To some industry ears, 'best interest' may sound like fightin' words

Securities and Exchange Commission Chairman Gary Gensler is pursuing a long list of priorities that befits his reputation as an aggressive regulator.

As you scroll down the agency’s latest regulatory agenda, you’ll notice pending rule proposals for climate change and human capital management disclosures, money market reform, cybersecurity risk governance, proxy voting and custody for investment advisers.

This is only a small slice of the litany of items. Revisiting Regulation Best Interest, the broker-dealer standard of conduct that went into force in June 2020, is not on the list, but it is on Gensler’s radar.

In recent public appearances, Gensler said the agency will monitor Reg BI and make sure it delivers on its promise to curb broker conflicts of interest.

“Best interest needs to mean best interest,” Gensler said in an Oct. 19 discussion with former SEC Commissioner Robert Jackson Jr., hosted by the New York University School of Law. “We have significant tools in examination and across the agency to try to ensure that Regulation Best Interest means just that — when a broker makes a recommendation, it’s in your best interest, the investing public.”

The sharpest tool is enforcement. We’re still waiting for the first major Reg BI penalty to hit. When it does, it will have repercussions not only for the brokerages and registered representatives involved but also for Gensler, who likely will have to face down criticisms of “regulation by enforcement.”

You’ve likely heard the term used in connection with the SEC’s crackdown on inadequate disclosures surrounding the sales of high-fee mutual funds. The agency’s initiative targeted dually registered financial firms whose reps recommended funds with 12b-1 fees to clients in advisory accounts without telling them less expensive share classes were available in the same fund.

The SEC returned $139 million to harmed investors by the time it wrapped up the two-year program in April 2020. Since then, the agency has pursued dozens of additional share-class enforcement actions.

The SEC’s share-class effort drew a sharp rebuke from some parts of the financial industry, led by the Financial Services Institute, which asserted the SEC was engaging in “regulation by enforcement.” That means, according to critics, that the SEC was penalizing financial firms for disclosure violations it never articulated in formal rulemaking or guidance.

Share-class opponents might also paint Reg BI with the same brush, and FSI has already indicated it will watch how the measure is enforced.

Reg BI is principles-based. It does not define “best interest” nor does it specify how a broker can act in a customer’s best interest or mitigate conflicts.

Determining whether a broker is complying with Reg Best Interest will be in the eye of the beholder — an SEC examiner or enforcement staffer. There’s a good chance the target will say the SEC never made clear the activity in question would be a Reg BI violation.

“It doesn’t matter what [Gensler] does, he’ll be accused of regulation by enforcement because we start largely with a blank slate,” said Knut Rostad, president of the Institute for the Fiduciary Standard.

The first enforcement cases related to the Reg BI rulemaking package targeted the lowest hanging fruit, the client disclosure document known as Form CRS. The SEC has fined more than two dozen brokerages and advisory firms for failing to meet deadlines for developing and delivering the document.

The first major substantive violation of Reg BI will be a judgment call by SEC staff. It could spark controversy if the enforcement of Reg BI essentially demonstrates that Gensler and the SEC see ‘best interest’ as a close sibling to — but not the identical twin of — fiduciary duty, the standard investment advisers must meet.

“They’ll want ‘best interest’ in practice to be a nearly functional equivalent of the fiduciary duty that investment advisers owe to their clients,” said Kurt Wolfe, counsel at Quinn Emanuel Urquhart & Sullivan. “The closer they get to interpreting and enforcing the rule that way, the more we’ll hear complaints about regulation by enforcement.”

The tougher the SEC makes Reg BI compliance, the more it will have to steel itself for financial industry blowback.

Take the share-class problem, for example. The violation the SEC largely has focused on is lack of disclosure. What if in future share-class enforcement, under the auspices of Reg BI, the SEC determines recommendations of high-fee share classes shouldn’t have been made in the first place?

“It is the advice that’s not in the best interest of the client, not the lack of disclosure,” Rostad said.

Making sure that “best interest means best interest” is not just felicitous rhetoric. It could spark a fight, and the SEC better be ready to absorb some punches and hit back.