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Advisor Insights

SEC Takes Stance on Advisor Conduct

New rules package aims to raise standards.

Many of us probably have fiduciary rule whiplash. On March 15, the 5th U.S. Circuit Court of Appeals struck down the Department of Labor’s wide-ranging rules package, known as the fiduciary rule, which would have dramatically changed the way the DOL regulated advisors. The Trump administration was widely assumed to be planning further changes, but after four district courts upheld the rule, the circuit court’s decision came as a bit of a shock.

But the saga of government efforts to provide more muscular regulation of financial advice continued anyway. On April 18, SEC commissioners weighed in, voting four to one to release the SEC’s rules package, which aims to raise standards for advisors. Although the SEC has had the authority to write these kinds of regulations since 2010, earlier efforts petered out in 2013 before the DOL took on its fiduciary rule project.

Before we dive into the SEC’s rule, it is important to note that it is still a proposal. The DOL changed its final rule from its initial proposal, and we can expect the SEC to make some adjustments. Every commissioner who voted for it voiced 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. To complicate matters, commissioner Michael Piwowar stepped down July 7, so the five-member commission will look different when it votes on the final rules package. Still, the most likely outcome is that the general principles in the proposal 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 Registered Investment Advisors. Further, new interpretive guidance aims to clarify the high standard of care the SEC expects from RIAs. The reason for the proposed changes is that regulators have worried for some time that broker/ dealers have incentives that may lead them to give conflicted advice and that ordinary investors do not know the differences between types of financial professionals.

Despite being one of the key tools the government uses to help investors, the regulation of advice has been uneven and confusing. Divergent regulations for broker/dealers and RIAs have been overshadowed by converging business models. Further, the standards of care are different depending on whether an advisor is acting as a fiduciary under the Employee Retirement Income Security Act or not. Representatives from broker/dealers and RIAs (operating under and outside of ERISA) all represent themselves as advisors but operate under very different standards of conduct depending on how they are registered and in what context they give advice.

That mismatch is a big part of the reason many in industry and advocacy groups called on the SEC to propose a uniform standard of advice. But the SEC did not do so. Rather, it proposed raising the standard of care for broker/dealers, while maintaining a different, higher standard for RIAs.

The key things you need to know:

  • For the first time ever, 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. 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 was a main rationale for the DOL’s fiduciary rule, as well.

  • There are a lot of questions about what this best-interest standard means. For example, it is not clear yet to what extent the standard differs from the Financial Industry Regulatory Authority’s suitability standard. Clearly, the SEC proposal is a stricter standard, but exactly how much stricter seems open to interpretation and may depend on the appetite a future commission has for aggressive enforcement. The SEC declined to put clear bright lines around prohibited kinds of compensation.

  • Despite the new Regulation Best Interest rule, broker/dealers would not operate under the same fiduciary standards that apply to RIAs under the proposal. In other words, the SEC is not seeking to fully align standards across broker/ dealers and RIAs.

  • The preamble to the rule references rollovers from IRAs—a key concern the DOL had when issuing its fiduciary rule. Further, the interpretive guidance similarly emphasizes the obligations RIAs have when recommending rollovers. However, unlike the fiduciary rule, the SEC regulation does not specifically require different procedures and documentation for evaluating whether a rollover is in a client’s best interest, an area that needs further clarification.

  • Despite maintaining two standards of care for broker/dealers and RIAs, the rule aims to reduce confusion by requiring financial professionals to provide investors with a new form called CRS. This would provide a “relationship summary” to clients and prospective clients designed to help them 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 would no longer be able to use the term “advisor” (or “adviser,” with an “e”). However, dual-registrants would be able to continue to call themselves advisors.

How Is the SEC Proposal Different?
The SEC’s rule diverges from the DOL’s fiduciary rule in many ways, but three stand out:

  1. The SEC rule does not rely on lawsuits as an enforcement mechanism, which allows much more certainty in firms’ compliance plans.

  2. 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 advisors and certain insurance products, such as single-premium annuities.

  3. The SEC rule is more focused on mitigating conflicts of interest than avoiding them altogether. The DOL’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.

The differences are due to the different laws empowering the SEC and the DOL, and to historical differences in the agencies’ approach to regulation.

What’s Next?
The rules package was published in the Federal Register, and the period for public comment closes Aug. 7. The SEC will consider these comments before publishing a final rule. Meanwhile, uncertainty surrounds the DOL’s fiduciary rule. The department may not appeal the 5th Circuit’s ruling, but it also may write a narrower rule to complement the SEC’s approach.

In the end, however, we expect both rules to accelerate an existing trend: Advisors are moving away from a sales model toward a relationship model where they provide best-interest advice to clients. From our preliminary analysis of public filings, we think firms are doing an increasingly good job of managing conflicts of interest.


This article originally appeared in the August/September 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.