SEC official addresses criticism of best-interest standard for brokers

Director Brett Redfearn clarifies how the SEC defines 'best interest' and how it will determine whether a broker is in compliance

May 22, 2018 @ 2:34 pm

By Mark Schoeff Jr.

A Securities and Exchange Commission official defended the agency's proposal to raise investment-advice standards for brokers Tuesday, asserting it would increase investor protection while building on current broker rules.

Last month, the SEC introduced an investment-advice reform package that is now open for public comment until Aug. 7. One of the proposed rules is Regulation Best Interest, which would require brokers to act in the best interests of their clients.

Brett Redfearn, director of the SEC Division of Trading and Markets, addressed criticism that the proposal lacks a definition of best interest.

"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," Mr. Redfearn said at the Financial Industry Regulatory Authority Inc. annual conference in Washington. "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."

Mr. Redfearn said the proposed rule applies some of the same principles of the Investment Advisers Act of 1940, which requires investment advisers to adhere to fiduciary duty, as well as the Labor Department's fiduciary rule, which may be near death after being vacated in March by the 5th Circuit Court of Appeals.

The SEC proposal is based on the current suitability rule for brokers. But it goes beyond that regulation by requiring that brokers disclose and mitigate or eliminate conflicts of interest, according to Mr. Redfearn.

"Today, the obligations under federal securities laws largely center on conflict disclosure rather than conflict management," he said.

He compared assessing whether a broker acts in the best interests of a client to evaluating whether trade orders get best execution.

"It's a facts-and-circumstances determination," Mr. Redfearn reiterated to reporters after his Finra appearance. "The most important thing is that the broker-dealer is acting in the best interests of their clients, but that will vary depending on the investors' objectives and the details at the time of the recommendation."

The SEC doesn't want to be explicit.

"We think trying to nail it down probably would do more harm than good," Mr. Redfearn said.

Although the SEC rule "would put a greater emphasis on costs and financial incentives," brokers would not necessarily have to recommend the least expensive product, Mr. Redfearn said.

The rule suggests that firms consider mitigating conflicts that arise from differential compensation for products and from practices such as sales contests.

Regulation Best Interest is generating more questions than answers.

Stephen Cutler, a partner at Simpson Thacher & Bartlett, wondered whether a wirehouse would satisfy the SEC rule if it equalizes compensation for its registered representatives between its own products and those of competitors.

"What does it mean to mitigate [conflicts]? How much mitigation do you have to do?" Mr. Cutler said on the sidelines of the Finra conference. "There are aspects of the rule that don't have bright lines, and that's one of the them."

Robert Muh, chief executive of Sutter Securities Inc., criticized the SEC rule for being vague and potentially harmful.

"I doubt that most of us could write down what you have to do" to comply, Mr. Muh said on a Finra conference panel. "The rule will open up a potential flood of litigation."

Mr. Muh is on the Finra board, but spoke for himself.

The bottom line on the SEC rule is that everything comes back to best interests, according to Mr. Redfearn.

"Even if a broker-dealer has mitigated and disclosed its conflicts, its recommendation must still be in the best interest of the retail customer," he said.


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