W. Scott Simon
The fiduciary wars continue unabated more than a decade after they began. To wit: The SEC voted 4-1 to release a series of proposed rules on April 18 which total around 1,000 pages and include more than 1,800 footnotes.
These proposals include: Regulation Best Interest (Regulation Best Interest); Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers plus Request for Comment on Enhancing Investment Adviser Regulation (Investment Adviser Standard); and Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles (Form CRS).
SEC Commissioner Kara Stein described these proposals as “essentially maintain[ing] the status quo.” I’m with the commissioner.
Investment Adviser Standard
The Investment Adviser Standard seeks to better organize and clarify the already existing fiduciary duties that are required of registered investment advisory firms when dealing with their retail clients. To be sure, this proposal doesn’t attempt to create any new rules or requirements for RIAs.
However, it does seek comments from the public about possibly subjecting investment advisor representatives of RIAs to federal licensing and continuing education requirements for the first time. It also requests comments on whether RIAs should be required to provide account statements disclosing their costs for provision of advisory services. Finally, the SEC seeks public comments on whether RIAs should be subject to financial responsibility reporting rules akin to those required of broker/dealers.
Regulation Best Interest
Under Regulation Best Interest, the SEC proposes to require broker/dealers and their registered representatives to act in a retail customer’s “best interest” when recommending securities transactions and/or strategies. Retail customers include IRA owners and plan participants. (Regulation Best Interest does not pertain to RIAs and their investor advisor representatives or to insurance agents or annuity sellers.)
“Investment advice is in the ‘Best Interest’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims [this is the prudent person rule found in section 401(a)(1)(B) of the Employee Retirement Income Security Act of 1974 (ERISA)], based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor [this is akin to the Know Thy Customer rule 2090 of the Financial Industry Regulatory Authority (FINRA)], without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party” (this is akin to the fiduciary duty of loyalty).
Regulation Best Interest sets forth three obligations that broker/dealers must comply with in order to satisfy the regulation’s best interest standard of conduct. These include:
Care Obligation. Broker/dealers must use reasonable care, diligence, skill, and prudence when making recommendations to their retail customers. The three specific subsections of this obligation hew closely to FINRA’s suitability rule. The obligation adds certain disclosure, and policies and procedures, requirements.
Disclosure Obligation. Broker/dealers must communicate, at the outset of the relationship with their customers, certain facts regarding the terms and scope of their services. This more detailed disclosure obligation is on top of the more basic disclosures in Form CRS that both broker/dealers and RIAs must satisfy. Broker/dealers are also required to disclose certain conflicts of interest pertaining to their recommendations about securities transactions and/or strategies. These disclosures must be made prior to or at the time that a broker/dealers makes such a recommendation.
Conflict of Interest Obligation. Broker/dealers must establish, maintain, and enforce written policies and procedures reasonably designed to identify and disclose, or eliminate, all material conflicts of interest arising from their recommendations under Regulation Best Interest, and disclose and mitigate, if not eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.
Two conclusions can be made about Regulation Best Interest. First, it in no way subjects broker/dealers and their registered representatives to a fiduciary standard, and second, it doesn’t impose any kind of uniform standard on broker/dealers and RIAs.
But wait, didn’t the Wall Street Reform and Consumer Protection Act (Dodd-Frank) promise us in 2010 that, should a so-called harmonized standard of conduct be promulgated that would apply to both broker/dealers and RIAs, it would be “no less stringent” than the fiduciary standard of conduct applicable to RIAs?
“The [SEC] may promulgate rules to provide that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers … shall be to act in the best interest of the customer without regard to the financial or investment advisers … when providing personalized investment advice about securities …” (Section913(g) of the Dodd-Frank Act).
Well, yeah, it did–yet the SEC has chosen to ignore this federal statute passed by Congress and signed into law by President Barack Obama in its issuance of Regulation Best Interest.
Further, note that Regulation Best Interest doesn’t require that recommendations made by broker/dealers be made “without regard to … [their] financial or other interests … .” The deletion of this language found in section 913(g) of the Dodd–Frank Act (see above) is noteworthy because it shows that the SEC is concerned that this language “could be inappropriately construed to require a broker-dealer to eliminate all of its conflicts.” Not to put too fine a point on it, which the SEC does anyway: The SEC does “not intend for our standard to prohibit a broker-dealer from having conflicts when making a recommendation.”
Imagine that–the SEC wouldn’t want a few egregious conflicts of interest that could have a significantly negative impact on the lifestyle of, say, a couple in retirement to get in the way of the conflicted business models of many broker/dealers. Nope, we can’t have that.
