The Securities and Exchange Commission has been widely criticized for failing to define the term “best interest” when it proposed, and eventually passed, its Regulation Best Interest for brokers.
Since the rule took effect on June 30 — and the enforcement hammer looms — industry officials’ efforts to decipher exactly what “best interest” means have escalated.
To help broker-dealers and advisors comply with the newly effective Reg BI — as well as the customer relationship summary, or Form CRS — the agency has released frequently asked questions guidance, and did so again at this writing in mid-October on Form CRS.
(See related: SEC Chief: Firms ‘Meeting Their Obligations’ on Reg BI)
After Reg BI was passed last June, SEC Chairman Jay Clayton attempted to explain the difference between Reg BI and fiduciary duty:
There are all types of “fiduciary” duties, he said, but he zeroed in on an investment advisor’s fiduciary duty. “It’s a combination of care and loyalty. You owe somebody a duty of care, and you can’t put your interests ahead of their interests,” Clayton said.
“Best interest on the broker side has many of the same elements, but we want people to understand that the investment advisor space, and the broker-dealer space, are different,” he continued.
But the industry remains unclear as to exactly what “best interest” means.
Ron Rhoades, director of the personal financial planning program and assistant professor of finance in the Gordon Ford College of Business at Western Kentucky University, who was recently awarded the Tamar Frankel Fiduciary prize by the Institute for the Fiduciary Standard, told me during a recent Human Capital podcast that eventually the SEC or the Financial Industry Regulatory Authority — the enforcer of Reg BI — is going to have to explain it.
“FINRA has indicated that it’s going to interpret Reg BI, and I’m very cautiously pessimistic about their interpretation of that,” Rhoades said. “If Reg BI is nothing more than suitability plus a few more disclosures, and we know that disclosures really don’t work; investors don’t read them, and even the few that do read them don’t really understand them … then basically we just have suitability standard plus a little bit of disclosure.”
With Reg BI, Rhoades said, the SEC “is taking this phrase ‘best interest,’ which has an established legal meaning, and is redefining the English language. The question is: how are they going to redefine it?”
Rhoades maintained that there’s still “a lot that we don’t know about Reg BI,” including “how the term ‘best interest’ is going to be interpreted. We don’t know how the duty of care in Reg BI is going to be interpreted.”
Further, the name of Reg BI is “inherently misleading,” Rhoades argued.
“The term best interest has been used for centuries to describe acting for another in their best interest. It’s basically equivalent to the fiduciary duty of loyalty. Even here in the U.S., they have over 900 judicial decisions that use the term [that way]….
“Now we’re going to have brokers who don’t have a fiduciary duty of loyalty under Reg BI — the SEC is clear, this is not a fiduciary standard — they’re going to be able to say: ‘We act in your best interest.’ But you really can’t do both: you can’t represent the buyer and the seller.”
Is Reg BI going to improve the standard of conduct for brokers?
“Yes,” according to Rhoades, “but it remains to be seen how much of an improvement. It certainly won’t eliminate conflicts of interest. It will certainly minimize a few,” such as sales contests. “And hopefully it will lead to structures of broker-dealer firms that call for level compensation. We’ve already seen some indication of some firms that it might actually lead to lower levels of commissions.”
David Ackerman, an attorney with NICE Actimize, a provider of financial crime, risk and compliance solutions, agreed with Rhoades that brokers, like fiduciary advisors, will have to prove that they’re acting in clients’ best interest.
Where “a lot of firms are struggling” is showing that they’re “making a good-faith effort” to act in the best interest of the client. “What is the best way to illustrate that? How do I prove something that is so subjective?” Ackerman said.
“It’s the same challenge for the fiduciary advisors as well. They have a different legal standard but ultimately it’s up to them to prove or disprove that they held themselves to that level. Broker-dealers are going to be the same.”
Having said that, Ackerman believes the SEC has “made an honest effort” to get as much information out as possible since Reg BI was adopted in 2019.
Clayton “is not in the surprise business,” Ackerman said. “He has stated this is going to be one of the largest changes and increases in retail investor protection in the last 10 years, so you can’t have business as usual and then still maintain that this is an increase to investor protection.”
Fred Reish, a partner with Faegre Drinker in Los Angeles, states in a recent blog post the difference between best interest and suitability “is not easily defined.”
In the blog post, Reish explained that based on the SEC’s discussion in the Adopting Release for Reg BI, he sees examples of where best interest “appears to impose a more demanding standard than suitability.”
Reish’s examples focus on the Reg BI requirement that broker-dealers (and their registered reps) consider costs in the development of recommendations. While costs are not the only factor to be considered, the SEC says that “best interest” makes cost a more important factor than it was under the suitability standard.
The Reg BI Obligations for Care and Conflicts of Interest “are connected at the hip because the conflict of interest (‘compensation’) is often embedded in the cost of the recommendation and cost must be considered under the Care Obligation,” Reish explains.
“A financial professional must consider cost to the investor in making a recommendation, which could mean that the recommendation of a higher-cost investment would violate the Care Obligation (which is placed on both the broker-dealer and the financial professional) and the Conflict of Obligation to mitigate the compensation incentive of the financial professional (which is imposed on the broker-dealer).”
Recommending certain products, Reish explains, “invokes the heightened consideration of costs under” Reg BI. For instance, a higher compensating share class of a mutual fund or an annuity with a higher commission.
Form CRS Compliance
As to Form CRS, the SEC has been focusing on the form during exams. Advanced Regulatory Compliance notes in a recent alert that the securities regulator is looking at policies and procedures in place for filing Form CRS, updating it as required, posting it to firm websites, and delivering it to clients (Rule 206(4)-7).
The SEC, the compliance group says, wants to see the following:
• Documentation/evidence of Form CRS being delivered to new and existing clients by close of business as of X date.
• If the Form CRS was delivered electronically, was it presented prominently in the electronic medium? Was it easily accessible for retail investors (example: a direct link or provide the Form CRS in the body of an email or message? Please provide a sample).
• A record of the dates Form CRS was given to clients, including amendments to it, including prospective clients that became clients.
• In cases where a registrant’s website is currently under construction: Does the firm plan to include a link to the Form CRS on the website when the final updates are completed?
Washington Bureau Chief Melanie Waddell can be reached at [email protected].