SEC Director of Investment Management Answers Questions on Proposed “Best Interest” Standard

SEC Division of Investment Management Director Dalia Blass addressed general questions on the recently proposed “best interest” standard. (See here for a thorough review of the proposed rule.) In addition, Ms. Blass updated SEC activity since the adoption of the liquidity risk management rule.

At a PLI Investment Management Institute program, Ms. Blass explained that the Regulation Best Interest (“Reg. BI”) proposals “are intended to serve Main Street investors by bringing the legal requirements and mandated disclosures of investment professionals in line with investor expectations.” Ms. Blass described how Reg. BI “raises the standard of conduct for broker dealers” while “preserv[ing] the pay-as-you-go broker-dealer model by recognizing how it differs from the investment adviser model.”

Ms. Blass responded to the fact that the term “best interest” is not defined in the proposal, stating “although we have not defined the term in the proposed rule text, we have defined the contours of the obligation: a broker-dealer cannot put its interests ahead of the retail customer’s and must comply with specific disclosure, care and conflict of interest obligations.” In this way, she argued, “Reg. BI incorporates, but goes beyond suitability.” Further, she notes “Reg. BI draws from principles that apply to investment advice under other regulatory regimes, yet it reflects the structure and characteristics of a broker-dealer’s relationship with retail customers.” Ms. Blass drew further distinction between broker dealers and investment advisers, stating: “[t]he duties required under Reg. BI are tied to each recommendation a broker-dealer makes, whereas an adviser’s fiduciary duty applies to the ongoing relationship with a client.”

Finally, Ms. Blass explained that the new interpretive guidance for investment advisers would serve to clarify their fiduciary duty standards. She said the guidance reaffirms that investment advisers must act in the best interest of its client, but also owes a duty of care and a duty of loyalty. She said the “staff recommended proposing this interpretation in order to draw together a range of sources and provide advisers with a reference point for understanding their obligations to clients.”

Separately, Ms. Blass discussed three projects implemented by the SEC following the adoption of a liquidity risk management rule. The rule requires certain registered investment companies to create liquidity risk management programs. Ms. Blass stated that the agency responded to feedback concerning the rule by (i) issuing FAQs regarding “classification, sub-advisory relationships, ETFs and reporting,” (ii) providing affected parties with six additional months in which to comply with the “classification and related elements of the rule,” and (iii) reevaluating the public reporting requirement of the rule to stop subjective liquidity information from being misconstrued. Ms. Blass also announced that the SEC intends to issue a proposal to modify the public reporting requirements for liquidity risk management programs. She said the new amendment would replace the requirement to “disclose publicly aggregated liquidity buckets” and instead require funds to provide an evaluation of their liquidity risk management programs in their annual shareholder reports.

Lofchie Comment: Ms. Blass expresses support for both the concept of “full-service” brokerage, where broker-dealers are able to make recommendations to retail investors and be paid through trading commissions, and for the imposition of a higher duty on broker-dealers under newly proposed Regulation Best Interest. Two fundamental questions are: (i) how much time/money must a broker-dealer invest in learning about a client so that it would be in a position to satisfy its proposed best interest obligation, and (ii) how many trades would a broker-dealer have to execute for the client so that the investment would be worthwhile?

It seems very likely that it would take a substantial volume of trading by a retail investor for a broker-dealer to truly understand its retail investor’s circumstances to the extent mandated by the proposed Best Interest Requirement. If that is the case, a retail investor who might execute ten or twenty trades a year will not be able to “pay for” full-service brokerage.

Of course, the above is just an uninformed guess. It would be more meaningful if the SEC were to provide its own estimates of (i) the costs to broker-dealers of obtaining and understanding required suitability information, (ii) the revenues and profits to broker-dealers of executing trades for retail customers, and (iii) the volume level at which it will make sense for broker-dealers to offer full-service brokerage recommendations to retail investors.

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