What’s even worse, the SEC seems to have pulled a rope-a-dope on us. All the language in Regulation Best Interest about the best interest standard–as well as language emanating from SEC officials leading up to, and upon issuance of, the regulation that even though it isn’t a fiduciary standard, it’s consistent with fiduciary principles–masks the fact that should Regulation Best Interest be adopted, it might not apply to a single broker/dealer nor any of its registered representatives.
Say what? Yup, Regulation Best Interest makes clear that it would apply only to stand-alone broker/dealers, which currently account for about 30% of all broker/dealers. The other 70% of broker/dealers are dually registered; that is, they are RIAs, as well. This larger group wouldn’t be subject to Regulation Best Interest at all. And the 30% that would have to comply with the regulation would simply graft an RIA onto their broker/dealers and, in doing so, would also escape the need to meet the requirements of Regulation Best Interest.
Regulation Best Interest is not what it appears to be. It’s clear that the financial services trade associations representing brokerage firms have their fingerprints all over the regulation (and the two other proposals). The wholly predictable results flowing from this fact: a soft landing for broker/dealers and their registered representatives and a train wreck for retail investors.
This couldn’t be more inapposite to the mission of the SEC: “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public trust.”
So much of the rigmarole surrounding the proposals issued by the SEC has made for great headlines like: “The Best Interest Standard Plus the Suitability Standard Plus New Disclosures Plus New Policies and Procedures All Portend a Bright New Day for Investors in How They are Treated by Their Broker/Dealers!” But if you delve–even just a bit–into what’s really behind the headlines about Regulation Best Interest (as well as the other two proposals), you’ll see that it’s all a cynical play of smoke and mirrors.
My Own Proposals
Here’s what I’d like to see adopted.
- Thoroughly enforce the bright line established in the Investment Advisers Act of 1940 between broker/dealers and RIAs. A broker or dealer registered with the SEC under the Securities and Exchange Act of 1934 isn’t an investment adviser subject to the fiduciary standard if the advice it gives is: (1) “solely incidental” to the conduct of its business as broker or dealer, and (2) it does not receive any “special compensation” for providing investment advice. The SEC’s strict enforcement of this would go a long way in helping all understand that broker/dealers and their registered representatives are engaged in (nonfiduciary) sales while RIAs and their investment advisor representatives are engaged in providing (fiduciary) advice. Broker/dealers are not advisers but can be if they also (or just instead) become RIAs. This will help clear up the great mischief allowed by the SEC prior to, and even subsequent to, 2007 when it lost the Merrill Lynch case in the U.S. Court of Appeals for the District of Columbia Circuit. Amazingly, though, the SEC seeks in Regulation Best Interest to try yet again and enlarge the scope of the broker/dealers exemption in the definition of an investment adviser.
- Any dual registrant–that is, one registered as both a broker/dealers and RIA–that’s a fiduciary to a client on an account will be deemed to be a fiduciary for the entirety of that
- A mandatory requirement that the following appear on the business cards of dual registrants, as well as on all other communications that they may have with their retail customers: “Nonfiduciary Product Salesperson.” No other such descriptive language will be
- A mandatory requirement that the following appear on the business cards of registered representatives of broker/dealers as well as all other communications that they or their broker/dealers may have with their retail customers: “Nonfiduciary Product Salesperson.” No other such descriptive language will be permitted. This requirement is in accordance with the worldview of product salespeople as set forth in Chamber of Commerce v. U.S. Dept. of Labor (U.S. 5th Circuit Court of Appeals, March 15, 2018) in that they plead they have no relationship of “trust and confidence” with their customers so they cannot be fiduciaries; they simply sell products. So I take them at their word–although trust-based sales seminars may take a hit for a while.
- A mandatory requirement that the following appear on the business cards of investment advisor representatives of RIAs, as well as on all other communications that they or their RIAs may have with their retail customers: “Fiduciary Adviser.” No other such descriptive language will be permitted. (I, along with all those similarly situated as RIAs, cannot place the words “Registered Investment Adviser” on my business cards. Just like the lads in “Animal House” who never really knew what double secret probation really meant and so were wary of it, I too have always been wary about finding out why I couldn’t place those words on my business card. But I have lived with that requirement all these years and so can those–both fiduciaries and nonfiduciaries–under my proposals for limiting such descriptive language.)
In light of the fact that virtually no broker/dealers nor any of its registered representatives will be required to comply with Regulation Best Interest, it seems rather pointless to analyze and discuss this somewhat tepid proposal.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.