By Pam Krueger, Next Avenue Contributor
Last week, the Securities and Exchange Commission (SEC) adopted a rule to protect investors from bad brokers. The “Regulation Best Interest” (or BI) is the SEC’s answer to the Obama administration’s planned “fiduciary rule,” which the Trump administration killed. And SEC Chairman Jay Clayton said Best Interest would “substantially enhance the broker-dealer standard of conduct beyond existing suitability obligations.” But will the Best Interest rule really be in the best interest of investors?
First, a little background: For years, many investors and advocates of greater transparency and accountability in the financial services industry have been clamoring for rules requiring all financial advisers to act in their clients’ best interests. Currently, registered investment advisers (RIA) are required to meet that fiduciary standard but brokers are not. Brokers must only need to believe that the investments they recommend are “suitable” for their clients.
What the Fiduciary Rule Would Have Done
The fiduciary rule would have required any financial adviser who offered retirement-related financial planning or investment advice for IRAs, 401(k) plans or other retirement accounts to act as fiduciaries. In practical terms, they would have been required to put their clients’ best interests above their own, reveal and minimize all potential conflicts of interest and clearly disclose fees and commissions they would make from the investments they recommended.
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Most registered investment advisers applauded that initiative, mainly because it was directed at their chief competitors: registered representatives, or brokers. Since brokers are paid by commission for placing trades and selling investment and insurance products, they can’t necessarily say they’re acting in their clients’ best interests. And they’ve never had to.
The fiduciary rule was fiercely opposed, delayed and derailed by broker/dealers and opponents of government regulation, who spent billions lobbying against it. Ultimately, the U.S. 5th Circuit Court of Appeals nullified legality of the fiduciary rule in 2018.
Out of its ashes arose the SEC initiative to resurrect some of its guidelines for inclusion in a new set of highly controversial requirements primarily aimed at brokers.
Current Regulation of Brokers and Investment Advisers
To understand why a rule protecting investors matters, an analogy might help: Imagine you’re tapping into your retirement nest egg to buy a new SUV. You go to a dealer that sells different brands and your salesman strongly recommends you buy a certain higher-priced model that meets your general requirements. A week after delivery, you learn he earned a higher commission and incentive bonus for selling your model than he would’ve for other less-expensive vehicles with nearly identical features. Would this undisclosed information anger you?
If it would, understand that brokers work the same way. Many call themselves financial advisers and financial planners, but their job is to sell investment and insurance products.
It’s perfectly legal for a broker to recommend a mutual fund that pays him or her the highest commissions as long as it aligns with your investment objective and risk tolerance — the “suitability standard.” But those fees can be hidden and complicated, so you might not know what you’re paying. When you buy an investment product from a broker, commissions are deducted from the amount you invest. Some may be one-time sales charges (often 5% or more), others in the form of annual 12b-1 fees, which are essentially legal kickbacks paid by mutual funds to brokers.
What Regulation Best Interest Will and Won’t Do
Ideally Reg BI is supposed to change that.
In reality, though, Reg BI doesn’t uniformly require brokers to switch from a commission-based compensation model to one where they’re paid directly by clients, as investment advisers are.
Instead it vaguely requires brokers to prevent personal considerations such as commissions or incentive bonuses from influencing their investment recommendations. And it bans current industry practices offering brokers juicy vacations as incentives to sell certain products.
Reg BI also requires brokers to disclose conflicts of interest and other aspects of their compensation structure and relationship model to clients in a brief, easy-to-understand document known as Form CRS. Registered investment advisers will have to do this as well.
While this is an improvement over the way such disclosures are communicated today, there’s no guarantee that Form CRS will make them any easier for investors to understand. Nor will the SEC necessarily require clients to affirm their understanding of any conflicts.
What Critics of Reg BI Say
Critics of Reg BI claim that it’s a watered-down, largely unenforceable version of the Obama administration’s planned fiduciary rule. They note that it doesn’t define what “best interests” or “conflicts of interest” really mean or offer guidance on measures brokers need to take to fulfill the rule’s requirements.
And the SEC didn’t vote on a proposed provision that would have prohibited brokers from calling themselves “financial advisors,” a source of great confusion among investors.
Reg BI’s most prominent critic was its lone voice of dissent: SEC Commissioner Robert Jackson Jr. “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,” said Jackson in an open session after the votes were tabulated.
And here’s what the SEC Investor Advocate, Rick Fleming, said about Reg BI: “In summary, I believe Regulation Best Interest, while not as strong as it could be, is a step in the right direction because it is an improvement over the existing suitability standard for broker-dealers. However, what investors have gained in Reg BI has been undermined by what investors have lost in the Commission’s interpretation of the fiduciary duty that applies to investment advisers.”
And, Fleming added, while the new Form CRS relationship summary “will provide useful information to investors about their particular financial professional and account, it likely will not achieve its original goal of preventing the financial harm that results from investor confusion about the differences between investment advisers and broker-dealers.” Ultimately, Fleming noted, “The Commission has taken a step in the wrong direction in its interpretation of the fiduciary duty that investment advisers owe to their clients.”
In a recent interview with me, Phyllis C. Borzi, former Department of Labor assistant secretary in the Obama administration and the chief architect of the fiduciary rule (as well as a Next Avenue Influencer in Aging), recommended that investors cut through the confusion by taking matters into their own hands.
“There’s no shame in asking an adviser important questions like, ‘Who pays you?’ For brokers, their duty of loyalty most likely goes to the company that pays them, whereas genuine fiduciaries are loyal to their clients first, even if this sometimes means being in conflict with their firm’s business goals,” said Borzi, “Ultimately, it’s up to investors to decide for themselves if they believe that an adviser will act in their best interests.”
The Good Things About the Best Interest Rule
Even though Reg BI may be far from perfect, there is some good that has come out of its passage.
For one thing, it affirms — if not directly, then by implication — that investors are best served by financial advisers who serve as fiduciaries for clients.
It also puts registered investment advisers on the hook to make sure that any potential conflicts of interest that might affect their objectivity are clearly documented and communicated to clients.
And, quite possibly and most importantly, its emphasis on requiring brokers to put their clients’ best interests first highlights the difficulties they will face in meeting these obligations. This may convince many brokers to abandon this outdated and discredited service model, leave their brokerage firms and become fiduciary advisers and financial planners for their clients.