On June 6th, 2019 the SEC voted on a set of regulations best known as Regulation Best Interest. The new set of regulations is considered by some to be a sea change for the brokerage industry, codifying new standards for broker behavior. In 2016, the Labor Department imposed a fiduciary standard on registered representatives to put client interests above their own when recommending investment products. This standard was subsequently struck down in Federal Appeals Court, prompting the SEC to attempt to clarify its own rules around Rule Best Interest (BI). The SEC was granted regulatory authority to craft a fiduciary rule by the 2010 Dodd-Frank Act. In April of 2018, the SEC published a set of proposed regulations surrounding this BI standard, along with other proposed rule changes. After more than a year of public feedback, including 6000 written comments from stakeholders, the SEC officially voted 3-1 to pass four key items:
- Regulation Best Interest
- Form CRS, which stands for Customer or Client Relationship Survey, a relationship summary form for clients
- An interpretation of conduct for Registered Investment Advisors (RIAs)
- An interpretation of the “solely incidental” clause for broker-dealers (BDs)
When these new rules are implemented, likely some time during 2020, it will be important for broker-dealers to have processes in place to help them maintain compliance. Regulation Best Interest requires broker-dealers and affiliated registered representatives to act in the best interest of their clients. This is implicitly a higher standard than the current suitability standard for securities transactions and recommendations. SEC Chairman Jay Clayton believes that Reg BI is a good framework because it “incorporates fiduciary principles but is appropriately tailored” to different broker-dealer business models.
Form CRS was codified by these regulations. This new disclosure form requirement is aimed to give clients a clear understanding of whether they are working with an investment advisor or a registered representative. The two now function under legally different standards of conduct. Registered representatives now have the BI standard and advisors have the fiduciary standard. It was important to make sure that clients know which standard of advice and conduct they should expect. In this regime, BDs and RIAs are also expected to disclose their potential conflicts of interest to their potential and existing clients.
The “solely incidental” clause was a part of the Investment Advisor Act of 1940. The clause defined the difference between a broker-dealer and an investment advisor. The SEC established its interpretation of this difference with these regulations. An investment advisor is defined as:
“any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”
A BD is not an investment advisor if it acts as “any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation”. These clarifications should help differentiate the BD and IA roles which is vital for this new regulatory framework.
The proposed rule changes have been quite controversial. Opposition is centered on whether these new standards go far enough to protect investors or if they are misleading to investors who may expect protections that the new rules do not deliver. Chairman Clayton attempted to persuade skeptics by saying, “Regulation Best Interest will substantially enhance broker-dealer standard of conduct.” Brokers must mitigate and disclose conflicts of interest to clients, which is a codification of current FINRA rules.
Commissioner Robert Jackson was the lone dissenting vote in the SEC on the regulations. Jackson argued that the SEC should have better defined Best Interest in the regulation. He also thought the SEC should have taken up the mantle of crafting a fiduciary standard, which the SEC has the authority to do. Jackson predicted that Reg BI will invite court challenges saying that it “invites expensive and extensive litigation.”
Some are predicting that state regulators will implement fiduciary standards that are higher than what has now been agreed to federally. Nevada, Connecticut, and New Jersey are the most likely candidates to implement a fiduciary-type requirement. Opponents fear that this type of regulation will result in a mosaic of state regulation creating different conduct standards across the country. This would cause some brokers to be held to a fiduciary standard while others are not. It is likely that the regulatory environment around BI, suitability, and fiduciary standards will continue to evolve in the coming years. RIAs are likely to market the fact that they are held to a fiduciary standard to attract investors. Staying abreast of these changes and how they will affect the industry is important for investors, RIAs, and broker-dealers.
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