Written Testimony of Andrea Seidt Ohio Commissioner of Securities and
NASAA Regulation Best Interest Implementation Committee Chair
On behalf of The North American Securities Administrators Association
September 3, 2020
United States Department of Labor
Employee Benefits Security Administration
“Improving Investment Advice for Workers and Retirees”
Good afternoon. My name is Andrea Seidt and I am Ohio’s Securities Commissioner and Chair of the Regulation Best Interest Implementation Committee for the North American Securities Administrators Association (“NASAA”). NASAA is the oldest international investor protection organization with a membership consisting of 67 state, provincial, and territorial securities administrators in the United States, Canada, and Mexico. I am honored to represent NASAA before the Department of Labor (“Department”) today.
NASAA shares the Department’s goal of improving investment advice, and we have followed the rulemakings of the Department and the Securities and Exchange Commission (“SEC”) in this area very closely. Following the Fifth Circuit’s decision against the Department’s fiduciary rule in 2018, and the SEC’s adoption of Regulation Best Interest (“Reg BI”) in 2019, NASAA convened a committee to develop recommendations on implementation strategies. The Committee’s first order of business was to conduct a comprehensive examination of broker-dealer (“BD”) and investment adviser (“IA”) practices as they stood in 2018, to establish a baseline against which we could later measure the effectiveness of Reg BI.
In mid-February, the Committee launched Phase I of the examination, with 34 states participating. We collected responses from more than 2,000 BD and IA firms, representing more than 360,000 investment professionals and 68 million retail investment accounts.
Today I will share highlights from the examination to shed light on what American workers experienced in the marketplace for investment advice as recently as 2018. This data, along with the data that the Department and others collect prospectively regarding the quality of advice offered under Reg BI, will help the Department assess whether reliance on Reg BI is supported by the evidence. Until all of that data is in, however, that assessment cannot be done, and NASAA would therefore ask the Department to defer adoption of the proposed amendment.
In 2018, most BD and IA firms focused their customer recommendations on conventional securities, such as stocks, bonds, and mutual funds. We were curious to know how many firms offered complex, costly, and risky products like private securities, variable annuities, non-traded REITs, and leveraged or inverse ETFs, because those products are a perennial source of investor complaints. We found that most firms did not recommend them for their customers. In fact, approximately two-thirds of the firms surveyed did not make any of these products available to their customers.
When these products were sold, however, broker-dealers were usually the ones doing it. In fact, BDs were twice as likely as IAs to recommend the purchase of leveraged and inverse ETFs, seven times as likely to recommend private placements, eight times as likely to recommend variable annuities (by a measure of 42% compared to 5%), and nine times as likely to recommend non-traded REITs. It is too soon to know if Reg BI will narrow these gaps and bring BDs closer to fiduciary practices more aligned with customer interests. If the regulation works as intended, this is exactly what should happen. To that end, NASAA will collect post-Reg BI data as part of its Phase II examination next year, and we strongly urge the Department to do the same prior to finalizing any amendments that rely on Reg BI.
Due diligence is a critical part of any securities professional’s duty of care. One of the most important tools firms have to get to know their customers is the investor profile questionnaire. As such, it would be reasonable to expect all firms to use such questionnaires, and to expect those forms to thoroughly catalog all important investor facts and circumstances. That is not what the examination found. Some BD and IA firms reported that they did not use investor profile questionnaires (22% BD and 13% IA), while others reported using questionnaires that omitted key information like investment objective, age, risk tolerance, income, and time horizon. Surprisingly, only 20% of the firms documented their customers’ education level, and less than half documented investor debt. The Reg BI adoption release says very little about the SEC’s expectations in this area and it is hard to see how American workers are going to be appropriately matched with safe, cost-effective investment options without direct Department guidance in this area.
Another component of effective due diligence is understanding the products you sell, especially where those products are costly, complex, or especially risky. The examination initiative showed that few firms had policies and procedures governing specific product sales, and even fewer firms used tools to help agents compare investment opportunities. Only 30% of firms had any policies and procedures to guide agents on the proper handling IRA rollovers. Once again, there is no post-Reg BI data to indicate whether and how much progress will be made in reliance on a “best interest” standard.
