SEC Open Meeting on Reg BI

Securities and Exchange Commission

Open Meeting

Wednesday, June 5, 2019

Matters Considered

Key Takeaways

  • The Commission voted 3-1 in favor of all four items. Commissioner Jackson voted against each.
  • The implementation/compliance date is June 30, 2020.
  • Key changes from the initial Reg BI proposal include:
    • The scope of recommendations is expanded to include recommendations about account-type and IRA rollovers. This expanded scope applies to investment advisers as well under the investment adviser guidance.
    • Broker dealers must have policies and procedures to mitigate conflicts that incentivize the firm to place its interests ahead of the customer, and to eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.
    • Broker dealers must have policies and procedures to prevent material limitations on offerings, such as a limited product menu or offering only proprietary products, from causing the firm to plaice its interest ahead of the customer.
    • “Materiality” – the final Reg BI appears to take the Advisers Act definition, rather than the broker dealer definition from the Supreme Court’s Basic v. Levinson decision.

Opening Statements

Securities and Exchange Commission Chairman Jay Clayton
In his opening statement, Clayton explained that the Commission will be considering four recommendations from the Trading and Markets and Investment Management Divisions, and that the overriding issue being addressing today “has been at the heart” of the mission of the Securities and Exchange Commission (SEC) for the past 85 years. He stressed the importance of today’s proposed framework, as it will impact 43 million American households, calling it a “vast, multifaceted, complex, and critical part of the economy,” adding that it is “long overdue.” Clayton said that broker dealers and investment advisors work in different ways and under different regulatory regimes, and that it is important to enhance, elevate, and clarify their obligations in a comprehensive manner to better serve the interests of main street investors.

Clayton continued that no regulatory body has “comparable interest in these matters.” He said that the SEC is principally responsible for enforcing and examining for compliance with these obligations, and therefore must “constantly” ask whether action is “necessary or appropriate,” noting that “here the answer is a clear yes.”

He explained how the proposed rules for broker dealers and investment advisors are designed to “enhance the quality and transparency” of their relationships with clients, bringing their standards of conduct in line with “reasonable investor expectation” while preserving retail investor access to financial products.

Regarding Regulation Best Interest (Reg BI), Clayton explained that it is a “substantially enhanced” broker dealer standard of conduct that goes beyond suitability, requiring broker dealers to act in the best interest of their clients, drawing from key fiduciary principles that “cannot be satisfied through disclosure alone.” He continued that Form CRS requires a relationship summary with information in “plain English” about the relationships and services a firm offers, as well as fees, costs, conflicts, and the standard of conduct that is required. He explained that the package also reaffirms and clarifies the fiduciary duty investment advisors owe their clients, and that the interpretation of “solely incidental” delineates when a broker dealer becomes an investment advisor, both under the Advisers Act. He said these actions establish a framework for regulation of advice to main street investors that builds on the SEC’s past success and regulatory and enforcement expertise.

Clayton stressed that while today’s actions are “significant steps forward,” the financial markets are always changing and future efforts and adjustments will be necessary. He said it became clear during his confirmation process in 2017 that action in this area was “appropriate and timely,” and that action was necessary to address the “misalignment” between customer expectations and actual regulations. Clayton explained it was important to address this without increasing confusion or reducing investor choice, adding that increased regulatory complexity and a potential patchwork of state regulations would make oversight and enforcement more difficult. Clayton said that based on extensive feedback the SEC received on their initial proposal, he is certain the SEC has the right perspective and proposed the right framework, adding that they are “uniquely positioned” to set this standard of conduct.

Clayton noted that the Department of Labor (DOL) fiduciary rule provided a “highly relevant” data point, and the initial implementation of the rule illustrated that the SEC’s concerns about investor access and choice were not theoretical, saying their recommendations reflect a careful study of the rule in order to avoid unintended consequences.  Clayton said today’s recommendations enhance the standard of conduct but are appropriately tailored to the broker dealer relationship model, noting that the obligations cannot be satisfied by disclosure alone. He concluded that the SEC will next be rolling out a main street investor education campaign to help retail investors understand the key differences between broker dealers and investment advisors, as well as a committee to assist firms with compliance, adding that the SEC will continue its active dialogue with fellow regulators as the regulations go into effect.

