Finally, ten years after the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) was enacted to bring about sweeping changes to the securities industry, the best regulation the U.S. Securities & Exchange Commission (“SEC”) could pass, SEC Regulation Best Interest, is now the law governing broker-dealers giving investment advice to retail customers.
Although the SEC had the authority to impose a uniform and expansive “Fiduciary Duty” standard throughout the country upon broker-dealers and investment advisors, it yielded to the stock brokerage industry demands and enacted Regulation Best Interest (“Reg. BI”), which is better than the Financial Industry Regulatory Authority (“FINRA”) “Suitability Rule,” but not the best that it could have been done to protect investors.
Last month FINRA amended its Suitability Rule to conform with SEC Reg. BI and made it clear that stockbrokers now uniformly have duties related to disclosure, care, conflicts and compliance, which are equivalent to the common law “fiduciary duty” standard when making recommendations to retail customers. See, FINRA Regulatory Notice 20-18. 1
The controversy of the standard of care applicable to stockbrokers in a non-discretionary account relationship with their customers has been ongoing for decades.
Broker-dealers have long advocated for two standards: one standard being a non-fiduciary standard governing the non-discretionary account relationship and a fiduciary standard only governing the stockbroker with a discretionary account relationship.
On the other hand, the investment advisory firms have been crying foul for years and advocating for a level playing field where stockbrokers and investment advisers alike are both held to the same “fiduciary” standard in their entire relationship with customers.
The investment advisory industry recognized the importance of working in the “best interest” of their clients all of the time and the damage that stockbrokers (who are held to a lower standard) do to the reputation of “investment advisers,” especially those stockbrokers palming off the name “advisers” when doing business with the public.
Stockbrokers were able to take advantage of the goodwill and trust associated with “investment advisers” but not accountable to their clients as “fiduciaries.”
At the very least, the public was confused about the kind of “adviser” they were dealing with and the degree of investment professional duties the “adviser” owed to them.
The SEC recognized that although Congress, in enacting Dodd-Frank authorized it to impose a uniform “fiduciary” standard on stockbrokers, it was not going to do so.
It made that decision after the Trump administration took control. Are you surprised? The SEC’s public rationale was a bogus cost factor consideration; it reasoned if the standard was elevated broker-dealers would have to increase the transaction costs to investors with non-discretionary accounts to offset the increased compliance costs.
The SEC supposedly wanted to avoid destroying the commission-based broker-dealer business model but expand broker-dealer and stockbroker obligations when they give advice to retail investors. The compromise was Reg. BI which I will attempt to summarize below.
First, it is important to point out the new regulation only imposes new obligations upon broker-dealers and their associated persons when making recommendations to natural persons or their personal representative, such as trustees, executors, etc., who are retail customers (not institutions).
It’s unclear whether an individual’s wholly owned corporation or family limited partnership would reap any benefit from the new “best interest” rule even though those entities would probably be relying on recommendations for “personal, family or household purposes.”
Second, Reg. BI only applies to broker-dealers and their stockbrokers when they make recommendations of any securities transaction or investment strategy involving securities (including securities account type recommendations) to a retail customer.
Next, in general terms, the “Best Interest” rule imposes four obligations upon broker-dealers and their associated persons:
- Disclosure: to provide disclosures about the type of relationships they will have with their customer before or at the time of any recommendations (which will probably be buried somewhere in their website or the fine print of the 80-100 page customer agreement and disclosure booklets only made available via the internet when the account is opened).
- Due Care: to exercise reasonable diligence, care and skill in making the recommendation.
- Conflicts: to establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest, preferably to avoid or mitigate them and if they cannot be avoided to make sure they are disclosed to the retail customer in a way the customer will understand the conflict and appreciate its impact on the recommendation.
- Compliance: to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg. BI.
It goes without saying that the new SEC rule also requires broker-dealers to comply with new recordkeeping requirements to be sure Reg. BI is being implemented and enforced.
To retail investors, the “Due Care” and “Conflict” obligations will hopefully have the greatest impact.
This is because up until this point in time, broker-dealers and their stockbrokers would say, if we can match an investment recommendation to a customer’s profile, we have done our job and complied with FINRA Rule 2111 (formerly NASD Rule 2310), end of story.
For example, in the past, the recommendation of high fee proprietary structured products might fit the customer’s profile and be a suitable recommendation.
However, now that type of investment might not be in the “best interest” of the retail customer, particularly if the risk-reward analysis of another non-proprietary, plain vanilla, and less expensive security is the same.
To make it clear that Rule 2111 was no longer the rule when it came to future recommendations to retail customers, FINRA amended its rule (effective June 30, 2020) to state that Rule 2111 no longer applies to recommendations governed by Reg. BI because Reg. BI incorporates and enhances the principles found in Rule 2111.
Some writers of blogs for the defense bar have focused only on the Due Care obligation and said nothing has changed from the old suitability rule.
If that were true, the SEC and FINRA would have said so and the new rule would be meaningless! Instead FINRA said it “incorporates and enhances the principles” of the old rule, meaning it’s not the same.
We think of the new Reg. BI “fiduciary duty” standard as “Suitability Plus” when it comes to recommendations of securities transactions or investment strategies (including “hold” recommendations), because now broker-dealers and their associated persons better make sure they would have not only complied with the principles of Rule 2111 but be sure the transaction is in the “best interest” of the retail customer.
If anything is clear, Reg. BI may not be the best rule for investors, but it’s certainly better than old Rule 2111.We will be writing more about the “best interest” rule in the future and explain the four obligations in greater detail. We will also be watching for and writing about the new cases brought under Reg. BI by the SEC, FINRA enforcement, and investors.
In the meantime, if you have any questions about the new “best interest” rule and whether your broker-dealer and/or its stockbroker have complied with their obligations, please contact us, the call is free!
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Attorney Pearce and his staff represent investors across the United States on a CONTINGENCY FEE basis which means you pay nothing – NO FEES-NO COSTS – unless we put money in your pocket after receiving a settlement or FINRA arbitration award.
For dedicated representation by an attorney with over 40 years of experience and success in structured product cases and all kinds of securities law and investment disputes, contact the firm by phone at 561-338-0037, toll free at 800-732-2889 or via e-mail.
1 In many jurisdictions like New York, Broker-dealers have routinely argued they have no fiduciary duty in connection with any kind of customer accounts, often incorrectly citing, de Kwiatkowski v. Bear Stearns Co., 306 F.3d 1290 (2d Cir. 2002) as authority for that proposition. In other jurisdictions like our Eleventh Circuit and Florida state courts, the law is clear that a broker owes a fiduciary duty of care and loyalty to a securities investor. Thompson v. Smith Barney, Harris Upham & Co., Inc., 709 F.2d 1413 (11th Cir. 1983); DuPuy v. DuPuy, 551 F.2d 1005 (5th Cir. 1977); see also, Restatement (2d) of Agency (agents employed to make, or advise on investments have a fiduciary obligation). The Eleventh Circuit in Gochnauer v. A.G. Edwards, Inc., 810 F.2d 1042, 1049 (11th Cir. 1987) has cited with approval the detailed analysis of a broker’s fiduciary duties in the non-discretionary, discretionary and hybrid-account relationships in Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F.Supp. 951 (E.D. Mich. 1978). Reg. BI has added uniformity to the law throughout the United States governing stockbrokers handling retail customers non-discretionary accounts and the standard governing their conduct when making recommendations; that is, they must always act like “fiduciaries” when making recommendations and to only make recommendations that are in retail customers “best interest.”
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