The Securities Litigation Expert Blog

SEC Regulation Best Interest - The Five-Part Test

Posted by Jack Duval

Aug 1, 2018 8:51:34 AM

This post continues my blog post series on SEC Regulation Best Interest.

A note to long-time readers of this blog:  You may have noticed that I haven’t been posting for a while.  This is due to the launching of my RIA firm Bantam Inc.  I have posted over 20 blog posts on that site in the past three months.  They cover investments and should be of interest to anyone involved with securities litigations.  There are also many posts with attorney-related content.  You can find those here.

 

Accelerant SEC Regulation Best Interest - five-part test

 

The SEC Regulation Best Interest Standard

One of the most significant changes from the FINRA suitability regime to SEC Regulation Best Interest (“RBI”) is a move from subjectivity to objectivity. 

While there are some objective elements to suitability, such as what needs to be included in a client profile, the actual suitability determination is subjective.  This will change under RBI.

What the SEC has proposed is not only a new standard of best interest, but a five-part test to satisfy that standard.

The SEC defines the best interest standard as follows:[1]

The proposed standard of conduct is to act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer.

The Five Elements to Satisfy the Best Interest Standard

The SEC then lays out the five elements that must be met in order to satisfy RBI:[2]

This obligation shall be satisfied if:

  1. 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;
  2. (Disclosure of) all the material conflicts of interest associated with the recommendation;
  3. 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;
  4. The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all conflicts of interest that are associated with such recommendations, and;
  5. The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations. (Emphasis added)

A few quick points on the Best Interest standard.

First, one similarity between RBI and FINRA suitability is that both are recommendation-based rules.  This means the best interest obligation is episodic and only arises at the time of the recommendation.  (As with FINRA suitability, the exception to this arises from an explicit recommendation to hold.[3])

This is a critical distinction between RBI and the fiduciary standard to which registered investment advisors are held.  A fiduciary is held to the best interest standard in all their dealings with the client, not just for recommendations.  Also, the fiduciary standard is continuous and operates throughout the relationship, not just when recommendations are made.

Retail Customers

Second, RBI applies to “retail customers” which only includes individuals (and their trusts and IRA accounts) and not to any business entities they may own.  The SEC defines a retail customer as:[4]

“… a person, or the legal representative of such person, who: (1) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer or a natural person who is an associated person of a broker or dealer, and (2) uses the recommendation primarily for personal, family, or household purposes.”

The Commissions preliminarily believes this proposed definition is appropriate, and in particular, the limitation to recommendations that are “primarily for personal, family or household purposes,” as we believe it excludes recommendations that are related to business or commercial purposes, but remains sufficiently broad and flexible to capture recommendations related to the various reasons retail customers may invest (including, for example, for retirement, education, and other savings purposes).

There is no such distinction under the fiduciary standard.  Under RBI, business accounts would come under the FINRA suitability rules.

In my next post, I will unpack the five elements that must be satisfied.

Note to securities litigators:  I am working on a white paper on RBI and as part of that have been conducting a survey of attorneys involved with customer disputes.  If you would like to participate in the survey (it’s only six questions), please send me an email at: jack@accelerant.biz to schedule a call.

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Notes:

[1]           SEC Regulation Best Interest; Release # 34-83062; April 18, 2018; 1.

[2]           Id. at 1-2.

[3]           Id. at 82.  “The Commission proposes to apply Regulation Best Interest to recommendations of any securities transaction (sale, purchase, and exchange) and investment strategy (including explicit recommendations to hold a security or regarding the manner in which it is to be purchased or sold) to retail customers.”  Emphasis added.  Notes omitted.  FINRA has identical language under Regulatory Notice 12-25 at Q7.

[4]           Id. at 83-4.  Notes omitted.

For information about SEC Regulation Best Interest expert Jack Duval, click here.

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Topics: fiduciary duties, SEC Regulation Best Interest, FINRA, Investment Suitability, Best Interest five elements

The Historical Origins of Fiduciary Duties

Posted by Jack Duval

Jun 21, 2018 8:36:41 AM

This post continues my blog post series on fiduciary duties and the changing regulatory landscape around a unified fiduciary standard of care for investors.

