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SEC Adds Fuel to the Best-Interest Fire

The SEC's proposal will accelerate the trend of advisors moving from a sales to a relationship model.

Many of us probably have fiduciary rule whiplash. On March 15, a court struck down the Department of Labor's rules package, known as the fiduciary rule, placing in limbo the new rules as we wait to see if the agency appeals. 

Last night, the Securities and Exchange Commission weighed in in a big way, dropping their version of a fiduciary standard late after a vote of 4 to 1. The SEC has the ball now, and it wants to run with it.

Before we dive into the proposal, it is important to keep in mind that this rules package is a proposal. The Department of Labor changed its final rule from the initial proposal, and we can expect the SEC to make some adjustments. Every commissioner who voted for the package expressed concerns with some aspects of the 1,000-page package and expressed a desire to push for changes and clarifications before voting to pass a final rule. Still, we expect the general principals will underpin the final rule.

What's the bottom-line?
This is potentially a major change to how the SEC thinks about regulating the conduct of financial advisors. The rule aims to hold financial professionals to higher standards of conduct, even if they are registered as broker/dealers rather than as advisers. Although the SEC has had the authority to write these kinds of regulations since 2010, earlier efforts petered out in 2013 before the Department of Labor took on its fiduciary rule project.

Regulators have worried for some time that the incentives brokers have may lead them to give conflicted advice compared to registered advisors, and ordinary investors generally do not know the differences between financial professionals. In fact, we just published a paper discussing how regulating advice--despite being one of the key tools the government uses to help investors--has been uneven and confusing for investors. That's a big part of the reason many in industry and advocacy groups have been calling on the SEC to propose a uniform standard of advice. From a first read, this SEC rule appears to address some of our concerns with the regulation tool.

Since the rule comes in at over 1,000 pages, it is going to take some time to fully analyze the package, but here are four key points that jump right out from a first read:

  • For first time, the SEC would require broker/dealers to act in the best interests of their clients when they provide advice by imposing a new rule with the on-the-nose name of "Regulation Best Interest." This best-interest standard applies to recommendations to buy securities, follow an investment strategy, or roll money over from a 401(k) to an IRA. (The last kind of recommendation was a key concern for the Department of Labor.) The crux of this new regulation is that it requires broker/dealers to have policies and procedures to mitigate conflicts, particularly those caused by financial incentives to recommend one product over another. This kind of conflict of interest and the harms these misaligned incentives could cause investors was a main rationale for the Department of Labor's fiduciary rule as well. Over the coming weeks, we will analyze the SEC proposal to assess the effectiveness of this approach and ways in which we might suggest improving it.
  • Despite the new Regulation Best Interest, it is important to keep in mind that while broker/dealers would have to follow a higher standard of conduct when providing advice, they will not operate under the same fiduciary standards that apply to registered investment advisers under the proposal. In other words, the SEC is not seeking to fully align standards across broker/dealers and registered investment advisers.
  • The rule aims to reduce investor confusion by requiring financial professionals to provide investors with a new form called CRS, which would provide a "relationship summary" to clients and prospective clients. This summary is designed to help investors understand the services they can expect, conflicts of interest that might influence the advice they receive, and fees they will pay, among other disclosures. Additionally, broker/dealers will no longer be able to use the term "advisor" (or adviser, with an "e," the spelling used in law for "registered investment advisers"), a further effort to reduce investor confusion about whether they are working with a broker/dealer or a registered investment adviser.
  • The rules package also contains additional clarifications of the fiduciary obligations for registered investment advisers, much of which have come from court decisions over the years. As with Regulation Best Interest, this guidance states that advice on rolling retirement savings over to an account that is managed by the registered investment adviser must be in the best interests of the client.

In the end, however, we expect this rule to have a similar effect as the Department of Labor's rule and accelerate an existing trend: advisors are moving away from a sales model and toward a relationship where they provide best-interest advice to their clients.

How is the SEC proposal different from the Department of Labor's proposal?
The SEC rule diverges from the Department of Labor's in three key ways:

  • The SEC rule does not rely on lawsuits as an enforcement mechanism, which allows much more certainty in firms' compliance plans.
  • The SEC rule would apply to both retirement and nonretirement accounts, although it would not regulate some kinds of advice that are subject to state regulation, particularly very small investment advisers and certain insurance products, such as single-premium annuities.
  • The SEC rule is much more focused on mitigating conflicts of interest than avoiding them all together. The Department of Labor's warranty requirements explicitly prohibited sales quotas, differential compensation for selling similar products, and sales contests, among other potential practices that could lead to conflicted advice. In contrast, the SEC rule relies on requiring written procedures to mitigate conflicted advice stemming from broker/dealers' misaligned financial incentives, but it is far less prescriptive than Labor's rule.

The differences in approach are due to the different laws empowering the SEC and the Department of Labor and historical differences in the agencies' approach to regulation.

What's next?
The rules package will be published in the federal register and there will be a 90-day comment period. The commission will then consider these comments and publish a final rule. At the same time, there is still a lot of uncertainty with the Department of Labor's fiduciary rule. The agency still has two weeks to decide whether to appeal the 5th Circuit's ruling, and it also may write a narrower rule to complement the SEC's new approach.

In the end, no matter what the final rule looks like, we expect this rule to have a similar effect as the Department of Labor's rule and accelerate an existing trend: Advisors are moving away from a sales model and toward a relationship where they provide best-interest advice to their clients. This proposal adds fuel to the fire.