Former SEC attorneys are warning dual-registrant brokerage firms to brace for a crackdown over their recommendation of more expensive brokerage accounts—enforcement they say may rival the regulator’s massive share-class initiative that has cost more than 100 firms hundreds millions of dollars in penalties.
“Dual registrants may be particularly compelling targets for Reg BI enforcement so that the SEC can make side-by-side findings, one under the Advisers Act and the other under the Exchange Act (Reg BI), with respect to the same conduct by dual-hatted representatives implicating both regulatory regimes,” former SEC attorney Mark K. Schonfeld and other partners at the law firm of Gibson Dunn said in new note to clients.
Reg BI’s care obligation requires financial professionals to disclose all conflicts of interest with regard to the products and programs that reps recommend. In addition, the rule requires reps to compare, document and disclose their analysis of reasonably-available alternative investments and their costs, commissions performance and risks.
Gibson and Dunn attorneys also point to the SEC’s two 2024 Reg BI enforcements and continued updates of its Reg BI staff bulletin as “indicative of a more active SEC Reg BI enforcement regime moving forward.”
The enforcements underscore that the SEC expects firms to explain to reps “how to identify and address conflicts of interest related to compensation for product recommendations. The agency also wants firms to provide a ‘mechanism’ to identify and disclose conflicts of interest related to compensation for product recommendations. This action is likely only the beginning of enforcement actions following from the SEC’s increased Reg BI enforcement focus, particularly on the conflicts and duty of care elements of the Rule,” the law firm said.
The enforcement strategy against dually registered firms will enable the SEC “to add settled enforcement actions as precedent to support the SEC staff FAQs on Reg BI, which arguably seek to substantially expand the scope of the rule, in part by conflating the distinct roles of financial advisors when acting on behalf of the investment adviser versus the broker-dealer,” Gibson Dunn added.
Cetera Chief Legal Officer Lisa Gok, a former SEC attorney for 11 years, agreed that the SEC is training its sights on the types of costly conflicts of interest and insufficient disclosure that Reg BI was designed to eradicate. “The SEC wants to see specific disclosures any time there is a financial conflict. In other words, they want firms to tell clients clearly when one product would have a payout higher than another product. They want you to explain specifically why you recommended the higher-paying product. And disclose to customers that if you purchase product A, the advisor will benefit more than if you purchase product B,” Gok said.
“There could still be a valid reason for a recommendation, but that has to be disclosed, so the client can make an informed choice. It’s best to be very, very clear,” she said.
Gok said the agency is also zeroing in representatives’ lack of specificity when they compare, document, disclose their analysis of reasonably-available investments, when making an investment recommendation. Reps must also make sure to consider and highlight differences in specific costs, historical performance and risk, she said.
“Many firms have just had reps document their recommendations without clear explanation. I think this is an area where regulators will go next,” Gok said.
Former SEC attorneys agreed that the agency may use sweeps to ferret out Reg BI violations and target dually registered firms and others, as the agency did with 12(b)-1 fees as part of its Share Class Disclosure Initiative launched in 2018. Over seven years, the initiative has cost more than 100 broker-dealers and dually registered firms hundreds of millions of dollars in penalties. Firms settled the charges that they failed to disclose to investors that there were less expensive mutual fund share classes available, but reps recommended the fund share classes that were more costly and paid them and their firms more.
“When you look at the SEC 12(b)-1 fee enforcements, all of that had to do with firms’ lack of disclosures around conflicts and where you’re charging clients more and where you weren’t and what the ramifications of that are for the client. Disclosures is a fruitful area and one the SEC has gone to many times,” said Gok, who expects to see the SEC go after larger firms to “send a message” and use sweep exams to efficiently find Reg BI violators.
A former Merrill Lynch broker who spoke on condition of anonymity agreed that the SEC is targeting dual registrants.
"Reps are offering clients more expensive brokerage share classes when identical, but less expensive advisory share classes are available. There is nothing more reasonably available than the same thing in a less expensive share class.”
The former Merrill broker said that Reg BI enforcement will be make it tough for broker-dealers to conduct business as usual.
“The SEC says you have to do a comparison between advisory and brokerage. Once you do that, the advisory shares are cheaper 95% of the time. Right now, reps make an 8% commission to sell the brokerage shares and they sell hard. And if something goes wrong, the client has to prove it wasn’t ‘suitable.’ When Reg BI is enforced, the broker-dealer makes zero and if the product is bad, all the customer has to prove is that it was not in their ‘best interest,'” the former broker said.