Remarks at the FINRA Annual Conference

Brett Redfearn

Brett Redfearn
Director, Division of Trading and Markets

Washington D.C.

May 22, 2018

I would like to thank Robert Cook for the kind introduction. Thank you also for inviting me to join you at this conference. Today, I am very pleased to be able to discuss with you a topic that has occupied the Division’s thinking for a number of years, and that I am happy to say, the Commission recently took a very significant step forward on—the regulation of broker-dealer advice to retail investors.

Before I begin my remarks, let me pause for the disclaimer. I am speaking today only for myself and not for the Commission, the Commissioners, or the staff.[1]

As most of you know, last month the Commission proposed an important rulemaking package relating to the standards of conduct for investment professionals.[2] Broadly speaking, this package is intended to do three things:

  • First, help address investor confusion about the financial services that a retail investor may use through a proposed new short disclosure – Form CRS or customer or client relationship summary—and by prohibiting certain broker-dealers and their financial professionals from using the terms “advisor” or “adviser” as part of their names or title;
  • Second, enhance the quality of broker-dealer advice by requiring that recommendations be in the best interest of the retail customer, without placing the financial or other interest of the broker-dealer ahead of the retail customer– known as Regulation Best Interest; and
  • Third, reaffirm, and in some cases, clarify an adviser’s fiduciary obligations and seek comment on potential enhancements to investment adviser space drawing from investor protections available under the broker-dealer framework.

This entire package is out for a 90 day comment period ending on August 7.

In lieu of addressing each of these proposals, I’m going to focus my remarks today on Regulation Best Interest. Although my remarks are limited, I want to emphasize the importance of each aspect of this package and our strong desire to hear from you on each proposal. I invite every one of you to comment on what we have gotten right or wrong, so that we can continue moving forward and get to the right result on these issues – and I will go more into that later.

Focusing now on Regulation Best Interest, since the open meeting date, I have seen and heard a lot of commentary about what Regulation Best Interest is supposed to accomplish and the many ways in which it does too much or too little. The rule seems like a Rorschach test for many. Everybody sees something different in it. And, each tends to be predisposed to see what they want to see at this stage of the game.

What I see when I look at it—and I hope others appreciate—is a significant change from the status quo for broker-dealers that provide advice. But, it is a change that builds upon how brokerage advice has been regulated for decades. In undertaking this rulemaking, the Commission recognized the importance of the transactional or “pay-as-you go” brokerage model as a potentially cost effective, and sometimes less costly option for investors to pay for investment advice.

I want to explain what the proposal was intended to accomplish, what was proposed, and what we need from you and from other stakeholders.

What the proposal was intended to accomplish

The proposal tackles a fundamental question of vital importance to investors. And that is, “how should a financial professional provide advice in the face of conflicts?” We start by recognizing that every financial professional, no matter how he or she is paid, has some conflict when providing advice. We think of the conflict as the incentive that the firm or the financial professional has in giving that advice. Let’s state the obvious at the outset.

Most professionals want their clients to do well. That is what drives most of the advice given. But there are always other incentives that can affect the quality of advice provided, regardless of whether you recognize them as such or not. The incentives and related conflicts are typically tied to how the firm or financial professional makes or loses money. Once we identify the conflict, we must ask: “How does it affect the investor receiving the advice?” Depending on the type of conflict, a professional’s advice may lead the investor to trade too much or not enough; take on too much or too little risk; overpay for the account or for the product in the account; buy the wrong type of product, or one that does not best fit the investor’s needs; and so on. The point is the professional’s conflict can affect the investor’s outcome.

So that’s the issue Regulation Best Interest tries to address with two goals in mind. First, to enhance the quality of broker-dealer recommendations to retail customers. The Commission proposed to do that by reducing the potential harm from recommendations provided in circumstances where conflicts of interest—in particular financial incentives—are present. Second, in doing so, to preserve the brokerage “pay as you go” model as a viable choice for investors who want recommendations about securities. In my view, these two goals will be achieved if investors can get advice that fits their needs, and pay for it in a way that’s just right for them.

