The Securities and Exchange Commission (“Commission”) on June 5th, 2019, adopted Regulation Best Interest (“Reg BI”), the centerpiece of its four-part regulatory revision that will impact the way broker-dealers (“BDs”) and registered investment advisors (“RIAs”) conduct business with “retail” investors (meaning you, me, aunt Betsy and uncle Charlie, and others we care about.) This new rule attempts to raise “the standard of conduct for broker-dealers and natural persons (brokers)…when they make a recommendation to a retail customer of any securities transaction or investment strategy involving securities.”
Broker-Dealers (“BDs”) vs. Registered Investment Advisors (“RIAs”)
To properly assess the potential impact of the new regulation, we need to first understand the stark differences in the standard of conduct between BDs and RIAs before the Commission’s adoption of “Reg BI.”
RIAs have historically maintained a “fiduciary” relationship with their clients, which means they have a legal obligation to provide investment advice that acts in their clients’ best interests. We recognize these services as money management and wealth advisory services as opposed to sales. In fact, they are prohibited from selling securities, investments, or other packaged investment programs.
The BDs, on the other hand, are organized to legally buy and sell securities for their accounts or on behalf of their clients, taking a “sales” or “broker” role in the transaction. They play a vital role in our financial ecosystem. They supply liquidity through market making and trading activities, raise capital for companies, and provide investment advice to clients. Persons affiliated with BDs however, sometimes called brokers or stockbrokers, are not legally bound to act in their clients’ best interest but to merely meet “suitability standards” that which the Commission is endeavoring to raise.
In light of what it concludes is a complex and diverse retail investor base, the Commission chose to allow the myriad of financial services offerings, each with different incentives for brokers, to remain and play a role in the market place.
Regulation Best Interest: Closing the Gap in Conduct Standards
Reg BI tries to close this significant gap in the conduct standards between BDs and RIAs. The Commission, in its Adopting Release of this new regulation, noted that while the BDs would not have to abide by the existing fiduciary standard that RIAs follow under the Advisers Act, the key elements of the Reg BI standard of conduct are substantially similar to the standards set forth in the Advisers Act. The proponents for the new regulation point to the “best interest” language in Reg BI, which prohibits BDs from putting their financial interests ahead of the interests of their clients when making recommendations. In defense of the Commission’s decision to avoid implementing one uniform standard of conduct for both the BDs and RIAs (which most consumer advocacy groups have been supporting) the SEC Chairperson Jay Clayton, in his most recent investor roundtable discussion told the attendees, “I do not believe that a ‘one size fits all’ approach would best serve the diverse interests of our Main Street investors. Further, I believe in this area, a one-size fits all approach could reduce the availability and increase the cost of advice and services, particularly for those with relatively smaller accounts.”
The Commission had an opportunity to completely close the standards gap between BDs and RIAs by adopting one uniform fiduciary standard. But in light of what it concludes is a complex and diverse retail investor base, the Commission chose to allow the myriad of financial services offerings, each with different incentives for brokers, to remain and play a role in the market place. Moreover, even though the BDs standard of conduct under Reg BI is conclusively raised, it only applies when giving a recommendation, not when it is selling and not when the recommendation is incidental to selling. The Commission believes that an appropriate written disclosure outlining the material facts about the capacity in which the broker is acting (selling vs. advising), fees (commission vs. fee), the type and scope of services provided, conflicts, and limitations on services and products will be sufficient to address this potential marketplace confusion.
The Impact of Reg BI on Clients
The consumer advocacy group AARP does not agree and argues that the ambiguous nature of the definition of “best interest” may give investors a false sense of security about the motives of financial professionals. Many others have echoed similar sentiments, and cynics have gravely warned that a lack of follow-through with effective public education regarding the new rules may simply result in such rules becoming a Trojan Horse for nefarious and indefensible behaviors from some “bad actor” brokers, thus defeating the intention of Reg BI. We are reminded of analysts on CNBC that provides a conflict disclosure as if the explicit acknowledgment somehow negates the conflict of interest.
So, if a bevy of academians and policymakers struggle to understand and agree on the very set of rules they helped design and implement, what chance does aunt Betsy, uncle Charlie, you or I have in sorting through the additional disclosures, rules, and behaviors in determining who to engage for advice?
If this seems confusing, you understand perfectly. Sadly, the Commission’s nearly two decades of effort, culminating with the passing of these rules, to enhance investor protection, quality, and transparency of retail investor’s relationships with investment advisors and broker-dealers may have been for naught. The most prominent critic of Reg BI and a lone voice of dissent, Commissioner Robert Jackson Jr. stated, “I hoped to join my colleagues in announcing that the nation’s investor protection agency has left no doubt that, in America, investors come first. Sadly, I cannot say that. Rather than requiring Wall Street to put investors first, today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice.”
So, if a bevy of academics and policymakers struggle to understand and agree on the very set of rules they helped design and implement, what chance does aunt Betsy, uncle Charlie, you or I have in sorting through the additional disclosures, rules, and behaviors in determining who to engage for advice? Even if BDs and RIAs all subscribe to the new standard of conduct and follow the disclosure requirements, can we be sure that investors will indeed take the time to read and understand the fine print as suggested by the Commission? If uncle Charlie cannot be persuaded to abandon his “instinct” and instead peruse through pages and pages of disclosures, is he any better or worse off under the new regulation?