Journal of Financial Planning: August 2018
What you need to know about how the rules and interpretations may affect you, your clients, and your firm
Andrea Seidt is Commissioner of the Ohio Department of Commerce Division of Securities and a former president of the North American Securities Administrators Association (NASAA).
Micah Hauptman is a financial services counsel at the Consumer Federation of America (CFA), where he performs research and engages in advocacy on investor protection and systemic risk issues.
Editor’s note: The following is an edited transcript of a June 21 FPA member webinar on the SEC’s proposed regulatory package, hosted by the FPA Member Advocacy Council (MAC). If adopted, these SEC proposals will dramatically impact financial planning practitioners, firms, and clients. FPA is working with the Financial Planning Coalition to submit a comment letter to the SEC. The comment period closes August 7. Visit the Financial Planning Coalition’s website for the latest on the Coalition’s comment letter.
On April 18, the SEC issued three proposals (available at sec.gov/rules/proposed.shtml). First, there’s proposed Regulation Best Interest, also known as Reg BI, which would seek to establish a best interest standard of conduct under the Exchange Act for broker-dealers when making a recommendation to a retail customer.
Second, there’s proposed Form CRS, or Form Client Relationship Summary, also called Customer Relationship Summary, which is a disclosure form for both investment advisers and broker-dealers. It also includes restrictions on the use of the title adviser/advisor with an ‘e’ and an ‘o’ for standalone brokers.
And third, there’s a proposed interpretation to reiterate and clarify the fiduciary duty applicable to investment advisers under the Advisers Act. This is also known as the IA guidance.
The package was released for public comment by a 4-1 vote with SEC Commissioner Kara Stein dissenting, although several other commissioners raised serious concerns and indicated that they would not vote to finalize it as it was proposed.
Regulation Best Interest (Reg BI)
Micah: Reg BI is not a uniform fiduciary standard. The SEC had an opportunity to create a uniform fiduciary standard by following the will of Congress in Section 913(g) of Dodd-Frank and following the SEC staff’s recommendation, and it chose not to. Instead, it maintained two different standards for advice—one for brokers, and the other for advisers. It then relies on Form CRS and the disclosures in it to enable investors to distinguish between brokerage accounts and advisory accounts, and what is best for the investor.
Reg BI requires broker-dealers and their reps to act in the best interest of the retail customer at the time of the recommendation without placing the financial or other interests of the firm or rep ahead of the retail customer. Importantly, it applies only in the broker’s capacity when making a recommendation. So, if the broker is a dual registrant and acting in their advisory capacity, it does not apply to them.
Reg BI uses the words “best interest” a bunch of times, but it doesn’t define what best interest means, leaving a lack of clarity. The same language the SEC uses to describe the best interest standard has been used to describe broker-dealer’s existing obligations under the suitability rules, investment adviser’s fiduciary duty under the Advisers Act, and the requirements under the DOL fiduciary rule.
Instead of defining what best interest means, the SEC proposal said that the best interest standard is satisfied by complying with three obligations:
A disclosure obligation would require a broker-dealer to disclose, prior to or at the time of recommendation, material facts relating to the relationship with the customer. This is in addition to the Form CRS disclosure (more on that later).
Material facts would include, for example, that the broker is acting in his broker-dealer capacity as opposed to his advisory capacity with respect to a recommendation. It would include the broker-dealer’s fees and charges, the type and scope of the services provided, and material conflicts of interest. It doesn’t dictate the form, manner, timing, or frequency of the disclosure; that’s at the broker’s discretion.
A care obligation would require a broker-dealer to understand the potential risks and rewards of the recommendation, and to have a reasonable basis to conclude that (1) the recommendation is in the best interest of at least some retail customer; (2) the recommendation is in the best interest of the particular retail customer; and (3) a series of recommendations is not excessive.
If these sound familiar, it’s because they’re basically FINRA’s suitability requirements. But it’s not clear what would be allowed under current law but prohibited under the proposal. The only example that the release provides that would be a clear violation is recommending essentially identical securities with higher costs.
