The Securities and Exchange Commission just finalized the rule it proposed last year about this time. Although the rule itself is quite short (some seven pages, double-spaced), it is ensconced in some 770 pages of other documents and interpretations that supply a great deal of context to those seven pages. The rule is effective in July of this year, but for practical purposes broker-dealers and advisers will have until June 30, 2020 to bring their practices and procedures into compliance.
This is what the rule is and what it is not:
The rule applies only to recommendations relating to the sales of securities and not to insurance products or other types of investment recommendations
It is not a fiduciary rule like the one under ERISA. It does not hold advisors or advisers to the higher standards of ERISA. It does not create any new rights or remedies but rather relies on the existing securities laws statutory or regulatory scheme, such as FINRA rules for the arbitration of claims.
The rule does not apply at the plan level. This means 401(k) sponsors are not protected when they change providers or when they set up their plans. The rule, however, applies at the participant level and to self-employed individuals.
The rule puts brokers under the yoke of a four-part “general obligation” having the following components:
A disclosure obligation that applies at the time of the recommendation requiring the broker to disclose that it is acting as a broker and not as an investment adviser and revealing the material costs of the recommendation, the type and scope of services that will be provided, and a description of material facts relating to conflicts of interest that are associated with the recommendation.
A “care obligation” that requires the broker to exercise “diligence, care, and skill” when it recommends a transaction or series of transactions. Notably the rule omits the fiduciary word of “prudence” that was in the proposed rule text. The subcomponents of this obligation are generally those of the old suitability requirements under FINRA Rule 2111, imposing on the broker-dealer the obligation to understand the risks, rewards and costs of their recommendation, to have a reasonable basis to believe the recommendation is in the best interests of the customer based on the customer’s investment profile and to not place the interests of the broker ahead of those of the customer.
A conflict avoidance obligation that requires broker-dealers to establish written policies and procedures that identify and address conflicts of interest either by disclosing or eliminating them. The goal of this obligation is to remove incentives that cause brokers to make not-in-best-interest recommendations, such as sales contests tied to the sale of specific securities.
A compliance obligation that requires broker-dealers to maintain and enforce written policies and procedures reasonably designed to achieve compliance with the new rule.
Whether the care obligation together with the other parts of the “general obligation” imposes a higher standard of conduct on brokers than is required under the old suitability rules will likely depend on how the interplay of these obligations sorts itself out in future guidance, FINRA arbitrations, and in litigation. Regardless broker-dealers have much work to do in the next 12 months in shoring up their practices and procedures in reaction to the rule and avenues of attack are opened to inventive plaintiffs’ attorneys who will seek to exploit compliance failures.
In the meantime, the Labor Department is working on a replacement fiduciary rule for the one that was vacated by a federal appeals court in Louisiana last year. That rule is expected to be issued later this year and will be coordinated with the new SEC rules.
In my next post, I’ll talk about the challenges of the rule and the strategies 401(k) plan sponsors can employ to address them.
Chuck Humphrey is principal of Law Offices of Charles. G. Humphrey and can be reached at firstname.lastname@example.org at 716-465-7505. He is the author of the Fiduciary eSource available at ERISApedia.com.