these rules should be applied
consistently to all securities products, rather than (as today) just
to investment company securities, variable products and public
offerings of securities.''). See Letter from Kevin A. Zambrowicz,
Associate General Counsel & Managing Director, SIFMA (May 23, 2014).
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f. Consistency With Other Approaches
    The Commission believes that the proposed requirements relating to
the treatment of conflicts are designed to address, albeit in a less
prescriptive manner, the same concerns regarding broker-dealer
conflicts of interest as expressed by the DOL in adopting the DOL
Fiduciary Rule and related PTEs, including the conflicts associated
with financial incentives, underlying the BIC Exemption. Among other
things, the BIC Exemption includes provisions requiring: (1) Disclosure
of information on the firm's material conflicts of interest, including
web and transaction-based disclosure; and (2) adoption of policies and
procedures reasonably designed to: (i) Ensure that advisers (i.e.,
individual representatives) adhere to the Impartial Conduct Standards
(e.g., provide best interest advice); (ii) prevent material conflicts
of interest from causing violations of the Impartial Conduct Standards,
and (iii) prevent the use of compensation or other incentives (e.g.,
quotas, appraisals, bonuses, contests, special awards, differential
compensation or other actions or incentives) that are intended or would
reasonably be expected to cause advisers to make recommendations that
are not in the best interest of the retirement investor.\322\
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    \322\ See BIC Exemption Release.
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    The DOL has stated that the restriction on compensation incentives
under the conditions of the BIC Exemption does not prevent the
provision of differential compensation to individuals (whether in type
or amount, and including, but not limited to, commissions) based on
investment decisions to the extent that the policies and procedures and
incentive practices, when viewed as a whole, are reasonably and
prudently designed to avoid a misalignment of the interests of advisers
with the investors they serve as fiduciaries.\323\ However, the
differential payments must be based on neutral factors, such as the
time or complexity and the work involved (and not based on what is more
lucrative to the firm), and the DOL noted the importance of employing
supervisory oversight structures.\324\ As an example, the DOL described
a commission-based compensation schedule for representatives in which
all variation in commissions is eliminated for recommendations of
investments within reasonably designed categories, and the entity
establishes supervisory mechanisms to protect against conflicts of
interest created by the transaction-based model and takes special care
to ensure that any differentials that are retained are based on neutral
factors (e.g., time or complexity) and do not incentivize based on the
amount of compensation the entity would receive.\325\
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    \323\ See BIC Exemption Release at 21033-34. See also U.S.
Department of Labor, Employee Benefits Security Administration,
Conflict of Interest FAQs, Part I-Exemptions (Oct. 2017), available
at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-rules-and-exemptions-part-1.pdf
(``DOL FAQs Part I'').
    \324\ See BIC Exemption Release at 21035-40. For example, the
DOL notes that the touchstone is to always avoid structures that
misalign the financial interests of the adviser with the interests
of the retirement investor. See DOL FAQs Part I.
    \325\ See BIC Exemption Release 21038-39. See also DOL FAQs at
7-8.
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    Our proposed Conflict of Interest Obligations are designed to
address these same concerns, and support the objective that the
recommendations of broker-dealers will not be self-interested, with a
principles-based approach that is designed to provide flexibility to
broker-dealers as to how to disclose and mitigate such conflicts of
interest, depending on their business model, the level of conflicts
presented, and the retail customers they serve. While the Commission
recognizes that broker-dealers are subject to supervisory obligations
under Section 15(b)(4)(E) \326\ of the Exchange Act and detailed SRO
rules, including the establishment of policies and procedures
reasonably designed to prevent and detect violations of, and to achieve
compliance with, the federal securities laws and regulations, as well
as applicable SRO rules,\327\ for the reasons set forth above, the
Commission believes that broker-dealers should be expressly required to
establish, maintain, and enforce written policies and procedures to
identify and address (through elimination or disclosure, and mitigation
in the case of financial incentives) material conflicts of interest .
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    \326\ See Section 15(b)(4)(E) of the Exchange Act (authorizing
the Commission to impose sanctions on a firm or any associated
person that fails reasonably to supervise another person subject to
their supervision that commits a violation of the federal securities
laws).
    \327\ See FINRA Rule 3110 (Supervision) (requiring firms to
establish and maintain systems to supervise the activities of its
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations and FINRA
rules).
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    Furthermore, our proposed rule subjects broker-dealers to
additional requirements when certain material conflicts are present.
Specifically, Regulation Best Interest requires written policies and
procedures reasonably designed to identify and address, through
disclosure or elimination, of any material conflicts of interest that
are associated with the recommendation, and imposes heightened
obligations requiring written policies and procedures reasonably
designed to identify and address, through disclosure and mitigation, or
elimination, of material conflicts of interest that are related to
financial incentives. We believe that these requirements address the
same concerns that the DOL sought to address regarding conflicts of
interest and the duty of loyalty that underlies the detailed
obligations of the BIC Exemption, and also help ensure investment
recommendations will be in the retail customer's best interest,
consistent with our understanding of the DOL's objectives in the BIC
exemption.
    We also believe that the proposed Conflict of Interest Obligations,
in conjunction with our Disclosure Obligation, are consistent with the
principles underlying the recommendations of the 913 Study relating to
a duty of loyalty. In the uniform fiduciary standard recommended in the
Study, ``incorporating Advisers Act Section 206(1) and 206(2)'' would
require an investment adviser or broker-dealer to ``eliminate, or
provide full and fair

disclosure about its material conflicts of interest.'' \328\ In
addition, the Study recommended that the Commission consider whether
rulemaking ``would be appropriate to prohibit certain conflicts, to
require firms to mitigate conflicts through specific action, or to
impose specific disclosure and consent requirements.'' \329\ Further,
with respect to principal trading, the Study provided that the
Commission should address how broker-dealers should fulfill the uniform
fiduciary standard when engaging in principal trading.\330\ The Study
noted that under the standard a broker-dealer should be required at a
minimum, to disclose its conflicts of interest related to principal
transactions, including its capacity as principal, but it would not
necessarily be required to follow the specific notice and consent
procedures of Advisers Act Section 206(3).\331\
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    \328\ 913 Study at 112-13.
    \329\ See id. at 118.
    \330\ See id. at 118-20.
    \331\ Id.
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    We believe that the proposed Conflict of Interest Obligations
reflect and build upon the principles underlying these 913 Study
recommendations. As recommended by the 913 Study, we are proposing to
require, through implementation of policies and procedures, broker-
dealers to, at a minimum disclose, or eliminate, all material conflicts
of interest, which draws from principles of an investment adviser's
duty of loyalty under the Advisers Act, which includes an investment
adviser's duty to disclose. One difference between the Conflict of
Interest Obligations under Regulation Best Interest and the principles
in the 913 Study is that the proposed obligation for broker-dealers is
limited to disclosure of material conflicts associated with a
recommendation. As discussed above, the Commission believes this
limitation is appropriate because broker-dealers often provide a range
of services as part of any retail customer relationship, many of which
would not involve a recommendation, and such services already are
subject to general and specific requirements to address associated
conflicts of interest.\332\ As such, we are not proposing to change or
to have any impact on the disclosure obligations associated with these
services under the general antifraud provisions of the federal
securities laws rather than this more specific obligation.
---------------------------------------------------------------------------

