United States: SEC Regulation Best Interest: Charting A Course For Securities And Annuity Sales

Last Updated: September 10 2018
Article by James F. Jorden and Ben V. Seessel

In June, we circulated our fifth article on the continuing saga regarding the standard of conduct for sales of securities and annuities — and the efforts of federal and state regulators to impose new conditions on the existing standards. Our earlier articles focused on the potential for regulatory and litigation issues arising under the Department of Labor's fiduciary rule adopted in 2016, which was struck down by the Fifth Circuit Court of Appeals. Soon after the court's opinion, the SEC proposed a new regulation governing the regulation of broker-dealers in the recommendation and sale of securities — the Regulation Best Interest — which was the subject of our article last month. From the outset, we predicted that the change in regulatory treatment may create potentially significant changes in litigation involving sales of both securities and annuities. We predicted the following results for the DOL's fiduciary rule before it was vacated.

From a litigation perspective, this change to a fiduciary status for the sales agent is substantial and in many cases will afford litigants unhappy with investment results or the ultimate characteristics of a particular form of security or annuity the opportunity to second-guess the original decision applying a significant range of issues.

This article is the first in a series that will focus on what potential new or different litigation issues the SEC's RBI standards present. My co-author, Ben Seessel, will soon provide similar predictions and analysis on potential new/different FINRA enforcement issues.

We begin by reviewing some of the important differences between the BIC and the RBI.

Q. What are the key differences between the BIC and RBI standards as they relate to litigation exposure?

A. Starting with the enforcement mechanisms, as we pointed out last month, there are two key operational differences. First, on the type of transactions covered; and second on the "standards" for best interest. Each of these differences result in significant differences for potential litigation issues. There is a third difference which we did not highlight in our earlier piece — the difference in the vehicles for "enforcement" of the two standards.

The DOL's BIC Rule: This rule imposed best interest (fiduciary) standards on all recommendations and sales of both securities and annuities (and many other forms of "investments") to ERISA plans or IRAs, (characterizing such recommendations or sales as "Investment Advice"). Thus, the BIC applied to all forms of advice to ERISA plans and IRAs involving the purchase or sale of annuities, mutual funds, and virtually all other forms of investment transactions. The BIC, as a separate contract, effectively operated as its own enforcement mechanism creating a new private right of action to enforce the promises made in the BIC.

The SEC's RBI: The proposed RBI imposes a best interest requirement, but only on "recommendations" and sales of securities to "retail customers" (a defined term). The RBI applies to all such recommendations, regardless of the amount or type of compensation paid. It applies to both the "purchase" of a security and the "sale" of a security and specifically applies to transactions involving "rollovers" to IRA plans. Thus only variable annuities or other registered security annuities are subject to the RBI requirements.1 Enforcement of the principles under the RBI will rely on the existing SEC and FINRA enforcement tools.

Q. Are the different standards for what constitutes "best interest" really different under the BIC and the RBI?

A. Yes, clearly, but the differences, according to the SEC's release, are fewer than the similarities. There are two key differences:

The BIC Standards: The BIC exemption had required the acknowledgement of "fiduciary" status of the broker or agent rendering the "investment advice" and established a series of best interest requirements for the advice and sale, including the impartial conduct standards that formed a part of the BIC. These standards are:

  1. Act in the "best interest" of the customer, defined as acting with prudence and loyalty.
  2. Charge only reasonable compensation.
  3. Make no misleading statements.

The RBI Standard: The RBI will require broker-dealers "to act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer."2 It will effectively replace the current broker-dealer "suitability" standard.3 The RBI standard will be met if four component obligations are satisfied:

  1. The Disclosure Obligation — requires brokers to disclose the "scope and terms of the relationship" and all "material conflicts of interest." The SEC release contains an example of a disclosure format — a client relationship summary (CRS) setting forth the capacity, fees and charges, and type and scope of services, as well as the nature of any conflicts of interest.
  2. The Care Obligation — requires broker-dealers to exercise reasonable diligence, care, skill and prudence to:

    1. Understand the potential risks and rewards of a recommendation and have a reasonable basis to believe it is in the best interest of at least some of their retail customers. This "new" obligation will require the broker to be prepared to demonstrate a process of study and comprehension of the product before offering.
    2. Have a reasonable basis to believe the recommendation is in the best interest of the particular retail customer to whom the recommendation is being made. This broker obligation will presumably require analysis of customer information beyond that normally developed in a "suitability" determination?
    3. Have a reasonable basis to believe that, if the broker-dealer is making a series of recommended transactions – that such recommendations, even if in the best interest in isolation, are not excessive and are in the best interest when viewed in total. This is a "new" obligation and raises the question of what information and analysis is required to make such a determination.
  3. The Conflict of Interest obligations contain two related requirements as follows:

    1. Establish and enforce policies to identify, disclose, or eliminate all material conflicts of interest associated with each recommendation covered by RBI.
    2. Establish and enforce policies to identify and disclose and mitigate, or eliminate, material conflicts of interest that arise from financial incentives associated with all recommendations covered by RBI.

Q. What is the likelihood that, by establishing particular detailed standards and obligations, the RBI will raise the possibility of asserting a private right of action for failure to meet its terms?

A. The SEC's release states that it does "not believe" that adopting the proposed RBI will create a new private right of action and adds that it does not "intend such a result."4 We can expect individual claimants in particular transactions involving sales or purchases of securities by brokers to raise the failure to meet the RBI standards in normal FINRA arbitrations. For example, the new care obligations that impose requirements for a broker to have a "reasonable basis" that a particular transaction is in the customer's best interest may well entail requiring brokers to obtain, and make judgments about, a customer's financial status beyond that normally entailed in developing a "suitability" analysis. What are the analytical standards, how can they be reached and how should they be documented?