The release does say that brokers would be required to consider reasonably available alternatives to satisfy their care obligation. But the release, in my view, leaves considerable flexibility to recommend investments that have higher costs and higher compensation structures, as long as the broker can point to some other features that warrant recommending the product. And the proposal provides a list of potential reasons, including special or unusual features, that would warrant a recommendation. From a consumer perspective, it’s a little troubling because it seems like the more complex a product gets, the more unusual features the broker could point to that would enable them to make a recommendation.
A conflict of interest obligation would require broker-dealers to establish reasonably designed policies and procedures to identify and disclose or eliminate all material conflicts of interest associated with recommendations. It seems to distinguish material conflicts of interest from conflicts arising from financial incentives. For conflicts of interest arising from financial incentives, firms must disclose and mitigate, not just disclose. The list of conflicts of interest arising from financial incentives is quite broad.
It’s not clear what conflict mitigation practices are required, and what, if any, financial incentives are prohibited. The proposal leaves quite a bit of discretion to firms. The proposal also states that in formulating conflict mitigation policies and procedures, firms should consider adopting a non-exhaustive list of best practices that come from FINRA’s 2013 Report on Conflicts of Interest.1
When Reg BI does apply, it’s on a transaction-by-transaction basis; there is no ongoing duty. And, it applies pretty narrowly. It applies to a person or a legal representative of a person who will use the recommendation for personal, family, or household purposes. But the proposal doesn’t define or clarify exactly what this means. It is clear that it wouldn’t cover recommendations on the type of account being recommended (brokerage versus advisory). For that, it relies on Form CRS disclosures for the investor to decide which account is best for them.
It also doesn’t appear to apply to small plans. So, for 401(k) plan sponsors who receive advice about what investments to include in their plan menus, those conflicts can filter down to the participants, but the proposal wouldn’t appear to apply to them. And it also wouldn’t appear to apply to recommendations to rollover from pension funds to an IRA.
Finally, there is a record-keeping requirement where brokers would have to keep account record information for six years.
Lack of clarity. The lack of clarity in Reg BI has been criticized across the political spectrum and from investor advocates to securities lawyers. I expect the [Securities and Exchange] Commission will provide more clarity if this proposal becomes final.
Compounding the lack of clarity, the discussion is contradictory in spots. For example, the release states that the [proposed] standard requires broker-dealers to put aside their financial incentives. Yet later, it states that the broker’s financial interest can’t be the “predominant motivating factor” behind the recommendation, which suggests it could continue to allow a broker’s financial interest to influence recommendations to a certain undefined extent.
How does this affect you? If you are a broker and you’re moving toward compliance with the CFP Board’s revised Standards of Conduct, and you were moving toward compliance with the DOL rule, I don’t think you should have any concerns. CFP Board’s revised Standards of Conduct are much more robust than what the SEC has proposed. The only big lift I see is on the Form CRS disclosures, which is an entirely new thing you’d have to create.
If you’re an adviser, this doesn’t directly affect you, but it does indirectly affect you. This is a less-than-fiduciary standard, but brokers can still advertise effectively as advisers in a position of trust and confidence, and it preserves an unlevel regulatory playing field, so you may have concerns about that.
Form CRS
Andrea: Form CRS is a proposed new disclosure form to be prepared, filed, and delivered by both broker-dealers and investment advisers before or at the time services are first engaged, and then updated upon the opening of a new account or any time there’s a material change to the nature and scope of the relationship. The idea here is layered disclosure. It’s supposed to be a short, four-page document with a mix of prescriptive and narrative content among eight sections: (1) intro; (2) relationship and services; (3) standard of conduct; (4) fees and costs; (5) comparisons; (6) conflicts of interest; (7) additional information; and (8) key questions.
The Commission has provided sample mock-ups of Form CRS for broker-dealers, investment advisers, and those dually registered. It is also doing regional town hall meetings across the country, asking investors what they think about the form.2
The Commission is saying that broker-dealers will file their Form CRS on EDGAR, and investment advisers will file theirs on IARD as a new Part 3 to the Form ADV. The forms are also supposed to be posted prominently and made easily accessible and understandable to retail investors on firm websites.