    \332\ See Section II.D.1.b.
---------------------------------------------------------------------------

    Further, in line with the 913 Study recommendations as discussed
above, the Commission considered and believes that it is appropriate to
also propose a requirement to establish and maintain reasonably
designed policies and procedures to disclose and mitigate, or
eliminate, material conflicts of interest related to financial
incentives, in light of the concerns regarding potential harm to retail
customers resulting particularly from broker-dealer conflicts of
interest associated with financial incentives, such as compensation
practices.\333\
---------------------------------------------------------------------------

    \333\ See supra Section I.A. See also Tully Report.
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    The proposed Conflict of Interest Obligations differ from the 913
Study in that Regulation Best Interest, as proposed, expressly requires
a broker-dealer to establish, maintain, and enforce written policies
and procedures reasonably designed to identify and address material
conflicts, through elimination or disclosure (and mitigation in the
case of material conflicts of interest arising from financial
incentives), as opposed to expressly requiring that broker-dealers
eliminate or provide full disclosure of conflicts of interest.\334\ As
discussed above, the Disclosure Obligation separately requires that
broker-dealers disclose material conflicts of interest associated with
the recommendation prior to or at the time of a recommendation. For the
reasons set forth above, we believe that requiring broker-dealers to
develop reasonably designed policies and procedures to identify and
eliminate or disclose (and mitigate, as appropriate or required)
material conflicts of interest is critical to compliance with
management of conflicts of interest, and provides more flexibility to
broker-dealers, and better serves the Commission's goal of facilitating
the elimination or disclosure and mitigation (as appropriate or
required) of material conflicts of interest, and minimizing additional
compliance costs that may be passed on to retail customers.
---------------------------------------------------------------------------

    \334\ See 913 Study at 112-13.
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g. Request for Comment on the Conflict of Interest Obligations
    The Commission generally requests comment on the best interest
obligation relating to the treatment of conflicts of interest.
Specifically, we request comment on the following issues:
     Would the Conflict of Interest Obligations cause a broker-
dealer to act in a manner that is consistent with what a retail
customer would reasonably expect from someone who is required to act in
their best interest? Why or why not?
     Should the Conflict of Interest Obligations apply to
natural persons who are associated persons of a broker or dealer? Why
or why not?
     Are there any specific interactions or relationships
between the disclosure requirements under the Conflict of Interest
Obligations and the Relationship Summary that should be addressed? Are
there any specific interactions or relationships between the disclosure
requirements under the Conflict of Interest Obligations and the
Disclosure Obligation that should be addressed? If so, please explain.
     Are there any specific interactions or relationships
between the disclosure requirements in Regulation Best Interest and the
existing general antifraud provisions that should be addressed? If so,
please explain.
     Do commenters believe the general antifraud provisions
adequately address other non-recommendation related conflicts or should
Regulation Best Interest also cover such conflicts?
     Do commenters agree with the requirement to create
policies and procedures to promote and demonstrate compliance with the
Conflict of Interest Obligations? Why or why not? If so, how should
those policies and procedures differ, if at all, from those currently
required by FINRA? If not, what other approaches do commenters suggest?
     Instead of requiring policies and procedures, should the
Commission simply require broker-dealers to eliminate or mitigate and
disclose conflicts of interest?
     Should the Conflict of Interest Obligations apply to
natural persons who are associated persons? Why or why not?
     Do commenters agree with the Commission's approach to
provide flexibility to broker-dealers in meeting their Conflict of
Interest Obligations? Why or why not?
     Is the guidance concerning policies and procedures clear?
Would this guidance assist broker-dealers in understanding how they can
demonstrate compliance with the Conflict of Interest Obligation? Is
there additional guidance that would provide additional clarity?
     Do commenters have additional examples of processes or
systems the Commission should suggest or require broker-dealers to
include in compliance and supervisory programs?
     Should the Conflict of Interest Obligations specify
certain minimum policies and procedures? If so, what specific required
policies and procedures should we include?
     Should the Commission require in Regulation Best Interest
that broker-dealers undergo supervisory and compliance reviews? If so,
how

