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News April 23, 2018 Issue

SEC Proposes Broker-Dealer Best Interest Standard, Adviser Fiduciary Interpretation

The SEC on April 18 laid down its initial markers on the subject of standards of conduct for both broker-dealers and advisers – while making clear that it expects and welcomes changes.

The Commission, by a 4 to 1 vote at an open meeting, proposed two rules and an interpretation that would, among other things, create a separate best interest standard for broker-dealers and provide a separate "interpretation" on the existing fiduciary duty for advisers. The SEC’s proposals would also require advisers and broker-dealers to provide short-form disclosures to retail investors, and would limit how the term "adviser" or "advisor" can be used by broker-dealers.

"The big takeaways are that there is not one uniform standard for advisers and broker-dealers, as some had looked for, and that the new standard for broker-dealers is not a fiduciary rule," said Stradley Ronon partner Lawrence Stadulis.

The SEC proposals, which total more than 1,000 pages with more than 1,800 footnotes, are designed to at least partly address issues that have plagued advisers and broker-dealers for years. Perhaps chief among those questions is whether broker-dealers, long subject to a suitability standard in their dealings with clients, should be subject to a stricter standard, as advisers are.

The one certainty that came from almost all the commissioners’ comments, as well as early industry reaction, is that the final version of these measures are likely to look quite different from what was proposed.

"There will have to be changes," said Ropes & Gray counsel David Tittsworth. "There will be hundreds of comment letters. The comments at the open meeting confirmed just how controversial this is."

"This was a good faith effort to get the ball rolling, from the SEC’s perspective," said Stadulis.

The proposals

The new SEC proposals seek to address, to some extent, this issue and related topics. Here’s what the Commission proposed:

  • Regulation Best Interest. Under this proposed rule, a broker-dealer making a recommendation to a retail customer would have a duty to act in the best interest of the retail customer at the time the recommendation is made, "without putting the financial or other interest of the broker-dealer ahead of the retail customer," the SEC said. It would entail disclosure, care and conflict of interest obligations. One of the problems here, said Eversheds Sutherland partner Michael Koffler, is that the definition of "best interest" is not clear.
  • Investment adviser interpretation. Under this proposal, the SEC "reaffirms, and in some cases clarifies, certain aspects of the fiduciary duty that an investment adviser owes to its clients." The point of the interpretation appears to be to "pull together the existing law, common law, court precedents and more in one place," said Tittsworth.
  • Form CRS relationship summary. Under this proposed rule, advisers and broker-dealers would be required to provide retail investors with a "standardized, short-form (four-page maximum) disclosure [that] would highlight key differences in the principal types of services offered, the legal standards of conduct that apply to each, the fees a customer might pay, and certain conflicts of interest that may exist." Koffler suggested, however, that the very simplicity of the form may make it seem like advisers and broker-dealers do the same thing. "The more you make things look the same, the more you make it difficult for investors to distinguish between them."
  • Titles. The SEC would restrict certain broker-dealers from using, as part of their name or title, the words "adviser" or "advisor," because of their similarity to "investment adviser." The concern, said the agency, is that the misuse of these terms "may mislead retail customers into believing their firm or professional is a registered investment adviser." Tittsworth suggested that this may not go far enough, that a more comprehensive measure would be one addressing all those who "hold themselves out" as providing investment advice, including those with titles like "wealth manager" or "financial consultant."

Changes and the Commission

The proposed measures from the Commission are likely to change, and at least three commissioners – including two who voted in favor of the proposals – made clear that, to varying degrees, they see the proposed rules and interpretations as far from ready and simply building blocks for further changes, following review of public comments. SEC chairman Jay Clayton set a 90 day period for public comment and review. He made this point in his opening remarks at the open meeting. "I am excited for us to take this significant step forward. The word ‘step’ is appropriate. Today, in short, we are framing the issues and proposing a comprehensive path forward on which we anticipate and welcome robust public comment."

Commissioner Robert Jackson, one of the two Democratic commissioners on the Commission, in explaining his vote in favor of the proposals, said that "I am mindful of the fact that, in light of recent decisions by the Administration and the courts, investors currently lack any meaningful protections from conflicted advice from brokers. And I believe that an open, public rulemaking process is the best way for us to be certain that our rules are giving investors the protections they deserve. For that reason, I am reluctantly voting to issue these proposals for comment—and look forward to continuing to work with our exceptional staff to improve them."

Commissioner Hester Peirce, one of the two Republican commissioners, who also voted in favor, expressed concerns regarding the clarity of the proposals. She said that she supported putting the proposals out for public comment, describing them as "an excellent start on the path to reform."

The other Democratic commissioner, Kara Stein, in what might be described as a blistering critique of the proposals, was the only commissioner to vote against them. "The proposals before the Commission today squander the opportunity to act in the best interest of investors. Instead, the proposals essentially maintain the status quo."

She continued, "Does this proposal require financial professionals to put their customers’ interests first, and fully and fairly disclose any conflicting interests? No. Does this proposal require all financial professionals who make investment recommendations related to retail customers to do so as fiduciaries? No. Does this proposal require financial professionals to provide retail customers with the best available options? No."

The DOL and the SEC

The Department of Labor’s ill-fated adoption of its own Fiduciary Rule, vacated by a federal appellate court on March 15 (ACA Insight, 3/26/18), was an attempt to address this problem for financial professionals with retirement clients.

The SEC’s proposed interpretation for investment advisers differs from the DOL Fiduciary Rule and related DOL rules in "the manner by which conflicts of interest are addressed," said Drinker Biddle partner Joan Neri.

"Under the DOL rules," she said, "when a fiduciary to an ERISA plan or an IRA gives advice in which it has a conflict of interest, the fiduciary is required to either avoid or eliminate the conflict or rely upon a prohibited transaction exemption. The SEC’s proposed interpretation makes clear that an adviser is required to eliminate the conflict or adequately mitigate it only in those cases where full and fair disclosure and informed consent are insufficient. In other words, not all conflicts need to be eliminated or mitigated under the SEC’s interpretation."

Industry reaction

Given the size of the proposals, key associations welcomed the SEC’s involvement in the process, but said they would need to study the specific measures before further commenting on them.

The Investment Adviser Association, in a statement issued shortly after the proposals were voted on, said that it "applauds the SEC for proposing a package of rulemakings designed to raise the standard of conduct for broker-dealers and address investor confusion. We share concerns expressed by the majority of commissioners about whether the proposals will actually achieve those objectives, which we view as crucial for investor protection. However, we are committed to working with the Commission to get this right."

"Regarding the proposed interpretation of the federal fiduciary standard for investment advisers, we believe the fiduciary standard has been well-established by law, regulation and judicial decision and is well-understood by market participants," the association continued. "Therefore, we believe additional interpretation may be unnecessary or weaken the standard. We are pleased that, as the IAA urged, the SEC has provided an opportunity for comment."

It added that it found the proposal to restrict the misleading use of titles to be "a step in the right direction," but that titles are "only one piece of the total context of how services are marketed. We look forward to working with the Commission on this aspect of the proposal."

The Investment Company Institute, in its own statement, said that it "commends chairman Clayton for leading the Commission’s efforts to address standards of conduct for financial intermediaries" and that it has "long advocated for the SEC to take the lead in this area. We look forward to commenting in detail once we have reviewed the package in its entirety."