From the Buttonwood Tree to Best Interests: Kara Stein’s Very Bad Day


SEC Seal Blog

SEC Commissioner Kara Stein painted a bucolic picture of New York City at the dawn of the country in her remarks at the SEC’s open meeting on the proposed broker-dealer conduct standard. She described a spring day in 1792, where under the shade of a buttonwood tree on Wall Street, a few stockbrokers gathered together and agreed to a brief covenant that was the genesis of the New York Stock Exchange. She described how the move to exchanges fostered investor confidence in the trading of securities and benefited “the entire American economy.”

She did not have such kind words for the proposals that brought the Commission together this week, as she had little good to say about the package of measures put out for comment by a 4-1 vote. According to Commissioner Stein, the broker-dealer proposals failed to provide comprehensive reform or to adequately enhance existing rules. In fact, she quipped, “one might say, the Emperor has no clothes.” In her view, the SEC squandered the opportunity to act in the best interest of investors, and settled for releasing a thousand pages that did little more than to maintain the status quo.

Regulation Best Interest—Isn’t

The commissioner noted what she described as a “widespread concern” that the current regulatory system for broker-dealers, based on a suitability standard, fails to adequately protect investors. In her view, the proposed rules merely reaffirm much of what already exists under FINRA requirements or the federal securities laws. The changes would not serve to prevent harm to investors or allow those who suffer damage to more readily recoup their losses. “With so much we could do to protect retail investors, it’s hard to fathom why we are being asked to vote on this particular proposal today,” she said regretfully.

Commissioner Stein said that the SEC could have proposed a best interest standard, or crafted the rule changes to make the safe harbor for broker-dealers “a floor, instead of a ceiling.” She was disappointed that in her view the proposal merely requires broker-dealers to meet certain minimal performance and disclosure obligations to qualify for the protections of the safe harbor. The SEC could have required broker-dealers to eliminate or mitigate conflicts of interest, instead of being able to satisfy the rule’s requirements by promulgating reasonably designed policies and procedures. The required disclosures could have been subjected to a “full and fair” standard, she suggested, rather than a measure of reasonableness. She summed up her frustration with the proposed regulation by stating that “we could have expected more from financial professionals who provide retail investors with investment advice, for if they are going to give advice in the first place, broker-dealers should truly act in the best interest of their customers given the impact this advice can have on retail investors’ financial well-being.”

Form CRS—A Four-Page Form, a 471-Page Release

Commissioner Stein was slightly less critical of the other parts of the rulemaking proposals, but she still concluded that the rest of the package “nonetheless stops short of proposing meaningful change.Proposed Regulation CRS would require registered investment advisers and broker-dealers to provide a brief “relationship summary” to retail investors to inform them about the relationships and services the firm offers, the standard of conduct and the fees and costs associated with those services, specified conflicts of interest, and whether the firm and its financial professionals currently have reportable legal or disciplinary events. Retail investors would receive a relationship summary at the beginning of a relationship with a firm, and would receive updated information following any material changes.

She doubts that this required disclosure  would stand up to the test of a high-pressure sales situation, and questioned whether if retail investors do indeed find the different standards of care confusing, then a rote recitation of a broker-dealer’s obligations would only part of the way. In her view, for the disclosure to be meaningful, it should provide retail investors with a meaningful understanding of the application of the obligations to them. Investors should be fully apprised, in language they understand, of what the professional’s obligations are and what costs they will incur.

She also takes a “well, yes but …” approach to the rule provision that restricts the ability of a broker-dealer from using the words “adviser” or “advisor” in its name or title when communicating with a retail investor, unless the broker-dealer is a registered investment adviser. It is a good start, she says, but the rule falls short by focusing on preventing the use of two particular words. The Commission should have taken a more principles-based approach, she suggested, and acted to preclude broker-dealers from holding themselves out as investment advisers.

Investment Adviser Interpretation

Commissioner Stein was far less strident in her remarks about a proposed SEC interpretation of the fiduciary duty owed by an investment adviser, as she recognized that “clarification of the law is always a good thing.” She questioned whether it was wise for the SEC to issue interpretive guidance on an area “that is heavily informed by decades of common law.” In addition, she noted that the fact that the proposed interpretation is limited to certain aspects of an adviser’s fiduciary duty under Advisers Act Section 206 of the Advisers Act. By doing so, she wondered whether the SEC might be indirectly suggesting a narrowing of an adviser’s broader fiduciary duties.

Questions Anyone?

In addition to the Commission’s general request for comment, Commissioner Stein posted 20 questions for interested persons to consider during the lengthy 90-day comment period on the rulemaking package. The questions included:

  • general matters, such as whether the SEC should require financial professionals to provide retail customers with investment advice free of conflicts;
  • whether the rules should define what the “best interest” of a retail investor means;
  • how brokers should deal with material conflicts; and
  • matters involving the public Interest and investor protection.

Other Commissioners Too—But Slightly Less So

Commissioners Michael Piwowar, Hester Peirce, and Robert Jackson all voted to release the proposal package for public comment, but none did so with an unqualified endorsement. Commissioner Peirce stated that "the approach we are taking will simply mean a few more pages of unread paper landing in investor trash cans,” and expressed concern about "disclosure overload."

Commissioner Jackson, while supporting the issuance of the proposal, stated that he could not vote for the measures “if we were today considering making them final agency rules.” He expects that the final rules package the Commission will eventually consider will be significantly different from the one that was released for comment. He doubts that the rule proposal in its present state effectively strengthens “the so-called suitability standard that has for so long failed to protect investors from conflicted brokers.” In addition, he expressed displeasure with the lack of economic analysis in the proposing release dealing with the impact of the rules on investors.

Finally, according to Commissioner Piwowar, the proposals “are in need of substantial public input.” He also said that the language is “about as comprehensible to the average reader as Herman Melville’s Moby Dick.”

Readers, judge for yourselves. I give you the tiniest bit of Melville:

Finally, I always go to sea as a sailor, because of the wholesome exercise and pure air of the fore-castle deck. For as in this world, head winds are far more prevalent than winds from astern (that is, if you never violate the Pythagorean maxim), so for the most part the Commodore on the quarter-deck gets his atmosphere at second hand from the sailors on the forecastle.

And now the SEC:

This obligation shall be satisfied if: the broker-dealer or a natural person who is an associated person of a broker-dealer, before or at the time of such recommendation reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation; the broker-dealer or a natural person who is an associated person of a broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence; the broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations …

I think I’m going with the whale.