frequently and what would be the proper scope?
     Is it sufficiently clear to commenters that the Commission
does not require the policies and procedures required by the Conflict
of Interest Obligations be assessed on a transaction-by-transaction
basis, but rather that broker-dealers may use a risk-based compliance
and supervisory system? Why or why not?
     Should the Commission provide additional guidance on
identification of material conflicts of interest? Why or why not? If
so, what type of guidance should the Commission provide?
     Similar to the Care Obligation, should a broker-dealer be
required to ``exercise reasonable diligence, care, skill, and
prudence'' to comply with the Conflict of Interest Obligations? Why or
why not? Would this lower or raise the standard for the Conflict of
Interest Obligations?
     How will the Conflict of Interest Obligations affect dual-
registrants? Do commenters believe dual-registrants can adequately
comply with such requirements? Why or why not?
     Are the situations identified in this proposal those where
conflicts of interest are present, the most prevalent or have the
greatest potential for harm or both? To what extent are retail
customers harmed by these types of conflicts? \335\ For example, do
certain types of conflicts and/or recommendations result in
systematically lower net returns or greater degrees of risk in retail
customers' portfolios relative to other similarly situated investors in
different relationships (e.g., investment adviser, bank and trust
company, insurance company accounts)? Are there steps the Commission
should take to identify and address these conflicts? Can they be
appropriately addressed through disclosure or other means? How would
any such steps to address potential conflicts of interest benefit
retail customers currently and over time? What costs or other
consequences, if any, would retail customers experience as a result of
any such steps? For example, would broker-dealers be expected to
withdraw from or limit their offerings or services in certain markets
or certain products?
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    \335\ See Definition of the Term ``Fiduciary;'' Conflict of
Interest Rule--Retirement Investment Advice, 81 FR 20945 (Apr. 8,
2016) (to be codified at 29 CFR pts. 2509, 2510 and 2550) (stating
that conflicts of interest with respect to transactions pose
``special dangers to the security of retirement, health, and other
benefit plans'').
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     Has the Commission identified the types of conflicts of
interest that need to be addressed in connection with Regulation Best
Interest and are these appropriately addressed to meet the objective
that broker-dealers provide recommendations in the best interest of
retail customers? Are there new or different types of conflicts of
interest that the Commission should consider? If so, which ones?
     Do commenters have other suggestions on how broker-dealers
can eliminate material conflicts of interest, including financial
incentives? If so, please provide examples.
     Do commenters agree with the scope of the Commission's
proposed requirement related to disclosure and mitigation, or
elimination, of all material conflicts of interest arising from
financial incentives? Do commenters agree with the proposed
interpretation of such financial incentives? Why or why not? Please
explain. Do commenters believe any financial incentives could be
adequately addressed through disclosure or elimination (and do not
require mitigation)? If so, which ones? Why or why not? Which material
conflicts of interest do commenters believe must be mitigated? Why?
     Do commenters believe that retail customers recognize and
understand material conflicts of interest presented by broker-dealer
compensation arrangements, including the incentive to seek to increase
broker-dealers' compensation at the expense of the retail customers
they are advising?
     In lieu of or in addition to disclosure, should the
Commission explicitly require firms to mitigate conflicts generally and
not only those arising from financial incentives? Why or why not? Or
should we provide flexibility to firms to decide whether to disclose or
mitigate conflicts generally (e.g., to provide flexibility to firms on
how to address conflicts of interest)? Or are there certain conflicts
beyond financial incentives, that should be both disclosed and
mitigated (or eliminated)?
     Are there circumstances in which the Commission should
explicitly require elimination of certain material conflicts of
interest because mitigation would not be sufficient? Why or why not? If
so, please specify which ones.
     Should Regulation Best Interest expressly require broker-
dealers to regularly (e.g., at least annually) and rigorously review
their written policies and procedures to make sure that they have
supervisory and compliance systems to identify and address all of their
material conflicts of interest?
     Commenters in the past have highlighted several activities
of broker-dealers that are most likely to be impacted by an enhanced
standard of care for the provision of investment advice to retail
customers, such as a fiduciary standard. The Commission requests data
and other information related to the nature and magnitude of conflicts
of interest when broker-dealers engage in these activities and how
Regulation Best Interest would serve to increase or decrease broker-
dealers' conflicts of interest:
    [cir] Recommending proprietary products and products of affiliates;
    [cir] Engaging in principal trades with respect to a recommended
security (e.g., fixed income products);
    [cir] Recommending a limited range of products and/or services;
    [cir] Recommending a security underwritten by the firm or a broker-
dealer affiliate, including initial public offerings;
    [cir] Allocating investment opportunities among retail customers
(e.g., IPO allocation);
    [cir] Receiving third-party compensation in connection with
securities transactions or distributions (e.g., sales loads, ongoing
asset-based fees, or revenue sharing); and
    [cir] Providing ongoing, episodic or one-time advice.
    The Commission also requests comment on reasonable conflict
mitigation measures, specifically:
     What factors should broker-dealers weigh and evaluate in
establishing reasonable mitigation measures?
     Should the Commission take a more prescriptive approach
with regard to conflict mitigation measures? Why or why not?
     Do commenters have further examples of potential
mitigation measures beyond the non-exhaustive list provided above? Do
commenters believe that any of the examples provided on the list would
not be effective at mitigating conflicts related to financial
incentives? Why or why not?
     What impact should the firm's size have on implementation
of reasonable mitigation measures?
     Are there conflicts of interest that commenters believe
the Commission should prohibit? If so, which ones and why? For example,
do commenters believe the Commission should prohibit receipt of certain
non-cash compensation (e.g., sales contests, trips, prizes, and other
bonuses based on sales of certain securities, accumulation of assets
under management or any other factor)? Why or why not?
     Should the Commission require affirmative retail customer
consent for certain types of conflicts of interest? Why or why not?

     Would the guidance related to mitigating conflicts provide
clarity to firms? Why or why not? Is this guidance consistent with the
Commission's goal of improving the quality of recommendations that
retail customers receive? What are some areas in which commenters would
like more guidance?
     Are there certain product classes that commenters believe
the Commission should outright prohibit? If so, which ones and why?
     Do commenters believe neutral compensation across certain
products (e.g., equities, mutual funds, variable annuities, ETFs) is an
appropriate mitigation measure? Why or why not?

E. Recordkeeping and Retention

    In connection with proposed Regulation Best Interest, we are
proposing new record-making and recordkeeping requirements for broker-
dealers with respect to certain information collected from or provided
to retail customers. Exchange Act Section 17(a)(1) requires registered
broker-dealers to make and keep for prescribed periods such records as
the Commission deems ``necessary or appropriate in the public interest,
for the protection of investors.'' \336\ Exchange Act Rules 17a-3 and
17a-4 specify minimum requirements with respect to the records that
broker-dealers must make, and how long those records and other
documents must be kept, respectively.
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    \336\ See Exchange Act Section 17(a).
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    Under Rule 17a-3(a)(17), broker-dealers that make recommendations
for accounts with a natural person as customer or owner are required to
create and periodically update customer account information.\337\ As
part of developing a ``retail customer's investment profile,'' proposed
Regulation Best Interest may require broker-dealers to seek to obtain
certain retail customer information that is currently not required
pursuant to Rule 17a-3(a)(17). In addition, proposed Regulation Best
Interest would require broker-dealers to reasonably disclose in writing
the material facts relating to the scope and terms of their
relationship with the retail customer and all material conflicts of
interest that are associated with the investment recommendations
provided to the retail customer.
---------------------------------------------------------------------------

    \337\ See Exchange Act Rule 17a-3(a)(17).
---------------------------------------------------------------------------

    Accordingly, we are proposing to amend Rule 17a-3 to add a new
paragraph (a)(25), which would require, for each retail customer to
whom a recommendation of any securities transaction or investment
strategy involving securities is or will be provided, a record of all
information collected from and provided to the retail customer pursuant
to Regulation Best Interest, as well as the identity of each natural
person who is an associated person of a broker or dealer, if any,
responsible for the account. The new paragraph would specify, however,
that the neglect, refusal, or inability of a retail customer to provide
or update any such information would excuse the broker-dealer from
obtaining that information.\338\
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    \338\ Rule 17a-3(a)(17) applies to each account with a natural
person as a customer or owner, while proposed Regulation Best
Interest would apply to each recommendation of any securities
transaction or investment strategy involving securities to a retail
customer. Because of this difference, the Commission believes it
would be appropriate to locate the record-making requirements
related to Regulation Best Interest in a new paragraph of Rule 17a-3
rather than in an amendment to paragraph (a)(17).
---------------------------------------------------------------------------

