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SEC Adopts Regulation Best Interest, Raising Broker Standard of Care

The SEC adopted Regulation Best Interest for broker-dealers that make recommendations to retail clients. Regulation Best Interest, intended to enhance a broker’s standard of care beyond suitability, requires a broker-dealer to act in the retail customer’s best interest and to refrain from transactions that favor the interests of the broker over the customer. The new rule requires disclosure as well as policies and procedures to ensure that brokers identify and mitigate conflicts of interest. The SEC also adopted new Form CRS that requires both advisers and brokers to provide retail customers with standardized information about their relationship, including services, fees, conflicts, standard of conduct, and disciplinary history. The SEC also issued an interpretation that addresses an adviser’s fiduciary responsibilities. Part of this regulatory package includes a refining of the “solely incidental” exception to adviser registration for brokers. Firms have until June 30, 2020 to comply with Regulation Best Interest, although the new interpretations apply immediately upon publication.

Let’s rename this “The Compliance Officer Full Employment Act.” Compli-pros at broker-dealers will have to rework all of their Written Supervisory Procedures, revise client agreements, create disclosures, and eliminate all prohibited conflicts. Compliance offices at investment advisers must address the new Form CRS requirement and implement new client onboarding procedures while figuring out the changes required by the investment adviser fiduciary interpretation. And, we only have 12 months to get this all done.

The Friday List: 10 Examples of Brokers Behaving Badly

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

The debate about the now-vacated DoL fiduciary rule and the recently proposed Regulation Best Interest continues.  We have argued that a uniform fiduciary standard should apply to both retail brokers and advisers.  Why?  We accept the position that retail consumers should not have to hire a lawyer to determine the advice standards to which his/her financial professional adheres.   More significant, however, is that brokers behave badly and need a higher standard.  An academic study that was first published in 2016 reported that 7% of broker-advisers have misconduct records, prior offenders are 5 times more likely to engage in misconduct, and 44% of brokers fired for misconduct are re-employed within a year.  The authors concluded: “We find that financial adviser misconduct is broader than a few heavily publicized scandals.”   They also argued that a more stringent standard would help the industry by improving the low reputation of financial professionals.  Our reporting of cases also shows endemic broker misconduct.  In today’s list, we highlight examples of brokers behaving badly, which should inform the debate on a uniform fiduciary standard.

 

10 Examples of Broker Behaving Badly

  1. Stealing from clientsA broker exploited a weakness in his firm’s control systems that allowed third party disbursements, enabling him to misappropriate $7 Million from clients.
  2. Churning.   A broker recommended an unsuitable in-and-out trading strategy that generated significant commissions.
  3. Misrepresenting disciplinary recordA broker’s website claimed he never had a complaint, even though several customers filed and settled complaints over the course of an 8-year period.
  4. Misusing client information. A broker shared nonpublic personal information (including holdings and cash balances) about clients with a person no longer affiliated with his firm.
  5. Revenue sharing.   A broker received undisclosed revenue sharing on mutual fund trades from the clearing broker.
  6. Undisclosed markups/markdownsAn interdealer failed to disclose markups and markdowns on securities traded for clients.
  7. Commission kickbacksA trading supervisor demanded commission kickbacks from junior traders to whom he assigned clients.
  8. Pump-and dumpA broker engaged in an ongoing penny stock pump-and-dump scheme.
  9. Bribing public officials.    A broker spent nearly $20,000 on hotels, meals and concert tickets to bribe a public plan official to secure brokerage business from a public plan.
  10. IPO kickbacks.   A broker and his client conspired in a kickback scheme whereby the customer would pay back 24% of his profits in exchange for preferred IPO and secondary offering allocations.

The Friday List: 10 Things You Need to Know About Regulation Best Interest

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

A few weeks ago, the SEC proposed Regulation Best Interest, which requires a broker to act in the best interest of each retail customer at the time the recommendation is made, notwithstanding the broker’s own financial interests.  The SEC has been pondering a broker fiduciary rule for many years but lost the regulatory race to the Department of Labor, which promulgated its own rule.  Now that the 5th Circuit has vacated the DoL Rule and the SEC has proposed its own rule, the current state of the law is unclear.  Regardless, we have read the release and offer our list of the 10 things you need to know about proposed Regulation Best Interest.

