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The Friday List: The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

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.

Earlier in the summer, the SEC adopted Regulation Best Interest and new Form CRS and issued interpretations of an adviser’s fiduciary responsibilities and the “solely incidental” exception to adviser registration for broker-dealers.  All-in-all, the SEC published more than 1300 pages of regulatory information.  The compliance date for Regulation BI and Form CRS is June 30, 2020.  Many firms (including ours) have authored excellent pieces describing the new rules.  However, as we do nearly every day, we will attempt to provide the most important changes for your regulatory consideration.

The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

  1. Best Interest. Instead of ensuring that a recommendation is merely suitable, broker-dealers must act in the best interest of retail customers when making a securities transaction recommendation or an investment strategy.
  2. BD Disclosure. Broker-dealers must disclose (see Form CRS) material facts (e.g. fees/costs, services, conflicts, discipline) to retail customers at or before any recommendation is made.
  3. Policies and Procedures. Broker-dealers must adopt and implement written policies and procedures that address conflicts of interest (including proprietary products, sales contests, and non-cash compensation) and ensure compliance with Regulation Best Interest, which would include training, reviews, and testing.
  4. Form CRS. At or before entering into a relationship with a retail client, both investment advisers and broker-dealers must deliver new Form CRS (also filed with the SEC), which includes information about the firm’s regulatory status and obligations, fees/costs, and services.
  5. Use of “advisor”. Broker-dealers will be restricted in their use of the term “advisor” or “adviser.”
  6. Due Diligence. Advisers will have a need to conduct a greater amount of due diligence on retail clients (as compared to institutional clients).
  7. Account Monitoring. An adviser must continually monitor a retail client’s investment profile and situation to ensure that advice continues in the best interest of the client.
  8. Conflicts Disclosure. An adviser must include specific disclosure about applicable conflicts of interest and not merely describe conflicts as hypothetical or possible.
  9. Investment Discretion. Absent limiting circumstances, a broker dealer with investment discretion must register as an investment adviser.
  10. Monitoring Compensation. Receiving compensation to provide ongoing account monitoring would require investment adviser registration.

CCS Releases Summaries of Regulation Best Interest, Form CRS, and Companion Interpretations

 Last month, the SEC adopted Regulation Best Interest for broker-dealers making recommendations to retail clients and adopted the new Form CRS requiring advisers and broker-dealers to provide standardized disclosure to retail customers.  Companion releases included an interpretation of an adviser’s fiduciary responsibilities as well as the contours of the “solely incidental” exception to adviser registration for broker-dealers.  The CCS team has spent the last few weeks reviewing the new regulatory information and offer the following summaries.  Please feel free to contact Jay Haas, Mark DeAngelis, Suzette Hagan or Larry Clay directly if you want to ask any deeper questions.

 

Regulation Best Interest: The CCS Summary by Jay Haas

Form CRS: The CCS Summary by Mark DeAngelis

Fiduciary Interpretation: The CCS Summary by Suzette Hagan

“Solely Incidental”: The CCS Summary by Larry Clay

Massachusetts Proposes Its Own Fiduciary Rule

The Massachusetts Securities Division has proposed a fiduciary rule for all brokers and advisers for the provision of recommendations, advice and selection of account type. The proposed rule would require that all recommendations and advice be made in the best interest of customers and clients without regard to the broker/adviser’s interests. The MSD asserts that the suitability standard has not sufficiently protected customers against sales contests, churning, risky products and bad brokers. The MSD also criticizes the SEC’s recently adopted Regulation Best Interest because it (i) does not fully protect investors; (ii) relies too much on disclosure; and (iii) does not resolve customer confusion about the applicable standard of care. The MSD is accepting comments until July 26.

The expansive MSD proposal includes any type of financial adviser, any type of customer, and any type of advice. If adopted, the MSD’s rule would set up a court case about whether Regulation Best Interest preempts state fiduciary rules.

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.