Here is a brief overview of the eight sections of Form CRS, based on the investment adviser mock-up, because that will be most relevant to financial planners:
Intro. The introduction asks if an investment advisory account is right for you (the broker-dealer form asks if a brokerage account is right for you). It signals to investors that different services and different kinds of professionals are available to them.
Relationship and services. This part of Form CRS gets into more detail on relationships and services. One of the things you’ll pick up in reading the releases and looking at the Form CRS is that the Commission is focusing on at least three key differences between broker-dealers and investment advisers. The first difference is the timing or duration of the relationship. When they talk about broker-dealers, they’re trying to convey to investors on Form CRS the transactional or episodic nature of broker recommendations. If you look at the investment adviser mock-up, they are trying to convey more holistic, ongoing advice and monitoring.
A second difference is in the investment control. They suggest investors are generally more in charge of their investment decision-making with brokers, and they have the option of either retaining or ceding that authority when it comes to investment advisers. And the third major difference is that of fees.
Standard of conduct. The third section of Form CRS talks about the obligation to the investor. The language in this section is being mandated. Once [the SEC] settles on whatever the Regulation Best Interest obligations are in their final release, they will spell that out here for brokers. This section is also where they would expect an investment adviser to share with investors their obligation. Clearly, they’re focusing on fiduciary duties for investment advisers.
Fees and costs. It’s clear that the Commission believes this area of Form CRS is an opportunity to provide greater transparency and education to investors to help them make informed investment decisions. Certain types of fees get special attention, and in the release and in the instructions for Form CRS,3 you’ll see a sample and suggested language on markups, markdowns, negotiable fees, wrap fees, surrender charges, and custodian accounts or maintenance inactivity fees.
The Form CRS, as the Commission describes it, is generalized versus personalized disclosure. Whether it should be more personalized is something I think [will generate] a lot of comments.
Comparisons. This is probably one of the more controversial parts of Form CRS. The Commission is wanting to provide a comparison between typical broker accounts and typical investment adviser accounts. They are mandating prescriptive language here.
The controversial part, I think, is really [this language in the investment adviser mock-up]:
“You can receive advice in either type of account, but you may prefer paying
- a transaction-based fee from a cost perspective, if you do not trade often or if you plan to buy and hold investments for longer periods of time; or
- an asset-based fee if you want continuing advice or want someone to make investment decisions for you, even though it may cost more than a transaction-based fee.”
I’ve heard a lot of objections to that last bullet point, because it seems to suggest in all cases that adviser fees are normally higher than broker fees, so that’s something we may see some objections to in the comment process.
Conflicts of interest. The Commission is giving firms a lot of flexibility on what they disclose here. Only this line is mandatory: “We benefit from the advisory services we provide to you.” (Brokers have a similar disclaimer on their Form CRS). The rest is to be customized based on the conflicts emanating from your business model. The Commission does highlight in the mock-ups and in the instructions certain kinds of conflicts, including conflicts resulting from third-party or affiliate compensation, revenue-sharing agreements, as well as conflicts involved in principal and proprietary trading.
This section of Form CRS does not repeat or cross-reference the firm’s obligation to eliminate or mitigate any of the disclosed conflicts.
Additional information. This section of the Form CRS is focused on disciplinary information. Rather than provide personalized disclosure, you just need to say whether you have a disciplinary history on your record, and if you do, where the investor can find it. They route everyone through the SEC’s website, investor.gov, and ask firms to provide information where complaints can be filed.
There is no reference to the states here, so NASAA will likely comment along those lines, because we certainly do have a lot of investor complaints on these kinds of issues. Something else that’s missing from the Form CRS is guidance on the different dispute resolution mechanisms available to investors.
Key questions. The last section of Form CRS is key questions for investors to ask, including, for example, “Given my financial situation, why should I choose an advisory account?” and “What additional costs should I expect in connection with my account?” The Commission offers a lot of flexibility here, saying firms can modify or omit portions of any questions that are inapplicable to their business, and reminding firms to frame the questions to align with the brokerage, advisory, or dual model.
Titles and Registration Status
As Micah mentioned, [under the SEC proposal] broker-dealers and their reps are prohibited from using the titles “adviser” and “advisor” while communicating with a retail client, unless the broker-dealer is licensed as an IA with the SEC or state, or the individual offers investment advice on behalf of, and is supervised by, an IA registered with the SEC or state. And, broker-dealers and investment advisers must prominently disclose their registration status in print or electronic retail communications.
