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The SEC Issues New Rules for Broker-Dealers: Will They Help Investors?


New rules sign made of wood on a desk in a room with a blue background


On June 5th, the Securities and Exchange Commission (SEC) approved a final regulation that governs the conduct of broker-dealers and their advisors. The name of the guidance is Regulation Best Interest, but it is known as Reg BI.

Reg BI won’t apply until June 30, 2020, roughly a year from now, but it is already generating a lot of controversy. The big question is whether it leaves investors exposed to conflicted advice, as consumer groups argue, or whether it will enhance the quality and reduce the cost of investment advice as he SEC intends.

Let’s take a look at what Reg BI requires and why there are questions about it.

But, first, to give you context for understanding this change, the SEC regulation is different than the DOL fiduciary rule that was thrown out last year. The SEC’s Reg BI applies to investment advice to all retail investors, not just advice to plans and IRAs.

Reg BI imposes three duties on the representatives of broker-dealers. Those representatives use a variety of titles, so it’s not easy to know if your advisor is working for a broker-dealer. Some of the common labels are financial advisor, financial representative and wealth manager. Even though it sounds similar, an “investment adviser” is different than a “financial advisor.” An investment adviser provides investment advice for a fee. A financial advisor gives advice in connection with selling investments and the advisor (and the broker-dealer) are paid commissions. Both investment advisers and financial advisors offer valuable help and reasonable costs in the right circumstances. (For example, a financial advisor may be the best for buying a mutual fund you plan to hold for a long time, but an investment adviser, also called an RIA, is better suited for actively managing your investments.)

Going back to Reg BI, the three duties imposed on financial advisors are: A duty to disclose material conflicts of interest; a duty of care; and a duty to mitigate, or manage, financial conflicts of interest.

Taken together, those duties are called the “Best Interest Obligation.” Stated simply, the idea is that broker-dealers and financial advisors must act in the best interest of investors.

Let’s look at each of the three duties. The first duty—to disclose material conflicts of interest—means that broker-dealers and financial advisors need to tell investors when they have incentives to favor themselves over the investor. For example, if an investor buys an investment or an annuity from a financial advisor, the financial advisor will receive a commission. However, if the investor decides not to buy the mutual fund or annuity, the financial advisor will not earn any money. That’s a conflict of interest, and it must be disclosed. Unfortunately, though, the disclosures are often made in lengthy, legalistic documents or on websites with voluminous amounts of information. In effect, that means that the investor has a duty to look out for his or her own interest by reading those materials. The burden to understand the conflicts is on the investor.

Unfortunately, many investors don’t realize they have that responsibility and don’t closely review the disclosures. To make matters worse, the disclosures are often hard to read because they are dense and complicated.

To help with that, the SEC also requires that broker-dealers provide investors with a Customer Relationship Summary, or CRS. The CRS is a relatively short, plain-English document that generally explains the services, compensation and conflicts of a broker-dealer. It is a good starting point for investors to understand the nature of the relationship with a broker-dealer.

The second duty is the Care Obligation. It requires that financial advisors act with reasonable diligence, care and skill to make recommendations that are in the best interest of the investor. In addition, it says that a financial advisor cannot put his or her interests ahead of the investor’s. That means that a financial advisor must recommend investments that are in the best interest of the investor, even if another investment paid more money to the broker-dealer and the advisor.

The duty of care is an improvement over the standard currently imposed on financial advisors. After all, who wouldn’t want their advisor to be careful, skillful and diligent in developing recommendations and to make recommendations that are in the best interest of the investor?

One criticism of Reg BI is that the term “Best Interest” is not defined. In other words, it’s possible that different broker-dealers could interpret the standard differently. In that case, we won’t know how much the new rule helps investors until the SEC starts enforcing the rule, which could be years from now. Despite that, “Best Interest” is a pretty high standard. While there are arguments about whether it is high enough, it is better than the current rules.

The third duty—the Conflict of Interest obligation—requires mitigation, or management, of financial conflicts of interest. In other words, when a financial advisor sells an investment or annuity to an investor, the advisor will receive a commission. The commission is a financial conflict of interest that has to be mitigated. While “mitigation” sounds like a good idea, the SEC didn’t explain how to do it. As a result, there is some confusion about how mitigation will work. Even with the confusion, though, we know that the SEC’s goal is for financial conflicts to be managed in a way that a financial advisor is not unduly incented to make a recommendation just because it pays a bigger commission to the advisor; instead, the goal is that the advisor will prioritize the needs of the investor.

Here’s an example. If the investor is a participant in a 401(k) plan and is retiring, he or she might turn to a financial advisor for a recommendation about whether to leave the money in the 401(k) plan or to take a distribution and roll it to an IRA. If the financial advisor recommends that the money stay in the plan, the advisor will not be paid. On the other hand, if the financial advisor recommends that the money be rolled to an IRA with the advisor’s broker-dealer, the advisor will be paid by commissions from the IRA. That’s a material financial conflict of interest. How can it be mitigated? The trial is the process that the financial advisor uses to develop the recommendation. For example, if the advisor reviews the investments, expenses and services in the 401(k) plan, and then compares them to the investments, expenses and services in an IRA, and thoughtfully and carefully analyzes that information in light of the needs and circumstances of the investor, that is a robust process that indicates that the advisor is working in the best interest of the investor.

That’s a summary of the rules. But, where does that leave us?

All in all, it means that, beginning on June 30, 2020, investors will be better protected from conflicts of interest, high costs, and bad advice. But, we don’t know how strong the protection will be, because we don’t know how broker-dealers are going to apply the Best Interest standard or how they will mitigate material financial conflicts of interest.

Many will undoubtedly develop practices that look out for the best interests of investors. Others may take a lower road until the definitions are clarified by SEC enforcement or additional guidance. What should an investor do? The starting point is to have open and honest discussions with your financial advisor. For example, does the advisor clearly explain his approach to developing an appropriate mix of investments for your needs? If the advisor recommends an annuity, does the advisor explain how he or she has concluded that the insurance company is financially strong enough to make the annuity payments in the future? Has the financial advisor discussed the costs of the investments or annuities, in a way that you can calculate them as a dollar amount? Has the advisor explained his or her compensation in a manner that you can calculate the dollar amount that the advisor and the broker-dealer are receiving?

That’s not the whole story, but it’s a good starting point. If the financial advisor can clearly explain those matters, that’s a sign that you are working with someone who will look out for your best interests.

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