PART 1 OF A SERIES ON THE REGULATION OF FINANCIAL AND INVESTMENT ADVICE, AND THE FUTURE OF THE PROFESSION
Part I: Will the S.E.C. Aid and Abet Fraud in 2019?
by Ron A. Rhoades
The S.E.C.’s Regulation BI attempts to redefine the English language, and in so doing seeks to mislead individual investors for all time to place trust in their brokers, even though the actual language of the rule is clear that only an arms-length (seller-buyer) relationship exists.
THIS ARTICLE WAS ORIGINALLY POSTED AT WWW.RIABIZ.COM, ON DEC. 27, 2018. I repost it here, as a prelude to other articles in this series.
The following is a fictional exchange between the Chair of a U.S. Congressional Committee and current Chair of the U.S. Securities and Exchange Commission, Jay Clayton. Yet, the hypothetical dialogue that follows is the type of exchange that would result from proper Congressional oversight – if procedural rules permitted extended questioning, and if those testifying before Congress would not seek to answer evasively and ambiguously.
Committee Chair: “Welcome, SEC Chair Clayton.”
Mr. Clayton: “Thank you, Madam Chairman.”
Committee Chair: “We are here today to discuss the U.S. Securities and Exchange Commission’s proposed Regulation Best Interest, also known as Reg BI. Mr. Clayton, are you ready for questions.”
Mr. Clayton: “More than ready, Madam Chairman.”
Committee Chair: “What the &!*# are you doing?”
Mr. Clayton: “Excuse me?”
Committee Chair: “I wish you would not only excuse yourself, but also recuse yourself, for all time.”
Mr. Clayton: “I don’t understand.”
Committee Chair: “That is readily apparent from the language of Reg BI. Why don’t we take it one step at a time.”
Mr. Clayton: “O.K.”
Committee Chair: “Under your direction, the SEC has proposed ‘Regulation Best Interest,’ and since then the SEC has received dozens of comment letters and is looking to finalize this regulation, is it not.”
Mr. Clayton: “Yes.”
Committee Chair: “And under this proposal, as you testified before another Congressional committee on December 11, 2018, and I quote: ‘Specifically, proposed Regulation Best Interest would enhance broker-dealer standards of conduct by establishing an overarching obligation requiring broker-dealers to act in the best interests of the retail customer when making recommendations of any securities transaction or investment strategy involving securities. Simply put, under proposed Regulation Best Interest, a broker-dealer cannot put her or his interests ahead of the retail customer’s interests. The proposal incorporates that key principle and goes beyond and enhances existing suitability obligations under the federal securities laws. To meet this requirement, the broker-dealer would have to satisfy disclosure, care and conflict of interest obligations.’”
Mr. Clayton: “That was my testimony, Madam Chair.”
Committee Chair: “Mr. Clayton, are you aware that in a December 2, 2015 hearing before the Subcommittee on Health, Employment, Labor, and Pensions, of the U.S. House Education and Workforce Committee, Congressswoman Suzanne Bonomaci, questioning securities and insurance industry executives, inquired, ‘Just to be clear, does everyone agree that a ‘best interests’ standard means a ‘best interests’ fiduciary standard?’ And are you aware that each of the industry executives then answered in the affirmative?”
Mr. Clayton: “I was not aware of that, Madam Chair.”
Committee Chair: “In your own testimony, you have stated that brokers, under your Proposed Reg BI, will be ‘required to act in the best interests of the retail customer.’ Does this not mean that brokers will possess a fiduciary duty of loyalty to their customers?”
Mr. Clayton: “No, it does not. No fiduciary obligation is imposed.”
Committee Chair: “Despite the fact that under Section 913 of The Dodd Frank Act of 2010, the Congress expressly provided the SEC with the authority to impose a fiduciary standard upon brokers who provide personalized investment advice that is no less stringent than the standard for investment advisers?”
Mr. Clayton: “Correct, Madam Chair. The Commission has decided to not go down that path, at this time.”
Committee Chair: “But, you do require brokers to place their customers interests ahead of their own, under Reg BI, is that not true?”
Mr. Clayton: “Yes.”
Committee Chair: “Is it? Really? Let me quote from the proposed Reg BI itself, and specifically let me quote the ‘safe harbor’ language you provide that permits a broker to satisfy this ‘best interest’ duty:
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.
