When the Securities and Exchange Commission (SEC) voted 3-1 to adopt a package of new rules and interpretations that were, “designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers,” were they successful?
Industry participants are quite divided on how this new stack of regulations, called Regulation Best Interest, or Reg BI, will affect financial institutions and their customers. There are almost 800 pages of rules to examine, and opinions vary widely on whether Reg BI will help Main Street investors. Though language in Reg BI says that it covers both financial advisors and broker-dealers, the focus is on potential conflicts in advisory relationships.
Last fall, Congressional Democrats criticized the then-draft package of rules, saying it fell "woefully short" of protections they felt were needed. "Regulation BI for brokers and the SEC's interpretation of the 'fiduciary' obligation owed by investment advisers fail to clearly do this, enabling investors to 'consent' to harmful conduct in complex and legalistic disclosures that most will never read and would not understand if they did," reads a letter from 35 Democrats to the SEC.
To me, the biggest failing built in to Reg BI is that financial advisors can still recommend investments that harm their clients as long as they disclose the harm in advance. I would prefer language that prevents the harmful advice in the first place. I doubt that the disclosure will be worded clearly, but suggest that financial advisors who are looking to fatten their own wallets rather than increasing their customers' wealth just put out a statement saying, "Hey, I want you to buy this because it helps me. It may be good for you, too, but that's not my priority."
How Did We Get Here?
The U.S. Department of Labor took a stab at protecting retirement investments when, in early 2017, they proposed the Fiduciary Rule, which would have legally bound financial professionals who work with retirement plans or provide retirement planning advice to put their clients’ best interests first. That seems like a no-brainer, really, but it was blocked by the current executive branch of the Federal Government and killed in June 2018. A number of states started proposing their own versions of the fiduciary rule, so the SEC jumped in with Reg BI in an attempt to avoid a patchwork quilt of regulations that would differ once one crossed a state line.
Reg BI lays out four obligations, all intended to require broker-dealers to only recommend financial products that are in their customers’ best interests, and to clearly identify any potential conflicts of interest and financial incentives the broker-dealer may have with those products. The regulations require numerous disclosures that financial institutions must provide to their clients. These disclosures are likely to be packed with legalese, which may hide the conflicts they are meant to explain.
Why do financial institutions need regulations to force them to be more transparent, and to put their client’s best interests first? I am not a lawyer, but my interpretation of the bulk of regulations comes down to, “Hey, don’t cheat your clients out of their own money.” Not scamming clients should be Rule #1 for all businesses.
I saw these conflicts of interest live and in person when I had a part-time job at a branch of E.F. Hutton, a firm that is now long gone, during my time as an undergraduate. At least once a week, and sometimes more frequently, the brokers were offered bonuses on top of their usual commissions for selling a particular company’s stock to their clients. The clients were not told that their broker was recommending this stock for selfish reasons. As a relatively naïve economics major, I was appalled. But that led me to study the establishment of the SEC, and to understand that financial institutions do not operate out of an altruistic desire to make the world a better place.
After I started analyzing technical tools and websites for investors in the early 1990s, I was surprised to learn that many of the schemes that hurt individual investors at full service brokers had extended to the digital world. Brokers who crowed that they were not charging commissions were trading against their own clients, and in the days before decimalization, that could cost an investor a lot more than a $10 fee. Watching brokers route orders to venues that generate revenue for them without taking their customers' interests into account gave me flashbacks to my E.F. Hutton days. Mutual funds with huge front-end loads also appear to benefit the brokers and fund managers rather than investors.
What They're Saying
One of the anti-Reg BI voices belongs to SEC Commissioner Robert Jackson, the lone vote against adopting the package, who wanted the new rules to clearly state that investors come first. “Sadly, I cannot say that,” Jackson laments. “Today’s rules maintain a muddled standard. Today’s rules simply do not require that investors’ interests come first.”
Official responses from several online brokers and robo advisors essentially translate to: “We have to read this huge pile of regulations and figure it all out now that it’s final.” Fidelity Investments , which offers managed accounts as well as tools for self-directed investors, puts it this way, in a statement: “Fidelity remains committed to putting the needs of our clients first and supports stronger rules that are in the best interest of retail investors.” It continues, “We are currently evaluating the final rule and what it means for investors, businesses and intermediaries, and we have a robust team of experts in place to implement any required changes under the final rule.”
