United States: Clayton Comes Out Swinging Against Critics Of Regulation Best Interest

In a speech on July 8, 2019, SEC Chair Jay Clayton responded to criticism of Regulation Best Interest, setting out his arguments in a concise, step-by-step rebuttal.5

After a brief summary of Regulation Best Interest ("Reg. BI"), the Form CRS relationship summary, the clarification of a registered investment adviser's ("RIA") fiduciary duty (the "Fiduciary Interpretation") and the interpretation of the "solely incidental" prong of the broker-dealer exclusion under the Investment Advisers Act of 1940 (the "Advisers Act"), Chair Clayton got down to the business at hand:

"Let me now address some of the commentary, or, more specifically, the criticism and misinformation, I alluded to at the outset. I believe that much of this criticism—which is focused broadly on the extent of the investor protections under Reg. BI and our Fiduciary Interpretation—is false, misleading, misguided, and unfortunately, in some cases, is simply policy preferences disguised as legal critiques."

Complaint No. 1: The standard of conduct imposed on broker-dealers by Reg. BI will not do enough to protect retail investors.

Chair Clayton Response: In a swift one-two punch, Chair Clayton emphasized that Reg. BI substantially enhances the standard of conduct for broker-dealers by (1) establishing a standard of care for transactionbased advice that draws upon principles underlying the investment adviser fiduciary duty, and (2) being workable for broker-dealers. Under Reg. BI, (1) whether a retail investor chooses a broker-dealer or an investment adviser (or both), the recommendation or advice is required to be in the best interest of the retail investor and cannot place the interests of the firm or the financial professional ahead of the interests of the retail investor, and (2) the ability to choose between a broker-dealer transaction-based model and an investment adviser portfolio-based model—and choose among the various iterations and combinations of each—will be preserved.

Complaint No. 2: Reg. BI doesn't eliminate all conflicts of interest.

Chair Clayton Response: Calling this criticism "misguided," Chair Clayton acknowledged that there are conflicts of interest inherent in all principal-agent relationships, and the broker-customer relationship and the investment adviser-client relationship are no exception. However, Reg. BI recognizes that these conflicts exist, and requires that firms address those conflicts.

Complaint No. 3: Reg. BI fails because "best interest" is not defined and it doesn't require the broker-dealer to recommend the "best" security.

Chair Clayton Response: Reg. BI takes a principles-based approach, rather than a prescriptive approach, in determining what is in the best interest of the retail customer. Whether a broker-dealer has acted in the retail customer's best interest will turn on an objective assessment of the facts and circumstances. Neither brokerdealers nor investment advisers are required to recommend the "best" security, something that may only be known in hindsight.

Complaint No. 3: The fiduciary interpretation weakens the existing RIA fiduciary duty by not requiring RIAs to "put clients first."

Chair Clayton Response: "This claim is flatly wrong." The critics are again swinging at air here, in that the Fiduciary Interpretation reaffirms the existing fiduciary protections under the Advisers Act, as stated by the U.S. Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963). The core principle has always been that the adviser must at all times serve the best interest of its client and not subordinate its client's interest to its own, which principle the Fiduciary Interpretation reaffirms.

Complaint No. 4: The fiduciary interpretation weakens the existing RIA fiduciary duty by not requiring RIAs to avoid all conflicts.

Chair Clayton Response: "There is no legal or regulatory basis for this claim." Chair Clayton explained that some critics cited an instruction in Form ADV, adopted by the SEC in 2010, as the basis for a "no conflicts" requirement for RIAs. However, this would be a fundamental change from the existing legal standard for an RIA's fiduciary duty, as stated in SEC v. Capital Gains.

Complaint No. 5: The standards of conduct under Reg. BI and the Fiduciary Interpretation can be satisfied by disclosure alone.

Chair Clayton Response: Forcing the critics into a corner, Chair Clayton said that this claim "reflects a fundamental misunderstanding of how the independent component obligations of Reg. BI operate and a misconception of the investment adviser's fiduciary duty."

In order to satisfy the General Obligation of Reg. BI, a broker-dealer must satisfy all four of the component obligations, not just the Disclosure Obligation.6 To satisfy the Conflict of Interest obligation, conflicts will, in many case, have to be mitigated. In some cases, they will have to be eliminated. Even if a conflict can be addressed through disclosure, including the Care Obligation, which applies to all recommendations, whether a broker-dealer has disclosed, mitigated or eliminated the conflict of interest.

RIAs have an obligation to act in the best interest of the client, which encompasses a duty of care and a duty of loyalty. The duty of care cannot be satisfied by disclosure alone.

Complaint No. 6: Reg. BI is deficient because it does not require broker-dealers to monitor a customer's account or impose an ongoing duty.

Chair Clayton Response: Chair Clayton called this argument "fundamentally flawed" and reflecting a misunderstanding of how federal law applies. One of Reg. BI's goals is to preserve access to different types of services, and investor choice. Forcing broker-dealers to provide ongoing monitoring services lessens choice and increases investor costs. More fundamentally, imposing an ongoing monitoring requirement on brokerdealers would subject the broker-dealer to regulation as an RIA and also vitiate the "solely incidental" prong of the broker-dealer exclusion under the Advisers Act.

Complaint No. 7: Form CRS will not address investor confusion regarding the differences between brokerdealers and RIAs.

Chair Clayton Response: Chair Clayton deflected this shot by pointing to the extensive feedback, investor testing and SEC Staff expertise involved in creating Form CRS and the enhancements to the form made after the proposing release. Investors are confused about the roles of broker-dealers and RIAs; Form CRS is a substantial improvement over existing retail disclosures. According to Chair Clayton, Form CRS provides an unprecedented level of transparency and comparability across SEC-registered RIAs, broker-dealers and dual registrants.


Chair Clayton, by a knockout.

5 Chair Clayton's speech is available at: https://bit.ly/32UdIKo

6 For a more detailed discussion of Reg. BI, please see our legal update at: https://bit.ly/2Osrlxc.

Originally published in REVERSEinquiries: Volume 2, Issue 7.
Click here to read the articles in this latest edition.

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