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SEC Approves Best Interest Standard but Doubts Linger Over Whether the Rule Protects Brokers or Investors

By Rita Raagas De Ramos June 6, 2019

The SEC voted Wednesday to approve its Regulation Best Interest rule package, which requires broker-dealers to act in the best interest of their retail clients.

But whether or not the new rule package indeed puts the investors’ interests first continues to be the subject of debate long after the three-to-one vote, which saw Commissioner Robert Jackson Jr. as the lone but vocal dissenter.

SEC Chairman Jay Clayton said at the open meeting today that the feedback the Commission received since the rule proposal was released in April last year "solidified" his view that Reg BI has "the right framework" for the standard of conduct for broker-dealers.

Clayton said he believes the SEC has taken the "right approach" because Reg BI "incorporates fiduciary principles but is appropriately tailored" to the broker-dealer business model.

Jay Clayton

The "overriding" issue the SEC addressed today with the vote is the obligation of financial professionals, which "has been at the heart of our mission" but has been a "vast, multifaceted, complex" issue, according to Clayton.

"Today we elevate, enhance, clarify these obligations in a comprehensive manner," Clayton said.

Since the rule proposal was released in April last year, my view was solidified that Reg BI has the right framework for the standard of conduct for broker-dealers.
Jay Clayton
SEC

Commissioner Jackson didn’t mince words in his dissent.

“Today, the agency charged with protecting American savers has failed to force Wall Street to put investors first,” Jackson said.

“Rather than requiring Wall Street to put investors first, today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice,” he noted.

Jackson pointed out that half of America’s retirees “have saved less than $65,000 and face the terrifying prospect of running out of money in retirement.” And those individuals remain vulnerable under Reg BI.

Jackson said he hasn’t lost hope, however.

Robert Jackson Jr.

"Those of you who know me understand I am an optimist. I firmly believe that one day soon … the Commission will do more,” he said.

In the meantime, Jackson said he takes “comfort in the fact that so many states have imposed true fiduciary obligations on financial professions who do business within their borders,” which makes up for the SEC’s “failure to protect America’s savers from conflicted advice.”

The agency charged with protecting American savers has failed to force Wall Street to put investors first.
Robert Jackson Jr.
SEC

Clayton acknowledged that the SEC's "authority" over the standard of conduct of financial professionals "is not exclusive," noting "we enjoy cooperation" with other regulators, such as state regulators.

"But no other body has comparative authority over these matters," Clayton said.

The Reg BI Rule package consists of the following:

The SEC says the rule package is designed to enhance the quality and transparency of retail investors’ relationships with broker-dealers and advisors. The regulator says the rule package brings the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access – in terms of choice and cost – to a variety of investment services and products.

The lines that were drawn between advocates and critics of Reg BI before Wednesday’s vote remain.

Micah Hauptman, financial services counsel at Consumer Federation of America, describes Reg BI as “a bait and switch on investors.”

“The SEC claims to be imposing a new best interest standard on brokers, but it won’t change any practices in the brokerage industry,” Hauptman says. “Instead, Reg BI simply codifies the existing standard under Finra rules, just like the brokerage industry asked them to.”

Reg BI is a bait and switch on investors. The SEC claims to be imposing a new best interest standard on brokers, but it won’t change any practices in the brokerage industry.
Micah Hauptman
Consumer Federation of America

Hauptman says the investing public is “getting hoodwinked.”

“Instead of raising the standard for brokers, the SEC is dumbing down the standards on advisers. That’s clearly not what Congress intended in Dodd-Frank. I fear investors will be harmed considerably by the rules finalized today,” Hauptman says.

Broker-dealer lobby group Sifma continues to rally behind Reg BI.

“As written, the SEC’s Regulation Best Interest rule will impose a materially heightened standard of conduct for broker-dealers when serving retail clients,” according to Sifma president and CEO Kenneth Bentsen, Jr.

“Not even the so-called fiduciary standard under the Investment Advisers Act [of 1940] includes the obligation to eliminate or mitigate conflicts. It is undeniable that this rule will directly enhance investor protection and contribute to increased professionalism among financial service providers,” Bentsen adds.