    Under Rule 17a-4(e)(5), broker-dealers are required to maintain and
preserve in an easily accessible place all account information required
pursuant to Rule 17a-3(a)(17) \339\ for six years.\340\ We are
proposing to amend Exchange Act Rule 17a-4(e)(5) to require broker-
dealers to retain any information that the retail customer provides to
the broker-dealer or the broker-dealer provides to the retail customer
pursuant to Rule 17a-3(a)(25), in addition to the existing requirement
to retain information obtained pursuant to Rule 17a-3(a)(17). As a
result, broker-dealers would be required to retain all of the
information collected from or provided to each retail customer pursuant
to Regulation Best Interest for six years.
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    \339\ Under Rule 17a-3(a)(17), broker-dealers that make
recommendations for accounts with a natural person as customer or
owner are required to create, and periodically update, customer
account information. As part of developing a ``retail customer's
investment profile,'' proposed Regulation Best Interest would
require broker-dealers to seek to obtain certain retail customer
information that is currently not required to be created under Rule
17a-3(a)(17). Because broker-dealers are already required to seek to
obtain identical information pursuant to the FINRA suitability rule,
we believe that broker-dealers should already be attempting to
collect, pursuant to the FINRA suitability rule, or collecting under
existing Exchange Act books and records rules, the information that
would be required pursuant to Regulation Best Interest. Accordingly,
we do not believe that it is necessary to impose any new record-
making requirement upon broker-dealers.
    \340\ See Exchange Act Rule 17a-4(e)(5) (account record
information required pursuant to Rule 17a-3(a)(17) must be
maintained and preserved in an easily accessible place until at
least six years after the earlier of the date the account was
closed, or the date on which the information was replaced or
updated).
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    We are not proposing new record retention requirements regarding
the written policies and procedures that broker-dealers would be
required to create pursuant to Regulation Best Interest because such
information is already currently required to be retained pursuant to
Exchange Act Rule17a-4(e)(7).\341\ Rule 17a-4(e)(7) requires broker-
dealers to retain compliance, supervisory, and procedures manuals (and
any updates, modifications, and revisions thereto) describing the
policies and practices of the broker-dealer with respect to compliance
with applicable laws and rules, and supervision of the activities of
each natural person associated with the broker-dealer, for a specified
period of time.
---------------------------------------------------------------------------

    \341\ FINRA Rule 3110 requires written supervisory procedures
that are reasonably designed to achieve compliance with applicable
securities laws and regulations, and with applicable FINRA rules.
See FINRA Rule 3110(b)(1) (Supervision).
---------------------------------------------------------------------------

    The Commission requests comment on recordkeeping and retention
requirements related to Regulation Best Interest:
     Should the Commission impose additional record-making
requirements related to Regulation Best Interest? Why or why not? If
the Commission were to adopt additional requirements, what records
should we specifically require broker-dealers to make?
     Should the Commission impose additional record retention
requirements related to Regulation Best Interest? Why or why not? If
the Commission were to adopt additional requirements, what records
should we specifically require broker-dealers to retain?

F. Whether the Exercise of Investment Discretion Should Be Viewed as
Solely Incidental to the Business of a Broker or Dealer

    The Advisers Act regulates the activities of certain ``investment
advisers,'' who are defined in section 202(a)(11) of the Advisers Act
as persons who, for compensation, engage in the business of advising
others about securities. Section 202(a)(11)(C) excludes from the
definition of investment adviser a broker or dealer whose performance
of such advisory services is solely incidental to the conduct of his
business as a broker or dealer and who receives no special compensation
for those services (the ``broker-dealer exclusion''). The broker-dealer
exclusion shows, on the one hand, that Congress recognized broker-
dealers may give a certain amount of advice to their customers in the
course of their regular business as broker-dealers and that it would be
inappropriate to bring them within the scope of the Advisers Act merely
because of this aspect of their

business.\342\ On the other hand, the limitations of the exclusion show
that Congress also recognized certain broker-dealer advisory services
belong within the scope of the Advisers Act--namely those for which
they receive special compensation and those that are not solely
incidental to their regular business as broker-dealers.\343\
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    \342\ Opinion of General Counsel Relating to Section
202(a)(11)(C) of the Investment Advisers Act of 1940, Investment
Advisers Act Release No. 2 (Oct. 28, 1940) (``Advisers Act Release
No. 2'').
    \343\ In 1940, when Congress enacted the Advisers Act, broker-
dealers were already regulated under the Exchange Act. In the
Advisers Act, Congress expressly acknowledged that the broker-
dealers it covered could also be subject to other regulation. 15
U.S.C. 80b-8(b). Judicial interpretation of the broker-dealer
exclusion also has noted that Congress passed the Advisers Act to
provide certain protections to the public when receiving investment
advice and that there is nothing in the legislative history of the
Advisers Act ``to suggest that Congress was particularly concerned
about the regulatory burdens on broker-dealers'' associated with
their being subject to the Advisers Act in addition to Exchange Act.
Financial Planning Association v. SEC, 482 F.3d 481(D.C. Cir. 2007)
(``Financial Planning Association v. SEC'') (noting additionally
that ``[j]ust as the text and structure of paragraph 202(a)(11) make
it evident that Congress intended to define `investment adviser'
broadly and create only a precise exemption for broker-dealers, so
does a consideration of the problems Congress sought to address in
enacting the IAA'' and stating that the Advisers Act sought to
address these problems ``by establishing a federal fiduciary
standard to govern the conduct of investment advisers, broadly
defined'' and ``by requiring full disclosure of all conflicts of
interest'').
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    The Commission has on many occasions discussed the scope of the
broker-dealer exclusion. In particular, the Commission has for many
years considered issues related to a broker-dealer's exercise of
investment discretion over customer accounts and the extent to which
such practices could be considered solely incidental to the business of
a broker-dealer. Since at least 1978, the Commission has recognized
that the broker-dealer exclusion requires some limitations on a broker-
dealer's exercise of investment discretion. At that time, the
Commission solicited comment on the question of whether broker-dealers
who exercised discretionary authority over customers' accounts should,
per se, be considered investment advisers with respect to those
accounts.\344\ While the Commission declined to adopt such an
interpretation at that time, it noted that if the business of a broker-
dealer consisted almost exclusively of managing accounts on a
discretionary basis, the Commission staff would not consider the
broker-dealer to be providing investment advice that is solely
incidental to its business as a broker-dealer.\345\ In 2005, the
Commission adopted an interpretive rule \346\ that, among other things,
provided that broker-dealers are not excluded from the Advisers Act for
any accounts over which they exercise more than temporary or limited
investment discretion.\347\ The 2005 interpretation regarding
investment discretion was part of a rule whose principal purpose was to
permit broker-dealers to offer fee-based brokerage accounts (where a
customer pays an asset-based fee) without being subject to the Advisers
Act with respect to those accounts.\348\ In 2007, the rule was vacated
by the U.S. Court of Appeals for the District of Columbia Circuit on
the grounds that the Commission did not have the authority to except
broker-dealers offering fee-based brokerage accounts from the
definition of ``investment adviser.'' \349\ Though the Court did not
specifically address the validity of the provision regarding investment
discretion, it vacated the entire rule. After the rule was vacated, the
Commission proposed in 2007, though did not adopt, a similar
interpretive rule regarding investment discretion.\350\
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    \344\ Final Extension of Temporary Rules, Advisers Act Release
No. 626 (Apr. 27, 1978) (``Advisers Act Release No. 626'').
    \345\ Applicability of the Investment Advisers Act to Certain
Brokers and Dealers, Investment Advisers Act Release No. 640 (Oct.
5, 1978) [43 FR 47176 (Oct. 13, 1978)] (``Advisers Act Release No.
640'').
    \346\ Original rule 202(a)(11)-1 under the Advisers Act.
    \347\ See Certain Broker-Dealers Deemed Not to be Investment
Advisers, Advisers Act Release No. 2340 (Jan. 6, 2005) (``2005
Proposing Release''); Certain Broker-Dealers Deemed Not to be
Investment Advisers, Advisers Act Release No. 2376 (Apr. 12, 2005)
(``2005 Adopting Release'').
    \348\ See 2005 Adopting Release, supra note 347. Fee-based
brokerage accounts are similar to traditional full-service brokerage
accounts, which provide a package of services, including execution,
incidental investment advice, and custody. The primary difference
between the two types of accounts is that a customer in a fee-based
brokerage account pays a fee based upon the amount of assets on
account (an asset-based fee) and a customer in a traditional full-
service brokerage account pays a commission (or a mark-up or mark-
down) for each transaction.
    \349\ See Financial Planning Association v. SEC, supra note 343.
    \350\ Interpretive Rule Under the Advisers Act Affecting Broker-
Dealers, Investment Advisers Act Release No. 2652 (Sept. 24, 2007)
(``2007 Proposing Release'').
---------------------------------------------------------------------------