FINRAHow did the Commission approach achieving these goals? First, we stepped back and recognized that brokers are already subject to extensive rules that govern the advice that they can give. We are not starting on a blank slate. These rules are in the FINRA rulebook and well known to all of you who advise investors. We reflected on these rules, and lessons learned applying the anti-fraud provisions of the federal securities laws in enforcement actions going back decades. The proposal also draws from the Commission’s experience from the many policy discussions going back to the mid-1990s about the market for investment advice, and areas where improvements could be made, including from a 2011 staff study on these issues, and from requests for comment over time.[3] Finally, the proposal compares and considers fiduciary principles that apply to investment advice in other contexts—notably the fiduciary standard under the Advisers Act and principles underlying the recent Department of Labor rule applicable to broker-dealers.[4]

In short, Regulation Best Interest reflects extensive experience and expertise at the SEC on this very important issue. The result is an enhanced standard of conduct for broker-dealers that applies consistent, fiduciary principles across the spectrum of investment advice, but tailors those principles to existing broker-dealer relationships.

Some may wonder why this has taken so long. The issue we have been struggling with—and are still concerned about—is getting the calibration right. There are deeply held and conflicting views among competing camps of stakeholders about what is or isn’t necessary to address the conflicted advice problem, what potential impacts various approaches for doing so would have on advice relationships, and whether a particular solution – such as the uniform fiduciary standard recommended in the 2011 staff study—would have negative effects on the availability and cost of advice.

As you all no doubt have read, these concerns are not without foundation. Over the past decade, we have seen some broker-dealers transition from providing full-service brokerage to providing investment advisory services, and we have seen a substantial increase in the number of retail clients with investment advisers, both high net worth and non-high net worth clients.[5] Since 2012, more than 12 million new non-high net worth clients have been added.[6] While there are many reasons for this migration to advisory accounts, I am concerned when this transition reflects regulatory, and not, market forces. For example, I question whether paying an ongoing fee can be the less expensive choice for an investor who rarely trades, or who buys a variable annuity that he plans to hold for 20 years, or buys a bond that he intends to hold until maturity. How investors pay for recommendations can have a profound impact on returns over time.

To enhance the quality of brokerage advice and preserve the brokerage advice model for investors, the Commission needed to act in a way that recognized the range of services and the various types of advice—one-time, episodic, to more frequent—that a broker-dealer may provide its retail customers. It is important to give firms flexibility and a reasonable compliance path to develop systems to incorporate these new obligations. The proposal also would promote more consistent obligations across both retirement and non-retirement accounts, simplifying firms’ compliance.

This is how we landed where we are—so let’s get to specifics.

What does it mean to act in a customer’s best interest?

What’s missing in the current broker-dealer obligations is an explicit requirement that the broker-dealer must give advice that’s in the customer’s best interest. Not only do we believe that is what customers expect, and what many firms and financial professionals believe they are already doing, but it is what we believe retail customers should receive.

The Commission’s proposal begins by setting forth a broad, overarching obligation requiring that when making a recommendation to a retail investor, the broker-dealer must act in the retail customer’s best interest and can’t put its financial or other interest ahead of its customer’s interest. To provide clarity to investors and firms of what this duty entails, the rule then sets forth what the broker-dealer must do to meet its obligation. Namely, comply with specific disclosure, care and conflict of interest obligations, which I will turn to shortly.

In establishing this standard, the Commission defined the contours of a “best interest standard,” but didn’t define the term “best interest.” Some critics have stated this is a gap in our rule. I would challenge such critics to look closer, because Regulation Best Interest reflects common underlying principles consistent with the primary alternatives that have been suggested so far–the Advisers Act fiduciary duty and the DOL’s recent fiduciary rulemaking. At the same time, it is written to be understood by investors and broker-dealers and that takes into account the broker-dealer business model.

