Posternak Blankstein & Lund LLP is now Arent Fox. Read the press release

Does the SEC "Best Interest" Regulation Go Far Enough?

The US Securities and Exchange Commission (SEC) has adopted a new standard called Regulation Best Interest (Reg BI)[1] that shifts the focus on protecting customers first and foremost. Although the regulation possibly puts certain customers first, it leaves some important areas vulnerable. 
On

What is the SEC Regulation Best Interest?

Reg BI was a 2019 change to the Securities Exchange Act of 1934 to ensure that broker-dealers act in the “best interest” of their retail customers when recommending that their customers purchase, trade, or otherwise take action concerning any security.[2]

The stated goal of the SEC’s final rule on Reg BI is twofold: (i) to enhance the obligations that apply to broker-customer relationships when giving a recommendation and (ii) to reduce the potential harm to customers that may result from conflicts of interest affecting said recommendation.[3] Ultimately, Reg BI seeks to supplement broker-dealer obligations by building on principles inherent in the existing fiduciary duties of care and loyalty owed by financial advisors but historically not required of broker-dealers.[4]

Through these new obligations, a broker-dealer’s interest, financial or otherwise, should not be put above the interests of their customers.[5]

Four Broker-Dealer Obligations Under Reg BI

Under Reg BI, a broker-dealer has four specific obligations that must be satisfied:[6]

1. Disclosure Obligation

Prior to or at the time of the recommendation, the broker-dealer must write to the customer, giving them full and fair disclosure of all material facts relating to the scope and terms of their professional relationship and any conflicts of interest that may apply to the recommendation.

2. Care Obligation

The broker-dealer must use reasonable diligence, care, and skill in its recommendation. It does this by understanding potential risks, rewards, and costs of the recommendation and having a reasonable basis for believing that the transaction is in the customer’s best interest.

3. Conflict of Interest Obligation

The broker-dealer must maintain written policies and procedures that identify and disclose or eliminate all conflicts of interest, mitigate any such conflicts that create an incentive to put the broker-dealer’s interests first, and disclose material limitations on securities or investment strategies.

4. Compliance Obligation

To reinforce the three prior obligations, mandates that the broker-dealer establish, maintain and enforce written policies to comply with all facets of Reg BI. There is flexibility given to the broker-dealer entity on how best to design a compliance program that satisfies Reg BI’s goals and requirements.

Further proving the SEC’s commitment to enacting this customer-first change, the Municipal Securities Rulemaking Board (MSRB) was cleared to align its rules with Reg BI, which was subsequently done. The MSRB amendments apply to situations not already covered by Reg BI.[7] By doing this, potential avenues for misconduct are now being addressed in both the corporate securities and municipal securities areas.

Potential Protection Issues Resulting From Reg BI

There are conflicting opinions surrounding Reg BI and its effectiveness in the market. While this new system emphasizes the retail customer’s needs, concerns about the protections afforded by the regulation remain.

Lack of Fiduciary Duty for Most Brokers

Brokers that are not serving as financial advisors, with greater duties to customers, must follow the obligations outlined above.[8]

While these obligations are useful, the language in Reg BI fails to establish the more stringent fiduciary duty upon brokers required of investment advisors.[9] This lack of fiduciary duty leaves customers vulnerable to deceptive practices by brokers who may act as fiduciaries, gaining the trust of customers, while the written documentation highlights that the broker-dealer is not acting as an investment advisor to the customer who should instead seek professional advice.[10] 

Of course, with this documentation written in the proverbial small print. 

The responsibility then remains on sometimes unsophisticated customers to determine whether they are making appropriate financial decisions.[11]

EU Consumer Protections

Consumer protection initiatives are not unique to the United States.

Notably, on April 11, 2018, the European Commission adopted what is known as the New Deal for Consumers.[12] Following its adoption, two EU instruments have been implemented: (1) The Directive on Better Enforcement and Modernization of EU Consumer Protection (2019); and (2) The Directive on Representative Actions (2020).[13] These initiatives while broad, tackle issues such as transparency of online marketplaces, which has not been undertaken in the US, and implementation of stronger penalties for cross-border infringements.[14]

While not as directly focused on the banking system alone, the movement towards greater transparency for consumer protection is an international concern.[15]

Crypto Concerns

No US Regulatory Requirements

Until recently, the cryptocurrency industry continued to grow exponentially, leaving regulators concerned with what the future holds for banking, digital assets, and customer protection. Benefits from anonymity and lack of security allow for dark web transactions and other illicit activity in the crypto area.[16] 

Part of the initial draw to cryptocurrency for crypto companies and sellers of crypto assets has been the lack of regulation surrounding the virtual platforms. While this independence is one of the benefits of crypto, the lack of regulations creates great risk for customers and general investors, as evidenced by the recent turmoil in the cryptocurrency market. 

Potential SEC Oversight

As technology has advanced, so too have the issues surrounding how to regulate it. 

