SEC’s Best-Interest Proposal Challenged by Small-Firm CEO
(Updates with comments about Regulation BI from SEC Chairman Jay Clayton.)
Minutes after a Securities and Exchange Commission official gave a spirited defense of the regulator’s proposed Best Interest standard at the Financial Industry Regulatory Authority’s annual conference on Tuesday, the head of a broker-dealer criticized the rule as especially problematic for small firms.
“The problem is it’s one size fits all,” Sutter Securities Chief Executive Robert Muh said after SEC Trading and Markets Director Brett Redfearn gave a keynote address calling Regulation BI a “robust framework” for addressing potential customer harm that also respects firms’ different business models.
“I think the large firms can handle this fairly easily,” said Muh, who employs 12 people at his San Francisco broker-dealer and said that more than 1,000 Finra member firms have fewer than five registered representatives. (More than 3,000 of Finra’s 3,726 member firms have 150 or fewer registered representatives, according to a Finra spokesman.)
Muh, who has been a Finra board member since 2016, told AdvisorHub that he was not speaking in his role as a Finra governor.
While all firms are struggling to parse the sprawling 400-page rule proposal that requires firms and brokers to put their customers’ interests ahead of their own when giving investment advice, smaller broker-dealers will be particularly vulnerable to legal consequences, according to Muh. That is because they do not have the resources to marshall the product and statistical analyses that will be necessary to defend themselves against potential lawsuits accusing them of violating a best-interest standard by failing to disclose and mitigate conflicts involving compensation and other issues.
The rule’s failure to define the term “best interest,” which Redfearn said was a deliberate acknowledgement of the differences among customers’ investment profiles and circumstances, will likely open a “tremendous flood of litigation” from customers who challenge the reasonableness of an investment and of a firm’s commitment to their best interest years after it is made, Muh said.
The SEC is accepting comments on the proposed rule through August 7, but the executive isn’t relying on significant changes being made.
Muh said his firm is consulting with lawyers about whether it can offer a hybrid brokerage account in which it would charge a small upfront fee of perhaps 10-30 basis points to support its monitoring and review of investments on an ongoing basis, though the proposed regulation does not require that. Sutter would charge an additional low commission if it makes a trade to account for an investment change due to something like a municipal bond downgrade or a change in a customer’s risk profile.
“I’m not saying this is the right answer but it addresses our issue…of how to examine all of the alternatives” to comply with a best-interest standard, Muh said. “The Morgan Stanleys and JP Morgans of the world have the resources for a broker to rely on (and) the 1,000 small firms don’t. As long as there’s a one-size fits-all rule, the small firms are at a disadvantage.”
At least one official who sat on the panel where Muh made his remarks agreed that large firms appear fairly well-prepared for a best-interest rule.
“I’m cautiously optimistic,” said Dan Kosowksy, the chief compliance officer of Morgan Stanley Smith Barney.
The SEC’s plain-English understanding of the term best interest “captures what we’re getting at,” he said, noting that “a lot of the building blocks are already there.” The chief challenge for firms will be operational as they determine things such as the timing and methods of disclosing conflicts, and ensuring that compliance occurs at the branch level, he said.
The SEC’s proposal has taken on even greater weight following the apparent demise of the Department of Labor’s fiduciary standard rule affecting retirement account advice. The Fifth Circuit Court of Appeals on Tuesday denied a second attempt by New York, California and Oregon to intervene as plaintiffs in appealing the court’s earlier decision to invalidate the rule. The DOL under the Trump Administration has backed away from supporting the rule.
Leaders of the brokerage industry widely opposed the DOL rule, primarily because it would have allowed class-action lawsuits against firms, said several officials at the Finra conference. The proposed best-interest standard from the SEC, which would apply to taxable as well as retirement accounts, purposely avoids using the word “fiduciary.”
“Some call that a flaw,” Redfearn said, “but fiduciary doesn’t tell us much about the relationships” that vary between broker and customer, depending on the capacity in which the broker is serving and on the nature of a firm’s business.
Speaking to reporters later in the day at the Finra conference, SEC Chairman Jay Clayton said he didn’t want to confuse investors about distinctions between investment advisers who are subject to an ongoing fiduciary relationship under the Investment Advisers Act of 1940 and brokers subjec to a lower suitability standard under the Securities Act of 1933 that would be enchanced under Reg BI.
“In both cases [broker or investment adviser], you can’t put your interests ahead,” he said. “Brokers need procecures” to satisfy the best-interest standard and under the proposed rule also will have to take steps to mitigate egregious conflicts.
Redfearn encouraged his audience of compliance officials to comment on what’s missing in the proposal, but warned them to avoid discussions about “the word fiduciary.”