Discussion of Proposed Regulations

Brett Redfearn, Division of Trading and Markets, explained that the recommendations are designed to improve retail investor protection while maintaining their choice and access to a range of financial products and services, adding that they have been refined and improved following the consideration of investor testing, roundtables, and the comment letters the SEC received. Redfearn said adopting Reg BI would substantially enhance the standard of conduct for broker dealers, and require broker dealers to make recommendations in their customer’s best interest and require them to not put their interests ahead of those of their customer, saying this is in line with how customers expect to be treated. He said the recommendation takes into account the structure and characteristics of the broker dealer relationship model, though the key elements of the enhanced standard of conduct are similar to those applicable to investment advisers, and this consistency will enhance retail protections.

Redfearn discussed the modifications made to the proposals based on comments the SEC received. He said Reg BI includes five key enhancements to current obligations. First, Reg BI applies to account recommendations, including recommendations to rollover or transfer assets in a workplace retirement account to an IRA, or recommendations to open an account. Second, the care obligation enhances investor protection compared to current suitability standards, and explicitly requires recommendations to be in the best interest of the customer and requires the broker dealer not to place their interests ahead of their customer. It additionally requires the consideration of cost with making a recommendation, and the broker dealer to consider reasonable available alternatives. Third, the regulation imposes a conflict of interest obligation, requiring broker dealers to establish, maintain and enforce policies and procedures reasonably designed to mitigate conflicts of interest to reduce the likelihood that they impact recommendations made to customers. Fourth, broker dealers will be required to disclose material facts about the scope and terms of their relationship with their customer to enhance the customer understanding. Finally, broker dealers will be required to establish, maintain and enforce written policies and procedures for broker dealer compliance, allowing the SEC to identify and address compliance deficiencies or failures early on, reducing the chance of retail investor harm.

Dalia Blass, Division of Investment Management, explained that the staff is making three recommendations serving complimentary goals: new disclosure designed to reduce confusion in the marketplace and help customers make decisions; an interpretation that reaffirms and clarifies the fiduciary duties of investment advisers; and an interpretation addressing the key question of when advisory activities fall under broker dealer or adviser regulations. She explained Form CRS will provide clear, concise information to customers about services, fees, and financial incentives, and will be provided in “plain English.” She said that the SEC will allow more flexibility regarding the content of the disclosure and that Form CRS will help investors decide whether to work with a broker dealer or an investment adviser.

Blass said that the regulation makes clear that financial professionals must act in the best interest of the client. She outlined that the regulation clarifies the federal fiduciary standard for investment advisers, saying it is not a new or watered-down standard, it is the fiduciary standard the courts have recognized and the SEC has applied, examined for, and enforced for decades. She said the standard is enhanced by directly applying fiduciary and antifraud standards when investment advisers recommend types of accounts or rollovers from retirement plans. Blass also discussed the staff recommendation that the commission issue an interpretation on when advice is “solely incidental” to the business of a broker dealer. She said the Advisers Act excludes broker dealers from the definition of an investment adviser when their advice is solely incidental and they receive no special compensation, and the staff recommends that the SEC clarify its views on this term.

Emily Westerberg Russell, Division of Trading and Markets, discussed how the standard of conduct has four components, including disclosure, care, conflict of interest, and compliance obligations, and failure to comply with any will violate Reg BI, adding that the standard of care cannot be satisfied by disclosure alone. She explained that modifications made to the proposal include an expanded scope of recommendations covered by Reg BI in that it further applies to account and rollover recommendations. In addition, though broker dealers are not required to monitor accounts, if a broker dealer agrees to provide such monitoring services, any recommendations will be subject to Reg BI. Further, broker dealers will be required to provide full and fair disclosure of all material facts on the scope and terms of the relationship with a retail customer and all material facts on conflicts of interest, which must be in writing. Under the care obligation, a broker dealer must exercise “reasonable diligence and care” when making a recommendation, and the broker dealer must understand the potential risks, rewards, and costs. She explained that policies must eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or types of securities within a limited period of time.

Elizabeth Miller, Division of Investment Management, discussed how Form CRS will provide retail investors with key information about the services broker dealers and investment advisers offer, organized in a relationship summary designed to show a comparison across firms and business models, including services, accounts, and investments available, as well as fees, costs, conflicts, and the standard of conduct for those offerings. The form will also include suggested questions for investors to ask their financial professional, as well as instructions on how to obtain additional information. Miller explained that there will be more flexibility to describe offerings, and there will be a compensation disclosure to expand the discussion of fees. She noted the staff is not recommending the adoption of a separate rule restricting broker dealer use of the term adviser or advisor as they are being incorporated into Reg BI, and are not recommending requiring broker dealers and investment professionals to disclose the firm’s registration status.