    In considering why limitations on broker-dealers' exercise of
investment discretion are needed, the Commission has noted that
discretionary brokerage relationships ``have many of the
characteristics of the relationships to which the protection of the
Advisers Act are important.'' \351\ In particular, the Commission has
noted that the exercise of investment discretion is qualitatively
distinct from simply providing advice as part of a package of brokerage
services, because a broker-dealer with such discretion is not just a
source of advice, but has authority to make investment decisions
relating to the purchase or sale of securities on behalf of
customers.\352\ The Commission has stated that the quintessentially
supervisory or managerial character of investment discretion warrants
the protection of the Advisers Act and its attendant fiduciary
duty.\353\ This position aligns with the interpretations of the courts,
which have generally found that broker-dealers with investment
discretion owe customers a fiduciary duty under state law.\354\
---------------------------------------------------------------------------

    \351\ Advisers Act Release No. 626.
    \352\ See 2005 Proposing Release; see also 2007 Proposing
Release.
    \353\ See Amendment and Extension of Temporary Exemption From
the Investment Advisers Act for Certain Brokers and Dealers,
Investment Advisers Act Release No. 471 (Aug. 20, 1975)(``. . . it
is not appropriate to exempt from the Advisers Act for an extended
period those brokers and dealers who perform investment supervisory
services or other investment management services because of the
special trust and confidence inherent in the relationships between
such brokers and dealers and their advisory clients.''). See also
2005 Proposing Release; 2005 Adopting Release; and 2007 Proposing
Release.
    \354\ See, e.g., United State v. Skelly, 442 F.3d 94 at 98 (2d
Cir. 2006) (fiduciary duty found ``most commonly'' where ``a broker
has discretionary authority over the customer's account''); United
States v. Szur, 289 F.3d 200 at 211 (2d Cir. 2002) (``Although it is
true that there `is no general fiduciary duty inherent in an
ordinary broker/customer relationship,' a relationship of trust and
confidence does exist between a broker and a customer with respect
to those matters that have been entrusted to the broker.'')
(citations omitted); Leib v. Merrill Lynch, Pierce, Fenner & Smith,
Inc., 461 F. Supp. 951, 953-54 (E.D. Mich. 1978), aff'd, 647 F.2d
165 (6th Cir. 1981) (stating that courts have held that a broker who
has de facto control over a non-discretionary account generally owes
customer duties of a fiduciary nature; looking to customer's
sophistication, and the degree of trust and confidence in the
relationship, among other things, to determine duties owed). See
also Arthur B. Laby, Fiduciary Duty of Broker-Dealers and Investment
Advisers, 55 VILL. L. REV. 3 (2010) (``most courts and commentators
agree that when a broker has discretionary authority, the broker
owes fiduciary duties to its customer''); Barbara Black, Brokers and
Advisers--What's in a Name?, 11 FORDHAM J. CORP. & FIN. L. 31, 36
(2005) (stating that broker-dealers generally do not owe a fiduciary
duty unless operating with discretion).
---------------------------------------------------------------------------

    At the same time, the Commission has recognized that at least some
exercise of discretionary authority by broker-dealers could be
considered solely incidental to their business. Under a previous
interpretation, a broker-dealer's discretionary account was subject to
the Advisers Act only if the broker-dealer had enough other
discretionary accounts to trigger the Advisers Act.\355\ The
interpretive

provision that we adopted in 2005 and proposed in 2007 would have
required broker-dealers to be considered to be investment advisers
under the Advisers Act with respect to discretionary accounts, except
that broker-dealers would have been permitted to exercise investment
discretion on a temporary or limited basis.\356\
---------------------------------------------------------------------------

    \355\ A broker-dealer who exercised discretionary authority over
the accounts of some of its customers was generally regarded as
providing investment advice incidental to its business as a broker-
dealer but a broker-dealer whose business consisted almost
exclusively of managing accounts on a discretionary basis was not
regarded as providing advice solely incidental to his business as a
broker-dealer. See Advisers Act Release No. 626.
    \356\ The Commission stated that it would view a broker-dealer's
discretion to be temporary or limited within the meaning of proposed
rule 202(a)(11)-1(d) when the broker-dealer was given discretion:
(i) As to the price at which or the time to execute an order given
by a customer for the purchase or sale of a definite amount or
quantity of a specified security; (ii) on an isolated or infrequent
basis, to purchase or sell a security or type of security when a
customer is unavailable for a limited period of time not to exceed a
few months; (iii) as to cash management, such as to exchange a
position in a money market fund for another money market fund or
cash equivalent; (iv) to purchase or sell securities to satisfy
margin requirements; (v) to sell specific bonds and purchase similar
bonds in order to permit a customer to take a tax loss on the
original position; (vi) to purchase a bond with a specified credit
rating and maturity; and (vii) to purchase or sell a security or
type of security limited by specific parameters established by the
customer. See 2005 Proposing Release; 2005 Adopting Release; 2007
Proposing Release. In the 2005 Adopting Release, we noted that
accounts in which broker-dealers exercised such investment
discretion would continue to be subject to the existing Exchange Act
and SRO rules concerning broker-dealer exercise of investment
discretion. See 2005 Adopting Release.
---------------------------------------------------------------------------

