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2 threats facing today’s investors—and the regulatory response

This article was published in the NAPFA Advisor Magazine.

The U.S. economy and financial markets have entered a period of heightened uncertainty, posing fresh challenges for investors. Inflation is up sharply, a possible recession looms, and the securities markets are exhibiting significant volatility while venturing into bear territory. Commodity prices are also experiencing huge price swings. Add to this backdrop the financial industry’s never-ending stream of complex new investment offerings and inducements, from digital engagement practices to SPACs to cryptocurrencies, and it’s clear that investors face major risks.

In these times, strong financial regulation is more important than ever, so that markets can remain stable while under stress, opportunistic scam artists—who thrive on investor anxiety—are kept at bay, and investors can rely on objective, conflict-free advice. Retirement savers are especially vulnerable to the current economic and market conditions, not to mention predators, and they desperately need sound investment advice.

To provide context for today’s turbulent conditions, let’s remember the state of play with respect to the “best interest” rules aimed at ensuring that retail investors receive sound, conflict-free advice from their advisors. In sum, the SEC is relying on guidance and enforcement to fortify the anemic provisions in Regulation “Best Interest” (Reg BI)—I’ve deliberately put quotation marks around “Best Interest” because it doesn’t really deserve the label. For its part, the DOL is expected to move forward before the year is out with new rules to shore up its own compromised standards governing retirement advisors.

Then we will we examine cryptocurrencies, a rapidly evolving craze that poses huge risks of loss to investors, as demonstrated by 2022’s crypto carnage. The bottom line is that while regulators across the financial spectrum struggle to develop the optimal regulatory response, investors need greater protections now, and the SEC is striving to answer that call.

The SEC’s Reg BI

Reg BI was finalized in July 2019 amid strong criticism from investor protection advocates who rightly regarded it as a weak and ill-defined rule that fell far short of a fiduciary duty. As a result, the problem it was supposed to solve persists: Many advisors continue to recommend investments that line their own pockets with high fees and commissions but saddle their clients with low returns and high risks.

Recent evidence bears this out. In November 2021, the North American Securities Administrators Association (NASAA) announced the results of a nationwide survey conducted by state securities regulators that assessed broker-dealer policies and practices following implementation of Reg BI. NASAA found that a full year after the rule’s compliance deadline of June 30, 2020, little has changed when it comes to the powerful influence that advisor conflicts of interest exert on investment advice. It concludes that Reg BI firms have steadily increased their participation in complex, costly, and risky products; they continue to rely on financial incentives that Reg BI was intended to curb; and they still place their financial interests ahead of their retail customers’ in violation of the rule’s chief directive. These findings are consistent with FINRA’s own exam results, which identify a wide range of compliance failures under Reg BI.

Nevertheless, for now the SEC’s solution seems limited to fortifying Reg BI through guidance and enforcement, not rule amendments. The SEC’s Spring 2022 Regulatory Agenda confirms the absence of a planned rulemaking. And in the words of Chairman Gary Gensler, the SEC intends to get the most out of the rule “as written.”

That process has begun. On March 30, the SEC issued a staff bulletin elaborating on the standards that apply to advisors under Reg BI and the Investment Advisers Act. It contains some helpful guidance reaffirming that advisors must consider reasonably available alternatives; must always consider cost as a factor when making an account recommendation; and must consider whether a rollover itself, as well as the new account being recommended, are in the client’s best interest. On Aug. 3, the SEC issued another staff bulletin to clarify the rule’s requirements on identifying and addressing advisor conflicts of interest. It emphasizes that compliance must “not be merely a ‘check-the-box’ exercise, but a robust, ongoing process.” We hope and expect that the SEC will issue more guidance to put more meat on the bones of Reg BI, and Gensler has signaled as much.

We’ve seen some progress on the enforcement front. Although it took the SEC two years to act, the agency has filed its first case under Reg BI. Its case against Western International Securities alleges that the defendants, including a broker-dealer and five individual registered representatives, sold over $13 million in high-risk, unrated, and illiquid bonds to retirees and other investors who had only moderate risk tolerances. It claims that the defendants recommended the bonds without having a reasonable basis to believe the bonds were in their customers’ best interest, in violation of the explicit requirements in Reg BI. We hope to see more cases in the coming days, as compliance with Reg BI is plainly inadequate.

Ultimately, however, we are skeptical that the SEC can adequately protect investors from advisor conflicts of interest merely through guidance coupled with enforcement. If those doubts prove well-founded, then the SEC must return to the drawing board and revamp Reg BI.

The DOL’s best interest rule

On the retirement front, there is hope that the DOL will act before year-end to address the weaknesses in its own rule governing investment advice for retirement savers. The DOL must not only strengthen the conditions for exemptive relief found in prohibited transaction exemption (PTE) 2020-02, “Improving Investment Advice for Workers & Retirees,” but also close loopholes in the outdated rule defining who is an investment advice fiduciary.

The definitional rule is of particular concern. Dating back to 1975, it provides that an advisor’s recommendation won’t count as investment advice subject to the fiduciary standard unless, among other things, it is rendered on a “regular” basis. It further provides that advice must be rendered pursuant to a “mutual agreement, arrangement, or understanding” that the advice will serve as a “primary basis” for the client’s investment decisions. For decades, financial firms have exploited the “regular basis” and “primary basis” prongs of the definition to avoid application of the fiduciary duty. These loopholes—utterly baseless and at odds with the letter and spirit of ERISA—have proven especially harmful in the context of rollover recommendations, often leaving retirement investors unprotected at a time when the conflicts, risks, and potential long-term costs are greatest.

