SEC’s Clayton hits back at Reg BI critics

BOSTON — Jay Clayton has a few choice words for the many criticisms that fiduciary and investor advocates have leveled against his signature package of broker and advisor regulations.

Among them: "nonsense," "misleading" and "wrong."

In an address here at Babson College, Clayton, the SEC's chairman, offered a point-by-point defense of Regulation Best Interest and other elements of the regulatory package that the commission approved last month in a 3-1 vote.

"I believe that much of this criticism, which is focused broadly on the extent of the investor protections under Reg BI and our fiduciary interpretation, is false, misleading, misguided and, unfortunately, in some cases, is simply a policy preference disguised as a legal critique," he said.

His detractors, meanwhile, are returning fire —another sign that advisor standards of conduct remain hotly contested terrain.

Zach Gibson/Bloomberg

In his rebuttal, Clayton pointed to the additional steps that Reg BI requires brokers to take regarding their conflicts, which he says are drawn from the well-established fiduciary duty that governs investment advisors. Those include the obligation to mitigate conflicts that could incentivize brokers to put their interests ahead of their clients, restrictions on how firms promote proprietary products, and a ban on short-term sales contests.

"Disclosure alone is not enough," Clayton said. "It's not enough under the fiduciary duty. It's not enough under Reg BI."

Clayton has repeatedly made the case that while Reg BI borrows from fiduciary principles, it appropriately refrains from imposing full-fledged advisor-like regulations on a brokerage industry where client relationships, he argues, are essentially transactional. So while clients looking for a more holistic, financial planning service might be drawn to the advisor model, where fees typically are collected as a portion of assets under management, a buy-and-hold investor who simply wants episodic advice on a particular stock or bond is best served by a broker who works under commission.

But to critics of the rule, there was something off about Clayton's remarks in Boston.

"[I]t is rather extraordinary that the chairman's first big speech on this new regulatory package is a defensive, point-by-point rebuttal of his critics," Barbara Roper, director of investor protection at the Consumer Federation of America, writes in an email. "That speaks volumes right there."

In Clayton's speech, Roper hears "a series of straw man arguments" that she says the chairman offered "in order to avoid answering the real criticisms of the rule."

"Barb understates it," says Knut Rostad, president of the Institute for the Fiduciary Standard. "'Grossly misleading' gets closer — on items on which he should know better."

On Clayton's point about disclosure, Roper contends that he was misstating critics' argument.

"I don't think anyone has suggested that these standards can be satisfied through disclosure alone," Roper says. "We certainly haven't, though we have criticized the commission for relying too heavily on disclosure in instances where it is not adequate to address the risk of investor harm."

The disagreements are fundamental. Clayton, for instance, claims that "Reg BI substantially enhances the standard of conduct for broker-dealers."

Roper counters that by not extending fiduciary requirements such as the obligation to monitor a customer's account or an ongoing duty of care, the commission actually eroded the standards of broker conduct set by courts and arbitrators.

This is particularly true in client relationships "that brokers aggressively market as relationships of trust and confidence," Roper says.

So while legal precedent may have compelled brokers in the past to embrace fiduciary responsibilities for those clients, "they will be less likely to do so when brokers can point to a rule that explicitly states they have no such obligation," according to Roper.

"This is an area where the rule isn't just too weak, it actually weakens protections investors currently get," she says.

Rostad also sees the rule as giving too much latitude to brokers to determine when conflicts must be mitigated or when they can get by simply with disclosures.

"Reg BI lets BDs basically decide if conflicts must be mitigated," he says. "To then suggest BDs' conflicts will often be mitigated is to believe in the Tooth Fairy."

Clayton also addressed the frequently repeated criticism that in drafting Regulation Best Interest, the commission failed to offer a definition of the term "best interest."

Some commentators called for a "detailed, specific, situation-by-situation definition of best interest in rule text," Clayton said.

"We considered this issue very carefully," Clayton said. "We tried it; our view was that the best approach would be to apply the specific component obligations of Reg BI, including the best interest requirement and the care obligation in a principles-based manner."

The result, he says, is a rule that establishes objective criteria against which brokers' recommendations can be evaluated, but one that avoids an overly prescriptive approach that would be a poor fit in an industry "where the facts and circumstances of individual relationships can vary widely and change over time."

Roper again sees a straw man argument. No one in her camp was asking the commission to require brokers to recommend the single best security, and no one was asking it to lay out the level of "situation-by-situation" specificity that Clayton described, she says.

Instead, she and other critics wanted the SEC to include language that would have directed brokers to narrow the range of investments deemed reasonable to winnow out the ones with inappropriate costs, risk profiles or performance histories.

"And the SEC wouldn't even say they should do that," she says. "In short, it's not just that they didn't define 'best interest.' The problem is that there's no 'best' in their best interest standard, and it is misleading to apply the best interest label."