Accelerant - Jack Duval - Fiduciary Duties Expert Witness

Statue of Cicero

Given the tremendous amount of ink that has been spilled regarding the DOL Fiduciary Rule and now SEC Regulation Best Interest, I thought it would be useful to review the existence of fiduciary rules throughout history.

The idea of a fiduciary duty has existed from the beginning of humanity’s codification of the rules by which it would live.  Indeed, fiduciary duties have been central to the functioning of societies from ancient to modern times and from East to West.

In the most simple terms, a fiduciary duty arises when one person relies on another to perform a task or service for them.  The duty arises from the dependence of the one on the other.  In more modern language, trust and confidence is being reposed by the principal in the agent to carry out the agreed upon work.

Fiduciary Duties Throughout History

Perhaps the first known fiduciary duties exist in Hammurabi's Code from 1790 BC.[1]

Rules of agency, reflected in Hammurabi’s laws, developed along with commerce in Ancient Mesopotamia.  The laws primarily discuss situations in which a tamkarum, or principal/merchant, gives a samallum, or agent, either money to use for travel and for investments or purchases, or goods for trading or selling.

The Bible also has many fiduciary-related quotes, the most famous of which may be:[2]

No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other.  Ye cannot serve God and mammon.

Jumping to the East, somewhere between 475 and 220 BC, Confucius wrote in The Analects a heuristic for fiduciaries: “In acting on behalf of others, have I always been loyal to their interest?”[3]

From Ancient Greece, Plato’s Republic could be read as a metaphor for the fiduciary duties of leaders to their constituents, and the whole education process of philosopher-kings as instilling these virtues. 

The Roman’s coined the term “fiduciary” in their laws and defined it to mean:[4]

a person holding the character of a trustee, or a character analogous of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires.

Cicero also wrote of fiduciary obligations between agent and principal, known by the expressive terms: “mandatory” and “mandator”, respectively.  “An agent who shows carelessness in his execution of trust behaves very dishonorably and ‘is undermining the entire basis of our social system’.”[5]

Making a great leap across time, we come to Anglo-American law and the English Courts of Equity.  Scholars Aikin and Fausti write:[6]

Courts of Equity granted relief in numerous circumstances involving one person's abuse of confidence and, over time, concrete rules and precise terms related to fiduciary relationships began to form as Equity evolved.

The term "fiduciary" itself was adopted to apply to situations falling short of "trusts" but in which one person was nonetheless obliged to act like a trustee.

The second point makes sense because in non-trust fiduciary situations, the principle still owns the property, whereas in the trust situation, ownership of the asset(s) have been transferred to a trust which the trustee oversees.

Lastly, we get to American Law and Benjamin Cardozo, who, in Meinhard v. Salmon, wrote what are probably the most cited words on fiduciary duties:

Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties.  A trustee is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.  As to this there has developed a tradition that is unbending and inveterate.  Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the "disintegrating erosion" of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher that that trodden by the crowd.  It will not consciously be lowered by any judgment of this court.

Interestingly, the undermining of “the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions” is what is now contemplated in SEC Regulation Best Interest.  The SEC seeks to dress up FINRA suitability rules in the raiment of fiduciary language without the “uncompromising rigidity” of fiduciary law.

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Notes:

[1]       Keith Loveland, JD, AIFA, CIDA.  Available at: http://solisinvicti.com/books/Law/Fiduciary%20Law.pdf.  Accessed June 19, 2018.

[2]       Matthew 6:24; KJV.  Available at: http://biblehub.com/kjv/matthew/6.htm.  Accessed June 19. 2018.

[3]       Confucius; The Analects; Translated by Arthur Waley; Routledge; London and New York; 1938; 84.

[4]       Blain F. Aikin et al; Fiduciary: A Historically Significant Standard; B.U. Law Review; 158.  Available at: https://www.fi360.com/main/pdf/BULawReview_AikinFausti_Fall2010.pdf; Accessed June 21, 2018.

[5]       Id.

[6]       Id. at 159.

For information about fiduciary expert Jack Duval, click here.

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Topics: fiduciary duties, SEC Regulation Best Interest, FINRA, dol fiduciary rule, Investment Suitability

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