SEC's Proposal and Best Interest Regulation: Navigating the Future

1. The SEC Standard of Care Proposal and Best Interest Regulation: Where Do We Go from Here? December 13, 2018

2. Moderated by Featuring Today’s Speakers David Hollingsworth Senior Director, Public Policy & Content Development AALU Bridget McNamara-Fenesy CEO & President M Holdings Securities Jim Lundy Partner Drinker Biddle

3. Don’t ForgetUse the Q&A feature on your control panel to submit questions.

4. What is the State of Play Today?

5. Overview: We Will Discuss - • (1) SEC’s Regulation Best Interest (Reg BI) - Requiring Broker-Dealers to act in a retail customer’s “best interest” when recommending securities transactions and/or investment strategies • (2) SEC’s Interpretative Guidance relating to the fiduciary standard for Retail Investment Advisors • (3) The deceased DOL Rule compared to the new SEC Proposals and FINRA’s Proposed Amendment to the Suitability Rule • (4) State Law proposals regarding the standard of care • (5) ERISA and Internal Revenue Code Fiduciary Standard for Broker-Dealers recommending investments to qualified accounts and IRAs

6. What Is Reg BI? • It is a proposed “Best Interest” standard of care released by the SEC on April 18, 2018 which is attempting to address the confusion investors have regarding the services offered by their broker-dealers, and the standards of conduct applicable to broker-dealers

7. When Does Reg BI Apply? • Reg BI would apply to Broker-Dealers (BD) or Associated Persons (AP) when they make “a recommendation of any securities transaction or investment strategy involving securities” • Specifically, when making their recommendation, the BD or AP must: • (1) act in the “best interest” of their “retail customers” and • (2) Not place their own financial or other interest before their customer’s interest • A retail customer is defined within the proposed rule as a person, or the legal representative of such person, who receives the BD’s or AP’s recommendation and uses it “primarily for personal, family or household purposes”

8. How Do Broker-Dealers and Associated Persons Satisfy Their “Best Interest” Obligations? • To demonstrate that a BD and AP have acted in the customer’s best interest, Reg BI requires they satisfy three obligations: • (1) Disclosure • (2) Care • (3) Conflict of Interest

9. There are two basic things a BD and AP must disclose before making a recommendation: (1) Material facts relating to the BD’s and AP’s scope of services and terms of relationship with their customer (2) All “material” conflicts of interest relating to the BD’s and AP’s recommendation These two disclosures must be enhanced and in writing Obligation One: Disclosure

10. For purposes of Regulation Best Interest, we propose to interpret a “material conflict of interest” as a conflict of interest that a reasonable person would expect might incline a broker-dealer – consciously or unconsciously – to make a recommendation that is not disinterested Reg BI Definition of Material

11. Obligation Two: Care • A BD and AP must also exercise reasonable diligence, care, skill and prudence to: • (1) Understand the potential risks and rewards associated with their recommendation & have a reasonable basis to believe it could be in the best interest of some customers • (2) Have a reasonable basis to believe that a recommendation is in the best interest of a particular retail customer based on that customer’s investment profile and the potential risks and rewards associated with the recommendation • (3) Have a reasonable basis to believe that a series of recommended transactions is not excessive and is in a retail customer’s best interest

12. The Care Obligation Seems Familiar…… • The sources for Reg BI’s “Care Obligation” appear to include FINRA’s suitability concepts: • reasonable basis suitability • customer-specific suitability • quantitative suitability • One difference between Reg BI and the present Rule 2111 concerns quantitative suitability • While a broker under present Rule 2111 only has an obligation where the broker has actual or de facto control over a customer’s account, Reg BI would impose this obligation to all recommendations a broker makes, irrespective of any control

13. The Suitability Rule Is Under Review for A Change to Match Reg BI • On April 29, 2018, within days of the SEC’s proposed Reg BI, FINRA opened for comment a proposal to amend the present Supplementary Material to FINRA’s Suitability Rule (Rule 2111) • The proposed change would eliminate the present Rule 2111 requirement that a broker have actual or de facto control over a customer’s account for the quantitative suitability to apply. Like the proposed Reg BI, the new Rule 2111 would impose this obligation to all recommendations a broker makes, irrespective of any control • The comment period for the proposed amendment closed on June 19, 2018

