An Improvement on Regulation Best Interest

Instead of trying to fit square pegs into round holes, let's rigorously enforce the ’40 Act, suggests Scott Simon.

W. Scott Simon

 

In my June column, I weighed in on the continuing saga of what, over the years, I have termed the fiduciary wars. The Securities and Exchange Commission released a series of proposed rules on April 18. One of the rules, Regulation Best Interest, proposes that broker/dealers and their registered representatives be required to act in a retail customer’s best interest when recommending any securities transactions and/or strategies.

Regulation Best Interest doesn’t define “best interest” which, when you think about it, is rather odd, because that means there’s no way for anyone to know the real meaning of the central phrase of the most important of the SEC’s proposals. It’s like reading a headline but then finding out that there’s no story to explain it. The best that can be said for Regulation Best Interest is that it’s a convoluted muddle of bits taken from the existing B/D suitability standard here and pieces taken from the Department of Labor’s Conflict of Interest Rule there, with some lofty-sounding fiduciary language thrown in for good measure. When Fred Reish, one of the leading ERISA attorneys in the country, says that he read the SEC proposals twice through and still wasn’t wholly sure what they meant, then we’re all in big trouble.

All except, of course, those in the financial services industry who just do not want to be fiduciaries: registered representatives, insurance agents, annuity sellers. (Although Regulation Best Interest applies to B/Ds and their registered representatives, it was the organizations representing insurance agents and annuity salespeople that were successful in overturning the DOL’s Conflict of Interest Rule in the U.S. Court of Appeals for the 5th Circuit in March; they all, however, use variations of the same conflicted business model.) SEC Chairman Jay Clayton can say all he wants about the “fiduciary-like” principles found in Regulation Best Interest, and yet the SEC simply will not pull the trigger and hang the fiduciary moniker on B/Ds and their registered representatives. As a result, many consumers of financial products and services will be confused once they find out that the SEC’s version of the term “best interest” means something different from the term “fiduciary.”

Regulation Best Interest does define a “retail customer” as “A person or the legal representative of such person, who … [u]ses the recommendation primarily for personal, family, or household purposes.” The SEC leaves us scratching our heads as to what that actually means. Reish takes it to include “individual investors, family and personal trusts, IRA owners, and plan participants. However, it does not include businesses, retirement plans, and tax-exempt organizations.”

Right from the get-go, then, we can see that the SEC is tipping the playing field between B/Ds (and their registered representatives) and registered investment advisors (and their investment advisor representatives) toward the former–the nonfiduciary camp. If Reish is correct in his surmises, the SEC has roped off a big chunk of entities–businesses, retirement plans and tax-exempt organizations–which it has defined not to be retail customers.

These entities are therefore not within the realm of Regulation Best Interest, thereby freeing B/Ds from its constraints when dealing with them. Contrast this with the fact that RIAs and their investment advisor representatives, pursuant to the Investment Advisers Act of 1940 (’40 Act), are required to be fiduciaries with respect to all entities with which they do business and all advice that they provide to such entities. The SEC is obviously playing favorites here, contrary to its assertion that there’s practically no difference in the way that B/Ds are treated under Regulation Best Interest and RIAs under the ’40 Act.

But of course, there are significant differences–a magnitude of night and day– between the business model of B/Ds and RIAs. Harold Evensky, named recently as recipient of the 2018 P. Kemp Fain Jr. Award, the highest individual award presented by the Financial Planning Association, describes the inherent conflict concisely: “A broker relationship of three and an adviser relationship of two treat retail investors entirely differently.”

More expansively, in the RIA model there are two entities: an RIA (and its investment advisor representatives) and its client to whom it provides fiduciary advice. In the B/D model, though, there are three entities: a B/D (and its registered representatives), its customer to whom it sells brokerage products and services (and provides (nonfiduciary) advice which, legally, may be only “solely incidental” to the sale of such products and services) and the 800-pound gorilla in the equation–the various entities supplying the products and services. The latter are the principals to which their B/D agents owe them fiduciary duties.

