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Broker Rule Aims for Middle Ground, Hits No-Man’s Land

Broker Rule Aims for Middle Ground, Hits No-Man’s Land

In January, we predicted that 2018 would be the year in which the SEC created a new standard of care for broker-dealers. The Commission just held a hearing about a new rule on the subject, and after a full airing of views among Commissioners, a 1,000-page report, and a vote in favor of it, we’re happy to say we were right. Well, we are pretty sure we were right. We’re, like, 65% sure we were right. We think.

Allow us to explain:

Until last week, the SEC held investment advisors and broker-dealers to two different standards of care. As we said in our prediction post, “broker-dealers can recommend any course of action that is ‘suitable’ for their clients, while investment advisors are held to the more stringent fiduciary duty.” We also noted that SEC staff had found that disparity troubling as far back as 2011.

With its new rule, the SEC could have eradicated that disparity entirely and imposed a fiduciary standard on broker-dealers. As it happens, that was the approach the Department of Labor took in promulgating its own controversial and ill-fated rule on the subject under President Obama. Key provisions of that rule were delayed before the Fifth Circuit kneecapped it last month as an unlawful exercise of administrative power. (The Tenth Circuit has upheld aspects of the same rule, so things could potentially get interesting on that front down the line.)

For now that leaves things back with the SEC, which aimed for a middle ground between the permissive “suitability” standard and the fiduciary standard applied to investment advisors. So where, exactly, did the SEC draw the line between those two? Funny you should ask, because even after last week’s hearing, no one seems to know.

The text of the proposed rule holds broker-dealers to a “best interest” standard, but the phrase’s utility is limited by the fact that it is never defined in the rule itself. Meanwhile, Commissioner Jay Clayton’s description of the standard achieves an almost poetic obscurity. He says that while broker-dealers have to meet a best interest standard, not a fiduciary standard, “I want to be clear: for broker-dealers, there are core fiduciary standards embodied in that best-interest standard.” He went on to state that the rule seeks to “harmonize the actual duties” between broker-dealers and investment advisors, while simultaneously “recognizing those differences” between them. Got it?

If not, the text of the rule at least informs us that under the “best interest” standard, brokers must:

  • Disclose all “key facts” about potential conflicts
  • Possess a “reasonable basis” to conclude the investment products they recommend are in their clients’ best interest
  • Note and mitigate “material conflicts of interest” related to financial incentives.

Perhaps most enlightening is the fact that it does not “expressly prohibit practices that investor advocates say can encourage bad behavior, such as offering free vacations to brokers who meet sales targets.”

The SEC will receive comment on the proposed rule for 90 days, after which it will hold a second vote on whether to make the rule official. And then, depending on what “best interest” means, we can say our prediction was right.

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