16 April 2021

Regulatory Ambiguity Helps Keep the Industry in Compliance

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A representative of a major financial industry lobbying organization posed what seemed to be a simple question about complex products to a Securities and Exchange Commission official at an online event a few weeks ago.

The answer he received provides insight into regulatory ambiguity — one of the most potent tools deployed by the SEC, the Financial Industry Regulatory Authority, the Department of Labor and other agencies to police the financial markets.

The topic was Regulation Best Interest, the broker investment advice standard that went into force last June. In the first few months after implementation, the agency said it was looking for “good-faith” efforts by brokerage firms to comply with the rule, which prohibits brokers from putting their interests ahead of their customers’ interests.

But late last year, the SEC warned that it would be getting tougher on examinations and, presumably, starting enforcement of the measure in coming months. With that as the backdrop, the Securities Industry and Financial Markets Association held an online compliance webinar in late February.

The SEC has indicated that one of the areas it will review to determine whether brokerages are complying with Reg BI is how they handle sales of complex products. Those transactions can be a danger zone for conflicts of interest and potential investor harm.

But complex products also generate considerable revenue for registered representatives and financial firms. So, it’s natural that SIFMA would be curious about what kind of impact Reg BI will have in the area.

Kevin Carroll, SIFMA managing director and associate general counsel, noted that Reg BI doesn’t define complex products. So, he asked John Polise, associate director of the SEC’s Division of Examinations, to explain what the SEC considers a complex product.

Polise pointed to the 770-page Reg BI rule text and noted that inverse and leveraged exchange-traded products are mentioned. But he acknowledged that the measure does not provide specifics as to what constitutes a complex product.

“So, while there is no set definition, I think we often look to as a proxy for that whether the [registered] rep can explain [the product] in the first instance and also whether there are higher costs associated with it,” Polise said.

Carroll pondered that answer for a moment and then asked whether variable annuities and options are considered complex products.

Polise said VAs “certainly are” complex products as well as “derivatives generally.” Within options, there may be some wiggle room. For instance, covered calls and zero-cost collars can be in a customer’s best interest. But butterfly straddles probably aren’t.

Got it? You’re still not certain exactly what a complex product is? It’s in the SEC’s best interest that you’re not sure.

That’s what regulatory ambiguity is all about. It keeps a question in the back of your mind and helps ensure that you stay on your toes and within the law. It also provides the SEC with the leverage to crack down wherever it sees a problem and the latitude to define a regulatory violation.

Are your reps selling investments that they wouldn’t be able to explain to their grandparents? You may not know for sure whether the SEC considers them complex products, but it’s probably best that you back off promoting them — just to be safe. You never know when the SEC might come knocking on your door.

Securities regulators take a page out of Henry Kissinger’s book. The secretary of state in the Nixon and Ford administrations, Kissinger extolled the virtues of strategic ambiguity. In order for the United States to exert the most influence on the world stage, it’s best if our enemies — and our allies — don’t know exactly why we made a recent move or what we’re going to do next.

It’s kind of the same when it comes to financial rules. Regulators urge firms to establish a culture of compliance. That kind of attitude works best if it results in a firm following both the letter and spirit of securities law. If requirements were spelled out in too much specificity, it might be easier to cut corners — letting the spirit suffer while the letter is satisfied. Regulators want to keep the industry at least a little off balance.

This brings us to principles-based regulations. Reg BI and the new adviser marketing regulation fall into that category. They’re not filled with detailed rules to follow. In fact, Reg BI is the league leader in lack of guidance, despite its ocean of text. It doesn’t define “best interest” nor does it explain how brokers should mitigate conflicts of interest.

Maybe soon-to-be-Senate-confirmed SEC Chairman Gary Gensler and the Democratic-majority SEC will revisit Reg BI and add more specificity to Reg BI. But it will still be principles-based and somewhat ambiguous. The best way to ensure compliance is to do the right thing and act in the best interests of your customers. There’s no ambiguity in that.

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