If the Securities and Exchange Commission has its way,
brokers will have to make big changes to how they sell investments.
For the first time, brokers would be explicitly required to
act in the best interests of their customers, not their own paychecks, when
they make investment recommendations.
Furthermore, as SEC Chairman Jay Clayton made clear in an
interview, some sales contests — those competitions in which brokers earn
rewards for selling specific investments — are in danger of extinction.
The changes come from a package of proposed regulations introduced
in April. If it comes into force, the SEC would prohibit brokers from
putting their firm’s or their own interests ahead of their customers’ — a step
forward from the looser existing requirements that their recommendations must
be fair and “suitable.”
Through Aug. 7, the SEC is soliciting comments from
the public on the proposed rules, which the agency
outlined in roughly 1,000 pages of recommendations and analysis. The
regulatory package comes after a federal court struck down tougher rules imposed
by the Department of Labor, and the SEC’s initiative is unlikely to be enacted
anytime soon.
But the SEC’s Mr. Clayton is adamant about the need
for change. “What we’re really trying to do here,” he told me this week, “is
bring the standard of conduct in line with what an investor would expect of a
broker-dealer: that you’ve taken care in coming up with that recommendation and
that you are not putting your interests ahead of the investor’s.”
Under the proposed rules, a broker providing an investment
recommendation must disclose all fees and other facts that are material to the
relationship. The broker must also understand the risks and rewards of each
recommendation and determine that it is in the best interest of retail
investors in general and the particular customer. Finally, the broker must
disclose and mitigate — or eliminate — any significant conflicts of interest
and must not put his or her own interest ahead of the investor’s.
The rules would affect the nation’s roughly 2,800 brokerage
firms and more than 7,000 SEC-registered investment-advisory firms serving
individual investors. All told, such brokerage firms manage 128 million retail
accounts and more than $3.6 trillion in assets; these investment-advisory firms
have more than 34 million accounts and approximately $33 trillion.
In a move that could upend the way many brokerages do
business, the SEC is spotlighting the use of sales contests. In these
competitions, brokers who hit quotas for selling specific investments or
services can earn bonuses, prizes, or trips to resorts and the like.
Firms often use
such techniques to motivate brokers to bring in more assets and
generate extra fees. Brokers say these incentives can force them to steer
clients toward more-costly or less-appropriate decisions.
In its release of the proposed rule, the SEC said such
rewards could make brokers “predominantly motivated” by “self-enrichment,
self-dealing or self-promotion,” thereby violating their obligations under the
rule. As a result, says the regulatory document, firms making investment
recommendations to individuals should avoid “sales contests, trips, prizes, and
other similar bonuses” tied to specific targets.
Mr. Clayton hammered that point home this week. “Let
me be unambiguous on high-pressure sales contests,” the SEC chairman told me.
“A commission-based compensation scheme is fine, if properly disclosed and if
the broker-dealer is not putting their interests ahead of the clients’. You can
have a commission-based model, but you can’t have high-pressure, product-based sales
contests, where it’s just not possible to say with any credibility that
you’re not putting your interests ahead of those of your
clients. In that case, mitigation [of the conflict of interest] is not
practical.”
Effectively banning certain practices may be necessary if
the business of financial advice is to evolve into a profession, says Deborah
DeMott, a professor of fiduciary law at Duke Law School. “A profession places
limits on what its members may take into account in their decisions for
clients. Deciding that a professional does not give investment advice on the
basis of seeking to win a contest for a trip would be a good idea.”
Another feature of the suggested rules would prohibit
brokers from calling themselves “advisers” or “advisors” unless they are
registered as investment advisers. (It wouldn’t stop them from using
highfalutin but meaningless terms like “wealth manager.”)
The SEC is asking for feedback on whether a federal
licensing and continuing-education regime for financial advisers would help
ensure that they are competent and knowledgeable.
The rule proposals also sketch out a
four-page, standardized disclosure form that would explain, among
other things, how the broker or adviser is paid. The form recommends some
questions investors could ask a prospective adviser. In my view, this form is
nowhere near consumer-friendly yet.
Some in the investment industry fear that the proposed
rules still aren’t specific enough. “It’s difficult, without more guidance, to
know what it means to act in a customer’s ‘best interest,’” says Susan Grafton,
a partner specializing in securities regulations at Dechert LLP in Washington,
D.C.
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