That gorilla’s demands and requirements are never aligned legally with those of the customers, and often are not aligned with them in the everyday practices and customs of the marketplace. This is the great disconnect between these two vastly different business models–a broker relationship of three and an adviser relationship of two–and the great divide which defines what it means to be a fiduciary and not be a fiduciary.

In this column over the years, I have referred to the consequences of this disconnect and divide as trying to fit square pegs into round holes. That just does not–and cannot–ever work. And yet, that hasn’t stopped the SEC from listing a number of B/D practices in Regulation Best Interest that could create conflicts of interest but wouldn’t necessarily be verboten, including:

  • Charging commissions or other transaction-based fees;
  • Receiving or providing differential compensation based on the product sold;
  • Receiving third-party compensation;
  • Recommending proprietary products, products of affiliates or a limited range of products;
  • Recommending a security underwritten by the broker-dealer or a broker-dealer affiliate, including initial public offerings;
  • Recommending a transaction to be executed in a principal capacity;
  • Recommending complex products;
  • Allocating trades and research, including allocating investment opportunities (IPO allocations or proprietary research or advice) among different types of customers and between retail customers and the broker-dealer’s own account;
  • Considering cost to the broker-dealer of effecting the transaction or strategy on behalf of the customer (for example, the effort or cost of buying or selling an illiquid security); or
  • Accepting a retail customer’s order that is contrary to the broker-dealer’s recommendations.

As a result, I suggest an approach different from the mishmash offered by the SEC: actually enforcing the ’40 Act as it was written nearly 80 years ago. Toward that end, I suggest:

  1. Scrapping the proposals issued by the SEC on April 18 and consign them to the ash heap of history. This would also have the merit of helping meet the goals of the various and sundry federal Paperwork Reduction
  2. Requiring the SEC to rigorously enforce the “solely incidental” exception to the definition of an investment adviser in the ’40 Act which applies to “any broker or dealer whose performance of such [investment advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.” Let B/Ds sell their products and services, and RIAs provide fiduciary advice–and never the ‘twain shall meet.
  3. Enforcing Item 2 through a mandatory requirement that the following appear on the business cards of dual registrants and registered representatives of B/Ds, as well as on all other communications they may have with their customers or the general public: “nonfiduciary product salesperson.” No other such descriptive language will be permitted. Dual registrants will be deemed to be a fiduciary for the entirety of that relationship. Or ban dual registration altogether with, say, a three-year period in which a practitioner may choose on which side of the line they wish to fall. Further enforce Item 2 through a mandatory requirement that the following appear on the business cards of investment advisor representatives of RIAs, as well as on all other communications they may have with their clients or the general public: “fiduciary adviser.” No other such descriptive language will be permitted.

Two prominent commentators contacted me after my June column ran to tell me that my comment that dually registered firms (both B/Ds and RIAs) are not subject to Regulation Best Interest was incorrect. They are right, of course. What I meant to say–and should have said–is that B/Ds in dual registrants will not be subject to Regulation Best Interest if they take certain steps to avoid its reach.

Let’s recap: Stand-alone B/Ds are subject to Regulation Best Interest as are the B/Ds in dual registrants. But Michael Kitces suggests that B/Ds in dual registrants may escape the requirements of Regulation Best Interest altogether if they simply implement with a brokerage product or service the fiduciary advice provided by the RIA side of the dual registrant. That would obviate the need for any recommendations from the B/D which would otherwise trigger the strictures of Regulation Best Interest. In practice, then, a dual registrant would not need to comply with Regulation Best Interest–on the RIA side, of course, because it’s the ’40 Act that governs the RIA and on the B/D side because the B/D is not making any recommendations, but rather it’s the RIA that is giving fiduciary advice which the B/D simply implements with a brokerage product or service which would be subject to the current suitability rule.

Even stand-alone B/Ds could escape Regulation Best Interest by grafting an RIA onto them and proceeding as noted. In such cases, it would seem that the B/D would simply characterize any advice/recommendations as being fiduciary in nature to escape Regulation Best Interest. The end result is that it would possible for any B/D to return to being subject to the suitability standard and avoid Regulation Best Interest.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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