What the rule does not do is prohibit holding out as an adviser or engaging in marketing that conveys that trust or other type of relationship by brokers, even when they are only providing execution or episodic advice.
Fiduciary Duty Guidance
The last of the releases is the investment adviser fiduciary duty guidance release, which shares some things the SEC is considering for future rulemaking. It clarifies that the IA fiduciary duty standard of care includes the “best interest” duty of care, the duty of best execution, monitoring for ongoing relationships, and “client-first” duty regarding conflict resolution.
[The Commission] is soliciting comments and preliminary views on the following areas of potential future adviser regulation:
- Whether IARs of federal advisers should register with the SEC and/or have to undertake continuing education. (NASAA is already looking at the CE part of this, at the state level.)
- Whether the SEC should impose a uniform account statement requirement on investment advisers similar to that seen in the broker-dealer space.
- Whether the SEC should impose a uniform financial responsibility requirement on investment advisers, like a net capital requirement, bond, or other alternative.
Questions and Answers
FPA member question: Regarding the use of the term “adviser” by broker-dealers, does that also apply to a clearing firm using that term to generically describe to an accountholder who they should contact with questions regarding their account?
Andrea: If we read the rule technically, if you are not a licensed investment adviser at the state or federal level, you can’t use the term “adviser” referring to your firm. If you are referring in those account statements or in communications with a retail client about a licensed IA that you’re clearing for, then I think yes, you can refer to third parties that have those proper licenses in that way. But you couldn’t use that for your own firm.
Question/statement: For a retail customer, the choice between best interest and fiduciary [per the SEC proposal] would seem to make best interest sound preferable.
Andrea: Yes, I think that is a legitimate concern. Again, NASAA hasn’t issued comments on it yet, but I can tell you it’s something that we’ve discussed internally. It’s confusing on its face, from my perspective, because fiduciary duty has—as the releases themselves acknowledge—as the very first duty the best interest duty. So using a label that is a core component of both standards of care tends to confuse, in my opinion.
Question: Do you feel the SEC’s proposal goes far enough in terms of ensuring that the dually registered professional will lead with their license as an investment adviser representative?
Andrea: I’ll give the disclaimer that what I say here is the opinion of Andrea Seidt, not that of the Ohio Division of Securities. No, I don’t. I think what the SEC is doing in the rule proposals is preserving the hat-switching behaviors they have allowed for quite some time. All they require is more disclosure as to when you’re switching hats. If you’re dually licensed, depending on which account you’re utilizing with your client, you can switch hats.
Micah: I agree. You can be a dual registrant and only serve a client in a brokerage capacity and call yourself an adviser, and you can call your services advisory services. So, I don’t think it pushes the needle meaningfully for investors at all. And I think it has the potential to raise costs for standalone brokers considerably, because it requires them to change their names, but they can change their names to convey the same message, that they’re advice providers.
Question: Are there real, tangible changes in Reg BI, or is it simply rebranding suitability with a more palatable name?
Andrea: It’s anyone’s guess. I think there’s language in the releases that could be construed to say the answer is no, which is what Commissioner Stein essentially said in her dissent, that they didn’t move the needle; it’s nothing more than suitability dressed up a little bit. But there’s language in there—the rule says a broker cannot put their interests ahead of the client’s—that could be construed broadly, and if that were the case, it would really change the game. As always, the devil is in the details. A lot of commenters will be asking the SEC to provide that guidance and to figure out what it is they’re truly intending.
Micah: In addition to Commissioner Stein raising that concern, Commissioner [Hester] Peirce raised the same concern, maybe from a different perspective, but she said, “This is suitability plus.” But it’s not clear, plus what?
Andrea: Ambiguity is costly. If you’re not sure, then it’s going to be resolved through litigation, which is never the way we want to resolve things. If it’s suitability, let’s be clear about that. If it’s something more, then let’s be clear about that, too, so people aren’t misled and going down the wrong path.
