An SEC Commissioner’s Misfires

The fact that the commissioner thinks there are only two differences that stand out to her under the best interest standard governing RIAs and B/Ds is unnerving, says Scott Simon.

W. Scott Simon

 

Hester M. Peirce, one of five commissioners (with one current vacancy) of the U. S. Securities and Exchange Commission, was interviewed recently about the SEC’s proposed Regulation Best Interest.

In the interview, Peirce notes that she sees only two differences between the duties required of broker/dealers (under Regulation Best Interest and applicable securities laws to which broker/dealers are subject) and those required of Registered Investment Advisers (under the SEC’s proposed Investment Adviser Standard which does not seek to create any new rules or requirements for RIAs but is simply a clarification of already existing duties they must follow). (Note that Regulation Best Interest does not pertain to RIAs and their investor advisor representatives, or to insurance agents or annuity sellers.)

Duty to Monitor

The first difference she sees is that an RIA “generally has an ongoing duty to monitor over the course of its relationship with its client, while a [B/D] generally does not.” This statement is true.

The Investment Adviser Standard requires RIAs to engage in an ongoing duty to monitor their investment recommendations by examining them periodically to see if they continue to be prudent and appropriate.

Regulation Best Interest, in contrast, would not require of broker/dealers any monitoring duty. Once an investment recommendation is made, that’s it. A broker/dealer could then immediately speed off into the sunset with no legal worries about any continuing prudence of the recommendation.

The significance of the duty to monitor, of course, was underscored by a unanimous U.S. Supreme Court in 2015 in Tibble v. Edison International when the court held that a fiduciary “has a continuing duty–separate and apart from the duty to exercise prudence in selecting investments at the outset– to monitor, and remove imprudent, trust investments.”

Conflicts of Interest

The second difference between the duties required of broker/dealers under Regulation Best Interest and those required of RIAs under the Investment Adviser Standard pointed to by Peirce was that a broker/dealer “must either mitigate or eliminate any material financial conflict of interest it may have with its client,” while an RIA “is required only to disclose such a conflict.” This statement is outright false.

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. One to be complied with is the conflict of interest obligation which is comprised of two parts. The first part: a broker/dealer “will have obligations to disclosure and in some cases mitigate or eliminate conflicts of interest, including … [e]stablish[ing], maintain[ing], and enforce[ing] written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations.”

Under this part, broker/dealers are required only to disclose their conflicts of interest; there is no requirement per se to mitigate them. Broker/dealers may, at their option, always choose to eliminate their conflicts but it’s much more likely that they will simply disclose them. This allows the transactional practices of broker/dealers to continue to flourish with no need to mitigate or eliminate conflicts, only to disclose them.

In fact, the SEC helpfully spells out a number of broker/dealer practices that may very well create a conflict of interest and yet would not necessarily be verboten under Regulation Best Interest, such as:

>Charging commissions or other transaction-based fees

>Receiving or providing differential compensation based on the product sold

>Receiving third-party compensation

>Recommending proprietary products, products of affiliates or a limited range of products

>Recommending a security underwritten by the broker-dealer or a broker-dealer affiliate including IPOs

>Recommending a transaction to be executed in a principal capacity

>Recommending complex products

Meet the new broker/dealer business model–same as the old broker/dealer business model.

Contrast the preceding first part with the second part of the conflict of interest obligation: a broker/dealer “will have obligations to disclosure and in some cases mitigate or eliminate conflicts of interest, including … [e]stablish[ing], maintain[ing], and enforce[ing] written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.”

To reiterate, under the first part of the conflict of interest obligation of Regulation Best Interest, broker/dealers are required to disclose their conflicts of interest but not to mitigate or eliminate them. But in the second part, broker/dealers are required to “disclose and mitigate, or eliminate” conflicts that relate to the financial incentives of broker/dealers, such as sales contests involving trips to, say, Tahiti.

Pierce’s statement that an RIA is “required only to disclose such a conflict” is also incorrect. The proposed Investment Adviser Standard makes clear that in cases of conflicts where an RIA cannot obtain knowing consent from a client, it must either eliminate the conflict or be able to mitigate it so that it becomes one that may be disclosed and then consented to by the client.

Two Other Differences

Peirce missed at least two other areas where the Investment Adviser Standard and Regulation Best Interest would have a differing impact on RIAs and broker/dealers and therefore create an uneven playing field, leading to widespread investor confusion in the financial services marketplace.

One area involves the scope of those who are served by RIAs and broker/dealers. With respect to RIAs, the Investment Adviser Standard would apply to the investment recommendations they make to all their clients. But as far as broker/dealers go, Regulation Best Interest would apply only to investment recommendation they make to “retail customers.” These are defined to include, for example, IRA owners and participants in retirement plans. Of greater importance, though, is that this definition excludes certain customers of broker/dealers such as retirement plans, businesses and non- profits. So, for example, Regulation Best Interest would bind a broker/dealer when making investment recommendations to plan participants but not to plan sponsors.

Another area involves the scope of investment recommendations made by RIAs and broker/dealers. Again, with respect to RIAs, the Investment Adviser Standard would apply to all the investment recommendations they make to their clients. But as far as broker/dealers go, Regulation Best Interest would apply only to investment recommendations–or more exactly–recommendations of securities transactions or investment strategies involving securities transactions. This would exclude, for example, those ever popular IRA rollovers (unless a securities recommendation was also involved).

The fact that Peirce thinks that there are only two differences that stand out to her under the best interest standard governing RIAs (the Investment Adviser Standard) and that governing broker/dealers (Regulation Best Interest) is unnerving, to say the least.

This is especially so given the fact that she has a vote (of only three needed) to adopt the SEC’s various proposals including Regulation Best Interest and the Investment Adviser Standard. She also fails to spot at least two other differences where the Investment Adviser Standard and Regulation Best Interest would have a materially different impact on RIAs and broker/dealers. This is worrisome for a number of reasons, not least of which it could cause investor confusion in the financial services marketplace.

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.

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