Benjamin Kalish, Division of Investment Management, outlined the aspects of the interpretation of the federal fiduciary standard of conduct for investment advisers, noting that the interpretation reaffirms and, in some cases, clarifies the standard without it being “watered down.” Kalish noted that the advisers will be able to draw upon a consolidated source of decades of interpretation. The interpretation will address fiduciary and anti-fraud measures when advisers recommend rollovers from retirement accounts and will also include clarifications on how it applies in the context of institutional versus retail accounts. Finally, Kalish noted that the interpretation will provide several examples of “full and fair” disclosures, as well as impermissible waivers of fiduciary duty.

S.P. Kothari, Chief Economist and Director of the Division of Economic and Risk Analysis, noted that the updated economic analysis will outline the costs and benefits of the rule on retail investors, as well as the effects on efficiency and capital formation. He explained that a large body of literature from the 1970s through 2018 was reviewed. Specifically, Kothari highlighted that surveys have shown investors are confused by services and fees and he noted that Form CRS is aimed at directly informing consumers. He said Form CRS intends to benefit retail customers by reducing information asymmetry and provide better comparisons, which may promote competition among financial services providers through better comparison shopping. Kothari also noted that there are expected compliance costs related to development and implementation of Form CRS, which may be passed onto consumers. On Reg BI, Kothari noted that a misalignment of incentives may put broker dealer interests ahead of customers, which the regulation will address through an enhanced standard of conduct, enhanced disclosures, and new policies and procedures to reduce and eliminate conflicts.

Commissioner Robert Jackson

In his statement, Jackson noted that the nation is facing a savings crisis and retirees face a growing threat of running out of money in retirement. Jackson said Americans cannot afford to trust someone with their financial future whose interest can be contrary to theirs, and it is a “crucial task” of the SEC to protect these investors. Jackson expressed that while he hoped the proposed regulations would raise the standard for investment advice, today’s rules put forth a “muddled” standard that could put Americans at risk for conflicted advice. He said that contrary to decades of tradition, the SEC has concluded that investment advisors are not true fiduciaries, and today’s actions fail to arm Americans with the tools to survive the savings crisis, saying he does not intend to vote in favor of the proposals.

Commissioner Hester Peirce

In her statement, Peirce said it was important to adequately explain these rules and interpretation in “plain English,” as well as ensure all income levels can choose a broker dealer or investment adviser. Peirce said investors should be encouraged to ask questions, be skeptical, and seek the information they need to make good investment decisions. Peirce said the compliance period is “very ambitious,” as firms will need to start immediately, and encouraged firms to send feedback and ask for guidance where needed. Peirce asked staff why the conflict of interest definition is not limited to “material” conflicts. Staff responded that the change is for consistency, but under the disclosure obligation broker dealers must disclose material facts related to conflicts. In response to a question from Peirce about what brokers should be thinking about when designing their product menu, staff explained that every company limits their offerings in some respect and recognize certain limitations can be beneficial, saying firms should have a process in place to disclose and address the negative effects of product limitations. Asked if broker dealers are required to recommend only the lowest cost product, staff replied that cost should always be a relevant factor for a broker dealer to consider, and the inclusion of cost in the care obligation does not necessarily require the lowest cost recommendation, as cost is an important factor but not the only one, as a more expensive product might be better for the client.

Commissioner Elad Roisman

In his statement, Roisman said he supported each recommendation, noting the importance of enabling everyday Americans to receive better investment advice from an array of providers in whatever way is most useful and affordable to them, and that these recommendations preserve their choice. He said the need for SEC action in this space has reached a point of urgency, and while the SEC has studied these issues, other state and federal regulators have stepped in. He said the DOL fiduciary rule “proved unworkable” for many financial services providers, raised compliance costs, increased litigation risks, and many stood to lose access to investment advice, leading to the necessity for SEC action. Roisman said it is clear that Reg BI will enhance the required standard of conduct for broker dealers, including heightened disclosure requirements, clarity on obligations, and improved transparency, and encouraged both the financial service industry and investors to continue sharing their views with the SEC.

Chairman Jay Clayton

Clayton asked the staff if the rules weakened the fiduciary duty required by the Investment Advisers Act, to which staff replied it does not, explaining that the rule adheres squarely to that standard and in no way diminishes it. Clayton further asked about enforcement, to which staff replied that the rule is reflective of how the SEC has always interpreted the law, and will not diminish their ability to enforce federal securities laws and will make it easier to identify misconduct.

Vote

Regulation Best Interest – Standard of Conduct for Broker-Dealers, Form CRS Relationship Summary, Standard of Conduct for Investment Advisors, and the Interpretation of “Solely Incidental” all passed by a vote of 3-1. Commissioner Jackson voted no on all proposals.

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