Regulatory Outlook | 07.01.20
Amidst Rocky Start and High Drama, Conduct Standards Take Effect
In the eleven months since the Securities and Exchange Commission adopted "Regulation Best Interest," the ground surrounding the set of advice rules has significantly shifted.
Brokerage and advisory firms have been up to their eyeballs in logistical headaches tied to the pandemic. Opponents of Reg BI, meanwhile, have only escalated their attacks with eleventh-hour legal challenges and a barrage of public rebukes. And now the rule’s champion-in-chief, SEC Chairman Jay Clayton, suddenly is seeking to abdicate his post.
Despite these storm clouds, industry insiders are now underscoring that the SEC and the Financial Industry Regulatory Authority (FINRA) still employ large teams of lawyers with marching orders — and careers ahead of them in the private sector.
"Probably this is not how Jay Clayton drew it up, but it is what it is," said Dan Viola, a former SEC examiner and a partner at Sadis & Goldberg; referring to Clayton’s recent, weirdly timed and highly controversial decision to promote his candidacy for a new position as U.S. Attorney for the Southern District of New York.
"Regardless of whether [Clayton] is confirmed, the first phase of Regulation Best Interest — and regulation in general — is going to be impacted near term,” Viola said. “Although longer term, there’s no shortage of people under him to see this through."
Deputies on Deck
Two key SEC staffers will be out front leading on enforcement of the new conduct rules, which include Reg BI, as well as the Client Relationship Summary form (“Form CRS”) and a newly codified interpretation of the fiduciary obligations of federally regulated investment advisers.
Lourdes Gonzalez, Assistant Chief Counsel for Sales Practices in the Division of Trading and Markets, has been and remains in the lead on Reg BI and Form CRS.
At FINRA’s annual conference last year, Gonzalez, providing a clear window into her mindset, stopped just shy of describing the new rule as a stepped-up fiduciary standard — and while it’s true the SEC drew from the old FINRA suitability requirement when drawing up the best-interest proposal, she said. The agency also lifted ample elements from the Department of Labor fiduciary rule — in some ways, toughening the standard.
“The big leap forward for us is making the broker’s requirement – to act in the customer’s best interest – explicit in the rule,” Gonzalez said.
Another key enforcer is Dalia Blass, Director of the SEC’s Division of Investment Management.
Blass said last year at an Investment Adviser Association event that the division generally has made it a priority to engage with the industry.
“We need that dialogue,” she said. “We need people to tell us where we got it right, where we got it wrong and where we can do better.”
Blass has been coordinating with staffers across the entire division – rule makers, examiners and data analysts — in pushing its investor-experience-centric mission; one focused heavily on asset manager fee disclosures.
While the message from FINRA examiners and SEC risk alerts has been for firms to make in these difficult, pandemic-roiled times, in a good-faith effort to get compliant with Reg BI, there was just a head’s up from the SEC that it intends to be tough on improperly disclosed conflicts.
Flagging Disclosure Failures
On June 23, the SEC’s Office of Compliance Inspections & Examinations (OCIE) released a risk alert summarizing the deficiencies found when examining investment advisers managing private funds. In their bulletin, the OCIE flagged a host of issues relating to conflicts of interest and fees.
“The staff observed private fund advisers that did not provide adequate disclosure,” the alert said.
As Ben Marzouk, a Washington, D.C.-based securities attorney with Eversheds Sutherland, has noted, “the OCIE risk alert makes clear that conflicts of interest and fee disclosures for financial advisors will continue to be a recurring issue, even outside of Reg BI and Form CRS disclosures.”
Disclosing conflicts in plain, concise language (as opposed to an intimidating, impossible-to-follow bombardment of legalese) is at the core of the SEC's rule package.
It has come to be known as Reg BI on account of its centerpiece. The “best-interest” standard requires brokers to always put clients' financial interests ahead of their own, and to document how that gets achieved.
Only a few weeks ago, the legacy of Jay Clayton was snuggly intertwined with the ushering in of Reg BI and a new era of fairness and transparency, with respect to the ways financial advisors interact with retail investors.
How Clayton is remembered now largely remains to be seen.
Commissioner in a Firestorm
Clayton, was originally perceived as being overly cozy with all the big banks, due to his years as a securities lawyer. The Wall Street Journal recently noted, he has not been the deregulation machine that many republicans may have hoped for when he was appointed top Wall Street cop in 2017. He’s pecked at rules, pruning some, but hasn’t been afraid to flex the agency’s muscles.
Several industry members were baffled to see Clayton get caught up in a Department of Justice firestorm surrounding Attorney General Bill Barr’s removal, on behalf of President Trump, of the Manhattan D.A. in order to, ostensibly, give that job to Clayton; he then told Congress he instigated the chain of events leading to what has amounted to a dramatic showdown within the federal justice system.
Clayton should withdraw, said Senate Democratic Leader Chuck Schumer in a statement on June 20.
“The whole thing is just bizarre,” said one industry member.
In his current job, Clayton certainly seemed to be in full-steam-ahead mode when he declared in early May that the agency, despite the pandemic, would not push back the June 30 Reg BI compliance deadline.
In speeches and testimony, Clayton routinely referenced his guiding principles — the first one being fidelity to the SEC’s mission.
“We regulate two types of financial professionals that play important roles in this vast market — broker-dealers and investment advisers — but do so in significantly different ways,” Clayton said during remarks made at the June 5, 2019 open meeting at which the SEC voted to adopt Reg BI.
“With all those headwinds, how did we make it here today? A mix of law, expertise, duty, courage and commitment.”
The SEC will continue to work closely with FINRA to help ensure consistency, Clayton said earlier this spring in his statement regarding the decision to hold firm on Reg BI compliance.
Clayton is not expected to be confirmed as New York’s top law enforcer, industry watchers agree, as Sen. Schumer seems able and poised to nix it.
If he does remain at the SEC, Clayton would still have a chance to steer SEC examiners as they begin the first phase of the new regulatory era, focusing on whether firms have indeed made good faith efforts to implement policies and procedures to comply with Reg BI. Clayton also could, if his SDNY prosecutorial aspirations are politically thwarted, or if he withdraws, help collect industry feedback.
‘A Reasoned, Lawful Process’
Also holding firm on Reg BI was a federal appeals court which rejected a lawsuit aimed at vacating the SEC’s best-interest standard only days before it took effect at midnight on Tuesday, June 30.
In January, Dodd-Frank Act namesakes, former Democratic Sen. Chris Dodd of Connecticut and former Democratic Rep. Barney Frank of Massachusetts, filed an amicus brief in connection with the lawsuits, stating that Reg BI "perpetuates the very inconsistency in standards of care that Congress passed the Dodd-Frank Act to fix.”
Deepak Gupta, attorney for the lawsuit’s lead plaintiff, XY Planning Network, a Montana-based financial planning firm, addressed a three-judge panel during a hearing conducted in early June by telephone. "Reg BI makes it more difficult for customers to differentiate between financial planners who are bound by fiduciary obligations and for broker-dealers who may consider their own financial interests," Gupta said.
"Although Regulation Best Interest may not be the policy that petitioners would have preferred,” the 2nd U.S. Circuit Court of Appeals in New York wrote in its decision, “it is what the SEC chose after a reasoned and lawful rule-making process."