SEC Finalizes New Standards for Broker Dealers

SEC Finalizes New Standards for Broker Dealers

The SEC has adopted new rules for broker-dealers that expand disclosure requirements and require broker-dealer to act in the “best interest” of customers.

The SEC has finalized regulations establishing new standards of conduct and rules governing broker dealers.

It is an understatement to say that there is a lot to digest here — the SEC releases finalizing these rules weigh in at over 1,300 pages (although the regulations themselves are only 19 pages). It is also an understatement to say that these new rules are controversial–but more on that later.

It will take years — and may blog posts — to assess the implications of these new rules. So, let’s start with a blog post summarizing key features of the new regulations and, for the most part, defer analysis of implications to future posts.

Four Components
Regulation BI has four key components:
•      Disclosure Obligation. In making a recommendation, broker dealers must provide retail customers, in writing, full and fair disclosure of material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest that are associated with the recommendation.

•      Care Obligation. Broker dealers, in making a recommendation, exercise reasonable diligence, care, and skill to:

      ◘      Understand the potential risks, rewards, and costs associated with the recommendation, and
      ◘      Have a reasonable basis to believe that the recommendation is in the best interest of the customer based on that customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation, and
      ◘      Not place the financial or other interest of the broker dealer ahead of the interest of the customer.

•      Conflict of Interest Obligation. Broker dealers, in making recommendations, must establish written policies and procedures designed to:
      ◘      Identify and at a minimum disclose, or eliminate, all conflicts of interest associated with such recommendations;
      ◘      Identify and mitigate conflicts of interest associated with such recommendations that create an incentive for representatives of that broker or dealer to place the interest of the broker dealer, or such representative, ahead of the interest of the customer. This requirement is focused on compensation practices that are especially likely to affect representatives’ recommendations;
      ◘      Identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended; and
      ◘      Identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.

•      Compliance Obligation. Broker dealers must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.

Philosophical Underpinnings
There are certain philosophies/paradigms that permeate Regulation BI. These philosophical underpinnings create some common themes throughout Regulation BI; they also represent the source of many of the criticisms that are emerging with respect to the regulation:

•      Reliance on Disclosure. Regulation BI does contain some specific rules governing broker dealer conduct and does specifically require elimination of certain practices. But, overwhelmingly, Regulation BI relies on disclosure as the vehicle for achieving the stated goal of improving investor protections.

•      Flexibility in Complying. Regulation BI imposes a number of obligations on broker dealers — but offers broker dealers a significant amount of flexibility in determining how to satisfy those obligations.

•      Deference to Current Broker Dealer Business Model. The SEC, both in proposing and finalizing Regulation BI, frequently acknowledged that it sought to create rules that were consistent with — and not disruptive of — broker dealers’ business model Indeed, the SEC release finalizing Regulation BI referenced broker dealers’ business model over 40 times; many of those references were in the context of seeking rules that were consistent with broker dealers’ existing business model.

Better than Nothing at All?

As noted, the philosophical underpinnings behind Regulation BI also represent a source of the criticisms levelled against the regulation — that it does too little to protect investors and, instead, allows use of disclosure to continue permitting sales practices and products that are detrimental to investors. The SEC’s reliance on disclosure gives rise to a related criticism–that the disclosure required under Regulation BI (and the flexibility available to broker dealers in determining how to meet these disclosure obligations) will not improve investors’ ability to assess providers and products.

In effect, these criticisms raise a basic question–will Regulation BI actually provide greater protections for investors–or would investors have been better off if the SEC chose not to act. It is likely that this question will swirl around Regulation BI and the SEC for years.

Onward–But Where?

With the Regulation BI finalized, the debate over investor protection is likely to move to other venues:

•      State Regulations. A number of states (including Massachusetts, Nevada and New Jersey) have moved to create their own standards of behavior for investment professionals, representing an effort to fill in the gaps left by the demise of the DOL’s fiduciary proposal and dissatisfaction with the SEC’s approach to investor protection. We can now expect these states to move forward–and for these state actions to be challenged in court as preempted by the SEC.

The SEC acknowledged that these battles now loom–in a footnote the SEC stated:

Whether Regulation Best Interest would have a preemptive effect on any state law would be determined in future judicial proceedings, and would depend on the language and operation of the particular state law at issue.

•      The Department of Labor. Secretary of Labor Alexander Acosta recently stated that the DOL is working to revive the defunct fiduciary rule. If and when the DOL does move forward, it is simply not likely to create new standards that disrupt the financial industry’s efforts to protect the current business model that generates millions from plan rollovers. See The Lure of the Ira and the Power of Inherent Conflict. Rather, Secretary of Labor Acosta acknowledged that the DOL standard will be developed “collaboratively” with the SEC’s approach–so look for more disclosure. DOL working with SEC on fiduciary rule.

•      The Courts. There is already speculation that Regulation BI will be challenged in court. As noted in a recent newsletter (Will the SEC’s Reg BI be Challenged in Court?), opponents of Regulation BI are already marshalling arguments for challenging the regulation in court.

At this point, likely bases for a challenge including whether the SEC provided insufficient economic analysis in adopting Regulation BI and whether Reg BI is inconsistent with the Dodd-Frank Act (which authorized the SEC to issue rules providing “that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers … shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”)

As noted, the SEC releases finalizing these rules represent over 1,300 pages — of explanation and justification. There is much work to be done to make sense of these tomes. Stay tuned.