Question: What enforcement mechanisms are proposed for professionals who violate their best interests and/or fiduciary responsibilities?
Andrea: This is an area, again, where the releases are vague. Offline, but not in the releases, what we’ve been hearing is the Commission saying that you would have the same ability to pursue a claim as you would with suitability. So, with most investors, that would be an arbitration claim where you would bring a claim for breach of best interest, instead of the preexisting standard of care suitability. But that’s not really clear in the releases, and certainly something that we would want strong clarification on in the implementing release. This would be a huge joke, I would think, if you talk about elevating the standard of care for investors and give investors no right of recovery.
Question: If this passes, what will FINRA’s role be? Does FINRA die?
Andrea: I don’t think FINRA dies in any scenario. I think the SEC is expecting a lot out of FINRA by passing this rule. I think they’re viewing the Form CRS, in particular, as an examination and enforcement tool. That could only be the case if they’re really leaning on FINRA to be reviewing these and assuring compliance with them. I think it borrows heavily from suitability for a reason, because it doesn’t want to disrupt that regime.
They’re pretty transparent that one of the major motivating factors behind Reg BI is to preserve the brokerage model. When I started as [Ohio’s Securities] Commissioner in 2008, I think there were 6,500 broker-dealer firms registered with FINRA. I think it’s around 3,000 now; less than half in a 10-year period. So, I think there’s a lot of concern for preserving the brokerage industry. And if that is true, and if that’s the way to combat that, that would only benefit FINRA.
Micah: I agree. I certainly expect FINRA will have a role, although the proposal is silent on what role it will have. And I agree that the release makes clear that it wants to preserve the broker-dealer business model. In some places, it makes clear that it wants to preserve broker-dealer revenues and profits, which I found perplexing in a regulatory release, but that’s just me.
And from a consumer perspective, I think that the proposal puts its thumb on the scale of the broker-dealer business model (in favor of the broker-dealer business model at the expense of the advisory model), pointing to the Form CRS disclosure as one example (in which the SEC states that investors can get advice more cost effectively from a broker than from an adviser), but there are others. So I think that the brokerage industry will be very happy with this.
[The Consumer Federation of America] does not take a position on commissions versus fees. Investors should have the opportunity to purchase goods and services in a variety of ways that meet their needs and preferences. Regardless of how they pay, the advice they receive should be what’s best for them. They shouldn’t have to sacrifice a standard of care as a result of choosing one or another. But I think this definitely puts the thumb on the scale of the broker-dealer business model, without ensuring that this is the case. And ironically, if there was a strong standard of care for broker firms that did ensure this, I think that it would make the broker-dealer business model much more compelling from a consumer perspective. I think the jury’s still out on to what extent [these proposed SEC rules] will actually have that effect.
Endnotes
- See finra.org/sites/default/files/Industry/p359971.pdf.
- A mock-up of Form CRS for investment advisers, prepared by SEC staff, is found in Appendix E, available at sec.gov/rules/proposed/2018/34-83063-appendix-e.pdf. Mock-ups for broker-dealers (Appendix D) and those dually registered (Appendix C) are found at sec.gov/rules/proposed/2018/34-83063-appendix-d.pdf, and sec.gov/rules/proposed/2018/34-83063-appendix-c.pdf, respectively. The investor questionnaire, which is being used in SEC regional town halls, is available at sec.gov/rules/proposed/2018/34-83063-appendix-f.html.
- Instructions for Form CRS are found in Appendix B at sec.gov/rules/proposed/2018/34-83063-appendix-b.pdf.
GET INVOLVED!
The FPA Member Advocacy Council (FPA MAC) serves as the feedback mechanism for FPA members so that it can hear your thoughts, concerns, and opinions. It works closely with FPA’s Legislative and Regulatory Issues Committee (LRIC) to provide feedback and guidance to the FPA board for their consideration in terms of the points they will put forward with the Financial Planning Coalition regarding the proposed SEC rules.
FPA’s Public Policy and Regulation Knowledge Circle has ongoing dialogue on regulatory issues on FPA Connect and is open to all members.
Have an opinion? To share an opinion or concern, or to suggest something for the MAC to consider, send an email to FPAMAC@OneFPA.org.