The costs to implement will no doubt be significant, but, we believe, worthwhile to uniformly enhance investor protection to the level investors should and do expect, while preserving investor choice and access to investment advice.
Kenneth Bentsen Jr.
Sifma

Bentsen goes on to say that compliance with Reg BI will not be easy for the broker-dealer industry, however.

“Firms will need to make substantial changes,” Bentsen says. “The costs to implement will no doubt be significant, but, we believe, worthwhile to uniformly enhance investor protection to the level investors should and do expect, while preserving investor choice and access to investment advice.”

At Wednesday's open meeting, Brett Redfearn, director of the SEC's Division of Trading and Markets, said that among other things, Reg BI "explicitly" requires that the broker-dealer act in the best interest of client and it "explicitly" requires the consideration of cost of investment advice.

Repeated by several SEC staff, including Clayton, during the open meeting was how Reg BI will "help improve investor protection and decision-making while preserving retail investor choice."

SEC staff at the open meeting revealed the "key changes" to the final rule compared with the proposals put forward in April last year. These include, but are not limited to:

  • Modifying the scope of Reg BI to apply to account recommendations, including rollovers from 401(k) retirement accounts to IRAs. "These recommendations are often provided when investors are making a critical financial decision on retirement savings," an SEC staffer said.
  • Requiring broker-dealers to provide full and fair disclosure of all material facts relating to the relationship with the retail customer and with regard to conflicts of interest, which must be provided in writing. Oral disclosure is acceptable only if the broker-dealer has already provided a written summary disclosure.
  • Adding cost as a factor for consideration in conflict of interest. But this doesn't require that the least expensive recommendation be made by a broker; it's not the only factor.

Meanwhile, the SEC staff recommended that "the Commission presume" that a broker's use of the title advisor/adviser "is a violation" unless the broker is already dually registered as both a broker and an advisor.

What’s in the Reg BI rule package?

The Reg BI standard requires broker-dealers to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. The SEC says this will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations.

The best interest standard draws from key fiduciary principles and cannot be satisfied through disclosure alone, according to the SEC.

Broker-dealers are required to discharge their best interest standard duty by complying with four specific obligations:

1. Disclosure Obligation: Disclose material facts about the relationship and recommendations, including specific disclosures about the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services.

2. Care Obligation: Exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation. The broker-dealer must then consider these factors in light of the retail customer’s investment profile and make a recommendation that is in the retail customer’s best interest. The SEC says the final rule is an enhancement from the proposal because it explicitly requires the broker-dealer to consider the costs of the recommendation.

3. Conflict of Interest Obligation: Establish, maintain and enforce written policies and procedures reasonably designed to identify and at a minimum disclose or eliminate conflicts of interest. The SEC says this obligation is also an enhancement from the proposal because it specifically requires policies and procedures to do the following:

  • Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest;
  • Prevent material limitations on offerings, such as a limited product menu or offering only proprietary products, from causing the firm or its financial professionals to place their interests or the interests of the firm ahead of the retail customer’s interest; and
  • Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

4. Compliance Obligation: Establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with the Reg BI as a whole.

The Form CRS Relationship Summary requires advisors and broker-dealers to provide retail investors with simple, easy-to-understand information about the nature of their relationship with their financial professional.

The interpretation of the standard of conduct for advisors reaffirms and, in some cases, clarifies the SEC’s views of the fiduciary duty that investment advisers owe to their clients under the Advisers Act.

The interpretation of the “solely incidental” prong of the broker-dealer exclusion under the Advisers Act more clearly delineates when a broker-dealer’s performance of advisory activities causes it to become an investment adviser within the meaning of the Advisers Act, according to the SEC.

Specifically, the final interpretation states that a broker-dealer’s advice as to the value and characteristics of securities or as to the advisability of transacting in securities falls within the “solely incidental” prong of this exclusion if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions, according to the SEC.

The Reg BI standard and Form CRS will become effective 60 days after they are published in the Federal Register and will include a transition period until June 30, 2020 to give firms "sufficient time" to come into compliance.

The two sets of interpretations under the Advisers Act will become effective upon publication in the Federal Register with no transition period.