Suitability plus? Lawyers say SEC proposal lacks clarity

The Securities and Exchange Commission’s proposed Regulation Best Interest, intended to elevate FINRA’s suitability standard for broker-dealer recommendations to retail investors, is in need of clarification, according to attorneys from Drinker Biddle & Reath.

“Reg BI” would require broker-dealers to “act in the best interest of the retail customer without placing the financial or other interest of the broker-dealer ahead of the retail customer,” according to language in the proposal.

The SEC said the proposal intends to “provide clarity” to broker-dealers on the requirements of the best interest obligation.

But early in what is expected to be an arduous rulemaking process, that clarity is lacking, said Tracey Salmon-Smith, a partner at Drinker Biddle.

“The proposal doesn’t define best interest—it lacks some clarity,” said Salmon-Smith in a webinar hosted by the law firm.

The SEC’s proposed best interest standard does not rise to the level of a fiduciary duty, added Salmon-Smith, who characterized the rule as a “suitability-plus” standard, referring to the existing suitability standard to which brokers-dealers must adhere.

In order to satisfy the best interest standard, brokers would have to meet new disclosure, care, and two conflict of interest obligations, according to the proposal.

Under the care obligation, brokers would have to satisfy a three-part test on any investment recommendation or advised investment strategy to meet the best interest standard.

Language in the proposal tracks closely with FINRA’s suitability standard, said James Lundy, a partner in Drinker Biddle’s Chicago office.

Lundy said there is a disconnect in the SEC’s efforts. While the Reg BI proposal does not define a best interest standard, a separate proposal intended to clarify registered investment adviser’s fiduciary obligations goes further in defining a best interest standard.

“The hurdle is that Reg BI doesn’t define a best interest standard. This term is not defined in Reg BI, but it is in the RIA guidance. The staff of the Commission needs to go back and figure out how to better align the use of best interest terminology for fiduciaries, and then for broker-dealers,” said Lundy.

While Reg BI tracks closely with FINRA’s suitability standard, the SEC also imports language from the Labor Department’s fiduciary rule. That adds more confusion, said Bradford Campbell, a partner in Drinker Biddle’s Washington D.C. office.

“They borrowed some similar terms, but they are applied differently,” said Campbell.

Under the care obligation, broker-dealers must exercise “reasonable diligence, care, skill, and prudence” when making recommendations. That language is also found in the fiduciary rule’s Best Interest Contract Exemption.

“By importing that language it clouds whether this is a suitability plus standard, or something else,” added Campbell.

While Reg BI does not create a new private right of action, as the fiduciary rule did, industry should expect that it would create new exposure to litigation.

“Any new requirement or standard necessarily provides new compliance burdens, and therefore creates the potential for new litigation,” said Sandra D. Grannum, a partner in Drinker Biddle’s New York office.

Lundy likened the rulemaking process to the first miles of a marathon. The fast track for implementation of the proposal would be early 2020. But the announced departure of SEC Commissioner Michael Piwowar, who will step down in July, and assumed departure of Commissioner Kara Stein, whose term ends this year, could slow the process.

“If there is discord among the Commissioners, this could take longer than two years,” said Salmon-Smith, who noted that it has been seven years since the SEC first recommended a uniform fiduciary standard.

Politics, however, will motivate the SEC to move as quickly as possible, said Campbell.

“There is real incentive to get this thing done concretely in Trump administration, before next election,” he said.