This article originally appeared on Advisor Perspectives.
“No thinking man can believe that an economy built upon a business foundation … can permanently endure without some loyalty to that (fiduciary) principle.”
Justice Harlan Fiske Stone, Harvard Law Review, 1934
Last week’s off-year elections in Virginia, New Jersey, Buffalo and Minneapolis bodes big trouble for the Biden administration. But overlooked last week was a report from state securities administrators stating, frankly, the opposite. The “states” supported administration efforts to strengthen the regulation of broker-dealers (BDs).
On November 4, the North American Securities State Administrators Association (NASAA) released its latest installment of a national survey of investment advisor (IA) and BD policies, procedures and practices pre-2018 and 2021 post-Reg BI.
The bottom line, according to the report: “Many broker-dealer firms still place their financial interests ahead of their customers.” They offer and sell “complex, costly, risky products” (CCR) and fail to disclose to investors the availability of lower cost and less risky products.
Four CCR products were identified because they have all three characteristics: private securities, variable annuities, non-traded REITs and leveraged or inverse ETFs. These products, “Routinely appear in investor complaints and state enforcement actions,” according to the NASAA.
How BDs (under Reg BI) and fiduciary IAs compare regarding these products is stark. Among BD firms (in 2021) 76% recommended at least one product, versus 14% of IA firms (in 2018). Specifically, 66% of BD firms and 5% of IA firms recommended variable annuities.
Other findings in the NASAA report included:
- From 2018 to 2021, BD firms increased their commitment to CCR products. In 2018 (before Reg BI), 89% of BD firms offered CCR products, while in 2021 100% did so;
- 65% of BDs did not discuss lower cost or less risky products when they discussed CCR products; and,
- IA and BD practices for financial conflicts also differed dramatically. Compensation based on incremental sales growth was rewarded by 30% of BD firms and just 3% of IA firms; and differential comp was rewarded by 29% and .5%, respectively, of BD and IA firms.
How BD firms fell so short can be seen in Reg BI’s duty of care provision. The “care obligation” requires understanding the potential risks, rewards and costs to have a “reasonable basis” … to believe the recommendation is in the best interest of a particular retail customer based on his/her profile.
The NASAA correctly noted that, “Strong due diligence policies, procedures and tools are key to meeting Reg BI’s new standard of care obligation.” Specifically, effective use of customer profiles, the need to consider and discuss reasonably available alternatives with less risk and lower cost, were among the ways to operationalize the requirement.
Despite the evidence of little progress to date, NASAA officials argued major steps forward can be made. In an interview, NASAA President Melanie Senter and Maryland Securities Commissioner Andrea Seidt, chair of NASAA’s Regulation Best Interest implementation committee and Ohio securities commissioner made the case. Reg BI can elevate the suitability standard to a fiduciary standard for a BD’s transactional business. The Reg BI release stressed how key elements of best interest are “substantially similar” to the core fiduciary duties of care and loyalty, Seidt pointed out.
When it comes to the “care obligation,” the Reg BI release stressed, “facts and circumstances at the time of the recommendation” and if “the broker-dealer had a reasonable basis to believe” the recommendation met the best interest standard.
But only some facts are considered. Facts not required by the SEC of BDs include those documenting why the product was recommended. BDs are not required “to prepare and maintain documentation regarding the basis for each specific recommendation.”
Putting what the BD believed ahead of what the BD did to fulfill the fiduciary obligation of care is bizarre. It helps explain why BDs are still putting their interests first, as the NASAA concluded.
This “basis” is the core of the fiduciary duty of care, a prudent process and the management of investment decisions that result in superior returns, according to Donald Trone, an investment fiduciary expert. “Fiduciary standards of care create the necessity for written documentation evidencing the fiduciary’s diligence,” Trone said.
Last week’s elections were important. Last week’s NASAA report was far more important. The NASAA performed an important public service we can only hope the SEC and FINRA take seriously.