In April 2021, DOL released a series of “frequently asked questions” that helped strengthen PTE 2020-02 and narrow the loopholes in the definitional rule. However, more needs to be done, because with the existing rules still in place, retirement savers will never receive the full measure of protection they need and deserve under ERISA. Fortunately, the DOL’s Spring 2022 Regulatory Agenda indicates that, by December, it will propose rules addressing the gaps in the definitional rule as well as the weaknesses in the PTE.

Cryptocurrencies pose huge threats to investors

The recent meltdown in crypto
While the SEC and the DOL struggle to fix regulatory gaps in consumer protection that have existed for decades, the evolution of the financial world brings new challenges. None have drawn more attention or grown as rapidly as cryptocurrency. This is a new and fast-moving area that advisors, as well as the government, will need to understand to help protect consumers.

The cryptocurrency markets have always been volatile and risky, and 2022 developments have dramatically proven the point. During the spring and summer of 2022, this asset class experienced a rapid and steep decline, triggering massive investor losses, a series of bankruptcies, and daily headlines chronicling the latest financial wreckage and industry upheaval. Bitcoin, the most familiar and widely purchased crypto, had plunged over 50% by midsummer when it hovered around $21,000 per coin (and lost about 70% of its value since its all-time price peak of nearly $70,000 in November 2021). The overall market capitalization of crypto assets plummeted to less than $1 trillion from its November 2021 peak of $3 trillion. “Cryptomania has been succeeded by the great Crypto Crash,” as law professor Joel Seligman said in “The Lummis-Gillibrand Responsible Financial Innovation Act” on the CLS Blue Sky Blog.

It is too early to say whether and to what extent crypto might eventually make a lasting and positive contribution to the financial system and the economic well-being of everyday Americans. One thing is abundantly clear today, however: These markets pose enormous risks to retail investors, and they must be vigorously regulated to prevent fraud and abuse and potentially systemic disruptions in the larger financial system.

SEC’s approach
For its part, the SEC has not hesitated to apply its existing regulatory framework and enforcement authority to any cryptocurrency or related offering that is a security under federal law. In keeping with the view that the SEC already has the legal tools it needs to police many if not most cryptocurrencies, the Spring 2022 Agenda shows no signs of a crypto-related rulemaking. The SEC’s Gensler has acknowledged that some of the technological innovations underlying cryptocurrencies are “real” and that they may someday serve as a catalyst for change in the field of finance. However, he rightly insists that the vast majority of crypto tokens are securities and that—from a regulatory standpoint—securities in any form, no matter how novel on their face, should be subject to the same robust regulation, to protect investors and the integrity and stability of our markets. He has emphasized that for now, at least, cryptocurrencies are used primarily for speculative investment purposes; that the asset class is akin to the “wild west” and “rife” with fraud; and that investor protection in this area is clearly inadequate.

All of which means that the SEC expects those offering crypto securities, and the platforms trading them, to comply with the registration, disclosure, and anti-fraud provisions of the securities laws. The SEC has acted accordingly, bringing dozens of crypto-related cases in court and administratively. Those actions are largely predicated on the claim that crypto offerings are securities in the form of investment contracts, defined under Supreme Court precedent as instruments through which a person invests money in a common enterprise and reasonably expects profits or returns derived from the entrepreneurial or managerial efforts of others.

Other players
A vast array of regulators, market participants, and now legislators are focused on cryptocurrencies. The attention ramped up after President Joe Biden issued an executive order in March, establishing policy goals in response to the growth of crypto and calling for a series of reports and recommendations from a wide variety of agencies. Meanwhile, the Commodity Futures Trading Commission (CFTC) is evaluating an application submitted by FTX, a cryptocurrency exchange, which seeks to expand retail investor participation in the bitcoin futures market. It would do so without any intermediation by a futures commission merchant and subject to a novel monitoring and auto-liquidation system for clients’ margin positions that could increase rather than limit investor losses. As Better Markets has cautioned, the application raises huge concerns, as it threatens to draw more retail investors in to a market fraught with the dual risks of futures trading and crypto.

Congress has also entered the fray—unfortunately, with some proposals that would likely do more harm than good. Among the approaches on the table is largely sidelining the SEC and ceding primary authority over this huge and rapidly evolving market to the CFTC, a small agency that is chronically underfunded and understaffed. Proposed legislation also includes provisions favoring a self-regulatory model, proven to be ineffective, along with preemption of state law, another misstep that strips away an important layer of investor protection. These approaches represent a gift to the crypto industry that promises to reduce investor protections and ultimately increase systemic risk. While the CFTC chairman has welcomed some of these proposals, the SEC’s Gensler is less enthusiastic. While he has recognized that some non-security tokens may belong under the CFTC’s jurisdiction, he has expressed serious concern over any carve-out in the law that would exempt cryptocurrency-related offerings from the regulatory framework governing securities, which has protected investors and fostered robust economic growth for over almost 100 years.

Whatever direction crypto ultimately takes, it is clear today that strong investor protections, including robust standards applicable to advisors, are necessary to protect investors and the broader financial system.

Photo credit: NAPFA Advisor Magazine

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