When it comes to fee disclosure, the examination showed that all firms relied heavily on delivering prospectuses and account statements. Less than half reported providing individualized fee disclosures at the most important point for the customer – the point of sale. Many investors do not read prospectuses and do not understand the fees reflected on their account statements. They hire professionals to read and explain these documents to them and, if they have already made the decision to trust a financial professional with their entire life savings, they also trust that they will be treated fairly when it comes to fees.
What these investors do not realize is that most firms have a hard time themselves figuring out all of the fees they charge their customers, even when we regulators ask them. Investors also do not realize that they could save a lot of money by investing in lower-cost but equally suitable options because around 60% of BDs and IAs keep that information a secret. The result, as we all know, is that the average American worker who retires after 30 years with $100,000 in her account could have walked away with twice that amount, $200,000 or more. That is just appalling. American workers would find these unpleasant truths unacceptable, and the Department should as well.
Beyond fees, other compensation practices exist that can also be harmful to investors, including sales contests and the receipt of third-party compensation. Our examination revealed that virtually no firms used product-specific sales contests in 2018, the only type expressly prohibited by the SEC under Reg BI. A small percentage of BDs utilized product-agnostic contests, but such contests were rare at IAs (only 1%). The same was true for third-party compensation. Eighteen percent (18%) of BD firms accepted third-party compensation from product manufacturers compared to 2% of IAs. Fifteen percent (15%) of BD firms accepted third-party compensation from another BD, IA, or other financial institution, compared to only 3% of IAs. While these financial incentive conflicts appeared in relatively small percentages of firms (almost exclusively on the BD side), the long-term financial impact to American workers wrongfully steered into more costly products as a result of these conflicts is no small matter.
If harmful financial incentives are not prohibited by the Department, it must find ways for firms to effectively mitigate them to avoid harm to American workers. Most American workers cannot wait to retire, and would laugh in disbelief (or kick you out of the room) if you asked them to willingly sacrifice any of their life savings so their broker could get a trip to an exotic location or a bigger bonus.
Firms have a lot of work to do to effectively manage their conflicts, based on what we see in the 2018 data. Only about half of the firms had policies and procedures pertaining to conflicts. Less than half had conflict registers, and less than a third had conflict committees or officers. Again, it is too soon to know if Reg BI will fix these problems and, consequently, it is premature for the Department to rely upon Reg BI as an effective solution.
TITLES AND SERVICES
I will conclude by sharing exam findings on titles and services. As we know, the Fifth Circuit’s decision hinged in many respects on distinctions between financial professionals based on the kinds of relationships they have with retail investors. As I understand it, the Fifth Circuit took issue with the Department’s extension of fiduciary status to “financial salespeople” because they do not typically monitor investments on an ongoing basis or engage in other conduct that places them in a special position of trust and confidence vis-à-vis their customers. The Department properly accounted for these distinctions in its current proposal, recognizing a carveout for firms that engage in isolated, arms-length transactions but including firms that have a special relationship with their customers based on agreement or mutual understanding.
Let’s be clear; BDs want their customers to think of them as trusted advisors as evidenced by their marketing campaigns and staunch opposition to regulatory efforts that would curtail their usage of the “advisor” title. Forty percent (40%) of the BDs we surveyed allowed their agents to use the title while acting specifically in a BD capacity, but so did 26% of the IAs. Firms also allowed brokers to use titles like “wealth manager” and “financial consultant.” None of them, as far as I know, hold themselves out as a “salesperson.” These are not terribly surprising facts, but we know, based on the extensive factual record in the Department and SEC rulemakings, that American workers are very confused by these blurred lines, and about the services and standard of care they can expect to receive from people who exploit titles of trust.
As for the data, the examination showed that only about half (51%) of the BDs surveyed were even engaged in the sales-centric practice of customer-directed brokerage in 2018, the kind of service that the Fifth Circuit focused on in its decision. There were more BDs (52%) engaged in recommended brokerage, and a significant number of BDs engaged in core advisory services, such as managed brokerage (23%), financial planning (19%), and account monitoring (16%). BDs who hold themselves out as something more than salespeople, who affirmatively create a customer understanding and expectation of loyalty, and who receive ongoing compensation for monitoring, consultation, or other management services have very squarely placed themselves in a position of trust and should be deemed fiduciaries by the Department.
