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Everything Financial Advisors Need to Know About the SEC’s Reg BI

Effective 6/30/20 the Securities & Exchange Commission established a new regulation that governs the conduct of BDs and their registered representatives when they recommend the purchase or sale of investments (securities, funds).

Reg BI establishes a "best interest" standard of conduct for broker-dealers and registered representatives when they make recommendations to any retail customers for securities transactions or investment strategies involving securities and recommendations for particular types of accounts.

Two key enhancements to existing regulations are that Reg BI explicitly imposes a poorly defined best interest standard and also requires a consideration of costs. These two requirements did not exist prior to the adoption of this regulation. Unfortunately, the expense disclosure is more about methodology and fee schedules versus the actual expenses that will be incurred by investors.

 

What About Suitability?

 Reg BI places greater emphasis than the Suitability Rule on consideration of reasonably available alternatives. However, note the vague terminology “reasonably available alternatives” that is subject to interpretation about what is reasonable and what is available. Advisors are also supposed to determine what is reasonably available for a client. In reality, it is their firms and approved lists that determine what is available. It is the advisors’ role to sell it. There is also a potential conflict of interest when this determination impacts their compensation in a significant way.

Prior to the new Best Interest standard of conduct, financial advisors were held to a vague standard called Suitability. Advisor recommendations were supposed to be based on the advisors’ in-depth knowledge of investors’ goals, circumstances, and tolerances for risk. Their comprehensive knowledge of their clients’ needs was supposed to enable advisors to make “suitable” recommendations.

However, this was always a vague requirement that was very difficult to enforce. For example, three advisors could make three very different recommendations and all three could be deemed suitable. There was no one recommendation, based on best practices, that could be deemed more suitable than the alternatives.

 

Investment Expenses

The inclusion of expenses in Reg BI is a potential enhancement if it is based on full “written” disclosure that is provided to investors in advance (before investors sign any documents). Anything less would work to the detriment of investors who do not ask the right questions. As noted earlier the regulation requires advisors to tell investors how they are compensated and not necessarily how much they compensated. 

It stands to reason, advisors who are paid high commission rates will not want to disclose this to their clients. An even bigger issue is what advisor services investors receive for higher compensation rates. Perhaps, the only service was a sales pitch to sell a particular product that produces the greatest amount of compensation for the advisor.

Since Reg BI targets advisors who sell investment products for commissions, any disclosure should force advisors to describe their compensation in more detail. More astute investors will use the information to compare the services they receive to the advisors’ compensation amounts. Unfortunately, Reg BI does not require this level of disclosure.

In an ideal world, it should be easy for investors to compare the expense of a fee-only advisor to the expense of a commission-only registered representative.

 

Form CRS (Client Relationship Summary)

Form CRS is part of a new disclosure obligation under Reg BI that broker-dealers and financial advisors are required to provide to retail investors beginning in the Summer of 2020.

According to the SEC, the main purpose of Form CRS is to provide retail investors with simple, easy-to-understand information about the nature of their relationships with their financial professionals, in order to help them compare services between firms and make more informed decisions.

Any form of disclosure is a positive for investors if they understand what they are seeing and the information helps them make better decisions – in this case, select the best financial advisor. 

It is important to note, Form CRS may be misleading when it describes advisors, hybrids, and brokers as all the same. 

 

Blurring Key Differences

If Reg BI is the same as the fiduciary standard, why is there a need for Reg BI? The SEC correctly states it is not. Why not make BD’s and their representatives subject to the same ethical standards that apply to Registered Investment Advisors and Investment Advisor Representatives?

Is it possible that Wall Street and its army of lobbyists were concerned about financial liability if firms were required to adhere to a higher ethical standard?

The actions of the regulatory agencies have blurred the ethical differences between RIAs and BD’s without holding the BDs to the same ethical standards that apply to the RIAs. That was the intent of creating a separate set of ethical standards that apply to BD’s and their representatives.

Fiduciary advisors are required to put their clients’ financial interests ahead of their own. Registered reps are supposed to make recommendations that are in their clients’ best interests. It may sound very similar, but it is not. If it was the same there would be no need for two sets of regulations.

 

What About Hybrids?

 If the Fiduciary Standard applies to RIAs and IARs and Reg BI applies to BDs and securities licensed reps, then there are two sets of regulations that apply to hybrids based on registrations, recommendations, and method of compensation. 

Can investors assume the applicable regulation will be based on the advisors’ recommendations? If this is correct, then this could be even more confusing for the typical investors who do not know the key differences. 

Confused investors are more prone to make the wrong decisions.

Hybrids should always be held to the higher ethical standard.

 

Fee-Only

If Reg BI and the fiduciary standard provide roughly the same protection for investors, then fiduciary is no longer a differentiating characteristic. RIAs and their representatives will have to develop other valuable differences that benefit their clients.

One of the obvious ones is method of compensation – the difference between advisors who are paid a fee and reps who are compensated with a commission.

One could argue the purest form of financial advice is delivered by an RIA/IAR who is compensated with a fee (asset-based, fixed, hourly).

 

Summary

In the future, it may not be as simple as in the past, when advisors used their fiduciary status to support their claims of being trustworthy.

In the future, there will be five primary distinctions:

  • Licensing (RIA versus BD)
  • Code of Ethics (Fiduciary versus BI)
  • Written Disclosure (Fiduciary versus CRS)
  • Method of Compensation (Fee versus Commission)
  • Fully loaded expenses (layers of fees)

These differences should be documented in an investor education eBook that is sponsored by an independent third party (https://thefiduciaryinstitute.org) and provided to investors by RIAs.

Investors are always better off if they trust what they see and not what they hear. It starts with what they see on financial advisor websites.

Reg BI may be an improvement, but it does not elevate BDs and registered reps to the same level as RIAs and IARs.

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