(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.
(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.
Mr. Clayton: “That is Reg BI’s safe harbor, Madam Chair.”
Committee Chair: “So, when a conflict of interest is present, let’s review the broker’s obligations under the safe harbor. First, there must be disclosure of the conflict of interest.”
Mr. Clayton: “Yes.”
Committee Chair: “But there does not exist, in this part of the rule, any obligation to avoid a conflict of interest, nor is there a requirement – as exists under fiduciary law – to provide affirmative disclosure of a all material facts regarding the conflict of interest in a manner that ensures client understanding of the conflict of interest, and obtaining the informed consent of the client?”
Mr. Clayton: “That is correct, Madam Chair. The broker’s ‘best interest’ standard is not a fiduciary standard. All that is required is a disclosure that a conflict of interest exists.”
Committee Chair: “Second, the broker must exercise reasonable diligence, care, skill, and prudence in order to possess a ‘reasonable basis to believe that the recommendation is in the best interest of a particular retail customer.’ Is ‘reasonable basis’ defined by the rule, and is the term ‘best interest’ defined by the rule?
Mr. Clayton: “No, those terms are not defined in the rule itself.”
Committee Chair: “And is it not true that this second set of obligations – what might be called the ‘care obligation’ - is based upon existing reasonable-basis, customer-specific, and quantitative suitability obligations.”
Mr. Clayton: “Correct, this care obligation of the broker is closely analogous to the suitability standard.”
Committee Chair: “So, in applying this new standard, how would it be applied differently than the suitability obligation?”
Mr. Clayton: “The broker must act in the ‘best interests’ of the customer.”
Committee Chair: “But, your definition of 'best interest' is not defined by the rule. Things brings to mind ... who will be the primary enforcer of this new ‘best interest” standard upon broker-dealers?”
Mr. Clayton: “The broker-dealer firms’ self-regulatory organization, the Financial Industry Regulatory Authority, or FINRA, by means of examination and enforcement actions. The rule will also be enforced in arbitration hearings when customers bring complaints.”
Committee Chair: “And those arbitration hearings are governed by FINRA rules, are they not?”
Mr. Clayton: “Yes.”
Committee Chair: “Yet, as FINRA stated in its comment letter to the SEC on Reg BI, FINRA's suitability rule already implicitly requires a broker-dealer's recommendations to be consistent with customers' 'best interests.'”
Mr. Clayton: “FINRA has taken the position since May of 2012 that, and I quote from FINRA’s release, ‘The suitability requirement that a broker make only those recommendations that are consistent with the customer's best interests prohibits a broker from placing his or her interests ahead of the customer's interests.’”
Committee Chair: “I see. So, in essence, the term has already been defined by FINRA, and FINRA already has a rule in place that imposes this ‘best interests’ obligation. So, Mr. Clayton, here’s my question. What is different? Give me examples of how brokers’ conduct will be changed under this duty of care, from what brokers are obligated to do currently?”
Mr. Clayton: “Uh … uh …”
Committee Chair: “So we have here a rule, that will be predominately enforced by FINRA, the broker-dealer’s own organization, that does not actually impose any substantial new obligations under brokers.”
Mr. Clayton: “But, Madam Chair, there does exist a duty to mitigate conflicts of interests under Reg BI.”
Committee Chair: “Well, that appears true. Let’s return to the safe harbor. Third, the brokerage firm must adopt certain policies and procedures ‘designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives.’ Is the extent of ‘mitigation’ defined by the rule?”
Mr. Clayton: “No, it is not. But, Madam Chair, in our issuing release ….”
Committee Chair: “Let’s stop right there, Mr. Clayton. I knew you were going to point to the flowery language contained in your release of proposed Reg BI, SEC Release No. 34-83062. That flowery language, found throughout the release, seemsto make the rule very appealing to individual investors and consumer advocates. That language appearsto make the rule sound like it imposes very substantial obligations upon brokers. But, in point of fact, the language in the release is not part of the rule itself. So, when Reg BI, if it is finalized, is adopted, FINRA arbitrators will only be required to look to the language of the rule itself, and how the term ‘best interest’ has been interpreted by the broker-dealer firms’ own organization, FINRA. Is that not correct.”
