Predictions about the future are not very reliable. Yet planning is essential.
The Securities and Exchange Commission has scheduled a June 5 vote on adoption of Regulation Best Interest (“Reg BI”), a standard of conduct for brokers. While the final draft of the rule is not yet on the books, advisors should make some assumptions about its potential impact and plan accordingly.
How We Got Here
In April 2018, the SEC proposed Reg BI to establish new standards of conduct and disclosure requirements for brokers who serve retail clients. Some of its requirements are also applicable to advisors (“RIAs”) registered under the Investment Advisers Act of 1940 (“Advisers Act”).
As proposed, Reg BI would require a broker “to act in the best interest of the retail customer at the time the recommendation is made without placing the financial or other interest of the broker … ahead of the interest of the retail customer.” Both brokers and advisors would be required to deliver disclosure to their clients about their regulatory status (advisor vs. broker) and a Form CRS describing the differences between the two business models.
The primary goal of the proposal was to fill a regulatory void regarding the standard of conduct applicable to brokers whose advice to clients is more than “solely incidental” to their brokerage activities. It was issued shortly after the final meltdown of the Department of Labor’s efforts to create a new fiduciary standard for advisors and brokers serving retirement plans.
The SEC received thousands of comments on proposed Reg BI and has been diligently reworking the proposal. The SEC’s agenda for its meeting on June 5 also indicates it will consider whether to publish an “interpretation” of the “solely incidental” clause in the existing rules, perhaps giving more clarity around when a broker needs to register as an investment advisor.
How It Will Affect You
What should you expect and how should you prepare your firm? That depends on where you sit in the financial services ecosystem. If you are an advisor subject to the fiduciary standard under the Adviser Act, the news is not good for you.
There were hopes the SEC would create a level playing field for advisors and brokers, but that is not going to happen. In 2009 the Treasury Department recommended that the SEC “harmonize” the regulation of RIAs and brokers under a uniform fiduciary standard. In 2010 Congress embraced this idea in its Dodd-Frank legislation and in 2011 the SEC staff also advocated this idea. Unfortunately, true harmonization is dead.
Instead, similar conduct by RIAs and brokers will be subject to two differing standards. RIAs will continue to be subject to the fiduciary standard under the Advisers Act, while brokers will be subject to a “best interest” standard under Reg BI. There will be no level playing field.
No one knows exactly what the differences in the two standards of conduct will be. The term “best interest” is not defined in Reg BI and the word “fiduciary” is not used in defining the new standard. The differences are likely to be defined in the future by the courts and the regulators.
But today there is a great difference of opinion about how much of a change Reg BI is from the current broker suitability standard and how close it is to the existing RIA fiduciary standard:
- Former SEC Commissioner Kara Stein said the proposed “best interest” standard “maintains the status quo.”
- SEC Commissioner Hester Peirce initially labeled it “suitability plus,” then later suggested it might be “a stronger standard” than the RIA fiduciary standard.
- SEC Chairman Jay Clayton said, “It is definitely a fiduciary principle, just like the fiduciary duty in the advisor space is a fiduciary principle.”
Hopefully, this uncertainty will be resolved. When it is, however, RIAs should expect to be held to a stricter standard than brokers. Reg BI’s stated purposes include building on, not replacing, the existing brokerage regulatory scheme and preserving certain brokerage practices that sometimes put them in conflict with their clients. For example, Reg BI continues to allow brokers to charge commissions, sell proprietary products, and engage in principal trading.
In addition, RIAs will lose some of the marketing advantage they have had over brokers based on their status as fiduciaries. It has always been a bit unclear how much of an advantage this was. Much of the public doesn’t know what a fiduciary is, nor do they appreciate that RIAs and brokers historically have been subject to two differing standards of conduct. But whatever value fiduciary status had for RIAs will be diluted under Reg BI.
Imagine the following conversation with a prospect. You: “You’re better off working with me than your current broker because I am fiduciary.” Prospect: “What does that mean?” You: “It means I am required to act in your best interest.” Prospect: “What about my broker?” You: “Well, your broker is required to act in your best interest, too, but that obligation arises under a different set of regulations.” Prospect: “Then what is the advantage of working with you?”
Maybe in a moment of desperation you address the prospect’s question by showing her Form CRS, the four-page standardized disclosure form proposed in Reg BI to explain the differences between brokers and RIAs. Good luck with that. Independent research has shown Form CRS to be very confusing to investors and many experts believe it puts forth a highly misleading description of the differences between brokers and RIAs.
But there is some good news for RIAs under Reg BI. Brokers will no longer be able to call themselves “advisors.” It is unclear if this meager effort at truth-in-labeling will have any impact on competition between brokers and RIAs, or help the public discern the difference between the two. Brokers can still call themselves “wealth managers,” “financial planners,” or any term that does not include the word “advisor.” In addition, brokers who are dual registrants—over 80% of brokers—can still call themselves “advisors,” because sometimes they are. Perhaps, something is better than nothing?
The Bottom Line
The SEC had choices to make in proposing Reg BI. They could have emphasized investor protection by imposing the well-established RIA fiduciary standard on brokers who give advice. They could have emphasized regulatory fairness by creating a level playing field for advisors and brokers who engage in substantially similar conduct. They did neither.
Instead, they practiced the art of the doable. Reg BI was proposed in the wake of the collapse of the DOL’s effort to raise the level of fiduciary protection for retirement plan participants. The brokerage and insurance industries fought relentlessly to prevent the DOL fiduciary regulations from going into effect and were eventually successful.
In this context, the SEC sought a path that was less likely to result in a rerun of the DOL debacle and they seem to have found it. The brokerage industry has objected to certain aspects of Reg BI, but has generally supported the SEC’s proposal. Certainly, they have not thrown up the type of withering opposition the DOL’s fiduciary proposal encountered.
Unfortunately, the brokerage industry’s support was gained at the expense of a strong unified fiduciary standard applicable to all those who provide advice to investors. When Reg BI goes into effect, the SEC rightly will be able to claim credit for doing something after years of inaction in this area. But how much they will have altered the status quo remains to be seen. In any case, the heart of the brokerage business model remains intact.
For the brokerage industry, Reg BI is a solid victory. They have not popped the corks on their champagne bottles yet, but they already have those babies on ice.
The industry knew some form of higher standard of conduct was inevitable. They could not stonewall forever. It must have been a relatively easy decision, then, to support an ill-defined standard that was clearly not a true fiduciary standard, but looked enough like one to gut the RIA marketing advantage. RIAs lost the high ground while being denied a level playing field.
Having gained the upper hand, the brokerage industry is unlikely to let it go. Expect them to spread the word that they act in the “best interests” of their clients, while continuing to interact with their clients much as they always have.
Of course, the final form of Reg BI could contain some surprises, but for now Reg BI looks like a loss for fiduciary advocates, RIAs, and individual investors, and business as usual for brokers.