On the other hand, many of the "best interest" requirements under the care obligation appear to be modest enhancements to existing FINRA standards. For example, since 2012, the standards applicable to the recommendation and sale of complex products5 impose the same two-step process outlined in the RBI; first, determine that the product is suitable for at least some customers, then apply a second step to insure that it is suitable for the particular customer for whom the product is being recommended. To that extent, such standards will not result in any new or novel arguments in the context of a common law fraud or state unfair practices lawsuit.

Further SEC pronouncements on the proposed RBI standards will likely address the Commission's views and direction on these issues.

Q. What are the implications, if any, of creating these new standards as they apply to recommendations involving the purchase or sale of securities on common law complaints involving allegations of state law unfair trade practices or allegations of breaches of fiduciary duty, even if there is no private right of action under the federal securities laws?

A. While acknowledging that the RBI imposes a duty of prudence (see discussion later), the release asserts that the SEC does not intend to impose a duty of "loyalty" which is the second essential component of the "fiduciary" definition. To that end, the SEC's release states that RBI does not anticipate or require a "continuing duty" to monitor — a duty normally associated with the duty of loyalty.6 However, we should note that the SEC's release contains, at various points, a "fiduciary light" standard, without actually using that term. For example, the release in its discussion of the 913 Study provides:

While we are not proposing a uniform fiduciary standard, as recommended in the 913 Study, we nevertheless preliminarily believe that the proposed best interest obligation draws from principles underlying and reflects the underlying intent of many of the recommendations of the 913 Study. As a consequence, we also believe the rule draws upon the duties of loyalty and care as interpreted under Section 206(1) and (2) of the Advisers Act.7

Numerous other portions of the release include references to fiduciary duties as part of the framework of the broker's responsibilities and history as interpreted by some judicial decisions, such as the following footnote.

Under Regulation Best Interest, as proposed, a broker-dealer's duty to exercise reasonable diligence, care, skill and prudence is designed to be similar to the standard of conduct that has been imposed on broker-dealers found to be acting in a fiduciary capacity.8

Importantly, recent statements from SEC senior staff members suggest that the staff at least sees little difference in the fiduciary standards normally applied to, for example, investment advisers and the new standards under the RBI. For example, the director of the SEC's Division of Trading and Markets recently publicly remarked that the "[RBI] result is an enhanced standard of conduct for broker-dealers that applies consistent, fiduciary principles across the spectrum of investment advice, but tailors those principles to existing broker-dealer relationships."9

Q. What is the likelihood of a successful argument in state or federal court attempting to apply a "fiduciary" standard to a normal brokerage transaction due to the broker's obligation to comply with the RBI?

A. Absent a "special relationship," akin to that of investment advisor, succeeding in such an effort would be an uphill battle.

We assume it is likely that the SEC will adhere to its pronouncement that no traditional "fiduciary" duty is called for under the RBI standards. Nonetheless, the continuing rhetoric from the SEC that the RBI establishes principles of conduct that are somehow related or comparable to fiduciary duties could become problematic in future litigation over sales practices and broker conduct in the sale of securities.

However, any assertion of a "fiduciary" standard premised on the conditions in the RBI would be met with both the SEC's public denial of that intent, but perhaps more important with the analysis of the Fifth Circuit Court of Appeals decision vacating the DOL's definition of "fiduciary" and the BIC exemption.10 The court there found that the Rule not only conflicted with ERISA's definition of an "investment advice fiduciary," it noted that the Rule, as promulgated, was contrary to the common-law understanding of the term fiduciary as embodying the "touchstone of common law fiduciary status — the parties underlying relationship of trust and confidence." In addition, the court held that use of the term "rendering" of "investment advice for a fee" was consistent with both fiduciary "common law and the structure of the financial industry," describing the clear difference between investment advisers for a fee and brokers and insurance agents collecting a commission.11

Footnotes

1See Regulation Best Interest, SEC Release No. 34-83062 (April 18, 2018) (the "release") at 1, https://www.sec.gov/rules/proposed/2018/34-83062.pdf.

2 Id.

3 Id. at 40-43 ("we are proposing to enhance existing broker-dealer conduct obligations").

4 See release at 42 n.88.

5 See FINRA Regulatory Notice 12-03, http://www.finra.org/industry/notices/12-03.

6 See, e.g., release at 62, 65.

7 Release at 64.

8 Release at 134 n.222.

9 See Remarks of Brett Redfearn at 2018 FINRA Annual Conference, available at https://www.sec.gov/news/speech/redfearn-remarks-finra-annual-conference-052218.

10 The court's opinion contains a lengthy discussion of the DOL's 1975 Regulatory definition of "fiduciary" under ERISA, citing its standards and application with approval as a correct application of the term "investment advice fiduciary" consistent with the intent of Congress in enacting ERISA, as well as other federal and state legislation and case law since enactment of ERISA. Chamber of Commerce of Am. v. U. S. Dep't of Labor, No. 17-10238, slip op. at 5-7 (5th Cir. March 15, 2018). The court also addressed the Chevron argument by the DOL that the statutory definition is "ambiguous" and its interpretation in the Rule was "reasonable." In rejecting this argument, the court, among other things, noted that the Rule "disregard[s] the essential common law trust and confidence standard" and given "that it took DOL forty years to 'discover' its novel interpretation further highlights the Rule's unreasonableness." Id. at 33.

11 Id. at 14, 19-21.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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