The Implications of "Regulation Best Interest: The Broker-Dealer Standard of Conduct" in an Increasingly Regulated Industry.

• Date: 01 January 2021
• Author: Schadle, Neil S.
• Published date: 22 September 2020
• Author: Schadle, Neil S.

1. INTRODUCTION TO "REG. BI" 264 II. FINANCIAL ADVISER REGULATION BACKGROUND 265 A. Timeline of Legislation 265 1. The Securities Act of 1933 265 2. The Securities Act of 1934 266 3. The Investment Advisers Act of 1940 267 B. Registered Investment Advisers and Broker Dealers 267 1. The Registered Investment Adviser 267 2. The Broker-Dealer 268 3. Compensation 268 4. Standard of Care 269 a. Fiduciary Standard 269 b. Suitability Standard 270 c. Best Interest Standard 271 C. The Newest Addition-Regulation Best Interest: The Broker-Dealer Standard of Conduct 271 III. ANALYSIS OF REG. BI AND ITS IMPLICATIONS 272 A. Best Interest vs. Fiduciary--How Big Is the Shift? 272 B. Pros and Cons 275 1. Pro-Reg. BI Argument 275 2. Criticisms 276 a. Complexity and Ambiguity 276 b. Reg. BI Does Not Adequately Protect Retail Investors 277 c. Unnecessary Conflict of Interest Regulation 277 C. Lawsuits 278 1. Attorneys General Suits 279 2. XYPN Suit 279 IV. RECOMMENDATION 280 A. Deregulation in the Broker-Dealer Space 280 1. Market Efficiency 281 2. Cost Pass-Through Theory 281 3. Actual Risk of Conflict-of-Interest 282 B. If Not Deregulation-- Resist Raising the Duty of Care 282 V. CONCLUSION 283 I. INTRODUCTION TO "REG. BI"

   The recently published SEC policy entitled "Regulation Best Interest: The Broker-Dealer Standard of Conduct" imposes--among other changes--a heightened standard of care upon broker-dealers, requiring all registered broker-dealers to act in the best interest of their clients when making a recommendation on any securities transaction or investment strategy involving securities. (1) This new standard sets a higher bar than the previous "suitability standard," although it does not yet seem to impose the higher "fiduciary standard" required of registered investment advisers.

   To comply with the best-interest standard, which the SEC calls a "general obligation," a broker-dealer must satisfy four "component obligations," consisting of heightened obligations of disclosure, care, conflict of interest, and compliance. (2) The disclosure obligation requires broker-dealers to provide certain disclosures before or during a financial recommendation regarding the relationship between the broker-dealer and the client. (3) The care obligation requires the broker-dealer to "exercise reasonable diligence, care, and skill in making [a] recommendation." (4) The conflict of interest obligation requires broker-dealers to "establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest." (5) The compliance obligation requires broker-dealers to "establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest." (6)

   This Note will critically discuss the consequences of the heightened regulation in an evolving system and propose steps toward clearer, less burdensome regulation on broker-dealers. This Note argues less burdensome regulation can reduce market costs for broker-dealers and consumers without sacrificing meaningful consumer protection. Part II of this Note will examine the historical regulation imposed on financial advisers and broker-dealers, as well as the impacts of the current regulatory system, concluding with an overview of the newly implemented regulation--Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg. BI). Part III will analyze the major changes Reg. BI brings by exploring the potential benefits and drawbacks of the additional layer of regulation. Part III will conclude by identifying and discussing specific criticisms voiced by two prominent lawsuits filed in opposition to Reg. BI. Part IV of this Note responds to the criticisms of Reg. BI by suggesting two amendments to Reg. BI designed to decrease unnecessary compliance costs while preserving robust levels of consumer protection.

