W. Scott Simon
Over the years in this column, I have referred a number of times to the never-ending “Fiduciary Wars” that have raged over the past decade or so. The latest battle in this war took place on June 5, 2019, when the U.S. Securities and Exchange Commission issued Regulation Best Interest. With publication of Regulation Best Interest, the forces of darkness–nonfiduciary broker/dealers and their registered representatives (brokers)–decidedly outmaneuvered and thoroughly defeated the forces of light– fiduciary Registered Investment Advisors and their investment advisor representatives.
It was, of course, not a fair fight from the start. The SEC has a long history of favoring the brokerage industry (and the inherently conflicted suitability standard written by the industry’s self-regulatory organization, the National Association of Securities Dealers, which was succeeded in 2007 by the Financial Industry Regulatory Authority over federally registered RIAs–all to the financial detriment of retail investors.
It was, after all, the SEC that adopted a rule in 2005–Release No. IA-2376, “Certain Broker-Dealers Deemed Not To Be Investment Advisers”–which has been infamously referred to as the Merrill Lynch Rule. In it, the SEC deemed that fee-based brokerage accounts and wrap accounts offered by broker/dealers wouldn’t be subject to the fiduciary standard of the Investment Advisers Act of 1940. This meant that broker/dealers wouldn’t have to register as RIAs under the 1940 Act and therefore not have to abide by its fiduciary provisions even while offering fee-based accounts and wrap accounts.
The SEC granted this gift to broker/dealers under the “solely incidental” exemption of the 1940 Act, which reads, in part: “In general, a broker or dealer whose performance of [advisory] services is solely incidental to the conduct of [its] business as a broker or dealer [in effecting transactions in securities for the account of others] and that receives no special compensation therefor” is exempted from the definition of investment advisor. (My emphasis.) The SEC interpreted the solely incidental exemption in its 2005 release to mean that advisory services could be offered “in connection with and reasonably related to the brokerage services provided.”
This effectively overturned the clearly delineated roles of those who provide ongoing advice to investors in exchange for receiving fees (RIA fiduciaries) from those who sell products on a transactional basis in exchange for receiving commissions (broker/dealer nonfiduciaries). For many years, this arrangement required fiduciaries to meet the best-interest fiduciary standard of the 1940 Act while protecting nonfiduciaries that were not in the business of providing ongoing advice from having to comply with that standard.
But in its 2005 Release, the SEC gave broker/dealers, via regulation, the green light to invade the territory granted to RIAs by law since 1940, not only without penalty but also without having to play by the rules imposed on RIAs. In effect, this subordinated the interests of investors to those of nonfiduciary, commission-receiving broker/dealers instead of allowing those interests to be served by fiduciary, fee- receiving RIAs.
In 2007, however, the Merrill Lynch Rule was slapped down by the U.S. Court of Appeals for the District of Columbia Circuit in Financial Planning Association v. SEC. The Court held that the SEC overstepped its bounds by attempting to negate a long-standing federal statute–the 1940 Act–through its regulatory rule-making.
Instead of vigorously keeping fee-receiving fiduciary RIAs on one side of the line and commission- receiving nonfiduciary broker/dealers on their side, the SEC has chosen ever since 2007 not to enforce that clear divide. For example, a mere six months after the Financial Planning Association v. SEC decision, the SEC doubled down and reproposed a loosened “solely incidental” interpretation for broker/dealers in Release No. 2652, “Interpretive Rule Under The Advisers Act Affecting Broker-Dealers.”
Now, as part of its issuance of Regulation Best Interest, the SEC has, in effect, tripled down by officially adopting a rule in Release No. IA-5249 that readopts its interpretation proposed in 2007: “… a broker/dealer’s provision of advice as to the value and characteristics of securities or as to the advisability of transacting in securities is consistent with the solely incidental prong if the advice is provided in connection with and is reasonably related to the broker/dealer’s primary business of effecting securities transactions.”
What the SEC has done in issuing Regulation Best Interest is to broaden a broker/dealer’s solely incidental exemption of the 1940 Act–“… a broker or dealer whose performance of [advisory] services is solely incidental to the conduct of [its] business as a broker or dealer [in effecting transactions in securities for the account of others] and that receives no special compensation therefor”–to such an extent that broker/dealers will be able to offer advisory services virtually indistinguishable from those offered by RIAs. In short, the exception–in this case, exemption–has swallowed the rule.
Tying up the beautiful bow on this present offered by the SEC to the brokerage industry means that broker/dealers won’t be bound by the strictures of the fiduciary standard of the 1940 Act. Yes, they must follow a best-interest standard but, for all intents and purposes, that standard doesn’t differ all that much from the industry-created suitability standard. And “best interest” sure sounds like it’s in the “fiduciary” ballpark. You can be certain the marketing blitz that’s surely coming from the brokerage industry will associate these two phrases closely to imply that a broker/dealer is a fiduciary without mentioning the word “fiduciary.” To wit: “Are you a fiduciary?” “Well, we’re legally required to place the interests of our investor customers before our own exactly the same as RIAs are required to do.” Game, set, and match to the brokerage industry–courtesy of the SEC’s unceasing efforts to allow broker/dealers to operate as advisors in more and more areas and encroach on RIA territory without abiding by the fiduciary standard of the 1940 Act.
And here are some of those encroachments. Regulation Best Interest applies to a “recommendation” (that is, a “call to action”) of a securities transaction. According to the SEC, a recommendation could also apply to an “investment strategy,” such as creating a bond ladder, engaging in margin investing, liquidating a home’s equity or investing the proceeds, or engaging in day trading. The SEC also deems a recommendation to not only include securities transactions and investment strategies but also how they are invested and managed. This would include, for example, a recommendation about the type of account, such as a commission-based broker/dealer account or a fee-based RIA account, or whether to roll over or transfer assets from an employer retirement plan to an IRA, assuming that those assets will be invested in securities.
Mind you, in Regulation Best Interest the SEC has deemed all such recommendations–that is, the performance of advisory services–to be solely incidental to the brokerage services offered by broker/dealers, therefore exempting them from being defined as an RIA and being bound by its fiduciary standard. Such is the chutzpah of the brokerage industry, and the SEC is going along with it.
I will offer further observations about Regulation Best Interest in next month’s column.
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.