    Although we did not adopt our 2007 proposal, many commenters were
generally supportive of our approach.\357\ We believe that much of the
financial industry has treated broker-dealers as not excluded from the
Advisers Act for any accounts over which they exercise more than
temporary or limited investment discretion. Most commenters to the
Chairman's recent request for comment, including broker-dealers, have
indicated that financial firms generally treat discretionary accounts
as advisory accounts.\358\
---------------------------------------------------------------------------

    \357\ See, e.g., Letter of the Consumer Federation of America
and Fund Democracy (Nov. 2, 2007); Letter of the Investment Adviser
Association (Nov. 2, 2007); Letter of Charles McKeown (Oct. 30,
2007); and Letter of the Securities Industry and Financial Markets
Association (Nov. 2, 2007).
    \358\ See T. Rowe Letter; Stifel Letter (``In simple terms,
Brokerage relationships are non-discretionary, commission-based
accounts, through which a financial professional provides episodic
investment advice incidental to each transaction. By contrast, in an
Advisory relationship, a financial professional generally provides
ongoing investment advice and monitoring and charges a level fee,
generally based on assets.); see ICI August 2017 Letter (``broker-
dealers typically do not exercise discretionary authority over
customer accounts''); Vanguard Letter (``The investment advisory
business model is significantly different from that of a broker-
dealer. Advisers generally provide ongoing advice for a fee, take
discretion over client accounts, and engage other entities to carry
client accounts and handle client trading.'').
---------------------------------------------------------------------------

    Our staff acknowledged that broker-dealers may provide some
discretionary account services in the 913 Study.\359\ We have also long
recognized that a broker-dealer's ability to engage in discretionary
activity is circumscribed by existing rules under the federal
securities laws.\360\ In addition, broker-dealers that engage in any
discretionary activity are subject to SRO Rules that prohibit and
require specific conduct with respect to discretionary accounts.\361\
Further, broker-dealers vested with discretionary authority or that
exercise control over customer assets have been held to a fiduciary
standard under state law.\362\
---------------------------------------------------------------------------

    \359\ See 913 Study at 9-10.
    \360\ See, e.g., Exchange Act Section 3(a)(35) (defining
investment discretion). 17 CFR 240.15c1-7.
    \361\ See NASD Rule 2510 (Discretionary Accounts) and
Incorporated NYSE Rule 408 (Discretionary Power in Customers'
Accounts). Drawing upon the requirements of these rules and SRO
suitability rules, the Commission has found the exercise of
discretion over a customer's account may constitute a
``recommendation'' that additionally subjects a broker-dealer's
discretionary activity to SRO suitability requirements. See, e.g.,
In re Application of Paul C. Kettler, Exchange Act Release No.
31354, 1992 WL 320802, *3, n.11 (1992). See also In re James Harman
McNeill, (Case No.<PHONE_NUMBER>101, AWC, Mar. 12, 2013), available at
http://www.finra.org/sites/default/files/fda_documents/2012030927101_FDA_TP44051.pdf (associated person violated FINRA Rule
2510(b) by exercising discretion in five customers' brokerage
accounts without the written authorization of the customers). See
also supra note 139 and accompanying text.
    \362\ See supra note 15.
---------------------------------------------------------------------------

    We believe that it is appropriate for the Commission to again
consider the scope of the broker-dealer exclusion with regard to a
broker-dealer's exercise of investment discretion in light of both
proposed Regulation Best Interest and the proposed Relationship
Summary. Additionally, some commenters to the Chairman's request asked
that we expressly affirm the interpretive provision we adopted in 2005
and proposed in 2007.\363\
---------------------------------------------------------------------------

    \363\ IAA Letter; CFA 2017 Letter.
---------------------------------------------------------------------------

    In light of the foregoing, we request comment on the following:
     Should a broker-dealer's provision of unfettered
discretionary investment advice be considered solely incidental to the
conduct of its business as a broker-dealer?
     Should a broker-dealer's provision of limited
discretionary investment advice be considered solely incidental to the
conduct of its business as a broker-dealer? If so, what limitations on
a broker-dealer's exercise of investment discretion would make it
solely incidental to the conduct of its business as a broker-dealer?
     Should we propose an interpretive rule placing express
limits on investment discretion permissible under the solely incidental
exclusion as we did in 2007? What would be the consequences of such a
rule?
     In 2007, we proposed to permit broker-dealers to exercise
investment discretion granted by a customer on a temporary or limited
basis. Is that appropriate? Would it provide the intended investor
protection? Would it provide the clarity regarding the applicable
business model and standard of care?
     In 2007 we provided examples of when we would consider a
broker-dealer's investment discretion to be temporary or limited.\364\
Should we define situations in which investment discretion should be
viewed as being granted on a temporary or limited basis? For example,
should temporary investment discretion last no more than a very limited
time (i.e., not as long as two or more months)? Should we restrict a
broker-dealer's ability to exercise temporary investment discretion
repeatedly? Should limited discretion ``to purchase or sell a security
or type of security limited by specific parameters established by the
customer'' be restricted? \365\ What are some examples of specific
parameters that a customer could establish under this example? Should
we expand any of the situations in which investment discretion could be
viewed as being granted on a temporary or limited basis? For example,
should we explicitly allow brokers to exercise investment discretion
granted by the customer to rebalance the customer's account or to
invest a limited portion of the account in a particular sector?
---------------------------------------------------------------------------

    \364\ See supra note 356.
    \365\ Id.
---------------------------------------------------------------------------

     Do broker-dealers generally use the examples from the 2007
release to determine when to seek authorization to exercise temporary
or limited investment discretion from a customer? Are there other
circumstances that cause broker-dealers to seek authorization to
exercise investment discretion?
     The Commission requests data and other information related
to the nature and magnitude of discretionary services offered by
broker-dealers. To what extent do broker-dealers offer a range of
discretionary brokerage accounts? What is the range of discretionary
services offered, and what types of limits do broker-dealers apply to
such services?
     We understand that dually-registered firms generally treat
discretionary accounts as advisory accounts. Is this understanding
correct? To what extent and under what circumstances do broker-dealers
treat discretionary accounts as brokerage accounts? If broker-dealers
offer

discretionary management in brokerage accounts, who are the typical
investors in those accounts?
     Section 3(a)(35) of the Exchange Act defines ``investment
discretion.'' \366\ Should we consider a different, narrower definition
of discretionary management that would be deemed solely incidental to
the brokerage business?
---------------------------------------------------------------------------

