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From Securities Regulation Daily, August 9, 2018

State attorneys general urge SEC to rework Reg BI

By Anne Sherry, J.D.

A coalition of 17 state attorneys general wrote to the SEC with criticisms of Regulation Best Interest as currently proposed. The AGs urge the agency to strengthen investor protection, including by adopting a uniform fiduciary standard. New York Attorney General Barbara Underwood noted that Reg BI leaves key terms undefined, creating uncertainty for all involved, and fails to ban broker-dealer conflicts such as sales contests.

Under proposed Regulation Best Interest, broker-dealers making recommendations to retail customers would have a duty to act in the best interest of the customer at the time the recommendation is made, without putting the financial or other interest of the broker-dealer ahead of the retail customer. The rule imposes disclosure obligations, a duty to exercise reasonable care; and an obligation to enforce policies and procedures to identify and then address conflicts of interest.

In writing to oppose the rule, Attorney General Underwood is joined by the attorneys general of California, Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Mexico, Oregon, Pennsylvania, Rhode Island, Vermont, Washington, and the District of Columbia.

Deficiencies in the rule. The AGs identify four respects in which the proposal falls short. First, it does not impose the standard of care that the SEC itself concluded was appropriate. SEC staff, in 2011, recommended that the agency establish a uniform fiduciary standard for investment advisers and broker-dealers, consistent with the current standard for investment advisers. Retail investors incorrectly believe their advisers are acting in a fiduciary-like capacity, particularly because the financial industry itself uses titles like "financial advisor," "financial consultant," and "advisor" that connote a fiduciary-type relationship.

Second, the proposal leaves the issue of conflicts largely to the discretion of the broker-dealer. Even as the proposal recognizes and describes certain types of compensation incentives that can give rise to conflicts, it fails to prohibit these practices outright. The rule also provides no means of enforcement by the aggrieved retail investor, whose only recourse is likely to be arbitration. Broker-dealers themselves may have difficulty understanding their obligations under the rule as proposed.

The AGs also believe that while disclosure is important, Reg BI relies too heavily on disclosure. Their letter cites studies suggesting that disclosures alone are insufficient to protect investors. Furthermore, once a relationship is established with a broker, new information is not easily incorporated. Because disclosures are often written using jargon and complicated math, a regulation relying heavily on disclosure "does not adequately protect retail investors, and particularly the most vulnerable investors." The AGs also expressed skepticism that customers can simply shop for a better broker-dealer, especially if all broker-dealers are making similar disclosures.

Finally, the proposal contains ambiguity that is likely to lead to confusion in the marketplace. It fails to define key terms, instead leaving their interpretation to a "facts and circumstances" test. Undefined terms include what conduct constitutes acting in a customer’s "best interests"; when a "recommendation" is made triggering Reg BI; conflict of interest standards and the types of conflicted transactions; and standards for permissible disclosures as to fees and charges, type and scope of services, and material conflict of interest. This means that firms will need to construct a best interest program without any assurance that it will be compliant. Customers will have difficulty evaluating the conduct of their financial professionals, and there is no private right of action through which a body of case law could develop to clarify ambiguities.

Recommendations. To ensure investor protection, the SEC must amend the proposed rule to cure these defects, the AGs urge. The SEC should adopt a uniform fiduciary standard that imposes duties on the financial professional whenever that person is providing personalized investment advice about securities to retail investors. The standard should also require the professional to act in the customer’s best interest; make a reasonable inquiry into the customer’s financial situation; use reasonable diligence in assessing investment products; possess a reasonable belief that the advice is in the investor’s best interest; and provide advice and monitoring over the course of the relationship, factoring in any significant change in the investor’s financial profile. Finally, the SEC should ensure that all key terms and provisions of the uniform standard are clearly defined.

The SEC should also adopt enhanced conflict protections that require broker-dealers to eliminate the most pernicious conflicts of interest. Differential compensation between categories of products or providers should be based only on neutral factors, such as the time and complexity associated with recommending investments within different categories. At a minimum, a broker-dealer should be required to disclose its conflicts of interest related to principal transactions. And broker-dealers should be required to identify, disclose, and mitigate, or eliminate, all other conflicts of interest.

The AGs also have suggestions for how the SEC should focus on meaningful disclosure. In addition to mandating full and fair disclosure of conflicts, the SEC should consider what information would be most useful to investors, and when it is best provided. Any disclosures should be concise and direct; Form CRS should be strictly enforced. The disclosure mandates should require the contracts to include language affirming the proposal’s investor protections so that investors have a direct cause of action.

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