2. FINANCIAL ADVISER REGULATION BACKGROUND

   The term "financial adviser" is a broad one, and can encompass many different roles, but the term is generally used to describe "[a] person who is employed to provide financial services or guidance to clients." (7) Two important and distinct positions exist under the umbrella of the term financial adviser: broker-dealers ("BDs") and registered investment advisers ("RIAs"). For the purposes of this Note, a broker-dealer can be thought of as a person or company in the business of buying and selling securities, while an RIA can be thought of as a person or company who provides financial advising services such as portfolio management, financial planning, and investment advice. (8) An RIA is held to a fiduciary standard, and regulated under the SEC and the Investment Advisers Act of 1940, whereas a broker-dealer is held (only recently) to a best-interest standard, and regulated under the Financial Industry Regulatory Authority and the Securities Act of 1934. (9)

   This Section will first examine the current and historical regulatory environment under which these two advisers operate, and then discuss further the differentiating characteristics of these two types of advisers. This Section will conclude with a detailed look at the newest piece of regulation in the financial adviser space, and the main topic of this Note: Reg. BI.

   1. Timeline of Legislation

      Since the passage of the 1933 Securities Act--in response to the stock market crash of 1929--the regulatory climate of financial advisers has grown increasingly large and complex. (10) Prior to this landmark legislation, there was relatively little meaningful regulation imposed on the trade of securities, and thus, very little regulation restricting those in the business of advising customers on the trading of securities. (11) Since 1929, several pieces of regulation and legislation were introduced to regulate the sale of securities, as well as the professionals working in the industry. (12) The implementation of the following regulations eventually formed the current system of regulation for investment advisers that is in place today.

      1. The Securities Act of 1933

         After the crash of the stock market in 1929, the Securities Act of 1933 (the 1933 Act) was created to protect investors. (13) Appropriately, the legislation is often referred to as the "truth in securities law" because the legislation requires disclosure of financial information through the registration of securities, thereby creating a more transparent landscape for investors. (14) The 1933 Act laid the foundation for the regulation of securities in the United States, and, therefore, the regulation of broker-dealers and RIAs. The Securities Act of 1933 has two main objectives: "require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities." (15)

         While securities regulation has continued to expand after the 1933 Act, the basic idea of protecting investors through transparency remains at the center of regulation in this area. (16)

      2. The Securities Act of 1934

         The next major piece of financial legislation came in the following year in the form of The Securities Exchange Act of 1934 (the 1934 Act). (17) As the 1933 Act regulates the issuance of securities offered on the public market, the 1934 Act regulates the secondary market for securities. (18) To lead this endeavor, the 1934 Act established the Securities and Exchange Commission to "govern[] the way in which the nation's securities markets and its brokers and dealers operate." (19)

         The 1934 Act grants the SEC broad power and authority to regulate the securities industry. (20) This Act also identifies prohibited conduct in the industry and empowers the SEC with disciplinary authority to further regulate both persons and entities operating in the securities industry. (21) The 1934 Act also grants the SEC power to "register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation's self-regulatory organizations." (22) Perhaps the most notable self-regulatory organization (SRO) in the financial adviser world is the Financial Industry Regulatory Authority (FINRA). FINRA was created through the merger of the National Association of Securities Dealers (NASD) and the regulatory branch of the New York Stock Exchange (NYSE) in 2007 and is now the official self-regulatory organization for the U.S. securities industry. (23) While the SEC and the 1933 and 1934 Acts serve as the source of law for broker-dealers, in practice, FINRA oversees most ongoing regulatory duties involving broker-dealers. (24)

      3. The Investment Advisers Act of 1940

         Six years after the implementation of the 1934 Act, Congress passed the 1940 Investment Advisers Act (the Advisers Act) in response to concern regarding the quality of investment advice given by investment advisers. (25) The Advisers Act is thus the primary source of law for registered investment advisers, requiring "firms or sole practitioners compensated for advising others about securities investments [to] register with the SEC and conform to regulations designed to protect investors." (26) The Supreme Court later interpreted the Advisers Act to impose a fiduciary duty upon advisers acting for their clients. (27) Today, the Advisers Act and the 1934 Act--backed by the 1933 Act--serve as the framework of regulation used to govern investment advisers.

   2. Registered Investment Advisers and Broker-Dealers

      Financial advisers can be subcategorized into two groups: registered investment advisers and broker-dealers. (28) The two categories can be differentiated by three distinguishing characteristics: compensation, regulation, and standard of care. (29) RIAs generally use fee-based compensation, are regulated under the SEC through the 1940 Act, and have a fiduciary obligation to their clients. (30) Broker-dealers, on the other hand, are regulated under the 1934 Act through...