PLANADVISER - May/June 2018 - 50

compliance consult
A New Best Interest Model
The SEC steps up to the plate
T
he Securities and Exchange Commission (SEC), on
April 18, proposed to expand the standard of conduct
applicable to broker/dealers (B/Ds) and natural persons
associated with them. The SEC's action follows the demise
of the Department of Labor (DOL)'s definition of " investment
advice " brought on by the 5th Circuit Court of
Appeals in Chamber of Commerce of the United States v. United
States Department of Labor. Remarkably, the SEC intends that
the proposed standard be consistent with the best interest
standard established in the defunct DOL advice rule and
best interest contract exemption (BICE). And, ironically,
if the proposal were to be adopted as currently drafted,
broker/dealers could find themselves complying with a
best interest standard and addressing conflicts of interest
in a manner consistent with what they intended to use to
comply with the DOL's rulemaking.
The proposed " regulation best interest " is intended to
" enhance " investor protection while " to the extent possible "
preserving the traditional B/D model of providing services,
including the provision of incidental advice and receiving
transaction-based compensation.
According to the proposal, firms and their representatives
must " act in the best interest of the retail customer at
the time the recommendation is made, without placing the
financial or other interest of the broker, dealer or natural
person ... making the recommendation ahead of the interest
of the retail customer. " Therefore, the proposal contains
best interest language reminiscent of the DOL's best interest
contract exemption. However, unlike the DOL's definition of
investment advice and its exemptions, the SEC states that
it does not intend to change the law applicable for determining
when a person is making a recommendation or the
enforcement mechanism that applies once a violation of the
Securities Exchange Act of 1934 and its underlying regulations
occurs. Rather, the focus of the proposal is on a firm's,
and its representative's, standard of conduct.
The SEC further proposes that, in order to meet the
aforementioned best interest standard: 1) The firm and
representative meet a " disclosure obligation " ; 2) The firm
and representative meet a " care obligation " ; and 3) The firm
establish policies and procedures designed to meet " conflict
of interest obligations. " Of particular note is the care obligation,
which requires the firm and its representatives to
exercise " reasonable diligence, care, skill and prudence " in
forming a " reasonable basis to believe " that recommendations
meet reasonable basis suitability, customer-specific
suitability and quantitative suitability requirements like
those under current law. The language in the care obligation
looks a lot like the DOL's best interest standard. Note,
however, that the SEC specifically chose not to add language
that the firm or representative must act " without regard to "
its own interests, which many firms believed was an impossible
standard.
Additionally, the conflict of interest obligations describe
what measures a firm would have to take to resolve conflicts
of interest. The SEC would require that material conflicts
involving financial incentives be treated differently from
other material conflicts of interest with respect to mitigation.
In some cases, mere disclosure of a material conflict of
interest may be sufficient to address the conflict. However, in
other cases, particularly where the conflict involves a financial
incentive, disclosure likely would not be enough.
For example, the SEC points to variations in pricing
between securities and products. On one hand, the agency
believes differential pricing may be justified based on neutral
factors-e.g., the time and effort involved in advising the
client on a security or product. On the other hand, such a
differential may not be justifiable for two securities or products
that are otherwise the same. The SEC also pointed to
bonus, award and compensation program incentives that
may encourage sales not otherwise in the interest of investors
and suggested that elimination of such incentives or
at least enhanced supervision may be needed. Again, the
language in the SEC's proposal is strikingly similar to that
in the DOL's explanation of how to comply with the requirements
of its best interest contract exemption.
The promulgation of a final regulation best interest is far
from certain. Advisers should expect substantial changes,
in the event a final regulation is issued. However, firms that
have made or were in the process of making such changes
to their compensation practices, product and service offerings,
and policies and procedures in order to comply with
the DOL's rulemaking may be deciding how to unwind these
changes in light of the failure of the rulemaking. They should
keep in mind that the SEC may be heading in a very similar
direction with regard to the standard of conduct applicable
to firms and their representatives and what actions should
be taken to address conflicts of interest.
David Kaleda is a principal in the fiduciary responsibility practice group
at Groom Law Group, Chartered, in Washington, D.C. He has an extensive
background in the financial services sector. His range of experience
includes handling fiduciary matters affecting investment managers,
advisers, broker/dealers, insurers, banks and service providers. He served
on the Department of Labor's ERISA [Employee Retirement Income
Security Act] Advisory Council from 2012 through 2014.
50 | planadviser.com may-june 2018
Art by Tim Bower
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