Thursday, May 30, 2019

Regulation Best Interest Coming

The SEC recently announced it would go ahead and vote on Regulation Best Interest and a number of other provisions on June 5th.  Consumer and investor advocates have generally panned the draft regulation because it fails to meaningfully raise standards beyond the existing FINRA Suitability rule.  Although the proposal ran to 408 pages, the actual draft regulation only spans about four pages.

It's difficult to see how the draft rule moves beyond FINRA's suitability standard in any meaningful way.  The rule opens by saying that brokers must "act in the best interests of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the retail customer."  This language seems to parallel FINRA's guidance instructing brokers to make recommendations that are "consistent with" the best interest of customers.  Notably, the rule does not say that best interest means that a broker must place the customer's interests ahead of the broker's, which is what most people would think a best interest regulation would include.  The draft simply declares that the firm cannot put its interests ahead of the customers.

After this odd initial language, the proposal goes on to chart out how a best interest obligation may be satisfied.  It lays out three requirements, including a (i) disclosure obligation; (ii) care obligation; and (iii) conflict of interest obligation.  A loyalty obligation remains conspicuously absent.  

Disclosure Obligation

The disclosure obligation requires some written disclosure of the "material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation." The SEC may allow firms to satisfy this obligation with general boilerplate disclosures.  No doubt these documents will be detailed, thorough, technically accurate, and completely incomprehensible to the average financially illiterate American.

Care Obligation

FINRA's suitability rule contains three components: (i)  reasonable basis suitability; (ii) customer-specific suitability; and (iii) quantitative suitability.  Regulation Best Interest again seems to track FINRA's rule with a (i) reasonable basis to believe that the recommendation might be in some theoretical investor's possible best interest; (ii) a reasonable basis to believe that the recommendation is in the best interest of a particular customer; (iii) and a reasonable basis to believe that standing together a series of transactions will be in the best interest of a retail investor.

Conflict Obligations

The third part of the rule discusses the conflict of interest obligations for brokerages.  It requires some written policies "reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations."  It also requires "written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations."

The draft rule doesn't specify whether mitigation must be effective or what will count as mitigation.  If a brokerage wants its representatives to push its costlier proprietary products, it'll still be able to have its brokers make those recommendations.  This leaves the door open for brokerages to create financial incentives for brokers to tilt their recommendations in ways that generate more fees for the firm and lower returns for investors.  If the firm is allowed to create financial conflicts, its unclear what meaning the mitigation requirement has.  Would a rule saying that a broker will not be terminated for not selling a particular product be enough?  This allows the firm to leave the carrot and stay the stick, generating the ability to claim it has mitigated conflicts.  There does not seem to be any limiting principle for conflicts so long as the firm could point to some yet more horrid system that it claims to have moved away from.  

Bottom Line

If this goes through as it is, retail investors should not trust their brokers.  It means that a customer cannot rely on a broker to actually act in their best interest.  The same conflicts will continue to bias investment advice.  Customers will likely receive more useless disclosures but will also be barraged with largely rhetorical claims that they should trust their brokers because they are now bound by regulation best interest.


The SEC will also vote on a number of other proposals, all unlikely to provide any material benefit to investors. 

Form CRS

The SEC will consider requiring disclosures about the nature of the relationship.  Testing revealed that the draft regulation's sample disclosure mock up largely failed to help customers understand the nature of their relationship.

Investment Adviser Standard of Conduct

The SEC is also considering some interpretation on the investment adviser standard of conduct.  If it simply enshrines the disclosure-fetishistic position it has taken in recent enforcement cases, the interpretation may allow registered investment advisers to claim to be fiduciaries while betraying customer interests.  If an investor pays an investment adviser 1% a year, they should be able to trust the investment adviser.  In recent years, the SEC has leaned heavily on "eliminate or disclose" to address conflicts.  Allowing the "disclose" option as a solution to address conflicts means that an investor cannot trust their registered investment adviser without reading and understanding the disclosure.  

An investor considering whether to trust Wells Fargo will need to read the Form ADV specific to that particular program.  Consider this one. It's 37 pages of small print.  It also discloses that Wells Fargo's registered investment advisory arm has an incentive to pick the funds that kick cash to it:

Revenue sharing

Revenue sharing is paid by a mutual fund’s investment advisor, distributor, or other fund affiliate to us for providing continuing due diligence, training, operations and systems support and marketing to Financial Advisors and Clients with respect to mutual fund companies and their funds. Revenue sharing fees are usually paid as a percentage of our aggregate value of Client assets invested in the funds. Revenue sharing rates can differ depending on the fund family, and in some cases we receive different revenue sharing rates for certain funds and share classes within a particular fund family. In addition, not all mutual funds pay revenue sharing, as a result we have an incentive to include funds on our platform and recommend funds that pay revenue sharing and/or pay a higher rate. Advisory Clients are not permitted to restrict their Accounts to only mutual funds that do not pay revenue sharing. We do not collect revenue sharing payments on Program Accounts for ERISA plans, SEPs, and SIMPLE IRAs. Revenue sharing payments generated based on mutual fund assets under management in Participating Accounts are considered Platform Support and included in the Advisory Account Credit.

Allowing this sort of conflict to be solved through "disclosure" means that investors cannot trust their advisers.  Anyone who would read and fully understand the Wells Fargo disclosures probably has no need for Wells Fargo's asset allocation assistance.

Solely Incidental

The SEC may also issue an interpretation as to what "solely incidental" means.  The Investment Advisers Act does not apply to brokers as long as the "advice" they provide is "solely incidental" to their execution services.  For decades the term has had practically no meaning or restraining effect.  Brokers have long identified themselves as "financial advisers," putting it on the business cards, websites, and email signatures.  If they only gave incidental advice, they wouldn't be holding themselves out as advisers. With the horse so far out of the barn, SEC seems unlikely do much on this front.


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