Parallels Between the SEC Regulation Best Interest and the DOL Best Interest Contract Exemption (Part 1)

This is my 90th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The SEC’s proposed Regulation Best Interest (“Reg BI”) is remarkable in its similarities to the DOL’s vacated Best Interest Contract Exemption (“BICE”). This article describes some of those similarities. Keep in mind as you read this that Reg BI applies to securities recommendations, while BICE would have covered any investment or insurance recommendation by a fiduciary advisor.

Reg BI, if finalized, will require that broker-dealers and their representatives act in the “best interest” of “retail customers,” which includes IRA owners and participants. The DOL’s BICE also would have required that fiduciary advisors (including broker-dealers and their representatives) act in the “best interest” of participants and IRA owners. A major difference is that the SEC proposal covers all retail customers, while the DOL’s BICE would have covered “qualified accounts”—which includes only plans, participants and IRA owners. (I should note that Reg BI says that it covers recommendations to “legal representatives” of retail customers. That reference could include the trustees and plan committees for retirement plans. However, it’s not clear.)

Also, Reg BI is similar to BICE in that it covers recommendations to participants to take distributions from retirement plans and roll over to IRAs. Reg BI only applies where securities recommendations are made. But it appears to be the position of both the SEC and FINRA that a recommendation to take a distribution from a 401(k) plan implicitly includes a recommendation to liquidate the investments in the participant’s account, which would be a securities transaction. (I will get into more detail about recommendations to participants to take distributions and roll over to IRAs in a future article.)

In addition, both Reg BI and BICE include a duty of loyalty for recommended securities transactions. While the wording in the two pieces of guidance is slightly different, the outcome is the same . . . broker-dealers and their representatives cannot prioritize their own interests ahead of the interests of investors.

While some people refer to the new standard of care as being “suitability plus” or “enhanced suitability,” I see it differently. Based on my reading of the guidance and on comments by SEC commissioners, the suitability standard is incorporated into the new Best Interest Standard of Care, rather than the other way around. As a result, it might be better referred to as “transactional best interest.”

Unfortunately, the SEC proposal does not fully define the Best Interest Standard of Care. However, it does say that broker-dealers and their representatives have to act with “diligence, care, skill, and prudence,” which was also in the DOL’s Best Interest Standard of Care. (As an aside, the requirement to act diligently, carefully, skillfully, and prudently suggests the need for a process—similar to ERISA’s prudent man rule.) The proposed Reg BI goes on to say that its duty of care is based on the principles in the DOL’s Best Interest Standard of Care. To me, that means that a starting point for understanding the Reg BI requirements is to look at the DOL’s Best Interest Standard of Care which says that:

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.

If you read that closely, it easily divides into three categories: a prudent person rule; a know-your-customer requirement; and a duty of loyalty. The preamble to the proposed Reg BI discusses those three principles as being key elements of its standards.

However, while the proposal would require best interest for recommendations of securities transactions, it would not mandate a duty to monitor. That is significantly different from the role of an investment adviser (RIA), where best interest monitoring is generally expected.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.