M1 Finance's CEO, Brian Barnes, does not believe it will change the way his firm does business since they do not offer advice. But Barnes notes, "When people sign up for a financial account, they agree to about 84 pages of disclosures already. Now that will be 86 pages. I don't think firms will change that much." He is concerned that the disclosures could be mealy-mouthed catch-alls such as, "We may be compensated. There may be cheaper options out there."
TradeStation’s Nicholas LaMaina, senior vice president of product management and strategy, tells us, “We’ve been tracking these regulatory events since the SEC’s first real proposal over a year ago and have never expected that Regulation BI would have a material impact on the way TradeStation conducts its businesses.” Other self-directed brokers, including Interactive Brokers, tell us that they do not expect Reg BI to cause any major changes in the way they do business.
Lobbying groups have stated their support of the new regulations, which is to be expected since they were deeply involved in drafting them. Critics say that the investment industry lobbying groups believe the fiduciary standard imposes burdensome, costly and unnecessary requirements that don't have a corresponding investor-protection benefit.
Investment Company Institute President and CEO Paul Schott Stevens responded to the approval of Reg BI by saying, “Regulation Best Interest will better serve investor interests by ensuring investors are afforded strong protections when they receive recommendations from broker-dealers. We look forward to engaging with the SEC and our members as they work to implement the new standards.” Stevens urges the Department of Labor to get back on the horse, stating, “Now it is crucial that the Department of Labor complete its fiduciary rule-making in a manner that is complementary to the SEC’s rule-makings to ensure consistent standards for both retail and retirement investors.”
Dale Brown, President and CEO of the Financial Services Institute (FSI), issued a statement saying that his organization had been advocating for improved investor since before Dodd-Frank became law in 2010. “The SEC is the correct agency to develop and implement this standard and, while we have yet to fully review the final rule, what we heard during the hearing gives us hope that it will protect investors while also preserving investor choice and access to professional advice,” Brown said. He also cautions, “Now that we have a final rule from the SEC, we strongly urge the states to refrain from creating and implementing their own best interest standards, in order to avoid creating conflicting rules and further complicating regulatory requirements.”
Betterment’s CEO and founder, Jon Stein, agrees with Commissioner Jackson, and is not a fan of Reg BI. Stein says, “Regulation Best Interest will likely hurt retail investors who need quality advice that puts their interests first. Unfortunately, this misleadingly titled rule may best serve the marketing interests of large financial corporations to the detriment of individual investors. It is a gift of sheep’s clothing to the wolves of Wall Street.”
Aaron Klein, CEO of fintech firm Riskalyze, which helps financial advisors assess their clients’ attitude towards risk, says in a thread on Twitter, “Some fiduciary advisors do not want a uniform standard because it will reduce their differentiation on providing un-conflicted advice vs. selling a financial product.” Klein goes on to say, “… what we really need in this profession is TRANSPARENCY. Consumers need to know whether they are buying a product or buying advice. It should not take thousands of pages of rules to get that concept across.”
TradeStation’s LaMaina concludes, “Time will tell how the requirements will shape and evolve the retail broker-dealer industry, and if these new requirements will prompt firms to take increasingly conservative positions in the way they promote and present their products and services.”
We've seen a shift over the last ten years to greater transparency when it comes to fees charged by online brokers, but there are still some mysteries to be solved. How are brokers who offer commission-free trades of exchange-traded funds (ETFs) compensated, for example? As the disclosures required under Reg BI are put into place, advisory clients will end up clicking through statements describing conflicts and fees. Make sure you understand them, and if they seem opaque, ask for clarification.
What would move the bar to provide better information to investing clients? M1's Barnes says, "It's not an easy problem to solve. But one of the clearest things that could help is if brokers and advisors had to publish an all-in management cost, or report their revenue as a percentage of the assets under management." If a firm claimed to be very low cost, but reports that their all-in management fee is 2.5%, you know they're not making that money out of thin air. Barnes also suggest that an independent agency provides a scorecard that rates firms based on lack of conflict and transparency.
New rules like Reg BI are always caught in tug-of-war between established broker dealers who have made their money pretty much the same way for years, and new technology upstarts who claim to level the playing field for investors. The field has always been tilted toward the former, but investors could and should demand more.