CFA Institute says SEC proposal needs more definition

The Securities and Exchange Commission’s proposed rule for raising the suitability standard on brokers-dealers will potentially result in more investor confusion, according to CFA Institute.

“We were hoping the SEC would have added clarity in certain areas,” said Jim Allen, head of Americas Capital Markets Policy, CFA Institute.

Instead, the proposal risks leading to more “diffusion,” said Allen. The proposed Regulation Best Interest would create a third standards designation, along with FINRA’s existing suitability standard and the SEC’s registered investment adviser fiduciary standard.

CFA Institute, the world’s largest association of investment professionals, according to its website, had recommended several areas of action to the SEC.

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But the proposal fails to specifically define personal investment advice, or distinguish when brokers’ so-called incidental advice exemption under the Investment Advisers Act comes into play.

Addressing each of those gaps in the proposal would give brokers and their clients “a clearer perspective of where the dividing line is,” Allen told BenefitsPRO.

The question of whether brokers’ advice to clients is incidental to the sale of investments, or crosses the threshold to offering fiduciary advice, has been pondered by regulators, and courts, for decades.

That issue is particularly poignant when brokers exercise discretionary authority over customers’ brokerage accounts. The SEC says that by and large, broker-dealers treat discretionary brokerage accounts as advisory accounts, requiring a fiduciary level of care.

In SEC’s proposal, regulators signaled they are open to more restrictive policies for discretionary brokerage accounts.

“We are concerned that any approach to the broker-dealer exclusion in the Advisers Act that would permit broker-dealers unlimited investment discretion could increase incentives for improper conduct, particularly the incentive to churn accounts because broker-dealers receive transactional compensation,” write regulators in the proposal. The Commission requested comments on the questions of incidental advice and discretionary brokerage accounts.

Can Commission business coexist with best interest standard?

Allen said CFA Institute sees some promising developments in the SEC’s proposal, which it is still processing.

“On the positive side, it’s (the Regulation Best Interest) an attempt to improve, at least on the surface, the standard of care brokers must provide to retail clients,” said Allen.

The proposal also restricts stand-alone brokers’ use of adviser titles, something CFA Institute lobbied for.

And new disclosure requirements, limited to four-pages in length, are a move in the right direction, thinks Allen, but may still not be succinct enough to benefit investors. CFA Institute would also like to see clearer disclosure requirements on conflicts brokers have as agents of firms, as opposed to simply disclosing individual broker conflicts.

But it is the SEC’s reluctance to define “best interest” in the proposed standard that is raising the most questions from CFA Institute, and others.

“If they don’t define it, someone will try to fill that vacuum,” said Allen.

Instead of defining best interest, potentially by restricting certain sales activities and products, the proposal applies principles-based guidelines. Beyond new disclosure obligations, brokers would have a new Care Obligation that would require recommendations be tailored to customer’s investment profiles. Broker-dealers would have obligations to disclose and mitigate conflicts of interest under the proposal.

Much of the rationale for not defining best interest is the SEC’s intention to preserve investor choice and commission-based business models that benefit some investors, the proposal said.

But Allen thinks the SEC can achieve both—a clearer best interest requirement—if not a uniform fiduciary standard—and the preservation of commission models.

“That’s what we have been trying to accomplish—create a world with a uniform fiduciary standard that protects the transactional business model,” he said.

CFA Institute has members chartered on both the buy side and sell side of brokerage transactions, along with charter holders that are registered fiduciaries with the SEC.

“The transactional model is valuable to securities markets,” added Allen. “Our proposals were an attempt to accommodate it by creating clarity about where brokers can, and can’t go, on what is investment advice.”

Working with what Dodd Frank allows

While Allen believes the SEC could go further in creating a uniform fiduciary standard that still allows for commission-based models, he acknowledges the complexity in balancing the two.

In the SEC’s defense, regulators are bound by what Allen calls the “really peculiar language” in the Dodd-Frank Wall Street Reform Act, section 913 of which authorized the SEC to study the need for and potentially promulgate a uniform fiduciary standard for all retail advice activity.

Section 913 specifically says commission-based compensation models, and the sale of a brokerage firm’s proprietary investments, do not necessarily constitute a fiduciary breach.

In crafting the Regulation Best Interest, the SEC argues it has captured the spirit of Dodd Frank’s Section 913’s proposed fiduciary standard: “that a broker-dealer should not put its interests ahead of the retail customer’s interests when making a recommendation to a retail customer,” the proposal says.

And it achieves that without placing limits on sales activities that Dodd-Frank explicitly allows, the SEC says.

“The broker-dealer’s financial interest can and will inevitably exist, but these interests cannot be the predominant motivating factor behind the recommendation,” says the SEC’s proposal.

Some fiduciary purists are already calling that a dodge; at least one state securities regulator has suggested as much.

But as Allen notes, Dodd-Frank, and the protections it creates for commission-based brokerage models, are the law of the land.

“The SEC cannot come out with a rule that contravenes Sec. 913,” said Allen.

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