Must Investment Brokers Disclose Conflicts of Interest?

New rules proposed by the SEC could assist Illinois investors

By Doug Mentes, Esq. | Last updated on January 27, 2023

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In April 2018, the Securities and Exchange Commission (SEC), proposed new rules for securities brokers. Most notable among the new rules is “Regulation Best Interest, which would apply to brokers when giving advice to retail investors. The regulation proposes that broker-dealers “act in the best interest of their retail customers,” and not place the broker’s interests ahead of the retail investor. The new rules have been expected for some time after the 2010 Dodd-Frank Act provided the SEC authority to establish a unified customer standard of care for brokers and advisors. In 2016, the U.S. Department of Labor (DOL) issued its own rules for brokers who provide advice on retirement investments. But that rule was put on hold when President Trump took office, and has since been eliminated by the U.S. Court of Appeals for the 5th Circuit, which vacated the new DOL rules in a March 2018 decision.

What Is the Current Rule for Brokers?

Under current securities regulations, brokers need only demonstrate their investment recommendations are suitable for their investor client. To satisfy that standard, brokers are obligated to obtain an investment profile from their customers and have a reasonable basis to believe their advice could be in the best interest of that customer. These rules do not require that brokers address conflicts to the client. Many industry professionals find the suitability standard of conduct weak when it comes to protecting investors. Brokers often don’t disclose commissions and fees earned from putting clients in certain investments, and clients are often in the dark regarding whether another proprietary product might serve them better. Research that supported the DOL rule shows that retail investors lose approximately $17 billion annually due to conflicted broker advice.

What Is the New Rule on Broker Conflicts?

The current rule will remain in place but will be expanded by the new proposal to include new obligations for brokers, involving disclosure and mitigation of conflicts of interest. Brokers would be required to “reasonably disclose,” in writing, to the retail customer material facts relating to the scope and terms of their relationship, as well as all material conflicts of interest involved with the broker’s advice. The proposed new rule would also require that broker-dealers implement new written policies targeted at mitigation or elimination of “all material conflicts of interest” associated with the broker’s investment strategies. Specifically, the broker’s policies must mitigate or eliminate conflicts of interest that arise from financial incentives for the broker. The proposed rule appears to bring brokers closer to a fiduciary standard of care for their clients. However, many industry professionals believe the rules do not go far enough, and retail investors will still get pushed into products that benefit the broker. Several of the five SEC commissioners expressed concern with the new rule, but one commissioner voted against the rules completely. Commissioner Stein released a statement, explaining, “When there is a question of where the burden of uncertainty should rest—it should rest with the more informed party—the financial professional. Unfortunately, today’s package of proposals in many ways continues to place the burden on the retail investor.” Further among the proposed rule changes is a restriction on brokers from labeling themselves as “advisors.” This proposal is aimed at decreasing confusion for retail investors over the various titles used by investment professionals. Registered investment advisors are held to a fiduciary standard of care under the Investment Advisors Act, a standard brokers are exempt from. Until the new rules take effect, investment brokers are still subject to the suitability standard, and are not required to offer products that are in the customer’s best interest. Retail investors with concerns about broker conduct should discuss their concerns with an experienced Illinois securities attorney who can educate their clients on the broker’s obligations, or pursue damages if the customer is harmed by broker conduct. For more information about this area, read our securities and corporate finance law overview.

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