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From Securities Regulation Daily, May 27, 2015

FINRA chair pitches best interest standard in lieu of DOL fiduciary proposal

By Jacquelyn Lumb

FINRA Chair and CEO Richard Ketchum repeated his pitch for a best interest standard for broker-dealers in place of the expanded fiduciary standard proposed by the Department of Labor. He outlined a number of concerns with the DOL proposal and said a best interest standard tailored for broker-dealers would align investors’ interests with the goals of securities firms and would build on the current regulatory structure. Ketchum described his proposal in remarks at FINRA’s annual conference in Washington, DC.

In Ketchum’s view, a best interest of the customer standard under the securities laws is a better approach than DOL’s proposal. Broker-dealers already must perform due diligence on a product before recommending it to a customer to ensure that it is reasonably suitable. He noted that while broker-dealers are subject to a vast array of regulatory requirements, he believes it is time to move forward with a best interest standard since FINRA’s examinations continue to reveal instances of unsuitable sales of more complex products without adequate disclosure.

Ketchum added that some firms continue to approach conflict management on a haphazard basis and, despite issuing a notice on firms’ obligations with respect to conversions of 401(k) plans to IRAs, many firms do not provide balanced discussions about the potentially higher IRA fees to allow customers to make an informed decision. Ketchum also acknowledged investor confusion about the differing standards for broker-dealers and investment advisers.

Concerns with DOL proposal. The DOL proposal represents a good faith effort to address an important area of investor protection, according to Ketchum. However, he is concerned with the warranty and contractual mechanism it would use to address DOL’s limited IRA enforcement jurisdiction. For example, he said it would move the enforcement of these provisions to civil class action lawsuits or arbitration where the legal focus would be on a contractual interpretation.

A judicial arbiter may draw a sharp line that would prohibit most products with higher financial incentives regardless of how sound a recommendation might be, he explained. Under DOL’s proposal, firms likely would have to demonstrate that any higher compensation was directly related to the time and expertise necessary to provide advice on the product, which is not a simple proof standard.

Ketchum’s second concern is the lack of workable guidance for either firms or judicial arbiters on managing conflicts that exist in most firms’ business models, without moving to pure asset-based fees or a completely fee-neutral environment. Conflict concerns are valid, he said, but the uncertainties that may arise from contractual analysis and the lack of useful guidance may drive firms out of the IRA business entirely. Ketchum also does not believe it is optimal for investors to apply a different legal standard to IRAs and 401(k)’s than their other assets.

Best interest standard. He said a best interest standard should make clear that customer interests come first and customers must knowingly consent to any conflicts. The standard should be accompanied by sufficient guidance to ensure compliance. Financial firms should be required to establish procedures to manage their conflicts of interest. The standard would apply existing know-your-customer and suitability requirements. Ketchum also called for better disclosure through a Form ADV-like document that clearly describes conflicts and all product and administrative fees.

He also recommended more communications relating to investment recommendations, including conflicts, risks, and fees. He suggested that firms take steps to address the incentives from differential product compensation. One best practice is to create fee neutrality across products to minimize incentives to favor one product over another, he said. Another approach, in combination with fee leveling, is to add targeted compliance oversight focused on the sales of more expensive products to ensure that the sales are in the best interest of the customer.

Ketchum said his recommendations are not exclusive. They are meant to serve as a starting point to move the conversation forward. An effective best interest standard would provide firms with the flexibility to develop alternative means of showing that their recommendations are in customers’ best interests, he said. The key is to agree on a solution that identifies and manages firms’ conflicts; improves disclosures about risks associated any given product and the product-related fees; and more effectively manages compensation incentives for registered persons, he advised.

MainStory: TopStory FINRANews BrokerDealers

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