Mr. Clayton: “You are correct, Madam Chair. But, again, for the first time there is a requirement, under Reg BI, that brokers mitigate their conflicts of interest.”
Committee Chair: “Not true, Mr. Clayton. There is only a requirement that brokerage firms adopt policies and procedures to this effect. And mitigation might exist, for example, by mere disclosure of the conflict of interest.”
Mr. Clayton: “That was not my intent. The intent of Reg BI is to mitigate the most substantial conflicts of interest that currently exist in brokerage firms.”
Committee Chair: “But, as stated by the Financial Services Institute in its comment letter to the SEC regarding Reg BI, nothing in the rule would ‘per se prohibit a broker from transactions involving conflicts of interest, including for example: receiving commissions or transaction-based compensation, recommending proprietary products, principal transactions, or complex products.’ In fact, the rule imposes no substantive restriction on the most insidious conflicts of interest present in the brokerage industry today, is that not correct?”
Mr. Clayton: “Madam Chair, I … I … disclosures of conflict of interests must exist.”
Committee Chair: “I see. Mr. Clayton, is the form of disclosure of conflict of interest set forth under the rule?”
Mr. Clayton: “No, it is not.”
Committee Chair: “Let’s examine how a brokerage firm and its brokers, other than the generic disclosures contained in your proposed Form CRS, would be required to satisfy its disclosure obligations to its customers. Suppose a brokerage firm sold a mutual fund to a customer for which the brokerage firm receives compensation in the form of commissions, 12b-1 fees, payment for shelf space, soft dollars, and sponsorship of educational events such as a brokerage firm’s own educational conference sessions as well as sponsorship of seminars that market to new customers. Is the firm required under this proposed Reg BI to disclose to the customer the amount of compensation it receives from the mutual fund company, in total?”
Committee Chair: “Is the brokerage firm required under Reg BI to disclose to the customer each type, or form, of compensation it receives, from the mutual fund company?”
Mr. Clayton: “No, Madam Chair.”
Committee Chair: “Is the brokerage firm required to disclose that it gets paid more to sell some products than other products?”
Mr. Clayton: “No, Madam Chair.”
Committee Chair: “Could the brokerage firm, in essence, satisfy this obligation of disclosure of material conflicts of interest, found under your proposed BI, by just using the wide-criticized disclosure that the Commission proposed back in 2005 in connection with the ill-fated ‘Merrill Lynch rule’ … a form of ‘casual disclosure’ in which a broker might just state: ‘Our interests may not be aligned with yours’? And, as FSI suggests, ‘it is enough to disclose that different products are available with different costs,’ while not expressly disclosing all of the specific costs and specific types or amounts of compensation received by the brokerage firm and its brokers?”
Mr. Clayton: “We have not defined the extent of a broker’s specific disclosure obligations in Reg BI.”
Committee Chair: “Even if you did so, is it not true that disclosures possess limited effectiveness in protecting consumers, Mr. Clayton?”
Mr. Clayton: “Disclosures form the basis of federal securities regulation, Madam Chair.”
Committee Chair: “But not the basis of the Investment Advisers Act of 1940, and the fiduciary obligations imposed upon those who provide investment advice, Mr. Clayton. In fact, in situations where there is a vast disparity of knowledge and expertise in a complex environment, such as when investment advice is provided in the capital markets today with its myriad of different investment strategies and often extremely complex securities, disclosures are not effective as a means of consumer protection. If disclosures were effective, in essence there would be no reason for the fiduciary standard of conduct to exist under the law, and no reason for the Investment Advisers Act of 1940, is that not true?”
Mr. Clayton: “I’m not certain I follow you, Madam Chair.”
Committee Chair: “Come now, Mr. Clayton. You are the Chair of the SEC. Certainly you are aware of the huge amount of academic research concluding that disclosures are largely ineffective as a means of consumer protection when investment advice is being provided?”
Mr. Clayton: “But brokers are only providing incidental advice, and as such are exempt from the application of the Investment Advisors Act of 1940, Madam Chair.”
Committee Chair: “Is that so? The Advisers Act’s exclusion for broker-dealers only provides an exclusion for ‘solely incidental’ or ‘merely incidental’ advice, is that not correct?”
Mr. Clayton: “Yes, Madam Chair. And we have interpreted that to mean any advice that is ‘in connection with’ and ‘reasonably related to’ a brokerage transaction.
