Brokerages, alts advocates dispute state regulators’ Reg BI assessment

NASAA officials say sale of complex products provides insight into shortcomings of broker standard of conduct.

When a registered representative recommends that a client buy a certain mutual fund, she used to just have to make sure that the fund fit the customer’s investment objectives. That’s what occurred under the suitability standard.

Since the implementation of the new broker standard, Regulation Best Interest, in June 2020, the rep must now look at how her fund recommendation compare with other reasonably available alternatives on cost, return, risk and other criteria. There could be dozens of other similar investments for the evaluation.

“That’s a big leap from the suitability standard,” said Mark Quinn, director of regulatory affairs at Cetera Financial Group. “It requires a lot of time on the part of both the advisers who are making recommendations to clients and supervisors who are doing oversight. Having to document this process every time you do it is quite a lot of work.”

That’s why he has a problem with a report released last week by state securities regulators that found most brokerages continue to have conflicts of interest related to sales of complex products and compensation related to those investments.

“To say that Reg BI has not added additional protection for investors … is naïve at best,” Quinn said. “It really fails to recognize the huge efforts the industry has made to comply with Reg BI.”

The state regulators’ report was the second phase of a Reg BI study conducted by the North American Securities Administrators Association. It assessed Reg BI compliance among 225 firms that the organization began tracking in the first phase of the report, which came out in 2020.

Ohio Securities Commissioner Andrea Seidt said the progress reported was mostly disappointing.

“We’re happy to see some movement but it is still far short of what we were expecting on the state front in terms of firms upping their due diligence in order to better match their customers with products,” Seidt, chair of NASAA Reg BI implementation committee, said in an interview. Brokerages also fell “far short on eliminating and mitigating conflicts of interest, especially when you compare where [they] are now with fiduciary firms.”

Reg BI was designed to strengthen the broker standard of conduct so that it was similar to the fiduciary duty that investment advisers owe to their clients.

The NASAA study found particular problems with the sales of complex products, which it said had increased by 11% after Reg BI took effect. In addition, the study said 65% of brokerage firms didn’t discuss lower-cost or lower-risk products with their customers and 40% of firms that recommended leveraged or inverse exchange-traded funds had compensation conflicts.

The Institute for Portfolio Alternatives disputed the NASAA survey’s methodology and conclusions.

“The results ignore the numerous beneficial changes firms have made under Reg BI, and those made even before Reg BI, and the ways the law has thoughtfully increased investor protection while preserving investor choice,” IPA said in a statement. “The survey is significantly biased against certain products that NASAA has arbitrarily deemed ‘costly and risky.’”

The IPA asserted that NASAA ignored concerns it raised with the organization following the first phase of the study and “built the same fundamental flaws” into the second phase.

State regulators responded to industry criticism of NASAA’s methodology shortly after brokerage trade associations sent a letter to NASAA leadership in February 2020. Seidt said the organization did not hear any complaints as it was putting together phase II.

Issa Hanna, counsel at Eversheds Sutherland, also criticized NASAA’s focus on products.

“NASAA is very suspicious of certain products,” Hanna said. “But the theme of Reg BI was not product-oriented.”

Instead, Reg BI put an emphasis on acting in a customer’s best interest when it comes to opening accounts, such as recommending rollovers from company retirement plans to individual retirement accounts, and requiring brokers to consider available alternatives, Hanna said.

But NASAA officials pointed out the final version of Reg BI used the term “complex products” more than 100 times, making clear the SEC’s emphasis on this area.

“You can’t discuss how products are sold without discussing which products are sold,” Melanie Senter Lubin, Maryland Securities Commissioner and NASAA president, said in an interview. “The focus of the rule is to get brokers to do the right thing and act in their clients’ best interest. If it involves modifying how they sell these products, so be it.”

One area where the brokerage industry and NASAA agree is that the SEC needs to provide more specifics on how to comply with Reg BI.

“We’re hopeful that the SEC looks at [the NASAA study] where we’ve pinpointed issues and says, ‘Yes, we can clarify this, we can give more guidance about that,’” Lubin said. “That will help the firms come into better compliance with Reg BI and have Reg BI actually accomplish the purpose it set out to accomplish where the firms are acting in the customer’s best interest.”

Hanna would welcome such guidance.

“It would be helpful for the industry to know what kind of mitigation techniques are expected with respect to certain types of conflicts before anyone is held accountable,” he said.

An SEC spokesperson did not respond to a request for comment.