14. Two Basic Requirements BDs must create and enforce written policies and procedures that are reasonably designed to: (1) identify and disclose or eliminate material conflicts of interest stemming from a recommendation (2) disclose and mitigate, if not eliminate, material conflicts of interest arising from financial incentives associated with a recommendation Obligation Three: Conflict of Interest

15. What Is A Conflict of Interest? The SEC Has Said…as to Recommendations - “We preliminarily believe that a material conflict of interest that generally should be disclosed would include material conflicts associated with recommending: • Proprietary products, products of affiliates, or limited range of products • one share class versus another share class of a mutual fund • securities underwritten by the firm or a broker-dealer affiliate • the rollover or transfer of assets from one type of account to another (such as recommendations to rollover or transfer assets in an ERISA account to an IRA, when the recommendation involves a securities transaction) • allocation of investment opportunities among retail customers (e.g., IPO allocation)”

16. What Is A Conflict of Interest? The SEC Has Said…as to Financial Incentives - “For purposes of the Conflict of Interest Obligation in paragraph (a)(2)(iv), we preliminarily believe that material conflicts of interest arising from ‘‘financial incentives’’ associated with a recommendation generally would include, but are not limited to: • Compensation practices established by the broker-dealer, including fees and other charges for the services provided and products sold • employee compensation or employment incentives (e.g., quotas, bonuses, sales contests, special awards, differential or variable compensation, incentives tied to appraisals or performance reviews)

17. What Is A Conflict of Interest? The SEC Has Said…as to Financial Incentives - (cont’d.) • compensation practices involving third parties, including both sales compensation and compensation that does not result from sales activity, such as compensation for services provided to third-parties (e.g., sub-accounting or administrative services provided to a mutual fund) • receipt of commissions or sales charges, or other fees or financial incentives, or differential or variable compensation, whether paid by the retail customer or a third-party; sales of proprietary products or services, or products of affiliates • transactions that would be effected by the broker-dealer (or an affiliate thereof) in a principal capacity

18. The 2018 FINRA Examination Priorities included the following: “Employer-sponsored retirement plans play a critical role in many individuals’ retirement planning and for this reason will be an important area of focus for FINRA. In this regard, FINRA will focus on the suitability of firms’ and registered representatives’ recommendations made to plan participants, including individual Retirement Account rollover recommendations involving securities transactions. FINRA will also review the supervisory mechanisms firms establish for these recommendations” FINRA on Conflict of Interest

19. In Sum Regarding Reg BI • With respect to Reg BI it is important to understand what it does not do: • (1) Impose a traditional fiduciary standard on BDs and APs or • (2) Seek a uniform standard for BDs and RIAs • Moreover, it appears that following all three of Reg BI’s obligations may provide BDs with a “safe harbor”

20. Proposal Comparison

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25. The SEC issued proposed interpretive guidance in an effort to clarify the common law fiduciary standard for RIAs The Investment Advisers Act of 1940 does not contain the word “fiduciary” This fiduciary standard applicable to the investment advisory industry started with a U.S. Supreme Court opinion and evolved from there In SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the Supreme Court held that: An investment adviser is a fiduciary, and as such is held to the highest standard of conduct and must act in the best interest of its client The SEC’s proposed guidance clarifies that two fundamental duties RIAs need to fulfill to satisfy their fiduciary obligation to their clients are: A Duty of Care, and A Duty of Loyalty Overview of The Fiduciary Standard Relating to RIAs

26. The SEC’s guidance focuses on three aspects of the Duty of Care 1) Duty to Provide Advice that is in the Client’s Best Interest: • RIA’s must “make a reasonable inquiry into a client’s financial situation, level of financial sophistication, investment experience, and investment objectives” • To this end, the RIA must provide personalized advice that is suitable for the client based upon the client’s investment profile, meaning the RIA must take into account the client’s risk tolerance and financial sophistication • Some other factors an RIA must consider are: cost, liquidity, volatility, potential benefits. • This best interest duty aligns with the “Care Obligation” of Reg BI in its 2nd subsection, which can be traced to FINRA customer-specific suitability Duty of Care – Duty to Provide Advice in The Client’s Best Interest

27. 2) Duty to Seek Best Execution Where the RIA has the responsibility to select BDs to execute transactions, the RIA has a duty to seek best execution of the client’s transactions The RIA satisfies this duty by executing transactions with the goal of maximizing value for the client Maximizing value means more than simply minimizing costs Instead, an RIA should consider “the full range and quality of a broker’s services, including, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser” Duty of Care – Duty to Seek Best Execution