Committee Chair: “Mr. Clayton, words have meaning. The words ‘solely incidental’ - adopted into law by the U.S. Congress - appear to have been redefined out of existence, by the SEC’s interpretation. And now, in Reg BI, the Commission exacerbates this mistake. Regulation Best Interest as proposed repeatedly characterizes the broker-dealer model as a ‘model for advice.’ You suggest that preserving the broker-dealer model is all about ‘preserving investor choice across … advice models.’ And you further note in Reg BI that the broker-dealer model is ‘an option for retail customers seeking investment advice.’ In point of fact, did you not yourself recently state that brokers are in an ‘advice relationship’ with their customers.”
Mr. Clayton: “Madam Chair, you are quoting me out of context.”
Committee Chair: “Then let me quote your recent testimony, under oath, before this Congress, in which you stated, ‘Broker-dealers and investment advisers both provide investment advice to retail investors, but their relationships are structured differently and are subject to different regulatory regimes. However, it has long been recognized that many investors do not have a firm grasp of the important differences between broker-dealers and investment advisers ….’ Mr. Clayton, has not the SEC, over the past several decades, failed to draw a line between what is a seller-purchaser, arms-length relationship, such as exists between brokers and their customers, and what is a fiduciary-client, or investment adviser-client, relationship?”
Mr. Clayton: “We have drawn that line. If special compensation is received, such as ongoing asset-based compensation, by a broker, that broker must register under the Advisers Act and is subject to the Advisers Act’s fiduciary duties.”
Committee Chair: “Ah, the receipt of ongoing asset-based compensation is where you draw the line. So brokers cannot should not be receiving 12b-1 fees, such as those found in Class C shares, which are often 1% a year of the amount of the assets being managed, without being held to the Advisers Act and its fiduciary standard?”
Mr. Clayton: “That is not the position we have taken. 12b-1 fees are a form of commission.”
Committee Chair:“Mr. Clayton, what you are saying is that brokers can receive ongoing compensation, such as a 1% a year fee paid by a mutual fund the investor owns, for nearly any amount of investment advice they provide, without any real limit on the amount of the advice provided, and are still eligible for the broker-dealer exemption. I may be just an old country lawyer, but I know this – if it walks like an ugly duck and swims like a ugly duck and quacks like an ugly duck, that bird is and must be a duck. Even you, Mr. Clayton, the all-mighty Chair of the SEC, can’t turn that ugly duck into a white swan.”
Mr. Clayton: “If you say so, Madam Chair.”
Committee Chair: “Let’s get back to your over-reliance on disclosure. Do you think consumers read, and understand, even basic disclosures of mutual fund costs and their impact upon the returns of the fund?”
Mr. Clayton: “That is the purpose of the disclosures.”
Committee Chair: “Then you must be aware of the two research studies undertaken by Professors James Choi, David Laibson, and Brigitte Madrian, ‘Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds.’ In these research studies the subjects – Wharton MBA and Harvard students – were each given $10,000 to allocate across four S&P 500 index funds and were to be rewarded for their portfolio's subsequent return, but such research demonstrated that the studies’ participants overwhelmingly failed to minimize fees.”
Mr. Clayton: “Those are just two studies, Madam Chair.”
Committee Chair: “But, Mr. Clayton, there are so many more. In fact, the SEC’s emphasis on disclosure results from the myth that investors carefully peruse the details of disclosure documents that regulation delivers. However, under the scrutinizing lens of stark reality, this picture gives way to an image a vast majority of investors who are unable, due to behavioral biases and lack of knowledge of our complicated financial markets, to undertake sound investment decision-making. As stated by former SEC Commissioner Troy Parades, ‘investors are not perfectly rational … when faced with complicated tasks, people tend to ‘satisfice’ rather than ‘optimize,’ and might fail to search and process certain information.’ And, as Professor Ripken has written, ‘there is doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.’ And, as Professor Robert Prentice informs us, ‘instead of leading investors away from their behavioral biases, financial professionals may prey upon investors’ behavioral quirks … Having placed their trust in their brokers, investors may give them substantial leeway, opening the door to opportunistic behavior by brokers, who may steer investors toward poor or inappropriate investments.’”
Mr. Clayton: “We can all cite studies, Madam Chair.”
