Early fault lines form over SEC’s Regulation Best Interest

In the immediate aftermath of the Security and Exchange Commissions’ released proposal for a best interest standard, lines are being drawn over whether the regulation goes far enough to enhance the suitability standard broker-dealers currently operate under.

The tension will surprise no one at the SEC. At the end of this week’s open forum vote to release the proposal to the public, Chairman Jay Clayton insisted the proposal extends brokers’ duties to clients beyond the suitability standard, after Commissioner Kara Stein argued the proposal merely reiterates FINRA’s suitability standard.

In its proposal, the SEC goes to some length to explain how its rule would enhance suitability rules.

Regulation Best Interest, the part of SEC’s 1,000-page proposal that addresses brokers’ sales practices, is defined by new Disclosure, Care, and Conflict of Interest Obligations.

The Care Obligation requires brokers to have a “reasonable” basis to believe an investment would be in the best interest of “at least some retail customers,” have a reasonable basis to believe a recommendation fits a specific retail customer’s investment and risk profile, and a reasonable basis to believe a recommendation is “not excessive” for a specific customers’ needs.

The SEC says it is not defining “best interest,” but rather creating “minimum professional standards that encompass and go beyond a broker-dealers existing suitability options,” according to the proposal.

Lifting language from FINRA?

“Regulation Best Interest is designed to make it clear that a broker-dealer may not put her or her firm’s financial interests ahead of the interests of her retail customer,” says the SEC.

Barbara Roper, director of investor protection at the Consumer Federation of America, says the idea that the SEC has created a rule that prevents brokers from putting their interest first “is frankly misleading.”

One component of the Care Obligation potentially mitigates conflicts by requiring brokers base a recommendation on a client’s specific needs, Roper said in an email.

But other conflicts can be addressed through mere disclosure, she added.

“They (conflicts) don’t even have to be managed to ensure they don’t influence recommendations,” Roper said. “Since best interest is undefined, it will be impossible to enforce, certainly not at the level it needs to be enforced to deserve the best interest label.”

In a footnote in the proposal, the SEC acknowledges that components of its Regulation Best Interest “reflect(s) obligations” brokers have under FINRA’s suitability standard.

To Roper, that is proof the SEC did what CFA urged them not to do—simply rebrand suitability as a best interest standard “and pretend they’ve done something meaningful to protect investors.”

“Suitability has imposed only very limited restrictions on brokers’ ability to put their interests ahead of customers’ interests,” Roper added.

Tracking Labor’s BIC Exemption

Despite the overlap between the Regulation Best Interest and FINRA’s suitability standard, the SEC’s proposal still raises brokers’ required standard of care, says Kevin Walsh, an attorney with the Groom Law Group.

“It’s very clear this is a substantial increase in brokers’ standard of care,” Walsh told BenefitsPRO.

The proposal makes it clear that the SEC tracked Labor’s fiduciary rule in defining a new standard of care, said Mr. Walsh, who was expecting a less stringent rule. The proposal mentions Labor’s Best Interest Conduct Standard more than 130 times, he noted.

“This is the BIC, just put out by a different agency,” said Walsh, referring to Labor’s fiduciary rule’s primary prohibited transaction exemption.

That marks a dramatic departure from SEC’s traditional approach to regulations, thinks Walsh. The SEC has typically opted for disclosure-based regulations, while Labor has taken a more prescriptive approach to managing conflicts of interest.

“If this were adopted, it would signal the SEC is shifting in the direction of DOL,” said Walsh, who cautioned that is still “a big if.”

“That the SEC managed to get this out is impressive in itself, but we are a long way from an adopted package,” he added.

Predicting industry’s response

Industry trade groups that opposed Labor’s fiduciary rule have applauded the SEC for advancing the ball on a uniform best interest standard.

But on the proposal’s specifics, they have been reticent so far, likely due to needing more time to digest them.

Walsh expects there will be some pushback. “I can’t imagine industry will be happy having got rid of DOL’s BIC Exemption only to have it replaced with this,” he said.

The SEC says the Regulation Best Interest is not intended to favor lower cost investments. Actively managed mutual funds, variable annuities, structured products, and proprietary investments can be recommended, so long as brokers satisfy the provisions of the Regulation.

The SEC is sensitive to the prospect of brokers limiting product offerings to low-cost and low-risk investments in order to comply with a rule, say regulators, and is seeking comment from industry on the matter.

Louis Harvey, CEO of DALBAR, Inc., a compliance consultancy, says the disclosure-based nature of the proposal ultimately raises enforcement questions.

“Since the Regulation is primarily about what needs to be disclosed, there is no explicit standard of conduct but instead standards for disclosure. The question is how the standard will be interpreted by FINRA and the industry, and how it ultimately would be enforced,” Harvey said.

If something similar to the proposal were adopted, Harvey sees some broker-dealers continuing on with existing practices and disclosing them, and others changing practices to avoid disclosure. “It will ultimately depend on what FINRA rule changes are made to prohibit conflicts of interest.”

While the SEC has pledged to protect brokers’ transactional business model, Harvey does not see the proposal as slowing the migration to fee-models.

“The fee-based migration will continue until something prohibits it. Why not do less work for more pay?” Harvey said..

Whatever becomes of the proposal, Harvey noted there will always be a conflict between selling products and advising clients. “It is unreasonable to ask the public to take the advice of a seller,” he said.