The Big Problem With Defining "Best Interest"
The most common criticism against the SEC’s proposed Regulation Best Interest is the omission of what is meant by “best interest” in the context of what's expected of broker-dealers held to this standard. But some lawyers say defining the term could be more detrimental, compliance-wise, because broker-dealer firms have different business models.
The proposed best interest rule requires broker-dealers 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. And broker-dealers are required to perform this duty by complying with disclosure, care and conflict of interest obligations.
Four of the five SEC commissioners – all except SEC Chairman Jay Clayton – said at an April 18 open meeting about the proposed rule that the term "best interest" should have been defined because the ambiguity would lead to difficulties in compliance and enforcement, as well as confusion among investors.
Commissioner Kara Stein, a Democrat, voted against moving the proposed rule forward for public comment. Three commissioners voted yes to moving ahead with the public comment despite voicing some of their concerns about the proposed rule, including the absence of a definition of best interest. Clayton also voted yes.
But Kay Gordon, a New York-based partner at Nelson Mullins Riley & Scarborough and co-head of the law firm’s investment management group, says defining best interest in the proposed rule “could have caused more problems” because – among other things – “broker-dealers have different business models.”
Clifford Kirsch, a New York-based partner at Eversheds Sutherland, says “it’s hard to imagine what a precise definition would look like.”
Commissioner Michael Piwowar, a Republican, pointed out during the SEC open meeting that “the devil is in the details” and knowing that “best” is above “good” or “better” interest is not enough.
Piwowar said the proposed three-part best interest rule package is supposed to show that best interest is different from the “well established” Investment Adviser’s Act of 1940’s fiduciary standard and Finra’s suitability standard.
The package also includes an interpretation of the fiduciary standard for investment advisors and the creation of a new Customer Relationship Summary form that should clearly state to clients if they are dealing with a broker-dealer or an investment advisor.
However, he said that after he spent 45 days reviewing the package he was “not convinced that we have clearly and adequately explained the exact differences.”
Piwowar said the ambiguity is “worrisome” because it would make it difficult for broker-dealers to know how to comply with the requirements. That could, consequently, lead broker-dealers to treat retail investors differently or stop offering transaction-based services. If that happens, he said the SEC’s goal of preserving retail investors’ ability to access different types of financial services would be undermined.
Uncertainty about requirements would also make the rule costlier to implement, Piwowar said.
Piwowar isn’t expected to remain in the SEC for the final vote on the proposed Regulation Best Interest package. On May 7 he closed the doors for a potential re-appointment to his role when he informed President Donald Trump of his intention to resign on July 7 or earlier, if a replacement can be sworn in for him before that date. His term officially ends on June 5.
At a Practising Law Institute event on April 30, Dalia Blass, director of the SEC’s Division of Investment Management, spoke about why the SEC staff that prepared the proposed rule didn’t define best interest.
“Although we have not defined the term in the proposed rule text, we have defined the contours of the obligation,” she said. “A broker-dealer cannot put its interests ahead of the retail customer’s and must comply with specific disclosure, care and conflict of interest obligations.”
Blass said a “principles-based standard can serve Main Street investors well.” That approach would provide “valuable flexibility” in recognizing how customers vary from each other and how the industry may change over time, she said.
However, Commissioner Robert Jackson Jr., a Democrat, said at the SEC open meeting that “there should be no confusion” about the duty that investors are owed “by those who are entrusted with ordinary families’ economic futures.”
Jackson said he is worried “lawyers will use this ambiguity to defend broker conduct that has no place in our markets – a result that is good for brokers and their lawyers but not for investors.”
Yet Eversheds Sutherland’s Kirsch doesn’t believe defining best interest would necessarily be an advantage for investors in litigation compared with the absence of a definition.
Kirsch was at the SEC from 1985 to 1994. He was an assistant director for the SEC’s Division of Investment Management from 1988 until he left the watchdog.
“It’s hard to imagine why [having a best interest definition] would take away from lawyers defining certain terms when defending their clients,” Kirsch says, referring to how lawyers would be able to frame what their clients did as “best interest” with or without an official definition in the SEC rule.
Since there is “no one-size-fits-all investors” when it comes to recommending investment strategies or products, best interest “cannot be spelled out,” he says.
Kirsch believes the proposed rule’s current approach of disclosure and trying to avoid or mitigate conflicts of interest is better than trying to get a precise definition of best interest.
He says it’s more practical for broker-dealers to have a process-oriented approach to achieve a best interest recommendation rather than be subjected to a prescriptive approach because the former recognizes “there’s no one product that’s always correct” for investors.
And Kirsch believes the SEC should not create a uniform process-oriented approach for the whole broker-dealer industry. Instead, the SEC should let each broker-dealer firm design their own process-oriented approach because they have various business models, he says.
“The best thing to do is leave it to broker-dealers to determine that process and how to best achieve that” best interest recommendation, he says.