    \366\ 15 U.S.C. 78c(a)(35). Under Exchange Act Section 3(a)(35),
a person exercises ``investment discretion'' with respect to an
account if, ``directly or indirectly, such person (A) is authorized
to determine what securities or other property shall be purchased or
sold by or for the account, (B) makes decisions as to what
securities or other property shall be purchased or sold by or for
the account even through some other person may have responsibility
for such investment decisions, or (C) otherwise exercises such
influence with respect to the purchase and sale of securities or
other property by or for the account as the Commission, by rule,
determines, in the public interest or for the protection of
investors, should be subject to the operation of the provisions of
this title and the rules and regulations thereunder.''
---------------------------------------------------------------------------

     Do broker-dealers rely on the staff's 2005 statement that
it would not deem a broker-dealer to exercise investment discretion for
purposes of the then existing Advisers Act rule 202(a)(11)-1 as a
result of the exercise of investment discretion by one of its
associated persons over a ``related account''? \367\
---------------------------------------------------------------------------

    \367\ A ``related account'' is an account where the associated
person's discretionary authority stems from his or her serving as
executor, conservator, trustee, attorney-in-fact or other agent as a
result of a family or personal relationship, and not from employment
with the broker-dealer. No-Action Letter Under Investment Advisers
Act of 1940--Rule 202(a)(11)-1 (Nov. 17, 2005), available at https://www.sec.gov/divisions/investment/noaction/morganlewis111705.htm.
---------------------------------------------------------------------------

     We are concerned that any approach to the broker-dealer
exclusion in the Advisers Act that would permit broker-dealers
unlimited investment discretion could increase incentives for improper
conduct, particularly the incentive to churn accounts because broker-
dealers receive transactional compensation. To what extent would
permitting broker-dealers to exercise unlimited investment discretion
increase the risk of such conduct? Are there protections in addition to
those already in place, or limitations on the permissible use of
investment discretion, that we could take to reduce such risks? To what
extent would subparagraph (a)(2)(i)(C) of proposed Regulation Best
Interest reduce such risks?
     To what extent does broker-dealers' exercise of investment
discretion for their customers increase investor choice in financial
services? What are the benefits and risks to investors? How could the
risks be addressed through regulation, including Regulation Best
Interest?
     The Commission also requests commenters' views on
potential opportunities for broker-dealers to offer discretionary
brokerage services in the future. To what extent would broker-dealers
anticipate offering additional discretionary brokerage services?
     As discussed in this release and the Relationship Summary
Proposal, investors are often confused by the differences between
advisory and brokerage accounts. Would drawing a specific distinction
between discretionary and non-discretionary accounts resolve some of
this confusion?

III. Request for Comment

    The Commission requests comments on all aspects of Regulation Best
Interest. The Commission particularly requests comment on the general
impact the proposal would have on recommendations to retail customers
and on the behavior of broker-dealers, including the interaction of
Regulation Best Interest with the requirements of the Relationship
Summary Proposal. The Commission also seeks comment on the interaction
of Regulation Best Interest with FINRA and other SRO rules, the
antifraud provisions of the federal securities laws, the Advisers Act,
ERISA, and the Code. In addition, the Commission seeks comment on the
following specific issues:

A. Generally

     Does Regulation Best Interest clearly define the
obligations to which broker-dealers would be subject? Are there
clarifications or instructions to the proposed requirements that would
aid broker-dealers' compliance with the proposed rule? If so, what are
they, and what would be the benefits of providing clarifications or
instructions?
     As proposed, compliance with paragraph (a)(2) of
Regulation Best Interest is designed to satisfy the duty in (a)(1). Is
this the right relationship between these two pieces? Should paragraph
(a)(2) be expressed as a minimum standard? Or should the duty in
expressed in paragraph (a)(1) have residual force and effect apart from
the obligations in (a)(2)? Alternatively, should compliance with (a)(2)
be a safe harbor? Or should it create a legal presumption that the
broker-dealer has met the standard in (a)(1)? Should the Commission
create a compliance safe harbor for Regulation Best Interest? Why or
why not? If so, what conditions should a broker-dealer be required to
satisfy to claim the safe harbor? What impact would this have on the
recommendations that retail customers receive?
     Should broker-dealers be subject to any additional
requirements with respect to the best interest obligation proposed
under Regulation Best Interest? If so, what requirements and why?
     Should the Commission require policies and procedures to
assist with compliance with Regulation Best Interest? If so, how would
those policies and procedures differ, if at all, from those currently
required by FINRA?
     Should the Commission consider making other adjustments to
the regulatory obligations of broker-dealers, and if so, which
obligations?
     Should the Commission include in the rule text the
interpretations and recommendations included in the guidance provided
above? If so, which interpretations and recommendations and why or why
not?
     Do commenters believe any of the proposed definitions
under Regulation Best Interest should be eliminated or modified? Are
there any additional terms that should be defined; if so, what are
those terms, how should such terms be defined, and why?
     To what extent would Regulation Best Interest help address
any investor confusion about the standard of conduct that applies when
a broker-dealer provides advice in the form of recommendations? What,
if any, other steps should the Commission consider to attempt to
mitigate investor confusion?
     What impact would Regulation Best Interest have on the
range of choice--both in terms of services related to advice and
products--that is available to brokerage retail customers today? Would
it preserve such choice? What, if any, additional or different steps
should the Commission consider to attempt to preserve choice or
mitigate any negative impact on the range of choice available to
brokerage customers to receive financial advice?
     What impact would Regulation Best Interest have on the
ability of broker-dealers to compete with other financial
intermediaries to provide advice to investors in the future?
     To what extent would Regulation Best Interest be
consistent with relevant SRO requirements? Would Regulation Best
Interest be stricter or less strict than SRO obligations? Would
Regulation Best Interest conflict with or be redundant of SRO
obligations; if so, please identify which SRO obligations and whether
and how the Commission should consider to address such conflicts or
redundancies.
     Is it appropriate for Regulation Best Interest to be
designed to be generally consistent with DOL and SRO

regulations? Why or why not? Should we take a different approach?
     Does proposed Regulation Best Interest address current
deficiencies in the current standard applicable to broker-dealers who
provide advice? Why or why not? Please explain.
     Are there any recommendations in the 913 Study that should
be, but have not been, incorporated into the proposed rule? Please
elaborate.
     To what extent is the proposed Regulation Best Interest
consistent or inconsistent with broker-dealers' existing obligations?
How? What impact would such consistency or inconsistency have on retail
customers and broker-dealers?