“Best Interest” means what it says; you must act in the best interest of your client, and not put your own interests in front of theirs. Beyond that, it is a facts and circumstances determination, not a check-the box compliance exercise. Recognizing that what is in the best interest of one customer may not be in the best interest of another, it analyzes the reasonableness of the match between the recommendation and the needs of the retail customer. The release provides extensive guidance as to what “best interest” means (and does not mean).

This “facts and circumstances” approach is similar to “best interest” approaches under other advice standards, including the fiduciary standard applicable to investment advisers. These approaches do not specifically define “best interest” but provide principles-based guidelines. It is also something broker-dealers should be familiar with under existing obligations. For example, I personally think of it as similar to how a broker-dealer’s best execution obligation is evaluated today when executing an institutional-sized order. This takes into account a number of factors in determining best execution; the relevance and importance of each depends on the facts and circumstances at the time. It is also how the suitability of a recommendation is analyzed today, although as proposed the standard applied would be different, as I will discuss later.

The proposed rule does not use the word “fiduciary.” This is a significant flaw to some critics. But to us, the word “fiduciary” by itself doesn’t tell us much about what the standard means for the particular relationship. As the Commission noted, fiduciary standards vary among investment advisers, banks acting as trustees or fiduciaries, or ERISA plan providers.

Fiduciaries are generally required to act with a duty of care and loyalty towards their clients. Regulation Best Interest incorporates these underlying principles from the Advisers Act. To those who think that this is the key missing standard, please let the Commission know by commenting—and be specific—what is missing from this proposal apart from the word “fiduciary.”

The main difference between the Advisers Act fiduciary obligation and Regulation Best Interest is when each of the obligations will apply. Specifically, Regulation Best Interest applies to each recommendation a broker-dealer makes, whereas an adviser’s fiduciary duty applies to the entire relationship with a client. We think that tying a broker-dealer’s duties to each recommendation—as currently understood under existing broker-dealer regulation—is important for a number of reasons. Among other things, it helps provide clarity as to when a communication is a recommendation to which the duties attach. It preserves and recognizes the varying levels of advice relationships broker-dealers may have, and the differing services they may provide to retail customers. I also want to emphasize that Regulation Best Interest would apply to recommendations to roll over or transfer assets from one type of account to another, such as recommendations to roll over or transfer assets in an ERISA account to an IRA.

Finally, Regulation Best Interest, plus existing FINRA processes, would create a robust framework for enforcing Regulation Best Interest and addressing potential customer harm.

So, what would the broker-dealer making a recommendation have to do to act in the customer’s best interest?

First, we start with a disclosure obligation to address some of the widely documented investor confusion. Of the three requirements in the rule, this is the most incremental of the new obligations, although it will result in change nonetheless. This disclosure obligation is designed to both foster retail customer awareness and understanding of the relationship with the broker-dealer, and enhance the disclosure of material conflicts of interest so that investors can better evaluate recommendations received from their broker-dealers.

The broker-dealer would be required to disclose material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts associated with the recommendation, the services provided, whether the firm is acting in a brokerage or advisory capacity, and fees. These disclosures will build upon the four-page customer relationship summary that the Commission proposed at the same time. The Commission did not propose to mandate the manner that such disclosure would be provided, opting instead to give firms flexibility in how they satisfied this obligation.

Second, a broker-dealer would be required to meet a care obligation that the recommendation is in the best interest of the retail customer. Specifically, a broker-dealer would need to exercise reasonable diligence, care, skill and prudence in making the recommendation. That concept of reasonableness which is found throughout the rule is an important one. Reasonable does not mean perfect advice—a standard that no one can meet. The recommendation also must be in the best interest of the retail customer at the time it is made, rather than being evaluated in hindsight. In other words, the proposal recognizes that there may be circumstances where a broker-dealer’s advice does not work out in hindsight, even though it was reasonable at the time when it was given.