Currently, the SEC is struggling to fill the regulatory gaps in the banking system that has emerged through the proliferation of cryptocurrencies. As a result, the SEC has begun exploring the possibility of regulatory oversight surrounding cryptocurrency. Currently, the test to determine if something constitutes a security requires the following elements to be met: (1) the investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, and (4) to be derived from the efforts of others.[17]

Ideally, the SEC would apply these elements to cryptocurrencies so that more stringent standards like Reg BI could be invoked.[18] As a result, retail customers who choose to invest in this form of currency would be protected just as vociferously as investors in more “traditional” currencies. 

EU Regulation

Other jurisdictions are also dealing with growing pains associated with the crypto-boom. Currently, the European Union requires all parties involved in a crypto transaction to be disclosed to the consumer.[19] 

The European Union has also made recent efforts to promote consumer protection through their 2020 consumer policy strategy known as the New Consumer Agenda.[20] After investigating whether additional legislation is needed, the European Commission initiated what is known as a Fitness Check of EU Consumer Law on Digital Fairness.[21] This program looks to the efficacy of consumer protection and consumer vulnerabilities, targeting the digital space.[22]

Conclusion

The existence of Reg BI illustrates two important points. 

First, it demonstrates the regulatory direction the financial industry is headed in. Retail customers are beginning to be seen as more than merely a ready source of reliable profits to a broker-dealer without necessary protections. This comes after the Consumer Financial Protection Bureau was established, precipitated by the Great Recession, to center the customer above all else. Now, the customer-investor’s interests must come first — at least on paper. 

Therein lies the second and equally important lesson to be learned from Reg BI: it isn’t enough. 

What constitutes putting the “best interests” of customers above the financial and personal interests of the broker is a potentially malleable concept. Further, it does not reach far enough to protect vulnerable customers in markets that are altogether less regulated or, for that matter, non-retail customers who are less sophisticated in understanding financial products or can ill afford truly independent financial and legal help. 

Novel and complex innovations in the financial markets necessitate novel and complex solutions. It remains an open question whether Reg BI will meet the moment or if something else will rise to meet, or supplement, this dire need. 

Additional research and writing from Clayton Spivey, a 2022 summer associate in ArentFox Schiff’s Boston office and a law student at Boston College Law School, and Kimia Pourshadi, a 2022 summer associate in ArentFox Schiff’s Boston office and a law student at Boston College Law School.


[1] 17 C.F.R. § 240.15l-1 (2019).
[2] See Regulation Best Interest, US Securities and Exchange Commission (Sep. 23, 2019), https://www.sec.gov/info/smallbus/secg/regulation-best-interest (“SEC Reg BI Summary”).
[3] See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Securities and Exchange Commission (n.d.), https://www.sec.gov/rules/final/2019/34-86031.pdf.
[4] Id at 72; also see the Client Alert, dated July 22, 2021, entitled ‘LIBOR Transition: (Bet You Didn’t Know) Municipal Advisors’ and Underwriters’ Duties.’
[5] See SEC Regulation BI Summary.
[6] Id.
[7] MSRB Harmonizes Rules with Requirements of Regulation Best Interest, Municipal Securities Rulemaking Board (Jun. 26, 2020), https://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/~/media/DC84329EC1A14A0B9A1BA1C116A24CB9.ashx.
[8] Kelly Anne Smith, What Regulation Best Interest Means for Your Financial Advisor, Forbes Advisor (Mar. 5, 2021), https://www.forbes.com/advisor/investing/financial-advisor/regulation-best-interest/.
[9] Id.
[10] See id. (When choosing which financial advisor to work with, clients should conduct their own due diligence by informing themselves of their financial advisor’s credentials through the SEC’s Investment Adviser Public Disclosure site and also by reading the Client Relationship Summary in full, albeit, again, in the proverbial small print.) 
[11] Id.
[12] Review of EU Consumer Law, European Commission (last visited Jul. 25, 2022), https://ec.europa.eu/info/law/law-topic/consumer-protection-law/review-eu-consumer-law_en (“Review of EU Consumer Law”).
[13] Id.
[14] New Consumer Rights: What benefits will I get, European Commission (May 2022), factsheet_on_benefit_consumers_en.pdf (europa.eu).
[15] See id. 
[16] Id.
[17] Paul Kim, The Howey Test: A set of rules that determine if an investment is a security, Insider Personal Finance (May 31, 2022), https://www.businessinsider.com/personal-finance/howey-test.
[18] Id.see also Kate Rooney, Federal Judge says SEC rules apply to initial coin offering, CNBC (Sep. 11, 2018), Federal judge says SEC rules apply to initial coin offering (cnbc.com).
[19] Helen Femi Williams, EU Pushes Hard for Crypto Regulation, Fintech Nexus News (Apr. 29, 2022), https://news.fintechnexus.com/the-eus-regulatory-push-for-crypto/.
[20] See Review of EU Consumer Law.
[21] Id.
[22] Id.

Contacts

Continue Reading