The SEC ramps up conduct expectations for Broker-Dealers

In April 2023 the US Securities and Exchange Commission (SEC) published a Staff Bulletin entitled “Standards of Conduct for Broker-Dealers and Investment Advisers Care Obligations”. This comprehensive Bulletin represents the latest guidance from the SEC for both Broker-Dealers and Investment Advisers on fair treatment of investors and their interests.

In the US financial oversight is managed by the SEC and FINRA (Financial Industry Regulatory Authority). These two bodies have overlapping areas of governance and have created rules that govern how financial companies need to operate with respect to operations, execution and investor disclosure. The emphasis in the US is rather different to European markets which have made investor protection a cornerstone of regulation for decades. Regulation in the US has always emphasised the need for a strong framework to prevent fraud and require fair and adequate disclosure more self-directed investors, supported by heavy legal and rules-based approaches. Investors have historically been broadly left to look after their own interests outside the minimal protections afforded.

US regulatory set-up

The size of the US market and the nature of its political and legal checks and balances means that a two pronged regulatory approach has worked well.

By contrast other regions (such as the EU and UK) have adopted a more prescriptive and at times interventionist approach. This can be evidenced by the very detailed and far-reaching EU MiFID directives and the PRIIPs regime for providing standardised comparisons for investments. The UK was arguably the first to raise standards for advisers and other intermediaries with the Retail Distribution Review (RDR) which banned commissions as far back as 2012. The UK FCA has now followed up with the new onerous and all-encompassing Consumer Duty regime which comes fully into effect in July 2023 aiming for very solid investor protections.

Previous attempts

The US has had one previous attempt to forge a similar path to place more emphasis on pro-active consumer protection rather than simply preventing fraud, bad practice and inadequate disclosure. The was the “DoL rule” (Department of Labor Rule) which sought to bring broker-dealers up to the fiduciary standard required of Registered Investment Advisors (RIAs) to act always in the best interest of the investor rather than be able to rely on weaker obligations of suitability and reasonableness.

This rule was drafted towards the end of the Obama administration and was resisted by many firms, although others notably agreed to enact its measures voluntarily. After the 2016 presidential election and a Republican administration coming to power this rule was never enacted. This whole initiative should have fallen within the SEC’s remit and regulatory “turf-defending” was a part of the reason for the rule’s demise. In the years that have followed the SEC has introduced its “Regulation Best Interest” which came into effect in 2020. This latest staff Bulletin is another significant step towards a greater duty of care for Broker Dealers towards rules required of Registered Investment Advisors.

This is a difficult task on many levels, one key reason being that the number of Broker Dealer Representatives dwarfs the total of Investment Advisors in the US and any changes that increase Broker Dealer obligations causing cost and time with the implications on reduced profitability of doing business are likely to be resisted by many.

The Staff Bulletin is presented in Q&A format, the full list of questions appear below

Most of the questions and the expected answers in the list would seem to be very self-evident to anyone engaged to deliver best outcomes for their investors. The fact that the SEC feels that these questions need to be stated so explicitly in 2023 speaks volumes of the concerns around the conduct of some broker dealer firms and representatives.

Examining SEC expectations

Section 1 - “Understanding the Investment or Investment Strategy” makes it clear that representatives should understand the investment that they are recommending as without this they cannot possibly assess whether it is right for the client or indeed explain it adequately. The factors that the SEC want considering are the basic investment goals, costs, risks and volatility of each proposed investment. This should normally be considered a basic checklist for any investor and so rightly is expected of the broker-dealer. Costs should also be considered and while the SEC states that the lowest cost investment is not necessarily the best, total costs including commissions and sales loads must be taken into account. The inclusion of these items suggests that the SEC might have these contentious aspects of broker-dealer business models in their targets. In the final question of the section the SEC makes clear that representatives cannot solely rely on their firm’s approved list. Only the representative knows everything about the end client and depending on the size and structure of a firm they may be several layers removed from an approval process. Adequate training supplied by the firm would help protect both them and the representative.

In section 2 (“Understanding the Retail Investor’s Investment Profile”) the basics of investor profiling and target market assessment are outlined. These are concepts that are well understood and the subject of significant regulation in Europe. Only by adequate assessment of both an investment opportunity and the individual investor to whom they might be targeted can a suitable recommendation be made or portfolio efficiently managed over the long term.

Sections 3 and 4 focus on “Considering Reasonably Available Alternatives” and “Complex or Risky Products”. These are important further concepts once a potentially suitable investment has been selected from the process in sections 1 and 2. Often it will be to identify cheaper and simpler investments which are more efficient or cost-effective. It would for example be very difficult to justify a high-cost fund or investment if it closely tracked a major index for which a liquid ETF was available at minimal cost.

Complex products are an area that has been discussed by both SEC and FINRA over the years. In this Bulletin it names several investment types that would be classified as complex, including reverse convertibles. It makes clear that sufficient evaluation is imperative to gain an understanding of the reasons to make such a recommendation. For structured products this would include the value of principal protection, seeking high yield at reasonable risk levels and getting above average returns in sideways markets.

This Staff Bulletin from the SEC neatly sets out some key themes in investment selection and investor categorisation and indicates the likely direction of travel to improve standards in the US market.

Tags: Regulation
A version of this article has also appeared on www.structuredretailproducts.com

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