10 Things You Need to Know About Regulation Best Interest

  1. Reasonable basis.  A broker must have a reasonable basis that the recommendation is in the best interest of the client.
  2. Applies to retail customers.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.
  3. “Recommendation” remains the same.  The proposal does not seek to change the definition of “recommendation,” preferring to defer to the current FINRA interpretations.
  4. No definition of “best interest”.  In 400+ pages, the SEC never defines the term “best interest” when proposing Regulation Best Interest.
  5. More than suitability, less than fiduciary.  Regulation Best Interest combines elements of the current suitability standard (e.g. suitable at time of transaction) with a few fiduciary-like elements (e.g. disclosure).
  6. Fails to harmonize RIA and BD standards.  Advocates of a uniform fiduciary standard want a single standard so that consumers are not confused by the differing standards of care applicable to advisers vs. brokers.  This proposal fails to ensure a “uniform” standard.
  7. Disclosure of conflicts of interest.  The most significant new requirement is that brokers must disclose (or mitigate) conflicts of interest.
  8. Must consider series of transactions.  Expanding traditional suitability, a broker must also consider the series of recommended transactions.
  9. Product neutrality not required.  Brokers can make more money on recommended products, including proprietary products, so long as the conflict is properly disclosed and mitigated.
  10. Regulation Best Interest is not law.  Comments are due on this controversial proposal by August 7, 2018.  Thereafter, we expect much debate and re-drafting before any final rule is adopted.

Fifth Circuit Vacates Fiduciary Rule

The Fifth Circuit Court of Appeals, in a 2-1 decision, vacated the Department of Labor’s fiduciary rule primarily on the grounds that the DoL unlawfully expanded the definition of the term “fiduciary” to include commissioned brokers.  The Court opined that the DoL departed from the common law and contextual definition of “fiduciary” and dispensed with the criteria used for the past several decades.  The Court agreed with business groups that argued that the Rule would cause many financial service providers to exit the market for retirement advice, thereby hurting the people that the DoL intends to protect.

OUR TAKE: We assume that the DoL will consider appealing this decision to the Supreme Court, which could take months/years.  In the meantime, our recommendation is to comply with the best interest standard that went into effect last June and see what happens in the courts, in Congress, and at the DoL.

 

Massachusetts Sues to Enforce Compliance with Fiduciary Rule

The Massachusetts Securities Division has commenced administrative proceedings against a large broker-dealer because it ran sales contests that violated its own policies adopted to comply with the Department of Labor’s fiduciary rule.  The DoL rule, which became effective in June 2017, requires firms to follow an “impartial conduct standard” including acting in the best interest of customers, charging reasonable compensation, and ensuring full disclosure.  In response to the rule, the BD adopted compliance policies prohibiting conflicts of interest when dealing with retirement accounts.  Following adoption of the new policies, the firm launched sales contests, which the MSD alleges involved misrepresentations and conflicts of interest.  The MSD alleges that the firm violated Massachusetts ethical conduct standards by failing to abide by its own policies and the DoL rule.

OUR TAKE: Even though he DoL won’t enforce the fiduciary rule, the impartial conduct standard applies to firms that recommend products to retirement accounts.  Nevada has already passed its own fiduciary legislation.  Now, Massachusetts uses its enforcement powers to compel fiduciary compliance.  Expect other states to follow.

 

CFP Board Proposes Fiduciary Standard

The CFP Board has proposed a broad fiduciary standard in its new Code of Ethics and Standards of Conduct.  The proposed fiduciary standard requires a CFP professional to exercise a duty of loyalty, which requires placing the client’s interests above those of the CFP or his/her firm, avoiding or fully disclosing conflicts of interest, and acting without regard to personal or firm financial interests.   The new Code requires disclosure of all conflicts of interest such that a client can provide informed consent.    Comments on the proposed Code are due on August 21.

OUR TAKE: Whether or not the DoL or the SEC moves ahead with a fiduciary standard, the CFP Code would apply a best interest standard to many of the high-end planners carrying the CFP designation.  The fiduciary genie appears to be out of the lamp.

