SEC begins process of drafting its own fiduciary rule

Ever since the Department of Labor issued its fiduciary rule in the waning days of the Obama administration, critics have argued that it was the Securities and Exchange Commission that should have taken charge instead.

The argument was based on mandates in the Dodd-Frank Act. There was also a sense, realistic or not, that the SEC’s take on such a rule would be more informed and favorably tailored to the financial services industry.

On April 18, the SEC made good on past promises and proposed a package of proposals—more than 1,000 pages long with 1,800 footnotes—to “address retail investor confusion about the relationships that they have with investment professionals.”

The proposed rules

The stated intent of the SEC was to propose rulemaking and interpretations designed “to enhance the quality and transparency of investors’ relationships with investment advisers and broker-dealers while preserving access to a variety of types of advice relationships and investment products.”

In June 2017, Chairman Jay Clayton kickstarted the SEC’s eventual rulemaking process by seeking public input on issues associated with standards of conduct for investment professionals. 

Clayton’s efforts dovetailed with the apparent demise of the Labor Department’s rules. In March, the U.S. Court of Appeals for the Fifth Circuit ruled in favor of plaintiffs—the U.S. Chamber of Commerce, Financial Services Institute, Financial Services Roundtable, Insured Retirement Institute, and Securities Industry and Financial Markets Association—who challenged its legality. By a 2-1 vote, the appellate judges ruled that the Department of Labor exceeded its statutory authority under the Employee Retirement Income Security Act.

An appeal to the Supreme Court remains a possibility, but an unlikely one given the Trump administration’s unfavorable view of the Labor Department’s rules.

New rules for investment relationships

Under the SEC’s newly proposed Regulation Best Interest, a broker-dealer making a recommendation to a retail customer would have a duty to act in the customer’s best interest, without putting their own financial or other interests ahead of the client.

Firms face requirements to disclose to their retail customers key facts about the relationship, including material conflicts of interest.

Under a “care obligation,” firms and individuals would need to “exercise reasonable diligence, care, skill, and prudence, to understand the product; have a reasonable basis to believe that the product is in the retail customer’s best interest; and have a reasonable basis to believe that a series of transactions is in the retail customer’s best interest.”

A “conflict of interest obligation” requires that broker-dealers “establish, maintain, and enforce policies and procedures reasonably designed to identify and then at a minimum to disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives.” Other material conflicts of interest “must be at least disclosed.”

To address investor confusion about the nature of their relationships with investment professionals, the SEC proposed a new short-form disclosure document—a customer or client relationship summary. Form CRS would provide retail investors with “easy-to-understand information about the nature of their relationship with their investment professional” and would supplement other more detailed disclosures.

“Perhaps it would be more accurate to call this proposal ‘Regulation Status Quo.’ The proposal merely requires broker-dealers to meet certain minimal obligations to get the protections of the safe harbor and thus be in compliance with their ‘best interest standard.’ ”
Kara Stein, Commissioner, SEC

The Commission also proposed, in an effort to clarify the confusion that can be caused by titles, restrictions on broker-dealers and their financial professionals from using the terms “adviser” or “advisor” as part of their name or title with retail investors. Investment advisers and broker-dealers would also need to disclose their registration status with the Commission in certain retail investor communications. The specific obligations of investment advisers and broker-dealers, under the SEC’s rules, would be tailored to the differences in the types of advice relationships that they offer.

The SEC has initiated a 90-day public comment period for feedback on the proposals.

Voices of dissent

In his opening remarks at the SEC’s open meeting, Clayton summarized his decision to step into the fray.

“Broker-dealers and investment advisers both provide investment advice to retail investors but have different relationships and are subject to various different regulatory regimes,” he said. “However, it has long been recognized that many investors do not have a firm grasp of the important differences between BDs and IAs, from differences in the variety of services that they offer and how investors pay for those services to the regulatory frameworks that govern their relationship.”

Opinions among his fellow commissioners varied. The loudest voice of dissent, and ultimately the lone vote against issuing the proposal, was Commissioner Kara Stein, who took issue with packaging the proposals as Regulation Best Interest. “Despite repeated requests to define what best interest means in the rule text, it was decided that there was no need to,” she said.

“Perhaps it would be more accurate to call this proposal ‘Regulation Status Quo,’ ” Stein added. “The proposal merely requires broker-dealers to meet certain minimal obligations to get the protections of the safe harbor and thus be in compliance with their ‘best interest standard.’

“Despite the hype, the proposals fail to provide comprehensive reform or adequately enhance existing rules. One might say, the emperor has no clothes.”

Commissioner Hester Peirce shared some of her colleagues’ concerns about the rule’s lack of clarity. “Nevertheless, I do not agree with the assessment that the emperor has no clothes. If this proposal is adopted, the emperor will be wearing more clothes than he is wearing now.”

