The SEC’s New Regulation for Brokers May Be Getting Lost in Semantics

Jun 12, 2019 | Blog

On Wednesday, June 5th, the U.S. Securities and Exchange Commission (SEC) approved its new Regulation Best Interest proposal amid concerns that the new regulation may lack the legal legs to stand on when it comes to effecting actual change in the financial industry. First introduced by the SEC last year, the now-passed proposal outlines new standards governing brokers’ ethical obligations to clients who rely on their recommendations regarding securities transactions.

The evolution of and recent proposals on this issue have been the impetus to endless debate and speculation as to the scope of a fiduciary standard to be imposed on the Broker-Dealer world. For those of you who operate in a hybrid scenario or solely in the Registered Investment Advisory space, the fiduciary obligations you are held to have not changed. Many in the industry would say that only now has the Broker-Dealer world begun to catch up with the heightened standard that RIA’s have held themselves to for some time.

Until now, the regulations dictating the terms of fiduciary duty for brokers have been set by the Financial Industry Regulatory Authority (FINRA). When advising clients on investment opportunities, brokers must follow a “suitability rule” which demands that brokers’ recommendations must be reasonably suited to a client’s circumstances and reasonably thought to work to the client’s benefit:

“FINRA Rule 2111 requires that a firm or associated person have a reasonable basis to believe a recommended transaction or investment strategy involving a security or securities is suitable for the customer. This is based on the information obtained through reasonable diligence of the firm or associated person to ascertain the customer’s investment profile.”

This rule is meant to serve as a basic level of protection for clients seeking advice on investment opportunities, helping prevent brokers’ personal interests from interfering with the guidance they offer clients. However, investor groups have long since criticized what they believe is an insufficient standard when it comes to putting their financial well-being into someone else’s hands. The persistent concern that the “suitable rule” simply wasn’t enough to adequately ensure the protection of investors and their assets was clearly the catalyst for the implementation of the new Regulation Best Interest rule.

While broker recommendations made in a client’s “best interests” may sound denotatively stronger than recommendations that are merely “suitable” for a client, the legal implications of these terms may get lost in semantics. Despite issuing an almost 800-page document detailing the new regulation, nowhere in the text of this document does the SEC ever clearly define just what exactly “best interest” means. And without a universal and definitive understanding of “best interest,” brokers’ ethical obligations may once again be left up to interpretation.

The new regulation lays out certain ground rules, mandating that brokers must disclose any material conflicts of interest to a client and must actively mitigate situations that may result in the prioritization of their own interests over the client’s. Several investor groups, however, have been quick to point out that adherence to these criteria alone does not necessarily ensure that a broker’s recommendation is always going to be purely in the “best interest” of the client. Those opposed to the new regulation fear that its terminology may be misleading and has the potential to give investors a false sense of security.

The SEC has also balked at determining whether the new federal regulation will preempt those regulations set by individual states. For now, the SEC has left it up to the courts to decide, on a case-by-case basis, whether federal or state law will have the final say in any conflicting broker requirements. And with so much gray area remaining regarding the specifics of broker conduct standards and the actual legal viability of the rules themselves, it is likely that the details will indeed have to be decided upon and fleshed out in the courts. This means that the practical application, implementation,  and enforcement of Regulation Best Interest will rest squarely on the advisors and lawyers who end up as the initial litigants in the seminal cases.

It is this author’s humble opinion that no one wants to be the proverbial test subject to see where the industry ends up on the regulation. That being said, if you have any questions regarding SEC compliance or broker requirements, please contact James E. Heavey.