The SEC Enters the Fiduciary Fray


The SEC has now weighed into this fiduciary fray, proposing new rules governing the behavior of broker-dealers.

Our last blog (Nature Abhors a Vacuum – and So Should Fiduciaries) discussed the decision by the U.S. Court of Appeals for the Fifth Circuit to invalidate rules, issued by the U.S. Department of Labor, for financial professionals who sell financial services and products to retirement plan participants. One part of the Court’s rationale was that the conduct of these financial professionals is more appropriately regulated by the Securities and Exchange Commission (SEC). The SEC has now weighed into this fray, proposing new rules governing the behavior of broker-dealers.


The SEC release regarding this proposal contains over 400 pages of explanation and justification for the new rules and four pages for the new rules themselves. So, let’s dive in with a few key points:

•      The SEC proposal is not targeted exclusively at retirement plan participants. Rather, it covers all broker-dealer relationships. In so doing, it will cover broker-dealers who encourage retirement plan participants to rollover plan distributions into IRAs – but only if the broker-dealer is recommending an underlying investment governed by the SEC.

Although the SEC’s proposal may be described as an “alternative” to the DOL rule, it is not focused on the unique needs or circumstances of retirement plan participants. And, as will be discussed below, the SEC proposal is less stringent than the DOL fiduciary rules invalidated by the Fifth Circuit.

•      As noted above the SEC proposal is limited to broker-dealers who are subject to SEC regulation. So, the SEC proposal does not affect investment advisors or insurance agents. Investment advisors — who are compensated for the advice provided, rather than the actual transactions executed — are subject to different sets of SEC rules. And insurance agents — who sell insurance products not regulated by the SEC — are only subject to state laws that may (or may not) impose meaningful limits on their conduct.

•      In case you were wondering who is covered by the SEC proposal, a “broker” is defined in Federal securities law as “any person engaged in the business of effecting transactions in securities for the account of others”. In effect, a broker is paid for the financial products sold (typically a commission) and is not paid for providing advice. Of course, brokers provide investment advice, but under the SEC’s framework that advice is “incidental” to the underlying transactions of buying and selling financial products. (For purposes of this blog, we don’t need to worry about the dealer part of broker-dealers; dealers are defined as those engaged in the business of buying and selling securities for their own account.)

The SEC’s Proposal

So, what is the SEC proposing for broker-dealer conduct? Under the SEC proposal, broker dealers would be subject to a new “best interest” obligation. Under this proposal a broker- dealer “shall act in the best interest of the retail customer . . . . without placing the financial or other interest of the [broker-dealer] ahead of the retail customer.” In explaining this standard, the SEC defined four key components:

•      A disclosure obligation;
•      A minimum standard of care;
•      Two components dealing policies regarding “material” conflicts of interest.

Here is an explanation (and some commentary) on this standard:

•      Although the SEC requires that broker-dealers act in the “best interest” of customers, the SEC’s interpretation of the term “best interest” may leave some surprising gaps. Most notably, the SEC specified that a broker-dealer may not place the financial interest of the broker-dealer “ahead” of the financial interest of the customer. However, under the SEC’s proposal a broker-dealer can continue to consider the broker-dealer’s financial interests in making a recommendation; indeed, the SEC specifically declined to create a standard that would have required broker-dealers to place customers’ interests ahead of those of the broker dealer. So, under the SEC proposal a broker-dealer can consider his/her financial interests to be as important as the interests of a customer — and still be considered as complying with the SEC’s “best interest” standard.

•      The first component of the SEC’s best interest standard requires that the broker-dealer disclose, in writing, “the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation”. In effect, the broker-dealer can make a recommendation that involves a conflict of interest with the customer as long as the “material” conflicts are disclosed. And, conflicts deemed by the broker-dealer to not be “material” need not be disclosed.

•      The second component of the SEC’s proposed standard describes the standard of care required of broker-dealers. The proposal requires that a broker-deal exercises “reasonable diligence, care, skill and prudence to …[u]nderstand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest” of the customer.

This requirement uses fiduciary terminology – “reasonable diligence, care, skill and prudence” – but, merits closer review. A broker-dealer is not required to exercise diligence, care, skill and prudence” in selecting the securities to recommend to a customer (the standard that would be applied to an ERISA fiduciary) — rather, the diligence must be in assessing whether the recommendation is in the customer’s best interest.

And, the SEC has specifically declined to define the term best interest. Instead, the SEC has described considerations for broker-dealers to apply in making this “best interest” assessment. Notably, as discussed above, the SEC specified that a broker-dealer’s can consider his/her financial interests in making a recommendation to a customer as long as the broker-dealer’s financial interests are not placed ahead of the customer’s interest. But, otherwise, the SEC has left it to broker-dealers to determine best interest based on a variety of factors, such as “a customer’s investment objectives, financial situation and needs”.

•      The third and fourth components of the SEC standard require that broker-dealers establish and maintain policies reasonably designed to identify “material” conflicts of interest and either disclose or eliminate such conflicts.

Most notably, elimination of material conflicts is not required; rather, it is an alternative to disclosure.

What to Make of This?

For starters, we can expect a long, drawn out regulatory process.

Additionally, do not expect any final rules to contain major changes to the current regulatory landscape. The SEC’s release contains a number of passages where the SEC specifically declined to impose more rigorous standards or to adopt proposals that would disrupt broker-dealers’ business model. Look for more of the same as this proposal progresses.

The DOL’s (now suspended) fiduciary rules were targeted at the retirement plan market and represented a significant regulatory shift. The SEC’s proposal represents the broader scope of the SEC’s jurisdiction and a greater reluctance to disrupt broker-dealers’ existing business models. So, at the end of the day, the SEC proposal may generate some more disclosure to customers — but do not look to the SEC’s proposed rules to have the kind of impact that we would have seen under the DOL’s fiduciary rule.