In closing, the Department should defer final rulemaking until it has a factual record validating the effectiveness of the SEC’s approach. There is no such data at this time. Should the Department proceed in the absence of that record, NASAA would ask that it follow the recommendations outlined in NASAA’s comment letter and stand resolute on the helpful guidance noted in its adoption preamble so that American workers are given a fighting chance to have a secure retirement future.
 See Chamber of Commerce of the U.S. v. U.S. Dep’t. of Labor, 885 F.3d 360 (5th Cir. 2018) (holding that the Department acted in an arbitrary and capricious manner when, among other things, it expanded the class of advisors regulated as “investment advice fiduciaries,” and created a new broad-based ERISA prohibited transaction class exemption known and referred to as the “Best Interest Contract Exemption”).
 NASAA’s Regulation Best Interest Implementation Committee was established by the NASAA Board of Directors in October 2019. During the first quarter of 2020, the Committee launched an examination initiative to identify a baseline of broker-dealer and investment adviser firm policies, procedures, and practices involving sales to retail investors, as those policies, procedures, and practices existed in 2018, prior to adoption and release of Reg. BI. The Committee plans a second phase of the initiative, scheduled for 2021, to evaluate key industry changes as firms seek to achieve compliance with Reg BI and the SEC’s updated interpretation of investment advisers’ fiduciary duties under the 1940 Advisers Act. The initiative will inform states as they update their own regulations, policies, and examination practices in light of new federal standards.
 The 34 participating jurisdictions are Alabama, Alaska, Arkansas, California, Colorado, Connecticut, District of Columbia, Delaware, Florida, Georgia, Illinois, Indiana, Kentucky, Louisiana, Maryland, Michigan, Minnesota, Mississippi, Montana, Nebraska, Nevada, New Jersey, New Mexico, New York, Ohio, Oklahoma, Oregon, Rhode Island, Texas, Vermont, Washington, West Virginia, Wisconsin, and Wyoming.
 The above-referenced conclusion, and many other findings discussed in my testimony, are based on data collected and analyzed during the course of the NASAA Regulation Best Interest Implementation Committee’s Phase 1 Examination Initiative. NASAA expects to release a report summarizing this data in the coming weeks.
 See also “Point Of Sale Disclosure In The Insurance, Banking And Securities Sectors.” The Joint Forum: Basel Committee On Banking Supervision, International Organization Of Securities Commissions, and International Association Of Insurance Supervisors (Apr. 2014), available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD439.pdf.
 The term “third party compensation” refers to compensation for the sale of specific products and services arrangements and other types of compensation from third parties (such as payments for order flow, cash sweep payments, mutual fund revenue sharing or marketing support payments, or cash referral fees from investment advisers) that are not tied directly to securities transactions. Third party compensation structures are often associated with conflicts of interest.
 See Chamber of Commerce, 885 F.3d at 31 n.13 (stating that “[t]o the extent . . . that some brokers and agents hold themselves out as advisors to induce a fiduciary-like trust and confidence, the solution is for an appropriately authorized agency to craft a rule addressing that circumstance, not to adopt an interpretation that deems the speech of a salesperson to be that of a fiduciary, and that concededly is so overbroad that . . . it must be accompanied by a raft of corrections”).
 On October 12, 2018, the SEC’s Office of the Investor Advocate and the RAND Corporation published a research report consisted of a literature review, focus group interviews, and a quantitative survey that examined consumer perceptions of financial professionals. Overall, the study found that focus group participants had a low understanding of financial services and the various types of financial professionals, and that there was some degree of confusion, or ambiguity, in the marketplace for investment advice and, consequently, potentially significant matching and search frictions for investors. See Rick Fleming, Investor Testing Regarding Standards of Conduct for Investment Professionals (Oct. 12, 2018), available at https://www.sec.gov/comments/s7-07-18/s70718-4513005-176009.pdf.
 See Letter from Christopher Gerold, NASAA President, to Office of Exemption Determinations, Employee Benefits Security Administration, United States Department of Labor, Docket ID Number EBSA-2020-0003: Improving Investment Advice for Workers & Retirees (Aug. 6, 2020), available at https://www.nasaa.org/wp-content/uploads/2020/08/NASAA-DOL-Comment-Letter-8-6-2020.pdf.