Broker reps warn NASAA conduct rule goes beyond Reg BI

In proposing modified conduct standards for broker-dealers, a state regulators group maintains it's merely trying to mirror federal rules.

But industry representatives warn that a new proposal from the North American Securities Administrators Association would go well beyond existing regulations. Among other things, they think the group representing state industry watchdogs is seeking to ban almost all forms of broker-dealer compensation save for commissions. They're also worried that the proposal could make any sort of statement about investment options — including advertisements — a recommendation that triggers brokers' obligation to look out for clients' best interests.

The concerns come in response to NASAA's proposal on Tuesday to make various changes to its model business practices rule, officially known as the "Dishonest or Unethical Business Practices of Broker-Dealers and Agents" policy. In the main, the modifications are meant to bring a model regulation that NASAA holds out for adoption by states in line with the federal government's Regulation Best Interest conduct standard for broker-dealers.

Reg BI calls on brokers to never put their own interest ahead of their clients' and to disclose unavoidable conflicts of interest. Ever since Reg BI's adoption in June 2019, NASAA has been looking to incorporate it into its own model rules for conduct — which states are free to adopt in whole, in part or not at all.

Steve Bouchard, the chair of NASAA's broker-dealer section committee, said the proposal draws from both the original Reg BI rule and various guidance documents the Securities and Exchange Commission has since released to help brokers remain in compliance. Rather than go beyond what the SEC intended, he said, NASAA is merely clarifying certain terms and practices in the context of the 3-year-old federal regulation.

"We're really just trying to ensure that Regulation Best Interest is a conduct standard that lives up to its name," Bouchard said.

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NASAA's proposal on investment recommendations, for instance, is meant to "provide greater regulatory certainty regarding a key term." Under the model rule, brokers would be making a recommendation triggering their obligations under Reg BI anytime they used "any means, method or mechanism to feature or promote an account type, specific security, or investment strategy to a retail customer, whether directly or through a third-party."

Questions over when brokers are making actual recommendations, rather than merely listing investment options, figure at the center of a recent court battle between the popular brokerage Robinhood Markets and one of the most aggressive state securities regulators. Massachusetts Secretary of the Commonwealth William Galvin sued Robinhood in December 2020 over allegations that the firm had not taken care to make sure investment options it was presenting to customers could be reasonably considered in their best interests.

Galvin said he refused to buy Robinhood's argument that the only thing its online brokerage was offering to in-state investors was investing options rather than actual recommendations. The Massachusetts Supreme Judicial Court sided with Galvin in August in a decision upholding his right to subject in-state broker-dealers to a stricter code of conduct. 

The decision has been hailed as opening the door for other states to adopt tougher rules for broker-dealers in their jurisdictions. But Bouchard said he doesn't think NASAA's proposed model rule would necessarily mean that all investing options listed by Robinhood and other brokers would become recommendations triggering Reg BI obligations.

"I think the question is still being developed in the law and really requires a facts and circumstances analysis," he said. "We are not prejudging in this provision what kind of digitally enhanced programs or artificial intelligence tools might rise to the level of a recommendation."

Mark Quinn, the director of regulatory affairs at the financial services firm Cetera Financial Group, has a different reading of the proposal. Originally, Quinn said, Reg BI was meant to apply only to brokers who had issued a "call to action" to someone who had come to them for investing advice.

NASAA's interpretation, he said, could extend the conduct standard to anyone advertising investment options on TV and in print.

"If JPMorgan runs a television commercial saying their short-term fixed-income fund is a good investment, is that a recommendation?" Quinn said. "That's a big leap."

Quinn said he thinks NASAA's proposal regarding broker-dealer compensation also goes beyond what was contemplated in Reg BI. NASAA's model rule explicitly would not bar brokers from receiving commissions, which it deems "the compensation model that is inherent to the broker-dealer model (and consequently cannot be avoided or eliminated altogether, but which can be mitigated)."

But the model rule states brokers "will be presumed" to have placed their financial interests ahead of clients' if they take part in sales contests or receive performance-related bonuses or forms of non-cash compensation.

Quinn said sales contests haven't been used in the industry for 10 years or more, so NASAA's proposed ban on them is immaterial. He's more concerned the proposal could eliminate the common industry practice of revenue sharing, in which mutual funds pay a portion of their earnings to brokers who offer their products to clients.

NASAA's proposal states that extra forms of compensation would not be banned under the new conduct standard. But, "firms will need to rebut the presumption that they are placing their financial interests ahead of their customers when they affirmatively choose to engage in these conflicts."

Quinn said the industry has long dealt with revenue sharing by simply making sure investors know how the system works.

"If the whole world is doing it, then that is something that can be handled with disclosure," he said.

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Allison Mutschler, a spokesperson for the Financial Services Institute, said her organization is still reviewing the proposal.

"Any deviations from Reg BI are likely to create unnecessary complexity and cost without improving investor protection," she said in an email.

The rule would also adopt Reg BI's prohibition on brokers holding themselves out to the public as "advisors." Registered investment advisors are held to the fiduciary conduct standard, which pledges them to always put their clients' interests first and is generally viewed as being stricter than Reg BI.

Knut Rostad, the president of the Institute for the Fiduciary Standard and a critic of Regulation Best Interest, said if NASAA's proposal adds anything to Reg BI, it's some much needed clarity. 

"The original rule was written intentionally to be unclear," he said. "So the objection now really is that brokers will put up against clarity as opposed to ambiguity."

Regulators have been slow to bring enforcement actions alleging Reg BI violations in the little more than three years that the new rule has been in effect. The latest case accused a Red Bank, New Jersey-based firm of not having supervisory systems in place to prevent excessive trading in clients' accounts. 

NASAA proposal, which the public now has until Dec. 4 to comment on, was released the same day as the latest results of an ongoing study attempting to gauge how well firms are doing at abiding by Reg BI. NASAA's general conclusion was that broker-dealers have made improvements but could still be doing quite a bit better. 

The study, for instance, found that brokers could be taking more steps to avoid conflicts of interest and to present reasonable alternatives to any recommended investments. It also said that firms could do more to look for low-cost, straightforward alternatives to complex products like nontraded real estate investment trusts and variable annuities.

Previous rounds of the study had made the situation sound much more dire, warning too many brokers "are still placing their financial interests ahead of their retail customers in violation of the rule's chief directive." The latest results, compiled from examinations of more than 200 offices in 25 states, suggest that, "Efforts to address the standard of care concepts established by Reg BI remain perfunctory. In short, more work needs to be done to truly elevate the standard of care for retail customers."

Bouchard said the findings from the recent exams influenced NASAA's proposal for incorporating Reg BI. He said most states now use some form of NASAA's model rule for broker conduct, and he expects most will also adopt the proposed changes as well.

"At the very least," he said, "this serves as a best-practices guide for states."