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
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
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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