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Our Take on the SEC's Proposed Conflict of Interest Rules

With the DOL's fiduciary rule dead, we're calling for more clarity on the best interest proposal.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Securities and Exchange Commission has proposed new regulations to reduce conflicts of interest for broker/dealers. Joining me to discuss this is Aron Szapiro. He is director of policy research for Morningstar.

Aron, thanks for joining me today.

Aron Szapiro: Thanks so much for having me.

Glaser: Before we get into the SEC's proposal, let's start with the Department of Labor's proposal that would have imposed a fiduciary rule on anyone proffering financial guidance in retirement accounts. What happened to that proposal?

Szapiro: A couple of months ago the 5th Circuit Court of Appeals struck it down, DOL declined to appeal. And so, the rule is dead. That said, there's sort of a long legacy of changes that we might see from that rule. As I like to say, I think the SEC rule, it's certainly not a reflection of the DOL rule, but it is an echo of it. The commission is concerned about similar kinds of conflicts of interest that the department was. That's where we are with the Department of Labor rule. 

We are in a moment of sort of an uneasy status quo where we have returned to the pre-Department of Labor fiduciary rule days and we are waiting to see what the SEC will finalize based on this proposal, the comments for which close today.

Glaser: Morningstar recently submitted a comment letter in relation to the SEC's proposed regulation. Let's talk about what the SEC is thinking about doing here.

Szapiro: Sure. Maybe I will contrast it a little bit against the DOL rule. 

Glaser: Sure.

Szapiro: What the SEC is proposing is a couple of things. First, they want to raise the standards of conduct for broker/dealers but not align them with Registered Investment Advisers' standard of conduct. That's complicated. They introduced a best interest standard that elevates the requirements for broker/dealers when they give advice to ordinary retail investors but doesn't quite align those standards with RIAs. 

This is in contrast to the Department of Labor rule, this would apply to any investments that an ordinary retail investor is seeking advice on, whereas the Department of Labor rule only applied to retirement accounts. That's one difference between the rules.

Another thing that the SEC is doing is requiring a new short disclosure called Form CRS, which is the customer or client relationship summary that's supposed to help people understand the differences between a broker/dealer or Registered Investment Adviser or dual registrants who could act as both. That's another aspect of the proposal. Those are the major things that the SEC is doing.

The big difference between what DOL was proposing and what the SEC is proposing apart from this account-type issue is that SEC's rule, while it has a requirement to manage and mitigate or disclose conflicts of interests, it doesn't have the kinds of strict prohibitions that DOL's rule had. That's a pretty big difference between the two sets of regulations or the DOL rule and the proposed SEC rule.

Glaser: In the comment letter you noted that Morningstar research actually points to the fact that key conflict of interest for broker/dealers appears to be kind of ebbing away. Let's talk about that and what our data show on that front.

Szapiro: It's interesting. These are payments that come out of the loads that an investor would pay and go from the asset manager, from the mutual fund back to the intermediary who is selling the fund to an investor. Those have been in a long-term decline. I think the really interesting thing that we've found was in 2015 those payments, which are a kind of conflict of interest, are no longer associated with greater than expected flows. 

It seems like in response to the Department of Labor signaling that they were going to roll out this rule and then proposing it that a lot of intermediary firms, a lot of firms that are actually selling to ordinary investors, changed the way that they recommended funds, the processes they had around recommending funds. That's certainly one explanation.

Another thing that could be possible with this data is simply that there were long-term declines that didn't have anything to do with regulation. Given that we see a statistically significant shift in 2015, that suggests to me pretty strongly that this was at least somewhat in response to rationalizing mutual fund distribution because of the Department of Labor rule. 

The open question now is, will the SEC's eventual final rule maintain some of that momentum which is probably quite positive for investors, at least in that sense.

Glaser: The bottom line question is then, does Morningstar think that this proposed regulation goes far enough in terms of reducing conflict of interests for broker/dealers? 

Szapiro: That there just needs to be more clarity around this new concept of a best interest standard. As we get that clarity, I think the answer is, it could go far enough. It really is just not that clear to what extent this new best interest standard for brokers differs from a suitability standard. It is likely at least until we get more clarification hopefully in a final rule, I think it is likely to confuse investors more.

This idea that there's an RIA who is acting as a fiduciary and a broker who is acting in your best interest but not in a standard that's as high as a fiduciary, that's complicated for even for professionals. Ordinary people are going to have a hard time figuring out what that all means. 

We had a number of suggestions for how to make the Form CRS maybe little bit clearer on this point. We had some suggestions for making it more clear what the standards are supposed to be for brokers. There's a number of different ways to go about doing that. 

The way the rule is written right now, it would really come down to how it is enforced. A rule that says you've got to mitigate your financial conflicts of interests, but we are not going to tell you where the sort of ceilings and floors are for that could be implemented in a number of different ways depending on the appetite for enforcement of regulators in the future. It'd be nice to get more clarity there.

On the other area where there could probably be a lot more clarity is on rollovers. If I recommend a rollover, I always have a conflict of interest in the sense. I always want your employer money to me, of course, I do.

Glaser: The company retirement plan and through the advisor, where he or she could presumably earn some of type of a fee on that money.

Szapiro: Exactly. That would be the most typical case. Even from one broker-advised IRA to another or something like that. There's a question which the Department of Labor answered quite definitively of whether or not you need to have a process to document why that rollover was in the client's best interest. DOL said, yes, you absolutely need to do that kind of documentation, here are the factors you need to consider. 

Whereas the SEC, although in the preamble they say--which is the lengthy thing where they explain why they are doing the regulation and what they think it will mean--they say this is a concern for us. The regulation doesn't have any specific requirements on these rollovers. We think that will be helpful. That's a unique kind of conflict. 

A lot of money is saved in 401(k) plans, they have institutional fees. I am sure a lot of rollovers make sense, but certainly some don't. Having some clarity on what the obligation is to ensure that is in a client's best interest I think would be very helpful.

Glaser: Looking at disclosures, it sounds like the SEC gets applause in your eyes for having a short-form version that's easy digestible. But you think that there's room for improvement on the disclosure front as well?

Szapiro: We think there's room for improvement in a couple of ways. Firstly, the series of behavioral recommendations about just getting those disclosures to people at the right moment in time where behavioral research suggests that we are most likely to use the information. People, especially, ordinary people who are investing for retirement but aren't investment experts, they really need that information just in time. If they get the disclosure months before a future conflict actually, if that's the recommendations they are getting, that may not be bad.

The second thing is, we'd like to see a lot more public-facing disclosures, that third-parties can aggregate and look at and contextualize, to tease out key messages from. It's interesting, although the SEC is very focused on conflicts of interests, there are a number of conflicts that other than--there's disclosure that they're happening but there isn't disclosure about the amounts or how they are being mitigated that would help us assess or help the SEC assess or other regulators assess whether the disclosure mechanisms are working. 

We think this is a golden opportunity for the SEC to rethink some of the disclosure around conflicts of interest, particularly around revenue sharing arrangements which, right now, there's basically no disclosure of and could potentially influence which fund a broker recommends over another--the exact kind of conflict the SEC is concerned with with this proposed rule.

Glaser: Really helpful summary. Thanks for joining me today, Aron.

Szapiro: Thanks so much for the opportunity to talk about this.

Glaser: For Morningstar I'm Jeremy Glaser. Thanks for watching.