April 18, 2018

Securities and Exchange Commission “Open Meeting”

Key Topics & Takeaways

Commission Votes: All three items were voted favorably 4-1, with Commissioner Stein voting no on each one.

Best Interest Standard for Broker-Dealers: The proposal would add a new “Regulation Best Interest” under the Exchange Act. The regulation would establish a standard of conduct for BDs and natural persons who are associated persons of a BD when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.

Opening Statements

Chairman Jay Clayton

In his opening statement, Clayton noted that the three proposals being considered are a package, that they collectively address standards of conduct for investment professionals and propose a comprehensive path forward. Clayton said that in 2017, it became apparent that a wide range of market participants believed setting standards of conduct for investment professionals was an area in which the Securities and Exchange Commission (SEC, Commission) could take action, in coordination with fellow regulators, and that the Commission should lead but not dictate in this area. Following a Request for Information on a range of issues, scores of meetings with investors and industry participants, and substantial prior work by the Commission, Clayton noted the proposals outlined in the meeting would have a 90-day comment period and that the Commission welcomes further public input. Clayton noted many questions related to the proposals, including how many individual clients will be affected, how changes will affect products available to investors, the effect on the cost of investment advice, and other concerns. Clayton explained that the proposals are focused on how best to bridge the gap between what retail investors expect and what our laws and regulations require, while preserving investor access and choice.

Regulation Best Interest — Standard of Conduct for Broker-Dealers

Brett Redfearn, Director, Division of Trading and Markets, explained the proposed new rules to raise the standard of conduct for broker-dealers when providing investment advice to retail investors is a package designed to protect investors while maintaining access to a full range of advice. Redfearn noted that in an attempt to address investor concerns, the Department of Labor, various states, and others have sought to articulate a heightened standard for broker-dealers that has created a patchwork of regulations resulting in higher costs to investors and limitations in product and service offerings. He explained that the SEC proposed Regulation Best Interest would require broker-dealers to act in the best interest of their clients, which would provide clarity and greater consistency for retail investors while continuing to meet demands for investment advice.

Lourdes Gonzalez, Assistant Chief Counsel, discussed further particulars of the standard. She explained that under the proposal, the term “recommendation” would be defined under FINRA rules, and thus would include a 401k rollover recommendation. She continued that the standard would be principles-based and is designed to give flexibility, while also providing clarity on what the enhanced obligations entail. Gonzalez stated that the new standard would include new disclosure obligations, a “care” obligation that imposes reasonable diligence, care, skill, and prudence obligations to understand the product and have a reasonable basis to believe that the product is in the retail customer’s best interest. She continued that the proposal also includes a duty not to make excessive recommendations and to consider cost as a factor. It was also noted that proprietary or complex products would not necessarily violate the standard, and that the lowest cost product is not required. Regarding conflicts of interest, it was explained that the proposal outlines a requirement for firms to establish, maintain, and enforce written policies and procedures to identify, disclose, and either mitigate or eliminate conflicts of interest, such as financial incentives, in order to reduce potential harm caused by conflicted advice.

Jeff Harris, Chief Economist, noted that the proposal could affect 43 million U.S. households, over 12,000 investment advisors and over 3,000 broker-dealer firms. Harris noted that there may be compliance costs, as well as changes to the ways broker-dealers are compensated, as well as effects on the variety of products and services offered and competition in the market.

Form CRS Relationship Summary; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles

Dalia Blass, Director, Division of Investment Management, discussed the differences between broker-dealers and investment advisors, noting that because they provide similar services, it can be difficult for investors to identify the differences despite the two offering “fundamentally different approaches” to investment services. Blass explained the proposed Client Relationship Summary (CRS) disclosure, which would require registered broker-dealers and registered investment advisers to provide a brief relationship summary to retail investors. She continued that the proposal would require a four-page disclosure highlighting key differences in services, legal standards of conduct, fees, and conflicts of interest, as well as key questions for the customer to ask their investment professional, and will allow for digital, paper and web-based disclosure.

Emily Westerberg Russell, Senior Special Counsel, discussed the proposed titling requirements. She explained that the proposal would include new restrictions on the use of the term “adviser” or “advisor” by broker-dealers in specified circumstances (i.e., where the broker-dealer is not dually registered).

Harris noted there may be compliance costs associated with preparing, delivering, filing, and updating Form CRS, as well as training costs. He also said there may be compliance costs to prominently disclosing registration status, as well as costs incurred by the titling limits due to compliance and marketing.

