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Fiduciaries Aren't Free of Conflict, Warns SEC Lawyer

By Rita Raagas De Ramos May 17, 2019

Investment advisors tend to emphasize to existing and prospective clients how they can be trusted because they are fiduciaries. But the SEC’s assistant chief counsel for sales practices says the fiduciary label isn’t an automatic guarantee.

“The fundamental problem that we’re trying to tackle is how do you provide advice in the face of conflict,” Lourdes Gonzalez, assistant chief counsel for sales practices, a division of the SEC’s trading and markets division, said Thursday at the Finra annual conference in Washington D.C.

“Everybody who’s an agent has a conflict. It is inherent in the agent relationship,” Gonzalez added, referring to financial professionals who provide investment or product advice in exchange for compensation.

Showing the lack of distinction among brokers and advisors in this regard, Gonzalez said: “The brokers’ conflict comes from the way they are getting paid, the advisors conflict comes from the way they are getting paid.”

The SEC’s proposed Regulation Best Interest — which is in the final stages of rulemaking — is trying to address conflicts that arise out of the financial incentives of brokers, such as trading too much or recommending products that are too expensive, according to Gonzalez. She didn’t give examples of financial incentives of advisors.

Gonzalez — who stressed she was sharing her views and not necessarily the views of the SEC, the commissioners or the staff — said she laments reading articles that paint fiduciaries to be conflict-free.

“It is unfortunate when I see write-ups that say fiduciaries have no conflicts and therefore: ‘Pick a fiduciary.’ But this is about the inherent conflict in the agency model, and that conflict is not only specific to brokers,” Gonzalez said.

When people talk about the fiduciary standard, Gonzalez said her next question is what specific fiduciary standard they are referring to. There are fiduciary obligations in the Employee Retirement Income Security Act of 1974, the Investment Advisers Act of 1940

And trust law, for example, she said.

“It’s very easy to brandish this word around but it’s an empty word until you fill it with something,” Gonzalez said.

The SEC’s investment management division is working on language to “clarify the fiduciary standard for investment advisors because there’s no one single place where all this information is [located],” according to Gonzalez. “That’s not very regulatory friendly to do it that way.”

The proposed Reg BI 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.

Gonzalez said she has been working on what it means to act in a customer’s best interest for 15 years, “in various iterations.”

“What the commission is trying to do with the proposed Regulation Best Interest is really raise the standard of care of brokers have to retail customers while at the same time preserve the business model,” Gonzalez said.

What gets lost in the conversation is “oftentimes, the cheapest option” — particularly for retirement or buy-and-hold investors — is the broker-dealer model, where they are “better off paying commission one time than paying a 1% or 2% fee on that product of yours forever.”

Gonzalez said the SEC “pulled from lessons learned” from the Department of Labor’s vacated fiduciary rule, Finra’s suitability rule, and the Adviser’s Act when it crafted the proposed Reg BI.

“We just pulled the best that we could find and put them in the proposed Regulation Best Interest,” Gonzalez said.

When the SEC unveiled the proposed rule in April last year, the regulator’s staff said the nearly 1,000-page package took 11 months to complete.

The proposed rule requires brokers to discharge their best interest 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.

Gonzalez said the disclosure obligation “broadens the requirement” from what currently exists for brokers.

She acknowledged that the care obligation “looks a lot like the suitability rule, but it also incorporates the idea of acting in the customer’s best interest.”

Conflict of interest goes a step further by requiring that brokers mitigate the conflicts, she said.

Gonzalez said relevant SEC staffers read the more than 6,000 comment letters it received from brokers, advisors, product manufacturers, state securities and insurance regulators, members of Congress, attorney generals, consumer groups, and individual investors. She added that SEC chairman Jay Clayton conducted seven roundtables around the country to speak directly with retail investors and other stakeholders.

“Everyone sees in the proposal what they want to see,” Gonzalez said.

Also at the Finra annual conference, Michelle Oroschakoff, chief legal and risk officer at LPL Financial Holdings, said the risk of not having a finalized SEC Reg BI would be the “vacuum” it would leave.

“We will end up with something that creates investor confusion because if in every state, you’ll have a different set of rules and firms will operate differently to comply, you will just confound investors,” Oroschakoff said.

SEC’s Gonzalez notes the vacuum that has existed for many years appears to have hurt the broker-dealer industry.

“While we’ve been busy debating these issues, the industry has moved to the advisory side,” Gonzalez said. “There may be very good reasons why a customer feels the best match is an advisory account. But if the reason that a customer is in an advisory account instead of a brokerage account is because of a regulatory impetus or lack of action, that’s unfortunate.”