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SEC Unveils Best Interest Regulation But Critics Complain It Merely Maintains the Status Quo

By Rita Raagas De Ramos April 19, 2018

In a much-awaited move by many in the financial advisory industry – particularly broker-dealer firms – the SEC Wednesday unveiled its proposed “Regulation Best Interest” package, which establishes a best interest standard of conduct for broker-dealers, interprets the fiduciary standard for investment advisors, and creates a new Customer Relationship Summary form aimed at clearly stating to clients if they are dealing with a broker-dealer or an investment advisor.

In a two-hour open meeting, the SEC staff took turns explaining the pertinent points of the nearly 1,000-page proposed regulation package, which they said took 11 months to complete.

During the presentations, common themes emerged explaining their motivations and goals in crafting the proposed package. SEC staffers said they wanted to create a best interest standard that was in line with investor expectations without limiting investors’ product choices. They also said they didn’t want to create the unintended consequence of significantly disrupting the business operations of broker-dealer firms because of the proposed package.

In a vote of four yes to one no, the five SEC commissioners, including Chairman Jay Clayton, voted in support of the proposed package, which is now subject to a 90-day comment period.

Here are the highlights of the proposed package.

Regulation Best Interest

The proposed best interest rule requires a broker-dealer to have a duty to act in the best interest of retail customers when making a recommendation – at the time the recommendation is made – without putting his/her own financial or other interest ahead of the retail customer.

The proposed rule requires the broker-dealer to discharge this duty by complying with three specific obligations:

  • Disclosure obligation: Disclose to the retail customer the key facts about the relationship, including material conflicts of interest.
  • Care obligation: Exercise reasonable diligence, care, skill and prudence, to understand the product; have a reasonable basis to believe that the product is in the retail customer’s best interest; and have a reasonable basis to believe a series of transactions is in the retail customer’s best interest.
  • Conflict of interest obligation: Establish, maintain and enforce policies and procedures reasonably designed to identify -- and then, at a minimum, to disclose and mitigate, or eliminate -- material conflicts of interest arising from financial incentives. Other material conflicts of interest must be at least disclosed.

Investment Advisor Interpretation

The proposed package includes an interpretation of the investment advisor’s fiduciary duty. The proposed interpretation reaffirms – and in some cases clarifies – certain aspects of the fiduciary duty an investment advisor owes to his/her clients.

Customer Relationship Summary

The proposed regulation requires investment advisors and broker-dealers (and associated persons of broker-dealers) to provide retail investors with a customer relationship summary (CRS). Simply put, this is meant to make it clear to investors whether they are dealing with an investment advisor or a broker-dealer. This standardized disclosure form -- to be a maximum of four pages in length -- requires an explanation of the principal types of services offered; the legal standards of conduct that apply to the investment advisor or the broker-dealer (whichever relationship applies); the fees a client might pay; and certain conflicts of interest that may exist.

The need to clarify the relationship with the client bars broker-dealers and their associated persons from referring to themselves as either “advisor” or “adviser” unless they are specifically also registered as investment advisors with the SEC. This would mean eliminating such references in any form on all materials, including business cards, firm websites and marketing materials. The SEC notes that the loose use of the terms "advisor" or "adviser" by broker-dealers may have led retail clients to believe they were dealing with investment advisors.

SEC Commissioner Kara Stein, who didn’t mince words during the open meeting, was the lone dissenter among the commissioners, although three other commissioners – Robert Jackson, Hester Peirce, and Michael Piwowar – expressed certain concerns about the proposed package.

While acknowledging the “herculean task” that was thrust before the SEC staff in a “short period of time,” she said the proposed package “squanders the opportunity to act in the best interest of investors,” and instead, it merely “maintains the status quo.”

Stein said she is particularly disappointed because after “listening week after week” to SEC staff reporting on irregularities or misconduct committed by industry participants, “it is clear to me that the best interest standard currently (in the proposed package) is not going to be enough” to protect vulnerable investors or help those that are harmed by bad actors in the industry.