Standard of Conduct for Investment Advisers

Jennifer Songer, Senior Counsel, discussed the proposed interpretation of the federal fiduciary definition for investment advisers (IA), including an obligation to act in the best interest of the client, an obligation to seek the best execution of transactions, and an obligation to provide advice and monitoring over the course of the relationship. She continued that the proposal will include interpretive guidance for IAs, and will provide that IAs cannot “disclose away” their fiduciary duty. Songer explained that IAs must avoid conflicts, provide full and fair disclosure of conflicts and, as necessary, obtain an investor’s informed consent to certain conflicts. She added that the proposal will also include recommended enhancements to IAs licensing, continuing education and financial responsibility requirements.

Commissioner Statements

Commissioner Kara Stein

In her statement, Stein expressed her concerns about the proposal, stating that it “fails to provide comprehensive reform or adequately enhance existing rules.” Stein continued that the proposal maintains the status quo, saying that existing standards are not sufficient. Stein noted that the proposal does not define “best interest standard,” and that the name of the regulation itself could cause confusion by customers and broker-dealers, pointing out the possibility that FINRA and the SEC could interpret the language in the suitability standards differently, leading to higher compliance costs that would be passed on to investors.

Stein said that strong disclosure “empowers” customers to make decisions, but they must take the appropriate form and content, and be presented at the appropriate time in order to be effective. Stein expressed concern that the disclosure mandated in the proposal would result in boilerplate language that would put the burden on the customer to cure their own confusion when the responsibility should be placed on the financial professional.

Commissioner Michael Piwowar

In his statement, Piwowar noted that the proposal seeks to reduce confusion and prevent unnecessary ambiguity for retail customers. Piwowar explained that Form CRS is premised on standard economic theories on the value of disclosures, but that he looks forward to public input and the results of investor testing that the SEC will carry out. Piwowar said that there is a relative lack of case law regarding the SEC’s legal authority to carry out the proposal and is “eager” to know what the legal authority exists to support it. Piwowar stated that while he has some “misgivings” about certain aspects of the proposal, he “overwhelmingly supports” putting it out for public comment and looks forward to receiving input.

Commissioner Robert Jackson

In his statement, Jackson said the proposal offers hope that the SEC will step in to fill an “enormous” gap in the country’s securities laws. He stipulated that he does not support approving the proposal in its current form as a final rule, but there is a need for SEC action in this area made even more urgent by the recent Fifth Circuit Court decision to strike down the Department of Labor’s fiduciary rule. Jackson said the SEC can and should provide investor protection, but noted that the proposed standard is “confusing” and “ambiguous.” Jackson called for more cost-benefit analysis and the use of widespread economic literature that already exists on the issue.

Commissioner Hester Peirce

In her statement, Peirce expressed her concern that the approach to disclosures will only result in more “unread pages” in the trash cans of investors, noting that while the proposal does allow for electronic delivery, it falls back on a paper-based default. Peirce pointed to the problem of “disclosure overload” in reference to the proposed Form CRS which may not be useful to investors. Peirce said that suitability standards have “served investors well” and the proposal lacks clarity, specifically that it is not sufficiently clear about what the best interest standard is or how it relates to existing standards, calling for clarifications of the rule text. Peirce also said the term “best interest” sets an “impossible standard” that could lead to financial professionals expanding their offerings to include ones they do not understand. Peirce expressed concerns that the proposal will lead to declining relationships between financial professionals and their clients, focusing too heavily on delivering documents and disclosure checklists rather than focusing on the investor’s needs.

Comments by Chairman Clayton
Clayton noted the 43 million households that have relationships with their IAs that would be impacted and how our capital markets are the “envy of the world,” including how “nimble” it is for investors to save for retirement. He stressed the importance of improving and preserving the market and how his staff has been dedicated to looking out for Main Street investors. Clayton noted his hope that the standards in the proposal are “clearly understood by all parties” and that they will not result in excessive compliance costs, adding that the standards should be able to be tested and enforced.

Q&A

Clayton asked the staff if the package will make it more clear to investment professionals that the bar is being raised when it comes to requirements and that their interests cannot be put ahead of their clients. Staff responded with yes, that the standards draw on principles from the original fiduciary rule, but makes it more clear that conflicts of interest must be disclosed, addressed, and either eliminated or mitigated, as “disclosure alone isn’t enough.”

Clayton asked if the package will reduce investor confusion, allowing investors to understand the key terms of their relationship with their investment professional better, to include how the professional will be compensated and any other motives they may have. Staff responded that the relationship summary and Regulation Best Interest will give investors more information, but that it will also go one step further and give a “structure” or pathway for investors to better understand that information. Staff added that they want to hear from investors about how the summary can be more helpful.

Clayton then asked if the package would make it easier for regulators to identify and pursue those investment advisors that put their own interest ahead of their customers. Staff members explained that the package would “clearly articulate” the standards that apply under securities law and that the standard will improve compliance and the ability for regulators to hold them accountable.

Commission Votes
All three items were voted favorably 4-1, with Commissioner Stein voting no on each one.

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