Committee Chair: “What is asked of you, Mr. Clayton, is that you not hand-pick excerpts from studies to justify your intended actions, but that you carefully consider all of the academic research that does exist in your rule-making efforts, to ensure that your proposed regulation is grounded not in hope, but in reality, and that its economic consequences – both large and small – have been appropriately considered.”
Mr. Clayton: “Of course, Madam Chair.”
Committee Chair: “And what is also required it that you not seek to change the English language, as a means of deceiving the American consumer of investment advice. In the law the phrase ‘best interests’ has meant, for centuries, the fiduciary duty of loyalty. Mr. Clayton, as stated by our own U.S. Supreme Court, in SEC vs. Capital Gains, a case I am certain you are familiar with, ‘The court interprets Section 206 to establish a fiduciary duty which in addition to applying to misrepresentations and omission, also requires the investment advisor to act in the best interests of its clients.’
Mr. Clayton: “That is one definition of ‘best interests,’ Madam Chair.
Committee Chair: “Well, I have no idea where you get your definition from, Mr. Clayton. Certainly not from a recognized dictionary. In fact, Black’s Law Dictionary, defines a fiduciary duty as ‘a duty to act with the highest degree of honesty and loyalty toward another person and in the best interest of the other person.’ The meaning of ‘best interests’ as indicative of the fiduciary relationship is universal in other common law countries. As but one example, and as explained in Pilmer v Duke Group, the fiduciary obligation is a pledge, or undertaking, by one party to act in the best interests of the other, and this is what makes fiduciary relationships distinct from other relationships. Mr. Clayton, you seek to destroy the fiduciary standard, by redefining the term ‘best interests’ to mean nothing more than something a bit higher than the low suitability standard.”
Mr. Clayton:“I do not, Madam Chair, have that intention.”
Committee Chair: “But that is what will occur. Should you not, instead, heed the warnings of the great Justice Benjamin Cardoza, who so famously stated that ‘Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.’”
Mr. Clayton: “It is not my desire to erode the fiduciary standard.”
Committee Chair: “But that is the path that you are on, sir, whether you realize it or not. You seek to upend centuries of established jurisprudence with one swipe of cloudy ink from your reckless, leaky pen. You seek to have ‘best interest’ to be used by brokers, when in fact they remain in arms-length relationships with their customers.”
Mr. Clayton: “Madam Chair, I must state, Reg BI does – even if only slightly – raise the standard of conduct for brokers, and no one will be harmed by the rule when it is finalized.”
Committee Chair: “No one is harmed, Mr. Clayton? Not individual investors, who deal with brokers who represent themselves to their customers as acting in the ‘best interest’ of the customer, when in fact there exists no fiduciary duty of loyalty to the customer, and when in fact the interests of the broker-dealer firm, and the broker, can be and remain paramount to that of the customer?”
Mr. Clayton:“ Madam Chair …”
Committee Chair: “And certainly, Mr. Clayton, an educated man such as yourself, a graduate of Cambridge with a Masters in Economics, would certainly be aware of the Nobel Prize-winning work of leading economist George Akerlof, who is best known for his article, ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism.’ In this article, Mr. Akerlof so clearly demonstrates that in a market – such as that for financial and investment advice – in which a vast asymmetry of information exists, and where a consumer advice that purports to be in the consumer’s ‘best interests’ may not really be keeping the consumer’s best interest paramount or not, it is a natural consequence is that more ‘lemons’ appear in the market. This leads to a rush – not to the top for standards of conduct by providers of investment advice - but rather a rush to the bottom. In other words, what you are really fostering is conduct from those in the gutter. In essence, you will be harming not just the consumers who purchase lemons, but also harming those honest ’40 Act investment advisers who are bound by law under a fiduciary duty of loyalty to their clients, but whose distinction in the marketplace would be obliterated by this proposed Regulation BI.”
Mr. Clayton: “I am familiar with Mr. Akerlof’s work, Madam Chair.”
Committee Chair: “And will not this type of brazen misrepresentation – perhaps amounting to a massive fraud upon individual Americans by brokerage firms holding out as acting in their customers’ best interests when in fact such will not be the legal requirement – result in an even greater dissatisfaction by individual investors with all financial advisors, leading investors to not seek out the trusted, expert financial advice they so desperately need, fleeing the capital markets, and leading to a loss of capital formation which will, especially on a cumulative basis over many years, result in far less economic growth?”
