The Securities and Exchange Commission’s Regulation Best Interest rule may have a “significant flaw” that weakens investor protections when brokers use gamification to boost trading levels, according to the SEC’s Investor Advocate.
During a speech at the Practising Law Institute’s “SEC Speaks” virtual conference, Investor Advocate Rick Fleming also argued that the SEC should “go back to the drawing board” on the rule if its current design fails to protect investors when brokers use digital engagement practices, particularly considering the increased emphasis on "gamification" in retail investing.
“To me, it appears the DEPs are being used in ways that make the distinction between solicited and unsolicited trades almost meaningless, and brokers’ obligations under Reg BI should not turn on whether the customer technically initiates the trades after the broker has used subtle techniques to influence the customer to engage in active trading, trade on margin, trade options and engage in other risky practices,” he said.
In his speech, Fleming acknowledged the “positive trend” of more retail investors participating in the market, with b/ds lowering or eliminating commissions and using digital tools that can make it “more fun” to trade. Fleming said these changes reduced the barriers of entry for investors, particularly those with less money. But he echoed SEC Chair Gary Gensler and others in worrying that gamification would encourage more frequent or higher-risk trading than a given investor would otherwise pursue.
Fleming argued that under Reg BI, registrants must follow a number of obligations when providing a recommendation, but he stressed that there needed to be a recommendation, and not just an interaction, between the broker and client for the rule to apply. Therefore, Fleming reasoned that if a retail client independently asks their broker to conduct a trade without the broker making a recommendation to the client, the requirements of Reg BI may not apply.
But gamification might obscure the difference between solicited and unsolicited trades and “subtly nudge” investors to make certain trades or increase their trading frequency, Fleming feared.
“In my view, it appears that the use of certain DEPs, by gamifying securities trading for retail customers, could significantly influence these retail customers’ investment decisions in ways that were not fully contemplated when the commission adopted Reg BI with its important distinction between solicited and unsolicited trading,” he said. “This leaves open the possibility that investors would not receive the benefit of Reg BI protections even though they are being influenced to engage in securities transactions.”
Fleming urged the SEC's Enforcement Division to support the assertion that client recommendations include gamification when it could “reasonably” be seen as encouraging trading, though he acknowledged that the various types of digital engagement could make regulation challenging.
But Fleming also worried that the commission’s current approach enables brokers to operate in the same manner as an advisor, and is outlawed from being defined as one only if the advice they give is considerably “solely incidental” to their business.
“But now it seems that most if not all of the online discount brokers are influencing investor behavior with digital engagement practices, which further blurs the line between providing investment advice and traditional brokerage service,” Fleming argued. “At some point, if the commission fails to brighten the distinction between advisers and brokers, it will make little sense regulate the two with such distinct regulatory models."
