The SEC’s Best Interest Proposal for Advice Given by Broker-Dealers

The SEC’s Best Interest Proposal for Advice Given by Broker-Dealers

January 16, 2019
The SEC’s Best Interest Proposal for Advice Given by Broker-
Dealers
Introduction
standard, advisers are generally expected to serve the best
In April 2018, the Securities and Exchange Commission
interests of their clients and are required to subordinate
(SEC) proposed a change to the standard of care imposed
their own interests to that of their clients. Additional
on broker-dealers giving investment advice to retail
expectations include the notion that a financial adviser shall
investors. As described further below, broker-dealers are
either eliminate material conflicts of interest or will be fully
generally required to provide investment advice that is
transparent to the client about the existence of such
suitable for their clients with respect to factors like a
conflicts.
client’s financial goals and needs. In contrast, investment
advisors are held to a higher, fiduciary standard, which
By contrast, broker-dealers are generally subject to a less
requires they serve the best interests of their clients and
demanding standard of client care found in FINRA rules,
subordinate their own interests to that of their clients. The
the suitability standard. The suitability standard requires
SEC’s new “best interest” proposal would require a broker-
broker-dealers to reasonably believe that their investment
dealer “to act in the best interest of a retail customer when
advice is suitable for their clients with respect to factors
making a recommendation of any securities transaction or
such as a client’s financial goals and needs. (Broker-
investment strategy involving securities to a retail
dealers, however, are subject to a fiduciary standard in
customer.” The proposed rule has been controversial, with
either of two circumstances: (1) when they have control of a
Members of Congress, industry advisors, and consumer
client’s discretionary account, meaning that they have a
protection groups all expressing views. This In Focus
client’s authority to buy and sell securities on the client’s
provides background on the proposed rule and describes the
behalf; or (2) in a few states such as California, Missouri,
policy debate surrounding the rule. SEC Chairman Jay
South Dakota, and South Carolina where state courts have
Clayton has announced that completing the rule will be a
“imposed an unambiguous fiduciary standard” on them.)
key priority for the SEC during 2019.
Over time, the roles of various broker-dealers and
Background
investment advisers have converged. While differences
Broker-dealer firms or their affiliated persons act as brokers
remain, many broker-dealers today offer advisory services,
when they execute securities trades for their clients and as
such as investment planning and retirement planning
dealers when they trade their own securities for their own
similar to services offered by investment advisers.
benefit. Broker-dealers are largely regulated by the
Potentially compounding this confusion is the fact that
Securities Exchange Act of 1934 (Exchange Act; P.L. 73-
many financial firms are so-called dual-registered firms.
291) and principally overseen by the Financial Industry
Overseen by FINRA, they are registered as both broker-
Regulatory Authority (FINRA, an SEC-regulated entity).
dealers and investment advisers. As a consequence, various
surveys report that retail customers suffer from significant
Investment advisers are firms or persons who provide
confusion regarding the distinctions between broker-dealers
investment advice directly to their clients, including
and advisers as well as the legal import of those differences.
individuals and institutional investors such as mutual funds
and hedge funds. In general, advisers with over $110
In 2017, according to FINRA, approximately 30,000 firms
million in assets under management must register with the
were registered solely as investment advisers; 3,100 firms
SEC under the Investment Advisers Act of 1940 (IAA,
were registered solely as broker-dealers; and 600 firms
which regulates key aspects of investment advisers, 54 Stat.
were dual registered.
847). States generally register investment adviser firms with
lesser amounts under management.
The Best Interest Proposal
Propelled in part by concerns over investor confusion
Historically, brokers largely acted as securities trade
between investment advisors and broker-dealers, Section
facilitators compensated through transaction-based
913 of the Dodd-Frank Wall Street Reform and Consumer
commissions. Advisers were largely responsible for
Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203) did
providing investment advice and were typically
a number of things, including granting the SEC the
remunerated through annual management fees, asset-based
authority to impose fiduciary rules on broker-dealers
fees, or a percentage of assets managed.
subject to certain conditions and requiring the SEC to
conduct a study on various aspects of retail investor
Although not expressly written in the IAA, court rulings
standards of client care. Released in 2011, the required SEC
and decisions from SEC enforcement cases have led to an
study recommended a uniform fiduciary standard for retail
established investment adviser standard of retail client care,
advice given by all types of financial professionals,
known as the fiduciary standard. Under the fiduciary
including broker-dealers, under the SEC’s regulatory ambit.
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The SEC’s Best Interest Proposal for Advice Given by Broker-Dealers
On April 18, 2018, SEC staff issued a package of three
Opponents of Reg BI, including investor and consumer
proposals involving the duty of care financial professionals
advocates such as the Consumer Federation of America,
owe to retail investors, which were adopted by the agency’s