Mr. Clayton: “You are attempting to draw a lot of dots there, Madam Chair.”
Committee Chair: “But these are not connections that are very difficult to draw, Mr. Clayton; this is fundamental economics. As Professor Columbo stated in a 2010 paper on reforming securities litigation, ‘Trust is a critically important ingredient in the recipes for a successful economy and a well-functioning financial services industry.’”
Mr. Clayton: “You are very well-read, Madam Chair.”
Committee Chair: “Someone in government should be, Mr. Clayton. Would you not agree that efforts to improve securities regulation should be informed by insights from economics and from other academic disciplines, Mr. Clayton, to ensure our limited government resources are put to best use. In fact, have you not – yourself – just been wastingthe SEC’s precious resources, both now, and in the future, should Reg BI be finalized over strong opposition from two of your five Commissioners, since it is clear that a future SEC under a new Administration will have to unwind and fix the mess you are creating with this deeply malevolent rulemaking?”
Committee Chair: “The future is always uncertain, Madam Chair.”
Committee Chair: “Perhaps, Mr. Clayton, but perhaps your own future is something you have been deeply thinking about. Mr. Clayton, I would now like to unveil how proposed Regulation Best Interests came to be. Is it not true that Regulation Best Interests was derived in large part from a proposal advanced by the Financial Services Institute and SIFMA, both broker-dealer industry lobbying organizations?”
Mr. Clayton: “Madam Chair, you appear to overstate their influence.”
Committee Chair: “But, Mr. Clayton, did not FSI and SIFMA propose actual language for a ‘Best Interest’ broker standard a few years before, which was subsequently endorsed in major part by FINRA. And did not FSI President Dale Brown himself state in early 2018: ‘Earlier this year we had meetings with [SEC] Chairman Jay Clayton and [SEC Director of the Division of Trading and Markets] Brett Redfearn and we are ... hearing that many of our themes that we’ve hit on in our advocacy’ were finding their way into the SEC’s proposals.”
Mr. Clayton: “He may have been bragging.”
Committee Chair: “Chair Clayton, now I would like to understand the motivations behind your advancement of this deeply flawed proposed rule. Before you were appointed to the SEC, you were are partner in the New York City law firm of Sullivan & Cromwell, were you not?”
Mr. Clayton: “Yes.”
Committee Chair: “And while at that firm, you represented the interests of Wall Street firms, investment banks, and broker-dealer firms, such as Goldman Sachs, Bear Stearns, UBS, and Barclays Capital, did you not?”
Mr. Clayton: “Yes, Madam Chair, but …”
Committee Chair:“And, after your service at the SEC, since you are only age 52, is it not highly likely that you will go to work for a large Wall Street firm, or work again for a law firm that represents broker-dealer firms?”
Mr. Clayton: “Madam Chair, that is inherently speculative, and I resent the implication.”
Committee Chair: “And is it not true that many, if not most, of the attorneys on the staff of the U.S. Securities and Exchange Commission who worked on this proposal, have either worked for broker-dealer firms, for law firms that represented broker-dealer firms, or will likely depart the SEC at some time in the future to join such broker-dealer firms or their legal counsel?”
Mr. Clayton: “Madam Chair, the SEC requires industry expertise in its staff, and I resent the implication that we have a ‘revolving door’ at the SEC”
Committee Chair: “I am certain that there are many staff attorneys at the SEC who desire to do the right thing. I only question whether they possess effective leadership at the present time, Mr. Clayton.”
Mr. Clayton: “I disagree.”
Committee Chair: “So, permit me at this time to summarize what Regulation Best Interest is, or, rather, what it is not.
- Reg BI imposes little that restricts brokers from engaging in conduct that they engage in currently.
- There is no actual requirement that brokers avoid significant material conflicts of interest.
- Nor is there any actual requirement, in the rule, despite the flowery language contained in the release, that brokers properly manage any unavoided conflicts of interest.
- There is only a requirement that material conflicts of interest be disclosed, but there is no requirement that all material facts - including the ramifications of that conflict of interest to the customer - be disclosed.
- While there is a requirement that broker-dealers adopt procedures to mitigate their conflicts of interest, how this is to be done is not defined, and as suggested by brokers themselves all that might be required is disclosure that a conflict of interest exists, and nothing more.
