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Broker-Dealers Rebuked for “Web of Toxic Incentives” in Congressional Hearing on Reg BI

By Rita Raagas De Ramos March 15, 2019

The broker-dealer business model is broken and won’t be fixed by the SEC’s proposed Regulation Best Interest. That was the picture painted by all but one of five witnesses called to testify on the effectiveness of the proposed rule at a Congressional hearing Thursday.

“The brokerage business model, with all of these and other perverse incentives, is set up to pit broker against client. These incentives reward bad advice that harms investors. What’s truly shocking is that brokers are allowed to engage in harmful conflicts of interest all while leading investors and policymakers to believe they are trusted financial advisors who will do what’s best for investors,” Dina Isola, investment advisor representative at Ritholtz Wealth Management said at the hearing.

The broker-dealer industry is “caught up in a web of toxic incentives,” Isola added at the hearing before the U.S. House of Representatives Financial Services Committee’s Subcommittee on Investor Protection, Entrepreneurship and Capital Markets. The hearing was called to examine whether the proposed Reg BI does indeed put investors first, as claimed by the regulator.

Isola, who stressed that she acts as a fiduciary in her capacity as an investment advisor, said her critical comments of the broker-dealer industry are rooted in her own experience working for brokerage firms earlier in her career, which started 30 years ago.

The brokerage business model, with all of these perverse incentives, is set up to pit broker against client.
Dina Isola
Ritholtz Wealth Management

“At a brokerage firm I worked at, it was customary for brokers to scramble to transact business at month end that would count towards that month’s production. For some it could mean the difference between being employed or let go,” she said.

Isola said top-selling brokers and managers were rewarded with gifts and trips to exotic locations like Monte Carlo.

“With these perverse incentives, brokers routinely would make sales recommendations in order to win sales contests, hit quotas, and get to the next rung on the payout grid, regardless of whether their recommendations were in investors’ best interest,” she said. “Since I’ve left the brokerage industry, nothing has changed in this respect.”

In addition to her career experience, Isola said she also had an “alarming personal experience” with a broker-dealer that put her parents’ assets at risk when her father was diagnosed with Alzheimer’s.

Representative Warren Davidson (R-Ohio, 8th District) said, however, that implying that "payroll" incentives in the broker-dealer industry lead to conflicted advice is a "tainted" argument.

Davidson noted that in many other professions, individuals are incentivized to do well by their financial compensation.

Barbara Roper, director of investor protection at the Consumer Federation of America, said the proposed rule will do “more harm than good by misleading investors” about “providing protection the rule simply does not provide.”

Implying that monetary incentives in the broker-dealer industry lead to conflicted advice is a tainted argument.
Representative Warren Davidson
(R-Ohio, 8th District)

Roper is also a member of the SEC's Investor Advisory Council, which advises the SEC on regulatory priorities and other issues.

Roper said the SEC must do the following to improve the proposed Reg BI:

  • Define “best interest.” She said this is a “glaring omission,” since the same language has been used to describe three very different standards: the existing Finra suitability standard for broker-dealers; the Investment Advisers Act of 1940 fiduciary duty; and the vacated Department of Labor fiduciary rule.
  • Strengthen the prohibition on placing the broker’s interests ahead of the customer’s interests and incorporate the prohibition into the obligation to mitigate conflicts. She said without a clear requirement to place the customer’s interests first in the compliance safe harbor, there is little reason to expect firms will comply.
  • Brokers in ongoing advice relationships with their customers should be required to have an ongoing duty to monitor customer accounts. She said certain courts have already deemed that broker-dealers owe fiduciary duties to their customers, including an ongoing duty to monitor the account, but the proposed Reg BI would weaken those protections by artificially declaring that brokers have no such ongoing duty to their customers after the completion of a transaction.
  • Strengthen the guidance on the Investment Advisers Act of 1940. The interpretation of the Advisers Act standard included as part of the Reg BI regulatory package is “so weak and limited in scope that it would leave investors virtually devoid of meaningful protections when dealing with a conflicted adviser,” she said.
  • The Customer Relationship Form should be completely re-designed, re-tested and re-proposed. She said the qualitative testing which CFA and other groups conducted of Form CRS “clearly showed that it is more likely to mislead than to inform investors.”

In contrast, broker-dealer lobby group Sifma contended the following advantages of the proposed Reg BI in a written statement submitted to the subcommittee:

  • The regulation “significantly strengthens and materially exceeds” the existing Finra suitability standard.
  • It holds broker-dealers to an “even higher standard” than the one which applies today to investment advisers, because disclosure of conflicts alone does not satisfy the standard.
  • It “preserves access and choice for investors while providing meaningful protections” in areas that the vacated DOL fiduciary rule sought to address.
  • It “appropriately follows a principles-based, facts and circumstances approach.”

Representative Carolyn Maloney (D-N.Y., 12th District), who led the hearing, said the SEC’s proposed Reg BI is “still far too weak.”

Representative Bill Huizenga (R-Mich., 2nd District) was among those who defended the proposed rule. Although “not perfect,” the proposed rule “definitely” puts investors first by ensuring “consumers will be able to make more informed decisions,” he said.

While acknowledging the opposition to the SEC’s proposed Regulation Best Interest, Representative Brad Sherman (D-Calif., 30th District) asked whether it would be better to have the proposed rule rather than no new rule.

Ritholtz Wealth Management’s Isola said that faced with only those two options, it’s a “horrible choice” to make. Susan MacMichael John, founder and president of Financial Focus and chair of the Certified Financial Planner Board of Standards; Lee Baker, Georgia state president of the AARP; and the CFA’s Roper all said that having no new rule would be better than the proposed rule.

The SEC’s proposed Reg BI “undercuts” the protection investors already have under fiduciary rules, according to John.

Representative Andy Barr (R-Ky., 6th District), said it’s “ludicrous” to say having no new rule is better than the proposed Reg BI.

Meanwhile, Harvey Pitt, CEO of consulting firm Kalorama Partners, said the proposed Reg BI would be better than nothing. He added that he expects improvements to be made to the rule over time.

“We will never achieve perfection,” Pitt said, describing the proposed rule as “thoughtful and creative” and “designed to improve investor protection.”

Pitt said “experience will be the best determinant” of whether the proposed rule succeeds in its goal of protecting investors.