Peirce did question whether the reliance on traditional, paper-based disclosure forms for investors “will simply mean a few more pages of unread paper landing in investor trash cans. If instead we encouraged firms to be creative in their use of videos, interactive computer-based disclosure, mobile apps, and so forth, investors would be more likely to take in and think about the information we want them to understand,” Pierce said.

Did the rule fall short?

Commissioner Michael Piwowar described the Labor Department’s previous rulemaking as a “terrible, horrible, no good, very bad rule” that ignored input from the SEC, FINRA, state securities regulators, and insurance regulators.

A key question he wants commenters to consider: “Will Regulation Best Interest raise compliance costs to such a level that it becomes economically disadvantageous for broker-dealers to offer retail investors transaction-based advice?”

Among the consumer-focused critics of the SEC’s proposal is Dennis Kelleher, president and CEO of Better Markets.

“The SEC exists to protect investors, and the law should unambiguously require investment professionals to act in the best interests of their customers who entrust them with their hard-earned money,” he said. “The proposal appears to fall well short of that standard, relying too heavily on disclosure. While some provisions may offer modest benefits to investors, the SEC appears to have missed an historic opportunity to finally establish a strong, clear, enforceable best interest standard for all advisers.” 

Marcus Stanley, policy director at Americans for Financial Reform, said the SEC needs to produce “a straightforward, enforceable rule.”

“The standard of conduct the agency has articulated appears ambiguous at best,” he said. “It doesn’t simply ban the sales quotas and other compensation practices that lead brokers to put their clients into high-fee, lower-yielding investments.”

Is this what investors are looking for?

As the fiduciary rule takes shape, the “imperative for advisers is to demonstrate a strong commitment to transparency and ethics to win their clients and create real value for the fees they charge,” concludes a recent survey by CFA Institute, a global association of investment professionals.

With responses from more than 3,100 retail investors, the survey found a wide gap between what investors expect from financial advisers and how they deliver on expectations. Only one-third of retail investors say their financial adviser always puts their interests first. More than 80 percent said their trust in advisers was predominantly driven by full disclosure of fees, yet less than half felt advisers delivered on those expectations.

Given investor demands, why has it been such a daunting task to craft a suitable fiduciary rule for investment advice?

“I used to always say that if you were to do a fiduciary rule, you would need to write a rule the size of the old New York telephone book, but it would be riddled with holes, like swiss cheese, because of all the exemptions, carve-outs, and all that,” says Jim Allen, head of Americas capital markets policy for the CFA Institute.

The focus needs to first be on “the simple things,” like clarifying what personal advice is, who is providing it, and what incentivization they have.

“Stop using the title ‘adviser’ if you are not an advisor and start calling yourself a broker if you are a broker,” Allen says. “Clarity in titles actually makes sense and would alleviate the need for A 1,000-page rule.”

“I think there was a general consensus among the commissioners that the meaning of ‘best interest’ and how firms should comply with that duty remains somewhat vague and unclear,” says Larry Stadulis, a partner at the law firm Stradley Ronon Stevens & Young.

He co-chairs the firm’s fiduciary governance group, a 15-attorney, multi-disciplinary practice founded earlier this month.

“In fairness to the Commission, how do you really define best interest? In traditional trust law the standard was the client’s sole interest, and that is easy to enforce,” Stadulis says. “While the SEC didn’t define best interest, it did offer rules intended to get them to where they want to be.” These include the proposed disclosure requirements and requirement for written and enforced policies and procedures.

“That provides the SEC with the audit trail they need to get to a conclusion similar to a standard, while at the same time making it easier to supervise. Firms will need to fess up and identify what their conflicts are regarding financial incentives and eliminate or minimize them,” he says.

Peter Altman, a partner with law firm Akin Gump, sees Regulation Best Interest as “an attempt to ensure more transparency around why a particular recommendation is being made.”

“That falls right within the wheelhouse of Chairman Clayton’s priorities for what the SEC should be doing, namely looking out for retail investors,” he says.

A certain amount of complexity and ambiguity is to be expected as final rules are shaped by industry and investor feedback.

“What does it mean that a recommendation has to be made in a customer’s best interest? That is an inherently subjective comment and something that changes from one day to the next,” Altman says. “Any number of factors could affect what is in someone’s best interests:  their own liquidity position on a given day; volatility in a particular stock; and a client’s overall risk profile. Even their investment objectives could change day to day.”

“I think the omission of what it means to be in someone’s best interest was intentional, and the Commission wants to receive feedback from the public on what people think it should mean in this concept of a broker recommending a security to someone,” he added.