Does the SEC really need to define 'best interest'?

Now's the time for brokers and advisers to weigh in

Jun 9, 2018 @ 6:00 am

Best interest. Act in the client's best interest. Put the client's best interest ahead of your own. Regulation Best Interest.

The "interest" part of that phrase is pretty easy to understand. Words such as well-being, benefit and advantage are tied to it. If something is in one's interest, doing it will better their situation (or at least not worsen it).

It's the "best" part of that phrase that's so hard to nail down.

Perhaps that's why the SEC decided not to define "best interest" in its investment advice rule package proposed in April. That decision has caused no end of criticism in the proposal's short existence. But is the criticism justified?

An SEC official defended the decision at the Financial Industry Regulatory Authority Inc.'s annual conference last month.

"Best interest means what it says: You must act in the best interest of your client and not put your own interest in front of theirs," said Brett Redfearn, director of the SEC Division of Trading and Markets. "Beyond that, it is a facts-and-circumstances determination, not a check-box compliance exercise. It analyzes the reasonableness of the match between the recommendation and the needs of the retail customer."

This call to subjective action doesn't sit well with those more comfortable with a rules-based approach to compliance. Brokers have prescriptive requirements to meet, and enforcement hinges on them. Investment advisers are fiduciaries and fall more into a principles-based system, which demands conscientiousness and professional judgment in meeting the spirit of regulatory standards. With the one approach, a broker probably always knows where she stands in transacting business. With the other, an investment adviser has more flexibility in meeting a variety of circumstances, but is vulnerable to client and regulator interpretation of their recommendations.

Aligning brokers, advisers

SEC chairman Jay Clayton seemed to align the two a bit when explaining what is expected of brokers under the new rule proposal during a congressional committee hearing in April.

"We've called it the best-interest standard, but I want to be clear — for broker-dealers, there are core fiduciary principles embodied in that best-interest standard," he said. "In fact, those fiduciary principles are, I believe, the same as the fiduciary principles that are embodied in the investment-adviser standard."

One of the SEC's own, commissioner Kara M. Stein, questioned the efficacy of leaving out a clear definition of what is required. She asked in a statement about the rules: "If the commission does not define 'best interest,' will broker-dealers and their customers understand their obligation?"

Ms. Stein put forth a potential definition for comment, which included the words care, skill, diligence and, most notably, prudence.

The "prudent man rule," as included in the Employee Retirement Income Security Act of 1974, used just such words to explain the duty of fiduciaries of pension plans. Congress decided they should act "solely in the interest of the participants and beneficiaries." How? By conducting duties as "a prudent man acting in a like capacity and familiar with such matters would use."

That language places quite a responsibility on the adviser to know what a prudent person would do, and even then, requires filtering and finesse based on the particular circumstances of the client before them. In the case of ERISA, the ultimate judge of whether an adviser acts prudently is the courts.

In the new SEC rule, the idea is that brokers would now have to manage conflicts with company policies in order to mitigate or eliminate them, rather than just disclose them.

But as Stephen Cutler, partner at Simpson Thacher & Bartlett, told InvestmentNews senior reporter Mark Schoeff Jr. in a story about defining best interest: "What does it mean to mitigate conflicts? How much mitigation do you have to do?"

It's a gray area that brokers will have to feel their way through. At least as the proposal stands today.

But there's a lot of work to be done on the rules, and now's the time for brokers and advisers to weigh in. Is a definition of "best interest" necessary, or could it get in the way of providing the best advice by painting compliance into too narrow a corner? What needs more clarification? What aspects could actually strengthen the industry and move it closer to a profession? You have until Aug. 7 to contribute your invaluable insights.


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