 

SEC Chairman Commences Consideration of Uniform Fiduciary Rule

SEC Chairman Jay Clayton has solicited public comment concerning the standard of conduct applicable to retail advisers and broker-dealers.  The SEC seeks public input on such topics as the preferred standard of care, conflicts of interest, approaches to regulation, disclosure, technologies, and investor confusion.  Mr. Clayton asks, “If the Commission were to proceed with a disclosure-based approach to potential regulatory action, what should that be?  If the Commission were to proceed with a standards-of-conduct-based approach to potential regulatory action, what should that be?  Should the standards for investment advisers and broker-dealers be the same or different?  Why?”  Mr. Clayton notes that the SEC last solicited such information back in 2013 but that rapidly changing markets, participants, and regulations require updated information.  He welcomes coordination with the Department of Labor as it implements and re-considers the Fiduciary Rule.  The SEC has set up a webform and email box to receive comments.

OUR TAKE: The SEC should adopt a uniform fiduciary or best interest standard for all retail advisers and broker-dealers, and the DoL should incorporate that standard rather than create a separate regime solely for retirement products.  We hope that Mr. Clayton has begun the process to ending this internecine regulatory battle of agencies.

https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31

The Friday List: 10 Things to Know about the DoL Fiduciary Rule

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Last Monday (May 22), the Department of Labor issued guidance on the implementation of the long-debated Fiduciary Rule.  Most significantly, the DoL did not further delay the basic concept that financial institutions and advisers must apply a best interest standard to advice for IRAs and other retirement accounts.  However, the DoL did back off of some of some of the compliance requirements for the rest of this year and plans to collect more information.  Below is a list of the 10 things you need to know right now about the DoL Fiduciary Rule.

 

10 Things to Know about the DoL Fiduciary Rule

 

  1. Applies to IRAs: The DoL Fiduciary Rule applies to investment advice concerning IRAs, ERISA plans, and plans covered by Section 4975 of the Tax Code.
  2. Best Interest standard starts June 9: Beginning June 9, financial institutions and advisers to covered plans must provide advice in the retirement investor’s “best interest,” which includes a duty of prudence and loyalty.
  3. BIC exemption compliance starts January 1: The extensive compliance requirements of the Best Interest Contract (BIC) exemption, which would apply to non-level fee products, are not required until January 1, 2018.
  4. DoL expects changes by January 1: During the Transition Period (June 9-January 1), the DoL will collect additional information from the industry to determine how compliance practices such as the use of mutual fund “clean shares” should re-shape the Rule.
  5. Proprietary products with commissions permitted: During the Transition Period, firms can recommend proprietary products with commissions so long as they satisfy the best interest standard.
  6. Need policies and procedures: The DoL expects firms to adopt policies and procedures necessary to ensure compliance with the best interest standard.
  7. Robo-advisers can rely on BIC exemption: Robo advisers may rely on the BIC Exemption during the Transition Period to ensure compliance with the Rule.
  8. Investment advice narrowly defined: Investment advice, for purposes of the Rule, does not include plan information or general financial, investment and retirement information.
  9. Can rely on written representations from intermediaries: The Rule does not apply if an independent fiduciary provides written representations (including negative consent) that the fiduciary is a bank, insurance company, BD, RIA, or independent fiduciary managing at least $50 Million.
  10. DoL will focus on compliance over enforcement: The DoL says it will prioritize compliance over enforcement during the Transition Period so long as firms work diligently and in good faith to comply with the Rule.

Fiduciary Rule Goes Live on June 9 without Specific Compliance Requirements

The Department of Labor has confirmed that its Fiduciary Rule will go into effect on June 9, although affected firms need not comply with all of the BIC exemption requirements until at least January 1, 2018.  In an FAQ, the DoL confirmed that financial institutions and advisers must comply with the “impartial conduct standard,” which requires a duty of prudence (professional standard of care) and loyalty (advice in the best interest of the customer).  However, firms have flexibility to determine how to ensure compliance with the best interest standard and may offer proprietary products with commissions if they ensure that they meet the impartial conduct standard and the advice is in the best interest of the customer.  Firms should “adopt such policies and procedures as they reasonably conclude are necessary.”  The DoL plans to seek additional information to determine whether to further delay full implementation or change the Rule, which applies to IRAs, ERISA plans, and IRC 4975 plans.

OUR TAKE: Can we stop now?  We actually think the current state of affairs makes the most sense i.e. require a best interest standard without specifically mandating how firms must comply.  The Investment Advisers Act takes that approach, and it has worked pretty well since 1940.