B. Interactions With Other Standards of Conduct

     Are there any specific interactions or relationships
between the proposed rules and other federal securities laws that
should be addressed?
     Are there any specific interactions between the proposed
rules and other regulatory requirements, such as SRO rules or state
securities laws that should be addressed?
     Are there any specific interactions between the proposed
rules and any non-securities statutes and regulations (e.g., ERISA and
the Code) that should be addressed? If so, how should those
interactions or relationships be addressed or clarified?
     Do any of the proposed requirements conflict with any
existing requirements, including any requirement currently imposed by
an SRO or by a state regulator, such that it would be impractical or
impossible for a broker-dealer to meet both obligations? If so, which
one(s) and why?
     Do commenters agree that proposed Regulation Best Interest
is consistent with and similar to (if not the same as) related
obligations under the duties of loyalty and care as interpreted under
the Advisers Act? Why or why not? Please explain.
     If the Commission were to adopt this proposal, there would
still be different standards of conduct for retail customer accounts
subject to the DOL Fiduciary Rule and those that are not, as well as
existing differences between standards of conduct applicable to broker-
dealers and those applicable to investment advisers when providing
investment advice. Should the Commission consider harmonizing
regulatory obligations related to the provision of advice that are
applicable to broker-dealers and investment advisers? Why or why not?
If so, how so? Please be specific with regard to the existing
obligations and how they should be changed.
     To what extent would regulatory harmonization address
investors' confusion about the obligations owed to them by broker-
dealers and investment advisers? To what extent would regulatory
harmonization result in additional investor confusion or otherwise
negatively impact investors? What would be positive and negative
investor impacts of regulatory harmonization? To what extent would
regulatory harmonization affect investors' choice of financial firms
and options to pay for financial advice? Please explain.
     Are there any specific interactions between Regulation
Best Interest and state standards that should be addressed? What have
commenters' experiences been with respect to current state fiduciary
standards (regulatory and common law) for broker-dealers that provide
investment advice? How are these standards similar or different than
this proposal? What are commenters' views regarding proposed state
fiduciary standards for broker-dealers?

IV. Economic Analysis

A. Introduction, Primary Goals of Proposed Regulations and Broad
Economic Considerations

1. Introduction and Primary Goals of Proposed Regulation
    The Commission is mindful of the costs imposed by, and the benefits
obtained from, our rules. Whenever the Commission engages in rulemaking
and is required to consider or determine whether an action is necessary
or appropriate in the public interest, Section 3(f) of the Exchange Act
requires the Commission to consider whether the action would promote
efficiency, competition, and capital formation, in addition to the
protection of investors.\368\ Further, when making rules under the
Exchange Act, Section 23(a)(2) of the Exchange Act requires the
Commission to consider the impact such rules would have on
competition.\369\ Section 23(a)(2) of the Exchange Act also prohibits
the Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.\370\ The following analysis considers, in detail,
the potential economic effects that may result from proposed Regulation
Best Interest, including the benefits and costs to retail customers and
broker-dealers as well as the broader implications of the proposal for
efficiency, competition, and capital formation.
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    \368\ See 15 U.S.C. 77b(b) and 15 U.S.C. 78c(f).
    \369\ See 15 U.S.C. 78w(a)(2).
    \370\ Id.
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    Where possible, the Commission quantifies the likely economic
effects of proposed Regulation Best Interest; however, as explained
further below, the Commission is unable to quantify certain economic
effects because it lacks the information necessary to provide
reasonable estimates. In some cases, quantification is particularly
challenging due to the difficulty of predicting how market participants
would act under the conditions of the proposed rule. Nevertheless, as
described more fully below, the Commission is providing both a
qualitative assessment and quantified estimate of the potential
effects, including the potential aggregate initial and aggregate
ongoing costs, where feasible. The Commission encourages commenters to
provide data and information to help quantify the benefits, costs, and
the potential impacts of the proposed rule on efficiency, competition,
and capital formation.
2. Broad Economic Considerations
a. The Principal-Agent Relationship
    The relationship between a retail customer and a broker-dealer is
an example of what is referred to in economic theory as an ``agency''
relationship. In an agency relationship, one party, commonly referred
to as ``the principal,'' engages a second party, commonly referred to
as ``the agent,'' to perform some service on the principal's
behalf.\371\ Because the agent and the principal are likely to have
different preferences and goals, there is reason to believe that the
agent may not always take actions that are in the principal's
interest.\372\ This divergence in interests gives rise to agency
problems: Agents take actions that increase their well-being at the
expense of principals.\373\

Retail customers face agency problems when they seek advice from
financial professionals. For example, a retail customer may believe
that a broker-dealer will exert a high level of effort on a retail
customer's behalf to identify a security that helps the retail customer
meet her objectives. But to the extent that effort is costly to the
broker-dealer and the benefits of the recommendation accrue solely to
the retail customer, the broker-dealer has an incentive to exert a
lower level of effort than the retail customer expects.\374\ In this
section, we describe how principals (customers) and agents (broker-
dealers and associated persons) ameliorate agency problems in the
market for investment advice using contracts and discuss limits to the
efficiency of contracting in the market for financial advice.
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    \371\ For example, James A. Brickley, Clifford W. Smith, Jr.,
Jerold L. Zimmerman, ``Managerial Economics and Organizational
Architecture'' (2004, p. 265), ``An agency relationship consists of
an agreement under which one party, the principal, engages another
party, the agent, to perform some service on the principal's
behalf.'' See also Michael C. Jensen and William H. Meckling,
``Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure,'' Journal of Financial Economics (1976, vol. 3,
pp. 305-60).
    \372\ See Michael C. Jensen and William H. Meckling, ``Theory of
the Firm: Managerial Behavior, Agency Costs and Ownership
Structure,'' Journal of Financial Economics (1976, vol. 3, p. 308).
    \373\ See James A. Brickley, Clifford W. Smith, Jr., Jerold L.
Zimmerman, ``Managerial Economics and Organizational Architecture''
(2004, p. 265).
    \374\ Other manifestations of the agency conflict between
broker-dealers and customers include conflicts that arise when
broker-dealers act as principal (e.g., proprietary products,
principal trades) or when the broker-dealer opts to enter into
relationships with third parties (e.g., revenue sharing) that
creates their own conflicts.
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    Contracts are a common mechanism used by principals and agents to
ameliorate agency problems. They do so by explicitly setting out the
responsibilities of both parties under the contract. Typically, in
return for compensation from the principal, an agent agrees to perform
certain actions that will benefit the principal. For example, in a
typical contract between a broker-dealer and a retail customer, the
broker-dealer agrees to provide execution services in return for
compensation in the form of either a commission or a markup. The
contract ameliorates the conflict between the two parties because the
broker-dealer is compensated only if it provides the contracted
service.
    Explicit contracting is an efficient mechanism for ameliorating
agency costs when the principal can monitor the agent's performance at
low cost. For certain services, however, it may be difficult or costly
for principals to monitor agent performance. For example, in seeking
investment advice, retail customers may expect broker-dealers to
understand the potential risks and rewards associated with a
recommended transaction or strategy. While it might be possible, in