How the SEC's Regulation Best Interest Proposal Could Be Better

Last spring the SEC proposed a Regulation Best Interest rule that would raise standards of conduct for broker/dealers when they sell investments to ordinary investors. We have had a few months to digest the 1,000 pages of material the commission put out and formulate our response. In a nutshell: We think the rule could prove to be quite strong and maintain momentum toward best interest advice, but it could be even better.

While the SEC proposal incorporates some of the positive aspects of the now defunct fiduciary rule proposed by the Department of Labor in 2010, we think it could go even further to help consumers understand how much they're paying for financial advice and the conflicts of interest their advisors may be facing.

An Uneasy Status Quo In March 2018, the 5th Circuit Court of Appeals struck down the Department of Labor's fiduciary rule, which would have held broker/dealers and Registered Investment Advisers to a fiduciary standard whenever they gave advice on retirement accounts. When a professional is held to a fiduciary standard, he or she must act in clients' best interests, even when it means putting the clients' interest ahead of his or her own. RIAs already followed a fiduciary standard, but the fiduciary rule would have added scrutiny, particularly when RIAs recommended a rollover from a 401k to an IRA.

With the rule dead, we've returned to the status quo: broker/dealers operate on a "suitability" standard, while RIAs follow a much stricter standard of conduct. Finally, financial professionals who are fiduciaries under the body of law that governs retirement plans (called ERISA) follow an even higher standard of conduct. The now-dead fiduciary rule greatly expanded the number of people subject to ERISA standards, and it's not clear how many will continue to operate as ERISA fiduciaries now that they do not have to.

But the status quo is uneasy for two reasons. First, the yearslong process of the Department of Labor proposing and finalizing its rule led to a lot of changes in the industry and exposed some business practices that were not in the best interests of investors. Further, many of these changes have accelerated a movement toward financial professionals trying to act as impartial advisors rather than salespeople, and that momentum will likely continue. Second, the SEC leaped into the fray proposing its Regulation Best Interest, which is an echo of the fiduciary fule, if not a reflection.

What the SEC Proposal Gets Right As I observed when the SEC proposed the rule, Regulation Best Interest is potentially a major change to how the SEC thinks about regulating the conduct of financial advisors. The rule aims to hold broker/dealers to higher standards of conduct than they have ever had to follow. Specifically, it requires broker/dealers to provide advice in their client's best interest, principally by mitigating or disclosing financial conflicts of interest. This is where the SEC rule echoes the Department of Labor's fiduciary rule. That rule also focused on incentives that a financial professional working for a broker/dealer might have to recommend one investment over another. The SEC makes several helpful suggestions in the preamble on how firms can adopt policies and procedures to mitigate or eliminate conflicts of interest, but it does not require any of them specifically.

How It Could Go Even Further The rule does not align standards for broker/dealers and RIAs the way that the fiduciary rule would have (at least for retirement accounts). While the Department of Labor's fiduciary rule would have clearly prohibited certain kinds of conflicts of interest, such as differential compensation for selling similar products and sales contests, the SEC's proposal does not have such bright lines. We, along with many other firms, believe the rule needs to be clearer about how and when broker/dealers should mitigate conflicts of interest.

Most importantly, we believe that the regulation needs to identify rollovers from 401(k)s to IRAs as specifically requiring a prudent process and documentation to ensure they are in retirement investors' best interests. Rollovers require additional scrutiny because most financial professionals have an incentive to recommend that clients roll over their assets to an IRA rather than leaving them in employer-sponsored plans where the advisor cannot charge a fee based on those assets. Further, participants in most workplace retirement plans enjoy institutional pricing for investments and high levels of protections due to ERISA's strict fiduciary standards. The final regulations should specifically identify broker/dealers responsibilities when recommending a rollover.

Disclosure Proposal Also Falls Short The SEC also proposed a disclosure for ordinary investors, called the customer or client relationship summary, to complement Regulation Best Interest. While the goals of the disclosure are laudable, in focusing on keeping it short, there are a few things that are missing. For example, although the form will note some of the conflicts in a broker/dealer's business model, it will not be an exhaustive list with common language, nor will it explain how the broker/dealer works to mitigate these conflicts.

We also have some suggestions for leveraging behavioral research to make the disclosures as effective as possible. Our view on disclosures is that the SEC should require more publicly available information in a standard taxonomy on fees and conflicts. For example, every firm should need to disclose the "revenue-sharing" payments it collects from asset managers, and how it ensures it gives unbiased advice despite potential conflicts of interest from these payments. This approach will work best because such data can empower third-parties such as fintech and reg-tech firms to analyze and contextualize critical information and amplify a call to action for ordinary investors.

The bottom line is that many investors will not be able to use the disclosures effectively, particularly because best interest is going to differ from fiduciary in important but subtle ways that industry and consumers (and maybe the SEC) do not fully understand yet.

What Does the Data Show About the Need for Regulation? Our comment letter included a detailed econometric analysis showing harms from a key financial conflict of interest and found the link between some conflicted payments and questionable advice appears to have declined since 2010. That was the last year on which much of the Department of Labor's regulatory impact analysis for its fiduciary rule was based.

What caused this reduction in harms from conflicts? It could be due to regulatory pressure, pre-existing trends away from load-sharing, or a mix of the two. While it's hard to draw definitive conclusions without a randomized control trial particularly given the messy nature of the data we have, the preponderance of evidence points to regulatory action accelerating a move toward business models where financial advisors put their clients' interests first.

The SEC is likely to make some changes to its proposal, and we hope they will add the specificity we think is necessary. However, the way the rule is written right now is sufficiently vague to leave effectiveness of the rule up to future SEC enforcement lawyers. The rule could maintain the momentum toward advisors providing advice in the best interests of their customers, or it could come up short. More specificity would help lead to more uniform outcomes.