Sunday, October 28, 2018

Lipstick on a Pig and Reg BI: The SEC Aids and Abets Fraud

I may be just an old country lawyer, but I know when someone puts lipstick on a pig.

When the DOL Rule was being proposed, FSI (and then SIFMA), the broker-dealer industry lobbying groups, proposed a "Best Interests" standard be adopted instead. Subsequently, FINRA - the broker-dealer self-regulatory organization (no, it does not represent, nor govern, the entire "financial industry" as its name suggests), endorsed the FSI/SIFMA proposal and put its billion-dollar war chest and lobbyists to work.

As I pointed out at the time, "SIFMA, FSI, and their members seek, with the blessing of their 'self-regulator' – FINRA – to re-define the very nature of the term “best interests.” See my prior blog posts, "FINRA's Illusionary 'Best Interests' Standard" and  "FINRA Seeks the Death of the Fiduciary's Duty of Loyalty."

And the broker-dealer lobbying efforts paid off.

First, they waited for new leadership in the guise of SEC Chair Jay Clayton, a lawyer who has long represented the interests of Wall Street's broker-dealer firms and investment banks, including Goldman Sachs, UBS, Bear Stearns, Deutsche Bank, and many others. Since he is age 52 currently, everyone knows where Chair Clayton will return after his stint at the SEC is up - back to representing Wall Street. The SEC has long had a problem with its revolving door.

Then, through their extensive lobbying efforts, the broker-dealers firms' lobbying organizations were able to get the SEC to propose "Regulation BI" a.k.a. "Regulation Best Interest" in early 2018. It should have been called "Regulation B.S." instead. The language tracks that found in the proposals previously advanced by FSI, SIFMA, and then FINRA.


It is an abomination, plain and simple. In the language of Release the SEC talks of broker-dealers possessing a new standard of conduct that requires them to "act in the best interests of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation against the retail customer."

But the language of the proposed Regulation itself - which is what matters - falls far short of such a standard.


 The Regulation contains a "safe harbor" - in essence an exception (in paragraph "b" below) - that swallows the rule set forth in paragraph "a."

     § 240.15l-1 Regulation Best Interest.

        (a) Best Interest Obligation.

              (1) A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall 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 who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

MY COMMENT: The foregoing is strong language. But the next paragraph obliterates the above. It guts it, by creating a "safe harbor" that is nothing more than "suitability" enhanced with a few additional disclosure obligations.

             (2) The best interest obligation in paragraph (a)(1) shall be satisfied if:

                     (i) Disclosure Obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, prior to or at the time of such recommendation, reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation.

MY COMMENT: We know that disclosures don't work. Consumers don't read them. Even in those rare instances where they do, they don't understand them.

                    (ii) Care Obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence to:
                         (A) Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
                          (B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and
                          (C) Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.

MY COMMENT: The above language uses an old trick, that broker-dealers often use similarly in their advertising. It does not require a duty of due care. It only requires the broker-dealers and their registered representative to "believe" that they possess a "reasonable basis" for their recommendations. In essence, the duty of care remains "suitability."

                  (iii) Conflict of Interest Obligations.
                          (A) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations.

                          (B) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.

MY COMMENT: There is nothing in the "Conflicts of Interest Obligations" section above that mandates that the broker-dealer avoid, or even minimize, conflicts of interest. "Policies and procedures" must exist within the firm, but no substantive obligations are imposed. Moreover, the use of the language "at a minimum disclose" is nothing but a distortion of "best interests" requirement under state common law - i.e., the fiduciary duty of loyalty - based upon an incorrect interpretation of SEC v. Capital Gains Research Bureau.


I submitted extensive comments to the SEC outlining my objections. My main objections to Reg BI were summarized in my comment letter, as follows:

  • The term “best interests” is an expression of the fiduciary standard.
  • The Commission’s proposed Regulation BI exacerbates, rather than lessens, consumer confusion between the sellers of products and the providers of advice.
  • Should it adopt Regulation Best Interests, the Commission would open itself up to the charge of aiding and abetting fraudulent conduct.
And, I pointed out this prophetic writing by Professors Angel and McCabe:
  • “The relationship between a customer and the financial practitioner should govern the nature of their mutual ethical obligations. Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the customer’s best interest – is fraud. This standard should apply regardless of whether the advice givers call themselves advisors, advisers, brokers, consultants, managers or planners.” James J. Angel, Ph.D., CFA and Douglas McCabe Ph.D., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (Sept. 30, 2010).

A broker-dealer and its registered representative can represent securities issuers/owners and product manufacturers (as intermediary, or as a dealer in securities), or it can represent the client. It is impossible to do both.

As was well-known in the early case law: "The principle is undeniable that an agent to sell cannot sell to himself, for the obvious reason that the relations of agent and purchaser are inconsistent, and such a transaction will be set aside without proof of fraud.” Porter v. Wormser, 94 N. Y. 431, 447 (1884).