She goes as far as saying the proposed package merely echoes the suitability standards that broker-dealers are already held up against and merely reaffirms, but also potentially confuses, the fiduciary standard that investment advisors are held up against.

“With so much more we can do, it’s hard to fathom why we are being asked to vote on this,” she said before the votes were cast.

Stein described the proposed package as a “safe harbor” for broker-dealers because it “protects the broker-dealers from liability” and “not the customers.”

“It’s better to call this proposal 'Regulation Status Quo,'” she said.

Commissioner Piwowar supported the proposed package but said he has “misgivings,” which were all centered on whether it would lead to higher compliance costs for broker-dealers.

The current template for the CRS, for example, is too complicated, he said. “It’s as comprehensive as Herman Melville’s Moby Dick. It should be simple.”

Piwowar added that the lack of clarity in the definition of “best interest” in the proposed package “could lead to ambiguity in compliance.”

Commissioner Jackson also believes the SEC’s best interest standard is “confusing,” which would open it to several interpretations by lawyers who may be representing broker-dealers in future cases filed by harmed investors.

Commissioner Peirce said a better way to describe the standard might be “suitability plus.”

Clayton didn’t give any feedback on the proposed package during the open meeting but raised three questions: Will it make it clearer to financial professionals what is required of them? Will it reduce investor confusion about their relationship with their financial professional? Will it make it easier for the SEC and other regulators to pursue financial professionals who are not acting in the best interest of their clients?

(Getty)

Not surprisingly, Sifma reacted positively to the open meeting but refrained from giving feedback on the proposed package until the group reads the full content.

“We are pleased that the SEC, as the preeminent markets regulator, has initiated the formal rulemaking process to create a heightened best interest standard for broker-dealers while also providing interpretive guidance on the investment advisor regime,” Kenneth Bentsen Jr., president and CEO of Sifma, says in a statement.

Sifma – which represents hundreds of broker-dealer firms, banks and asset management companies – has been advocating for an SEC client best interest standard for broker-dealers. The group submitted a proposal to the SEC when it called for comments last year on standards of conduct. In its proposal, Sifma lobbied for duty of loyalty, duty of care and enhanced disclosures for broker-dealers.

Barbara Roper, director of investor protection at the Consumer Federation of America (CFA), is holding on to hope that the SEC’s proposed package won’t survive in its current form.

“Despite the 4-1 vote, Chairman Clayton appears to be a long way from having the three votes he needs to finalize the rule," she tells FA-IQ.

“All four commissioners voiced significant reservations about the proposal, and their concerns pull him in diametrically opposite directions,” she says.

Roper says the CFA shares the concerns about the lack of clarity in the proposed best interest standard.

“Unless it clearly requires the broker to recommend the best available investment option, based on reasonable assumptions and a careful assessment of the needs of the investor and the characteristics of the investment, it should not be called a best interest standard. It would be more accurate to call it enhanced suitability,” she says.

One area where Roper does see an improvement in the status quo is the proposed requirement for broker-dealer firms to mitigate financial incentives -- although she wants the SEC to go even further.

“We’d prefer an outright ban on the most egregious practices,” she says. “But, properly implemented, this could help to rein in practices that encourage recommendations based on the brokers’ financial interests rather than the customer’s best interests. The lobbyists for the broker-dealers who have been pushing a disclosure-only approach to conflicts are unlikely to be happy with that provision.”

Roper says commissioners Stein and Jackson provided “a good roadmap for needed improvements to turn this into a true best interest standard” and she plans to work with the SEC “to turn this imperfect proposal into the true best interest standard investors need and deserve.”

The SEC’s role in creating best interest rules became significantly more pronounced in March when the U.S. Court of Appeals for the Fifth Circuit ordered the Department of Labor to vacate the fiduciary rule in its entirety. The DOL still has a window to appeal the ruling before it becomes effective on May 7.

Before the vacate order, the DOL rule was partially implemented in June 2017 and was supposed to be fully implemented in July 2019, pending a review ordered by U.S. President Donald Trump.