Regulatory Outlook | 04.25.18
Unpacking the Fiduciary Rule Proposal: Lines Drawn, Standards Raised, but Still More to Play Out
On April 18, the SEC released its much-anticipated proposed set of fiduciary rules for broker/dealers. As the 90-day public comment period now gets underway, there are several key components of the proposal stirring debate with some particularly thorny issues — such as precisely how "best-interest" standards will be defined — that are still in need of further clarity.
To help shed detailed insight on the most important aspects of this ongoing rule revision process, on April 24, BISA hosted a webinar, “Connecting the Dots: The SEC Fiduciary Rule Proposal,” featuring partners at Eversheds Sutherland, Cliff Kirsch and Michael Koffler, as well as Ben Marzouk, associate attorney at Eversheds Sutherland, who heads the firm’s broker/dealer team in Washington, D.C.
Their discussion covered what was contained in the proposal, what was missing and what is possibly still to come. Below is a high-level recap of their discussion.
Key Takeaways from the Proposed Rule
Kirsch kicked off the webinar by spelling out the big-picture takeaways from the SEC's comprehensive rule set — over two decades in the making — for governing fiduciary duty and standard of conduct applicable to broker/dealers and advisors:
- The rules would create a clear-cut standard of conduct for broker/dealers recommending securities transactions and also require investment advisors to adhere to a new SEC standard of conduct interpretation. Additionally, there could be more new regulations on the advisor side of this dual equation. Industry members should get ready for the term "Regulation Best Interest" (RBI) as it applies now to both broker/dealers and investment advisors.
- Under the proposal, broker/dealers and advisors would be required to summarize their relationships with investors (and the services offered to them) by way of a Client Relationship Summary document, "Form CRS," written in plain English and not to exceed four pages; specific disclosures for dual registrants will also be forthcoming.
- The rule would restrict the use of the term adviser/advisor in certain circumstances.
"There's much more to play out, but this is a step forward," Kirsch said, noting the 4-1 vote to release the proposal came with some strenuous debate and more than a few sticking points over what the final proposal would look like in the end.
The commissioners’ statements would seem to indicate that there is to be an uphill battle before full adoption, which is no surprise. The issue has been widely and hotly debated by industry members and various regulatory entities, both state and federal. Broker/dealers have been moving into the advisory space for more than a decade, and the SEC proposal "is the most direct regulatory response to that we have seen in this time," Kirsch said.
In 2011, pursuant to Dodd-Frank, the SEC released a study on creating some well-defined and delineated conduct standards for broker/dealers and advisors. In 2016, the Department of Labor issued its controversial Fiduciary Rule, which relates to retirement accounts but inherently — and by natural extension — carries wider implications across the financial industry. Its implementation was delayed, and the rule itself just last month was vacated by the Fifth Circuit court.
"We still need to wait until June 13 to see whether the DoL will appeal that court ruling," Kirsch cautioned. Still more to play out, indeed.
Regulation Best Interest
Perhaps the single-most anticipated (and fraught) aspect of the rule set is a proposed interpretive release. The SEC intends for this part of the rule to reaffirm and clarify the fiduciary duty (which is two-pronged, comprising duty of care and duty of loyalty) that an advisor owes to his or her clients under Section 206 of the Investment Advisors Act. “About 90 percent of what’s here is merely the SEC putting in one place the guidance it has been issuing throughout the years,” Koffler said.
The SEC said in its proposal that best interests are to be evaluated in “the context of the client’s overall portfolio.” Interestingly, the language used is not unlike a proposal floated in the mid-1990s but was never adopted. Crucially, advisors would be required to make reasonable inquiries about the client's financial situation. The cost of a product or strategy is a consideration in the overall evaluation, but it should not be the driving factor or the only component assessed. Other important factors include client objectives, liquidity, risks and benefits.
“Cost is important, but the SEC went out of its way to point out that cost is not the be-all and end-all, rather it is just one factor,” Koffler said. “The SEC was clear in saying that ‘duty of care’ does not mean recommending the lowest-cost investment.” Recommending the lowest-cost investment or strategy would not in itself constitute satisfying “duty of care,” Koffler explained, that is, not without looking at the other factors in context of the broader portfolio.
Although the SEC appears to have tried in earnest to provide guidance on a move to a best-interest standard, there was some new confusion added into the mix with respect to certain scenarios — one being where a higher-cost product is recommended, and possibly if a potential conflict exists, whether it is properly disclosed. It remains fuzzy whether conflicts are to be flat-out avoided versus just disclosed. "In the same sentence the SEC says you must seek to avoid conflicts, but at a minimum you must make full and fair disclosure of your material conflicts," Koffler said. "People have asked, okay, so which is it, avoidance or disclosure — they don't answer this question."
One new important wrinkle, he stressed, was "a real emphasis on providing very good, clear, detailed disclosures." If you do have a conflict, it is not sufficient to merely say you “may” have one.
According to the proposed rule, “disclosure of a conflict alone is not always sufficient to satisfy an advisor's duty of loyalty," though it remains somewhat ambiguous under which circumstances a disclosure might be deemed insufficient. For example, there could be cases when an advisor would be required to eliminate or mitigate a specific conflict. "What it means to adequately mitigate a conflict was not addressed," Koffler said. "That's one of those interpretive questions that will have to play out during the rule-making process."
With its interpretive guidance on Regulation Best Interest as it would specifically pertain to advisors, the SEC is really driving home the notion — again, for advisors as opposed to broker/dealers — that this rule applies to the whole relationship with the client and not specific transactions. With this proposal, a clearer line now gets drawn between broker/dealers (transactional) and investment advisors (relationship-driven).
The type of business at bank-affiliated broker/dealers that will be most impacted would be wrap-fee business. Regulation Best Interest for broker/dealers — made not by the SEC’s Division of Investment Management but rather by the Division of Trading and Markets — applies specifically when recommending securities transactions or investment strategies to retail customer as defined by Dodd-Frank (and as opposed to institutional), Marzouk stressed.
The broker/dealer Regulation Best Interest requirement is to act in the best interest of the retail customer at the time the recommendation is made. "The standard has a broad scope," Marzouk said. "It would apply to the dual-hatted banking and brokerage employee when they are wearing the broker hat."
Some additional advisor-related issues are under review for consideration but were not formally proposed per se, including continuing education, federal licensing and periodic account statements regarding fees and financial responsibility in cases of fraud (e.g. fidelity bonds).