have expressed concerns that Reg BI does not contain the
commissioners with one dissenting vote. The three
word fiduciary; that it is not analogous to such a standard;
proposals are (1) the Investment Adviser Interpretation,
and that it leaves “best interest” undefined, thus raising
which would reaffirm and clarify various obligations that
compliance concerns. Referring to the package of
investment advisers owe their customers; (2) the Form CRS
proposals, particularly Reg BI, Kara Stein, the dissenting
Relationship Summary, a standardized, short-form
SEC commissioner, argued that the “proposals fail to
disclosure that would disclose key distinctions in the types
provide comprehensive reform or adequately enhance
of services offered by broker-dealers and investment
existing rules.”
advisers, applicable legal standards, and potential conflicts
of interest; and (3) Regulation Best Interest (Reg BI).
Supporters of Reg BI, including the Securities Industry and
Financial Markets Association (SIFMA), assert that Reg
Arguably the most contentious of the three proposals, Reg
BI’s principles-based and non-definitional approach will
BI, would require a broker-dealer “to act in the best interest
provide for greater regulatory flexibility when it comes to
of a retail customer when making a recommendation of any
gauging a broker-dealer client’s best interests at any point
securities transaction or investment strategy involving
in time. Supporters also argue, in response to criticism that
securities to a retail customer.”
the proposal does not provide a “fiduciary” standard, that
the word fiduciary is not defined in the IAA and that
The 2016 DOL Fiduciary Rules
various practitioners such as attorneys and financial
The SEC proposals followed on the heels of the Department
professionals lack a common conception of what the term
of Labor’s (DOL’s) 2016 adoption during the Obama
fiduciary means.
Administration of related rules that amended the Employee
Retirement Income Security Act of 1974 (ERISA; P.L. 93-
The SEC and others, including law firms with large
406, the major law governing private sector retirement
securities practices, have argued that, although the SEC’s
plans). Previously, under ERISA, securities brokers and
proposed rule would not impose a uniform fiduciary broker
dealers who provided services to retirement plans and who
obligation as authorized by Section 913 of the Dodd-Frank
were not fiduciaries were subject to a suitability standard.
Act, the rule would significantly expand broker-dealer
Under the 2016 rules, brokers and dealers were generally
obligations when they give advice to retail investors. The
deemed to be fiduciaries while providing recommendations
SEC has explained that Reg BI is designed so as not to
to retirement plan participants. The rules provided that
undermine the financial viability of the commission-based
implementation of major parts of the rules would not take
broker-dealer business model. The SEC argues that Reg BI
place until 2019.
would provide particular advantages to investors who most
benefit from having a more transactional and episodic
Supporters of DOL’s fiduciary rules, including investor
business relationship with their financial intermediary as
advocates, argued that financial advisers such as broker-
opposed to an ongoing relationship as is more often found
dealers would no longer be able to direct clients to products
with investment advisers.
that awarded them larger commissions at the client’s
expense. Detractors, including broker-dealers and financial
Congressional Concerns
planners, stressed that the rules would result in increases in
On September 12, 2018, 35 House and Senate Democrats,
the costs of retirement accounts and would curtail various
including Representative Maxine Waters, who is now
investors’ access to both investment advice and the number
chairwoman of the House Financial Services Committee,
of available products.
and Senator Sherrod Brown, ranking member of the Senate
Committee on Banking, Housing, and Urban, sent a letter to
In early 2017, President Trump ordered DOL to conduct a
SEC Chairman Clayton. The correspondence argued for a
new analysis of the rules with the prospect of possible
major revision of proposed Reg BI to ensure that broker-
revision or repeal. On March 15, 2018, in response to a
dealers comply with the “same high standard” of retail
lawsuit brought by business groups opposed to the rules, the
customer care currently applicable to investment advisers.
Fifth Circuit Court of Appeals vacated the rules, holding,
among other things, that DOL exceeded its statutory
This view contrasts with remarks made by Republican SEC
authority under ERISA in writing the rules. During the
Commissioner Hester Peirce during a July 2018 speech.
Trump Administration, DOL has not challenged the Fifth
Among other things, she argued that in certain critical
Circuit’s decision; however, in October 2018, DOL
ways, Reg BI would subject broker-dealers to a more
announced that it would introduce a revised final ERISA
exacting standard than does the fiduciary standard as
fiduciary rule in September 2019.
described in the staff report that accompanied REG BI: She
noted that broker-dealers would be required to “either
Debate over the Best Interest Proposal
mitigate or eliminate any material financial conflict of
Like DOL’s fiduciary rules, Reg BI would also generally
interest it may have with its client.” By contrast, she
apply to investment advice given by broker-dealers to
observed that an adviser subject to the fiduciary standard is
holders of ERISA-based retirement accounts. Also like
merely “required to disclose such a conflict.”
DOL’s fiduciary rules, Reg BI has been subject to
substantial debate.
Gary Shorter, Specialist in Financial Economics
IF11073
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The SEC’s Best Interest Proposal for Advice Given by Broker-Dealers

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