In an early speech by the Louis Loss, for long the leading scholar on the federal securities law, presented at a time when he served the Commission, Professor Loss stated:
  • [A]s an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, ‘Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that ‘a man cannot serve two masters.’ "
Address entitled “The SEC and the Broker-Dealer” by Louis Loss, Chief Counsel, Trading and Exchange Division, U.S. Securities and Exchange Commission on March 16, 1948, before the Stock Brokers’ Associates of Chicago. Louis Loss later became the author of the leading treatises on securities law.


In its 1940 Annual Report, the U.S. Securities and Exchange Commission noted:
  • If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States. Court of Appeals for the District of Columbia in a recently decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest.  He who would deal at arm's length must stand at arm's length.  And he must do so openly as an adversary, not disguised as confidant and protector.  He cannot commingle his trusteeship with merchandizing on his own account ....
Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.

In 1963, in its Special Report on the securities industry, the SEC also noted that:

  • [The SEC] has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may  have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.

1963 SEC Special Study.

The SEC now, with Regulation BI, ignores its own warnings.


In the United States, common law generally identifies nine elements needed to establish fraud: (1) a representation of fact; (2) its falsity; (3) its materiality; (4) the representer’s knowledge of its falsity or ignorance of its truth; (5) the representer’s intent that it should be acted upon by the person in the manner reasonably contemplated; (6) the injured party’s ignorance of its falsity; (7) the injured party’s reliance on its truth; (8) the injured party’s right to rely thereon; and (9) the injured party’s consequent and proximate injury.

What FSI, SIFMA and FINRA have done is to seek to commit a fraud, upon consumers of the investment securities and products that their members sell. How?
   (1) The broker-dealers undertake a representation as to a certain "fact" - i.e., that broker-dealers act in the "best interest" of their client.
   (2) The representation that brokers will act in the "best interest" of their clients, under Reg BI - should it be adopted, will be false - as the "safe harbor" imposes no fiduciary duty of loyalty. For centuries the term "best interests" has been equated, under the common law and in the minds of consumers - with the fiduciary duty of loyalty.
   (3) Certainly the representation made will be a material one - i.e., it will be considered by consumers in deciding whether to engage, and place trust and confidence in, their brokers.
   (4) FSI, SIFMA and FINRA know that brokers won't actually act under in the "best interests  of their customers, as that term has been known and understood for centuries. So, they seek to avoid this element of fraud by an old trick - if you don't like the English language and its meaning, try to force down a new meaning. Even if, in the process, you undermine trust in our society.

And the remaining elements of fraud will exist, as well, should Reg BI be adopted by the SEC, and then used by broker-dealers to tout their status as those who act in the "best interests" of their customers, when in fact they act in their own best interests - with free reign to sell more expensive products that pay them more, and reward consumers less.


Whenever fraud is promulgated, it must be confronted, head on.

The SEC is the decision-maker here. Once thought to be one of the most effective of our government agencies, over the past few decades it has been utterly and totally captured by Wall Street. Yet now it seeks to aid and abet fraud, and in so doing it ignores its own prudent warnings. The SEC has been tricked, by tricksters.

Only an outcry - by consumers and also by professionals who truly do act in the best interests of their clients - would likely change the SEC's current path.

I believe brokers should be permitted to sell. But they should not be permitted to hold out as trusted confidents - whether by using phrases such as "we act in your best interests" (or "we seek to act in your best interests"), or by using titles that denote a relationship of trust and confidence, or by otherwise disguising the merchandising aspect of their role.

But if brokers desire to offer investment advice - and financial planning advice - then they should do so under a bona fide fiduciary standard. In which they act with the requisite expertise (i.e., under the fiduciary standard of due care). In which they act in the best interests of their clients (i.e., under the fiduciary standard of loyalty). And in which they act with full candor and honesty (i.e., under the fiduciary standard of utmost good faith).

The SEC, with its Reg BI (and also Form CRS - a relationship summary that further obscures the distinctions between "sellers" and "trusted advisers"), needs to return to the drawing board. It needs to abandon Reg BI.

The SEC needs to act with integrity, to protect both the capital markets (for the erosion of trust will weaken them) and American consumers (who do not deserve to place their trust in "financial consultants" / brokers, only to have that trust betrayed).

The SEC needs to stop its own actions, in which it may aid and abet fraud.

The SEC should act to restore its own standing as a heralded, independent agency, rather than act to throw consumers to the wolves as an arm of the broker-dealer industry.

I may be an old country lawyer, but I know what it smells like to be at the south end of a north-facing cow. And Reg BI has that same smell.

1 comment:

  1. Ron is correct. Fraud is aided by up to 10,000 captured regulators in the US, several thousand in Canada, and nay other developed country. Developed is a key term which describes countries where banks and financial giants have almost completely captured (financially and politically) the rules, the regulators and the justice systems.

    My decades inside this industry gave me a glimpse of what goes on, and a decade or two of intensive research since shows that the unjust enrichment by systemic financial crimes drains as much economic health of society (US or Canada) than the economic cost of all traditional crimes in the land...combined. @RecoveredBroker


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