- There is no actual requirement that a brokerage firm, or its brokers, place its customers’ interests' before its own.
Mr. Clayton: “But I do believe that Regulation Best Interest will raise the standards of conduct of brokers.”
Committee Chair: “But not substantively, Mr. Clayton, as we have just observed in our review of the actual language of the proposed rule. Very little if any restrictions on broker’s conduct will exist, beyond the weak restrictions found under the current suitability rule. In fact, Reg BI seeks to redefine the term ‘best interests’ and its accepted meaning in the law and in the English language. Much the same as the SEC redefined what ‘solely incidental’ means over the past several decades, in order to accommodate brokers who migrated away from investment product sales and toward giving investment advice.”
Mr. Clayton: “I do not agree with that characterization, Madam Chair.”
Committee Chair: “Is not Regulation Best Interest, which originated from broker-dealer lobbying organizations, and which proposals were subsequently endorsed in large part by FINRA – the broker-dealer ‘self-regulatory organization’ – and which was subsequently pushed through at the SEC by industry lobbyists as well as those insiders with deep ties to Wall Street – just a means to misrepresent to the American people the true nature of the obligations of broker-dealers to their customers?”
Mr. Clayton: “I do not concur with your assessment.”
Committee Chair: “Mr. Clayton, does not Regulation Best Interests create the mere illusion that brokers act in the best interests of their customers, in essence as acting under a fiduciary duty of loyalty, when in fact such is not the case?”
Mr. Clayton: “I don’t agree.”
Committee Chair: “Chair Clayton, did not the SEC, it 1940, in its Seventh Annual Report, state at one time: ‘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 … ‘[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 ….”
Mr. Clayton: “I am not aware of the language from that Report.”
Committee Chair: “Then perhaps you will be aware of a more recent 1963 Study of the Securities Industry by the SEC, what stated that the U.S. Securities and Exchange Commission ‘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 … broker-dealer 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 ….”
Mr. Clayton: “I don’t recall that particular language from the 1963 Study, Madam Chair.”
Committee Chair: "So, Mr. Clayton, let me refer to something you should recall. In your testimony to the U.S. Congress in December, 2018, when you stated, ‘Simply put, under proposed Regulation Best Interest, a broker-dealer cannot put her or his interests ahead of the retail customer’s interests.’ Yet, as we have established here today, the term ‘best interests’ has an established meaning, in that it equates to the fiduciary duty of loyalty. And, as we have seen, Reg BI, with its safe harbor, does not actually require much above what the low suitability standard requires currently. Reg BI does notrequire that a broker’s interest be subordinate to that of the customer. Given such, then your testimony to the U.S. Congress has been false, and this proposed Regulation Best Interests is nothing but ‘Reg Bull $&*!’ in reality.
Mr. Clayton: “I would not characterize my prior testimony as false, Madam Chair.”
Committee Chair: “Then, SEC Chairman Clayton, I suggest that you reject truth, as you don’t appear to know the difference between ‘true’ and ‘false.’ Instead, you seek to make what is ‘false’ become ‘true’ by changing the English language. I further suggest to you that the SEC, once heralded as one of the most effective of government agencies, is in danger under your lack of effective leadership of falling into a dark hole. The SEC in recent decades has become the least effective of our government agencies, and apparently the SEC has now been captured by the very industry it regulates. Perhaps the SEC should be dismantled, and its regulation of market conduct transferred to a new, better agency. But, consideration of that issue is for another time. For now, the SEC appears to be aiding and abetting a massive securities fraudupon the American people. It is that plain. It is that simple. It is that undeniable. This hearing is in recess.”
Ron A. Rhoades, JD, CFP® is the Director of the nationally recognized Personal Financial Planning Program at Western Kentucky University’s Gordon Ford College of Business. A professor of finance, tax and estate planning attorney, investment adviser, and Certified Financial Planner™, he has long written about application of fiduciary law as the delivery of financial planning and investment advice. This article represents his personal views, and are not necessarily the views of any institution, organization, nor firm with whom he may be associated. Professor Rhoades’ comment letters regarding Reg BI which details legal authority for the statements set forth herein, can be found at the SEC’s web site, by visiting https://www.sec.gov/comments/s7-07-18/s70718-4174268-172351.pdf.