By LARRY SWEDROE
With the new Regulation Best Interest (BI) rule adopted by the US regulator, the Securities and Exchange Commission (SEC), in June 2019, certain industry participants are arguing that the bar is raised for those employed by broker-dealers. Unfortunately, while true, the comparison is relative to the old suitability standard, which, in my opinion, had little value. The reason is that “suitability” was never explicitly defined but rather was comprised of three very broad-based obligations for a broker-dealer that never provided enough protections for the retail investor.
For example, I have seen markups (spread above the inter-dealer price) on municipal bonds (beyond the well-disclosed nominal transaction fee, typically in the range of $10 to $50) of several percentage points and have read about cases where the spreads are as high as 6 percent. Yet, the regulators, arbiters and courts have not found these to be unsuitable despite the fact that the broker-dealer was taking no risk on the trade. And while certain structured notes sold by broker-dealers have been found to have excessive fees according to a number of studies (overvaluing the embedded options by, on average, as much as 8 percent), tens of billions of dollars of these investments are sold by broker-dealers every year. That is the big problem with the new best interest standard—the framework does not go far enough and fails to include an explicit definition, leaving plenty of room for the exploitation of investors. Let’s see why that is the case.
First, there is a major difference between the fiduciary standard (the highest standard under the law, which requires that an advisor’s sole loyalty is to the investor) and the new best interest standard (in which each state can enact its own law governing the definition because the SEC did not provide one). As SEC Chairman Clayton noted in his comments on the new standard in comparison to fiduciary duty, “Best interest on the broker side has many of the same elements, but we want people to understand that the investment advisor space, and the broker-dealer space, are different.” He added: “They’re very different in the way people get paid. In the broker-dealer space, you get paid usually a commission on a transaction by transaction basis. In the investment advisor space, it’s more of a long-term relationship, where you get paid on a quarterly fee, yearly fee, and the advisor has a more portfolio lifetime relationship with you. Those are two very different relationships and we want to be clear.” I would add that, in contrast to the fiduciary standard, the best interest standard does not require the advisor to have a continuing duty of care or of loyalty to the client after providing a recommendation.
Second, the new best interest standard still allows for commission-based compensation. The broker-dealers have fought to keep this form of compensation, arguing that doing away with it would deprive investors with smaller portfolios of the service they need. That argument holds less water than the proverbial sieve and cannot be defended. Here’s why. Consider the investor with $10,000 to invest, and the broker-dealer is charging a 6 percent commission to purchase an investment product. The 6 percent equals $600. Thus, the broker-dealer could instead charge a flat fee of $600. However, while the two forms of payment provide the broker-dealer the same compensation, there is big difference in incentives. In the case of the commission, the broker-dealer could direct the investor to purchase a product from the provider who is paying the largest commission. In the alternative scenario, since the broker-dealer gets the same compensation regardless of which investment is purchased, there is no incentive to direct the investment to an inferior product simply because the broker-dealer is more highly compensated. A flat fee or assets under management (AUM) fee, instead of a commission, eliminates this particular conflict of interest.
Third, the new standard does not include a formal restriction for broker-dealers from using the term “adviser” or “advisor,” which was included in the proposed rule, and this restriction is now part of the disclosure obligations of Regulation BI. Additionally, the final version of Form CRS (client relationship summary) eliminated the word “fiduciary” from the disclosure requirements for registered investment advisers (which was in the original proposal) and requires both brokers and investment advisers to use the term “best interest” to describe their standard of conduct. Thus, investors are likely to remain confused about the standard of care required, believing that best interest protects them the same way the fiduciary standard provided by registered investment advisors protects them. In fact, studies done on behalf of the SEC have found consumers do not understand the differences. Thus, the tougher fiduciary rule needs to be the standard.
Fourth, while sales competitions with award trips, bonuses and other rewards based on the sales of specific securities or specific types of securities were to some degree shot down in the best interest rule, they were not prohibited. Thus, broker-dealers could simply redo their sales competition models and allow them to continue. There are always smart people who are able to find ways to get around rules that allow for ambiguity.
The bottom line is that while the best interest standard is an improvement, it’s only a marginal one. As Forbes contributor Jaimie Hopkins noted, while the Department of Labor fiduciary rule has teeth, the new SEC rule has gums. Consumers will likely continue to be harmed by the absence of a uniform fiduciary standard that applies to all who provide personalised investment advice, and pay excessive fees and commissions. Consumers are exposed to even greater and unnecessary risks from products that may be deemed suitable for them but are inferior to other available options, and are only arguably in their best interests at the moment of the recommendation. The new rules simply do not provide investors with protections, as they are not explicit enough in their requirements to fully protect retail investors and thus may even lack enforceability.
The SEC could have mandated the fiduciary standard be imposed. The Dodd-Frank legislation required an evaluation of the regulatory standards of care. Sadly, it did not happen due to pressure from broker-dealers who spend huge sums on lobbyists, buying the loyalty of members of Congress who have failed to support the fiduciary standard. At the very least, the SEC could have mandated that in order to use the title advisor (or adviser), one must provide a fiduciary standard of care. Unfortunately, it appears that it was a “bridge to far.” While the best interest is an improvement, it still allows broker-dealers to operate as “wolves in sheep’s clothing.” In the meantime, the best advice for retail investors is to never work with a commission-based advisor and require that an advisor provide, in writing, evidence demonstrating they are providing a fiduciary standard of care on an ongoing basis. There is no reason for not doing so, as there are tens of thousands of true advisors who do. Forewarned is forearmed.
Since certified financial planners (CFPs) will be required to provide a fiduciary standard of care (or lose their professional designation) under the new CFP Code of Ethics and Standards of Conduct, there has been a flood of CFPs leaving the broker-dealer world. This trend is likely to continue until we have one fiduciary standard that applies to all.