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SEC Discusses “Regulation Best Interest” for BDs and Standards of Conduct for RIAs at Open Meeting: “Reg Status Quo”?
Posted on Categories Broker-Dealer, News, Regulation, RulemakingTags , , , ,

As we previewed in SAA 2018-14, the five sitting Commissioners of the Securities Exchange Commission held an open meeting April 18 at 3:30 PM on several issues that have begged for consideration for years.

While these discussions are just the opening play in a drama that could take further years to unfold, the attention that the new SEC Chairman, Jay Clayton, has concentrated on the nature of the relationship between customer and broker/BD, as contrasted with client and investment adviser/RIA, has led to expectations of substantive action.

At the late afternoon meeting, the set agenda called for discussion of three items: (1) Regulation Best Interest - Standard of Conduct for Broker-Dealers; (2) CRS Relationship Summary; and (3) Standard of Conduct for Investment Advisers. The Commission first listened to staff recommendations regarding all three topics and then, prior to a vote, gave their own views on the combined proposal. For Item #1, that meant considering "whether to propose a rule to establish a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer."

While this may seem like a retread of FINRA's Suitability Rule (Rule 2111) and the detailed guidance that FINRA has provided in a FAQs on Suitability and elsewhere, the Commission has been tasked by Dodd-Frank section 913(g)(1), to consider "promulgat[ing] rules to provide that, with respect to a broker or dealer, when providing personalized investment advice about securities to a retail customer ..., the standard of conduct for such broker or dealer with respect to such customer shall be the same as the standard of conduct applicable to an investment adviser under section 211 of the Investment Advisers Act of 1940.” The Staff's answer to that call is Regulation Best Interest, which calls for brokers to place the best interests of their customer, when offering financial advice, ahead of their own interests. The standard was described as a "Suitability-Plus" standard, one that equates to a "safe harbor," if the broker satisfies three obligations relating to disclosure, conflicts, and care.

Item #2 on the agenda might be called the "nuts and bolts" end of the proposal. The chief element in this segment of the recommendation is Form CRS, a brief explanation by the BD/RIA of the anticipated relationship with the retail customer. To explain by illustration, the Commission has provided a CRS "mock-up" for BDs, RIAs, and Dual Registrants. As clear labeling is part of this effort at clarifying the nature of the professional's relationship with the investor, IAs and BDs must be clear in their investor communications about their "legal form." Unclear labels, specifically "adviser" or "advisor," by "standalone" BDs and brokers who are not RIA-registered, will no longer be permitted.

Item #3, a "Commission interpretation" of the applicable standard of conduct for investment advisors draws on the common law and case law for guidance to clarify their role as a fiduciary under Section 206 of the 1940 Act. Of this effort, Chairman Jay Clayton said: "To the extent that current market conduct falls below what the Commission believes the IA fiduciary duty means, this interpretation would put the market on notice of the Commission’s views."

Chair Clayton's "overview" remarks provide a great summary of the proposals, on which the Staff then elaborated. At the conclusion, the members of the Commission each spoke and then voted on whether to issue the proposal and a huge release for public comment. Commissioner Kara Stein voted against all three segments. She expressed disappointment that the Staff and the Commission would not strive to go further in raising the current duty of care to that which brokerage customers expect, describing Reg Best Interest as "Reg Status Quo."

Other Commissioners worried about the SEC's legal authority to require certain of the proposal's provisions (e.g., net capital and fidelity bond requirements for RIAs) and one or two intimated that, if final adoption were the question, they would vote against the proposal. Most shared Ms. Stein's concerns about the length of the proposal (Hester Pierce joked that staffers lugging best interest binders through the corridors enjoyed an alternative to the SEC gym), when clarity was the expressed objective.

All, though, recognized (repeatedly) the vast amount of work, the years of consideration given, the dedication demonstrated by numerous members of the Staff and the cross-divisional coordination that involved virtually every department of the Commission. In the end, the historic proposal was accepted, in a 4-1 vote, solely for the purpose of issuing the package for public comment.

(ed: *We expect this package will hit the Federal Register at some nearby point and comments will begin to flow in. **What will happen to FINRA's suitability rule, if Reg BI is adopted? FINRA will presumably update or abandon Rule 2111 -- which raises the question, especially if legal authority is a major issue, why the SEC does not press FINRA into rulemaking. ***We see a similar, if not more apparent, issue on the RIA side. If the SEC wants financial safeguards like bonding and capital standards for RIAs -- and particularly if SEC wants more broadly to harmonize the exceptional regulatory burdens on BDs with the relatively light load for RIAs, should the SEC not seek an SRO for RIAs? ****Does the fact that the new standard will be expressed in a federal rule, as opposed to a SRO requirement, mean that courts will recognize a private right of action for its violation? Commissioner Stein was the only one who spoke about the idea of broker-dealers compensating customers for losses due to "best interest" breaches. *****Finally, it will seemingly fall to arbitrators to figure out what "best interest" means on the civil action side. Reg BI does not define the phrase (one of Ms. Stein's criticisms), so panels will have scant guidance.) (SAC Ref. No. 2018-15-01)

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