On June 5, 2019, the SEC released a new rule under the Securities Exchange act of 1934: Regulation Best Interest (Reg BI). The SEC’s press release on the rule can be found here: https://www.sec.gov/news/press-release/2019-89. For those more enterprising, the full 771 page rule can be read by following this link: https://www.sec.gov/rules/final/2019/34-86031.pdf
Not all financial advice is the same. At a high level, advisors are split into two camps – brokers and Investment Advisor Representatives (IARs). Until implementation of Reg BI,brokers are operating under a “suitability standard”. What does that mean? An investment has to be appropriate for a client at the time of sale, but there is nothing wrong with higher fee products being sold to clients. Additionally, it meant if a broker is contemplating two suitable investments for a client, they can pick the one that pays them a higher commission; in other words, the broker/ client relationship is transactional in nature and littered with conflicts of interest.
Investment Advisor Representatives work for Registered Investment Advisors (RIAs). IARs operate under a fiduciary standard. This means all of their advice has to be in the best interest of the client; how an IAR may benefit from the advice is not a consideration when making a recommendation to the client. It is a relationship with ongoing fiduciary responsibilities and, in our experience, has tended to be consultative in nature. The main conflict of interest,in our view, tends to be that clients pay a fee based on assets under management and the IAR is incentivized to grow assets.
What we’re seeing from Reg BI isn’t new. The previous administration attempted to pass something similar but ultimately fell short before being adopted as a rule when power changed hands. Our take is that this new version appears to be a watered-down version of the previous proposal.
At a high level the following changes have occurred:
Disclosure obligations– the fees of products and relationship between the sponsoring product and securities firm needs to be disclosed. While more transparency is better than less transparency, if the disclosure comes in the form of fine print buried within a 300-page prospectus then we’d argue this isn’t sufficient. Insurance products are notable for their 300+ page prospectuses, but that doesn’t mean the clients have a better understanding of the costs, benefits, features, and restrictions. The prior proposal required explicit written documentation of the fee difference and basis of recommendation of various products and strategies.Reg BI appears to fall short of the prior proposals in regard to disclosure obligations.
Care Obligation– a broker must exercise reasonable diligence, care, and skill when making a recommendation to a client. The broker must also consider the client’s investment profile when making a recommendation.
To us (as fiduciaries), exercising diligence, care, and skill is a fairly obvious obligation. We find the obligation to be a step forward for the industry but also telling that the Commission needs to codify those rules in such plain black and white language for some participants.
Reg BI also leaves a lot of discretion to the broker on what constitutes “reasonable diligence” and how a broker defines an “investment profile” for a client.
We find financial planning and investment management to be a mix between art and science. Determining the right investment, or investment mix, takes a keen understanding of a client’s goals and objectives,willingness and ability to take risk, time horizon, tax considerations,investment history and sophistication, as well as various other constraints. We think the end result for broker’s clients is that most investment profiles will be determined more by “paint by number” approaches than by consultative discussions.
Compliance Obligation– broker-dealers (employers of brokers) need to create and enforce policies and procedures designed to “reasonably” achieve compliance with Reg BI.
Pre-Reg BI compliance departments were designed to ensure nefarious actions against clients were not taking place. Reg BI does not seem to be advancing the standard and oversight over brokers. Instead, Reg BI is letting the compliance department set their rules to “reasonably” achieve enforcement of Reg BI. Having said that, we have no doubt the commission will punish those broker-dealers not adhering to their own rules.
The last high-level comment we have on Reg BI is that compliance with the rule for brokers is still determined at the point of sale. Similar to the current suitability standard, there doesn’t appear to be an ongoing obligation on behalf of the broker after are commendation is made. For example, an insurance company could have a solvency or business-related issue which puts a previously recommended annuity or life insurance contract in jeopardy of not being paid out. Based on our understanding of Reg BI, there is no obligation on the broker to revisit the appropriateness of that previously recommended product unless he or she is making yet another sale. We think this is one of the more misunderstood and under-appreciated differences between a fiduciary standard and a suitability/Reg BI standard.
While we believe this rule does do some things to protect investors, and in general more transparency is better than less transparency, we think there is still a wide gap between the standard a broker needs to follow versus an Investment Advisor Representative. Our opinion is that even with Reg BI set to take effect, it is more important than ever for investors to understand the incentives, motivations, and responsibilities of financial professionals operating under differing sets of standards and what that may mean for them.
