April 16, 2018
By Knut A. Rostad
The SEC will have an open meeting on Wednesday to vote on and release a proposed rule on conduct standards for brokers and advisers. The Institute has submitted two comment letters and met with commissioners and staff. Here is a brief on what we expect and will look for regarding a standard for brokers and title reform.
- Harmonizing standards won’t be sought. It’s too far a reach in 2018. Demarcating the standards will be.
- Demarcation will likely entail provisions to raise the suitability standard and to better distinguish sales brokers from investment advisers via controlling titles and language that suggests advice – holding out.
- Raising the standard for brokers accompanied by strict clarity in titles could be a good step forward.
What is a Best Interest Standard …. or a Broker Standard?
Is a uniform standard the same as a best interest standard? Our assumption is the SEC will not revise the 40 Act to create a single uniform standard. Rather, it will revise and seek to raise the suitability standard. A key question is whether this revised broker-dealer standard is required to meet the stipulations of a “uniform standard” as set out in Dodd Frank Section 913, and discussed in the January 2011 SEC staff study 1. If the answer is “yes”, this revised standard cannot be labeled a “best interest” unless, and only unless, it also includes specific and enforceable provisions and policies to mitigate and neutralize conflicted recommendations. Absent such provisions, this revised standard should be more accurately labeled what it is: a broker standard.
These stipulations say a uniform standard must be “no less stringent” than the 40 Act standard and will include, “the duties of loyalty and care.” However, the standard also preserves, “commission-based accounts, episodic advice, principal trading and the ability to offer only proprietary products.” The staff points out the challenge of such a uniform standard. “For the uniform fiduciary standard to be effective, investors need to understand any material conflicts of interest” and “the staff believes it is the firm’s responsibility – not the customers” to reasonably ensure such customer understanding.
What should a true best interest standard for a broker entail to effectively address conflicts?
- Warnings stating why the conflicts should be avoided over being disclosed, and that reflect conflicts’ inherent harms, as “Viruses (that are) a mortal threat to the body.”
- Certain products or practices – like sales quotas, hat switching, proprietary products, and upfront signing bonuses – be prohibited.
- Require that compensation be fully transparent, level and reasonable.
- Require certain disclosures of business models, I.E: that brokers are hired by issuers to distribute products and get paid only if they sell. Their advice is incidental to the brokerage transaction sale; it is not in an intimate relationship from a position of trust and confidence as set out by the 40 Act framers.
- Certain generic disclosures are pretested by the SEC. Material conflicts’ disclosures and informed client consents in writing, and the specific transaction is subsequently deemed fair and reasonable.
- A mandatory waiting period before client consent is delivered for certain material conflicts.
A real best interest standard for brokers entails new substantive requirements that reflect a reasonable understanding of what “best interest” means. This is vital. Without such substantive new requirements, as noted above, the suitability standard remains what it is: a broker standard. Demarcating investment advisers’ fiduciary advice from brokers’ advice incidental to the brokerage sale is important. As the Fifth Circuit recently reminded and I wrote on, brokerage sales incidental advice is not the same as intimate investment advice from a position of trust and confidence. https://thefiduciaryinstitute.org/2018/03/23/its-time-advisors-and-brokers-go-their-separate-ways/
Title reform cannot be an island unto itself. It must be consistent with and part of general “holding out” guidance and FINRA Rule 2210 that requires all communications be “fair and balanced” and not omit “any material fact” that “would cause the communication to be misleading.”
- Broker-dealers, as noted above, must be required to provide disclosure simply stating they are distributors and sellers of issuers’ products.
- Certain titles such as “advisor” or “adviser” or others are exclusively reserved for registered investment advisers or for those otherwise provide personalized investment advice. These professionals should be bound by a fiduciary standard.
The SEC has an historic opportunity, an opportunity not unlike 1940, to restate the inherent differences between brokers and advisers.
Given the stated assumptions above, the conduct standard rule can provide a good step forward by raising the suitability standard and also sharply demarcating the two standards through titles and controlling how firms “hold out.”
The conduct standard rule would miss the opportunity to provide a good step forward, however, if provisions to raise the suitability standard fall well short of the provisions identified above, yet were still branded “best interest.” Or, alternatively, if title / holding out reforms fall well short of differentiating and communicating who sells products and who renders investment advice. The Fifth Circuit Court notes the framers of the Investment Advisers Act of 1940 and Congress understood that these differences matter and are foundational in the law. Let’s hope the SEC does likewise.
- SEC Director of the Office of Compliance Inspections and Examinations, Carlo V. di Florio, in 2012. https://www.sec.gov/news/speech/2012-spch103112cvdhtm