The SEC’s Regulation Best Interest (Reg BI) turns two on June 30th. Reg BI was supposed to help investors better understand how advisors and brokers differ and have BDs meet a “best interest” standard based on fiduciary principles.
It turns out that Reg BI is doing the opposite.
Let’s start with a little background. The SEC fought hard for Reg BI, as explained in its April 18, 2018 proposal:
Investor confusion regarding the difference between broker-dealers and investment advisers …. (they) are subject to various different regulatory regimes … (and) many investors do not have a firm grasp on the important differences between BDs and IAs.
It was passed on June 5, 2019. Reg BI was championed by SEC Chairman Jay Clayton, who said it addressed “Investor confusion regarding the difference between broker-dealers and investment advisers…”
The 770-plus-page release explained what matters about BDs and IAs.The SEC wrote about brokers on page six:
As a general matter BDs and IAs have different types of relationships … different compensation models. … Broker-dealers typically provide transaction-specific recommendations (and) may include recommending transactions where the broker-dealer is recommending buying securities from or selling securities to retail customers on a retail basis or recommending proprietary products. …
The release then explained how a BD has “Inherent conflicts of interest” coming from “a transaction-based (e.g., commission-based) compensation structure” and that, most importantly, this structure incentives the BD to increase its own compensation or financial interests “at the expense of the customer.”
This language well describes BDs. It also then describes the IA role as “distinct.” This was a good start, but the finish was awful. The problem: When form CRS summarized IA and BD roles and obligations, they were virtually identical.
They were virtually identical in terms of legal obligations, conflicts, fees and services. The most recent SEC guidance on CRS effectively banished the word “fiduciary” because, the staff explained, citing fiduciary status was “extraneous.” The main difference between IAs and BDs, according to the SEC, is that the former provides ongoing advice.
Form CRS ignores many issues, including the core IA and BD differences. But the difference between fiduciary advisors representing clients and broker-dealers trading for themselves or selling for third parties is material. It is basic and understood by anyone whose interests have ever been well represented, in legal, healthcare or personal matters by someone looking out for them.
Form CRS ignores its own core tenets. In June 2022, four years after Reg BI was first proposed, the core tenets of form CRS – a best interest standard based on fiduciary principles and helping investors differentiate between IAs and BDs – are ignored. This is clear from the first major review of reg BI by North American Securities Administrators Association’s (NASSA) and the first major enforcement case by the SEC.
That first major review of Reg BI concluded that the suitability standard still prevails. The NASSA November 2021 report suggested not much has changed under Reg BI.
Melanie Senter Lubin, NASAA president and Maryland securities commissioner, stated. “This examination reveals that while there were some improvements, most firms are operating in the same manner as they were under the suitability rule, especially when it comes to harmful compensation conflicts.”
The first major SEC enforcement case released June 16th also underscored the focus on the suitability rule.
The SEC press release stressed that the defendants allegedly failed to comply with Reg BI’s “care obligation” and best interest standard. Yet, the basis of this case is not the undefined broker best interest standard; it is the well-defined suitability rule.
The SEC alleged that the brokers recommended and sold bonds to retail customers on fixed incomes with moderate risk tolerances. Yet, according to the SEC, the broker, GWG Holdings, stated the “L Bonds were high risk, illiquid and only suitable for customers with substantial financial resources.” These were unsuitable recommendations.
The prominence of the suitability rule in NASAA’s findings shows how the industry views Reg BI. The primacy of suitability in this first major enforcement case shows how the SEC views Reg BI.
This second unhappy birthday should be remembered for how Reg BI has transitioned since April 2018 to become the opposite of what it was conceived to do. In April 2018, the SEC sought to raise the broker standard and help investors understand how advisors and brokers differ. Today, the SEC has lowered the advisor standard and proclaims that advisors and brokers are the same.
This unhappy birthday affirms concerns that many expressed when the rule was released. A day before that release, in June 2019, three consumer groups criticized the SEC for falsely claiming Reg BI was “better for investors.” Congrats to the Consumer Federation of America, PIABA and Better Markets.
They got it right.