To exercise such reasonable diligence, care, skill, and prudence the broker-dealer would be required to do three things when it recommends a securities transaction or investment strategy to a retail customer.

  • First, the broker-dealer would need to understand the risks and rewards associated with the security or investment strategy, and have a reasonable basis to believe that it could be in the best interest of at least some retail customers.
  • Second, the broker-dealer would be required to match this understanding of the security or strategy to the particular retail customer to form a reasonable belief that the security or strategy is in the retail customer’s best interest. The customer’s investment profile would be developed using the extensive investment profile information that broker-dealers are required to attempt to gather today pursuant to FINRA rules. We thought that the investment profile information that is currently required has worked well, so we did not propose to change it.
  • Finally, the broker-dealer would be required to have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest when taken together in light of the customer’s investment profile.

As is no doubt evident to many of you in the room that are well familiar with suitability, the three components of the care obligation are based on existing reasonable-basis, customer-specific, and quantitative suitability obligations. So, how is this proposed care obligation different?

To be sure, the proposed obligation incorporates existing suitability obligations, but it also enhances them.

Most fundamentally, it explicitly requires that recommendations be in the “best interest.” Among other things, this standard would put greater emphasis on cost and financial incentives as factors in evaluating the facts and circumstances of a recommendation, and whether it is in the best interest and does not put the broker-dealer’s interest ahead of the retail customer’s interest.

Further, the standard would be codified in the Commission’s rulebook and would be directly enforceable by the Commission, and could not be satisfied by disclosure alone. In other words, even if a broker-dealer has mitigated and disclosed its conflicts, its recommendations must still be in the best interest of the retail customer.

Under this obligation, a broker-dealer generally should consider reasonable alternatives, if any, offered by the broker-dealer in determining whether it has a reasonable basis for making a recommendation. We do not mean that a broker-dealer has to analyze all potential alternatives for the retail customer to find the best product available on the market, nor necessarily recommend the least expensive or least remunerative security or investment strategy.

Nor does the regulation prohibit a recommendation from a limited range of products, or recommendations of proprietary products, products from affiliates, or principal transactions.

Of course, by offering only proprietary or other limited range of products a broker-dealer is not freed from its obligation to make a recommendation that is in the best interests of the retail customer. In other words, a broker-dealer would still need to determine that the products available are in the best interest of the retail customer, and if the broker-dealer can’t make that determination, it could not recommend the products.

Moreover, a broker-dealer would not satisfy its care obligation by simply recommending the least expensive or least remunerative security without any further analysis. Depending on the facts and circumstances, it could be in a retail customer’s best interest to allocate investments across a variety of securities, or to invest in riskier or more costly products. Importantly, under this standard, a broker-dealer could still recommend a more expensive security or investment strategy over another reasonably available alternative that it offered, if the broker-dealer had a reasonable basis to believe that the higher cost was justified based on other factors, in light of the customer’s investment profile. This is important in preserving investor choice and ensuring that investments other than the cheapest or least sophisticated can be offered to retail customers.

Finally, and probably the biggest change, would be a new requirement for broker-dealers to address conflicts. The proposed conflict obligations would require broker-dealer to establish, maintain, and enforce policies and procedures reasonably designed to identify and address material conflicts of interest. Specifically, conflicts that are financial incentives would be required to be mitigated and disclosed, or eliminated. All other conflicts would have to at a minimum be disclosed. Today, the obligations under the federal securities laws largely center on conflict disclosure rather than conflict management.

As a practical matter, the vast majority of broker-dealer conflicts would likely be “financial incentives” that would need to be mitigated and disclosed through the conflict and disclosure obligations. The Commission defined financial incentives broadly to cover a wide variety of compensation practices established by the broker-dealer, including quotas, bonuses, sales contests, special awards, differential, or special compensation, and so on. So, for example, if a broker-dealer today provides incentives to its representatives to favor one type of large cap mutual fund over another, the broker-dealer would need to mitigate that conflict, for example, by levelling the compensation for recommending similar funds so that the conflict does not taint the recommendation. This may not be a big change for some firms, but it may be for others.