28. 3) Duty to act and Provide Advice and Monitoring over the Course of the Relationship An RIA is obligated to provide ongoing advice and services during the course of the client relationship How often the RIA needs to give the advice needs to be consistent with a client’s best interest and the scope of the services the RIA provides The length of the relationship between the RIA and the client is particularly important Duty of Care – Duty to Act and Provide Adviceand Monitoring

29. Duty of Loyalty – Obligations The Duty of Loyalty Requires an RIA to “put its client’s interests first” This translates into several obligations: 1) An Investment Advisor Cannot Favor its Own Interests Ahead of its Clients’ • Cannot Favor Certain Clients or Accounts that Pay Higher Rates over Lower Paying ones 2) An Investment Advisor Cannot Favor Certain Clients over Others • For example, the trade allocation must be fair and the process fully disclosed

30. Duty of Loyalty – Obligations 3) An RIA must Avoid Conflicts of Interest and Fully and Fairly Disclose Existing Conflicts • Any disclosure “must be clear and detailed enough for a client to make a reasonably informed decision to consent to such conflicts and practices or reject them” • For example – if a conflict actuallyexists, its not enough to say itmayexist 4) Informed Consent May by Implicit or Explicit • An RIA may never infer or accept consent where (i) the facts and circumstances indicate that the client did not understand the nature and import of the conflict, or (ii) the material facts concerning the conflict could not be fully and fairly disclosed

31. RIA Request for Comments Re Enhanced Regulation • This proposal also seeks comments regarding areas where the broker-dealer framework provides investor protections that may have not have counterparts in RIA regulations • Specifically, the Commission requests whether: 1) RIA reps should have federal licensing and continuing education requirements 2) RIAs should be required to provide periodic account statements (directly or indirectly via the custodian) – while this request acknowledges that many RIAs provide this service – RIAs are not currently required to do so under the federal securities laws 3) RIAs should be subject to net capital or other financial responsibility requirements to meet their obligations, including whether the custody and other rules adequately address these issues

32. In Sum regarding the SEC’s Interpretive Guidance for RIAs • This proposal and that way it is structured is very novel • It is the shortest of the proposals by far, but it is the first official attempt by the Commission to propose and provide guidance and clarification of this fiduciary standard • It does not appear to be a rulemaking proposal though – so it is unclear if this will turn into rulemaking under the Investment Advisers Act of 1940 • That said, it does not profess to be altering the standard of care applied to RIAs, but rather attempts to clarify and guide • But it does seek to differentiate RIAs from BD and APs, but there are aspects of Reg BI and this IA Standard that indicate a convergence

33. Proposed Client Relationship Summary (Form CRS) • Must be delivered to the investor before or at the time (1) a new account is opened; or (2) changes are made to the investor's existing account(s) • Must be no more than four (4) pages in length, and must include specific disclosures: • Introduction - Comparison • Relationship and Services - Conflicts of Interest • Obligations to the Investor - Additional Information • Summary of Fees and Costs - Key Questions • Form CRS has received criticism from all sides . . . will the SEC shift the burden?

34. AALU Engagement – Comment Letter & SEC Meetings AALU Key Points – SEC Meetings:  • The life insurance industry has unique characteristics in terms of business models in the financial services industry. Life insurance business models and products add value for consumers. • The current regulation of the sale of variable life insurance and annuity products works well and protects consumers—it is not broken and does not need a makeover. • Commission-based compensation is appropriate and delivers the most value for some consumers depending on their particular goals and circumstances. • A significant departure from the current regulatory structure will be costly for life insurance firms and will ultimately result in reduced choice and access to professional financial advice for consumers.

35. SEC Proposal – Key Issues Outstanding • Key Issues • Proposal Oriented Towards Wirehouse BDs – Not Life Insurance BDs • Conflicts of Interest • Mitigation/Disclosure • Compensation/Sales Contests • Form CRS • Restrictions on Titling

36. What Do The States Have to Say about The Standard of Care?

37. What Do The States Have to Say about The Standard of Care?

38. What Do The States Have to Say about The Standard of Care?

39. What Do The States Have to Say about The Standard of Care?

40. Next Steps and 2019 Outlook • SEC Standard of Care Proposal • State Best Interest/Fiduciary Regulation and Legislation • Marketplace Outlook  • AALU Activity

41. Questions? David Hollingsworth Senior Director, Public Policy & Content Development hollingsworth@aalu.org (202) 742-4589