SEC Wants Brokers to Treat Clients Better: What's at Stake
(Bloomberg) -- Wall Street is known for making money by selling risky investments with complicated names. Some examples: equity indexed annuities, structured notes and leveraged inverse exchanged traded funds.
The days of marketing such products aren’t necessarily coming to an end. But things could get more challenging if regulators require financial firms to make sure whatever they are peddling is in their clients’ interests.
Last week, the U.S. Securities and Exchange Commission took the first step by proposing a new "best-interest" standard for brokers. At a high level, the strictures -- laid out in hundreds of pages of text -- are designed to root out sales practices that investor advocates say encourage firms to steer customers into inappropriate investments that boost broker compensation.
While the SEC has long been urged to do more to address broker misconduct, the issue started boiling over in 2016 when Barack Obama’s Labor Department approved tough conflict-of-interest rules. The pressure for SEC Chairman Jay Clayton to do something increased last month when a federal appeals court struck down the Labor regulations, putting them in legal limbo.
If the SEC’s plan takes effect, brokers would be required to disclose and mitigate a range of conflicts. Brokers would also be prohibited from using titles that give customers the impression that they have a fiduciary duty -- the requirement that they put clients’ interests ahead of their own. Investment advisers have long had a fiduciary duty, and the Obama-era rules sought to extend that obligation to brokers who handle retirement accounts.
But there is a lot of confusion about what the SEC’s regulations would actually require, and the head-scratching isn’t just happening on Wall Street. At the SEC’s April 18 meeting, Republican and Democratic commissioners expressed concern that the agency had left things too vague by failing to make clear what a best interest means.
Here are some key questions about the SEC’s proposal:
What is the SEC’s best-interest standard?
The SEC doesn’t define "best interest." Instead, it lists obligations meant to ensure brokers don’t place their own interests before those of their clients. The SEC said the regulations would also require firms to “establish, maintain and enforce policies” that are designed to spot conflicts and mitigate them.
Taken together, the rules are a step up from the current SEC requirements that specify that brokers offer “suitable” investments. But the proposal isn’t nearly as stiff as a fiduciary duty.
Specifically, the regulations would require brokers to have a "reasonable basis" to believe that a recommendation to buy or sell a security is in the best interest of the customer. The rule, however, doesn’t require brokers to assess what is the best investment. Instead, it says brokers should weigh factors beyond simple costs and financial incentives.
The SEC doesn’t outright ban any practices, either. Rather, it highlights activities that "generally involve conflicts of interest," such as brokers peddling their employers’ own products. The agency also lists practices that it suggests firms should consider avoiding entirely, including sales contests and offering free vacations and prizes for top performers. Generally, the SEC said the conduct policies that firms have to establish should address sales tactics that could be problematic.
What do brokers have to do to show they are in compliance?
It’s not entirely clear.
Rather than specifying exactly what constitutes compliance, the rules require brokers to "reasonably” share “material facts." The SEC says this open-ended approach will prevent firms from drowning clients with unnecessary information just to satisfy regulators’ demands.
The agency even gives advice for compliance departments: keep it simple. In its proposal, the agency encourages short sentences and an active voice, while avoiding jargon.
What are the implications of the SEC leaving things murky?
Not being prescriptive could give regulators flexibility to crack down on shady behavior where they see it. For instance, if the SEC says certain conduct is prohibited, brokers may gravitate to practices that aren’t banned but are just as detrimental to clients.
However, the vagueness has also fueled concerns that the SEC’s proposal fails to make clear what’s allowed and what isn’t. When things are left murky, compliance departments often act conservatively, telling brokers to avoid everything that they fear regulators might question.
The SEC is encouraging the industry and investor advocates to offer feedback on whether it would be a better approach to specifically define what it means to act in a clients’ best interest.
Is the broker business model irreparably conflicted?
The SEC’s proposal notes explicitly that brokers, who make money by charging clients commissions on transactions, are conflicted when they make recommendations. That’s because the more a customer trades, the more money their broker makes. In contrast, investment advisers get paid fees based on how much money they manage and how profitable their investments are.
The SEC said it doesn’t want to overhaul the industry and "prohibit a broker-dealer from having conflicts when making a recommendation." Instead, its approach is to force brokers to disclose more and avoid recommendations that clearly benefit brokers at the expense of their clients.
How have financial firms reacted to the SEC’s proposal?
Mostly with quiet relief.
The plan would probably force banks to spend money to comply with the new disclosure and conduct requirements. But that’s a small price to pay for another nail in the coffin of Labor’s dreaded fiduciary rule.
The SEC will take public comment on its proposal for 90 days, and Wall Street banks will undoubtedly find aspects of it to complain about. However, executives can probably sleep soundly knowing they won’t have to overhaul their business models.
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