In framing these conflict obligations, the Commission wanted to provide broker-dealers flexibility to develop mitigation measures based on each firm’s business model, such as the customer base, the nature and significance of the compensation conflict, and the complexity of the product. Mitigation measures could be more or less demanding depending on the complexity of the product, the sophistication of the customer, or the nature of the conflict. Broker-dealers would be free to develop a risk-based compliance and supervisory system. A note of caution is due, however. A firm cannot simply have comprehensive policies and procedures on paper. A firm must also maintain and enforce them.

The flexibility of a principles-based obligation may not provide the bright-line compliance test that some broker-dealers may be looking for. The Commission encourages comment on whether better guidance regarding the parameters of this obligation could help and how to avoid a “gotcha” situation.

Finally, in some cases, the broker-dealer may determine that some conflicts are best avoided, or avoided for certain categories of customers. Some have suggested that we ban sales contests, although some have been banned under FINRA rules for a number of years. The proposal requests comment on whether the Commission should prohibit receipt of certain non-cash compensation. Banning certain non-cash compensation such as sales contests could face what Chairman Clayton has called the “Whack-a-mole” problem—the Commission could ban one practice but not materially improve the advice provided because the practice would pop up elsewhere in a different form. This approach is also similar to an investment adviser’s fiduciary duty, which does not explicitly prohibit particular conflicts of interest.

What we need now

Regulation Best Interest, and the related package of proposals, is an important step forward, but it is only a step. Now we need you to take up the pen, so to speak, and provide us your views. For those of you who cracked the almost 500 pages of Regulation Best Interest, you will see that we asked for your input on a long list of questions—a few of which I have highlighted today. The Chairman recently announced roundtables in four cities to help us gather information. The Office of Investor Advocate is also in the process of performing investor testing, and we anticipate making the results of that investor testing available in the public comment file. The Chairman has also committed to engaging constructively with our fellow regulators, including the Department of Labor, state securities regulators, and state insurance regulators, as well as FINRA, to seek cohesion across the spectrum of investment professionals and products, and to promote regulatory harmonization.

To that end, it would be helpful if firms could provide us data on current industry practices related to advice and how they would change in response to the proposal. I encourage individual firms to consider providing descriptions of their current business practices and compliance systems. Any new and relevant information that we receive in response to this proposal will help improve our understanding of industry practices.

All of this outreach and push for comments and input ties back to what I mentioned at the beginning of my remarks, which are the twin goals of enhancing protection and preserving retail investor choice and access to the brokerage “pay as you go” advice model.

I look forward to the months ahead and working with interested parties on proposed Regulation Best Interest. Thank you for your time today.

[1] The Securities and Exchange Commission (the “Commission”) disclaims responsibility for any private publication or statement of any Commission employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

[2] See Regulation Best Interest, Exchange Act Release No. 83062 (April 18, 2018) (“Regulation Best Interest Proposing Release”); Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles, Exchange Act Release No. 83063 (April 18, 2018); Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. 4889 (April 18, 2018).

[3] See Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011), available at; Request for Data and Other Information: Duties of Brokers, Dealers and Investment Advisers, Exchange Act Release No. 69013 (Mar. 1, 2013), available at; Chairman Jay Clayton, Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers (June 1, 2017), available at See also Regulation Best Interest Proposing Release at I.A.1.

[4] On March 15, 2018, the DOL Fiduciary Rule was vacated by the United States Court of Appeals for the Fifth Circuit. Chamber of Commerce of the U.S.A., et al. v. U.S. Dep’t of Labor, et. al., No. 17-10238 (5th Cir.) (Mar. 15, 2018).

[5] Regulation Best Interest Proposing Release at 235-239.

[6] Id.