A breakdown of whether investors are safer after the SEC passes financial protection rule


The SEC this week voted to approve a financial investment reform package. Known as “Regulation Best Interest” or “Reg BI,” the package is intended to strengthen protections for investors by requiring financial advisors and in particular broker-dealers to disclose conflicts of interest.

Does it provide more protection for investors than previous rules?

It depends on who you ask.

Here’s the good news. Under the new Reg BI, both broker/dealers (a person or firm in the business of buying and selling securities on behalf of its customers) and investment advisors (a professional who provides financial advice to clients) will be required to place the interests of their clients above their own. Broker-dealers in particular will be required to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.

Both registered investment advisors and broker-dealers will be required to provide retail investors with a standard disclosure document that highlights the services being offered, the legal standards that apply, disclosure of any conflict of interest, and most importantly the fee structure — how they make their money.

That’s a positive. Under current law, financial advisors have a fiduciary obligations to act in the best interest of their clients and will remain fiduciaries under the new rules. The spirit of this new rule also requires broker/dealers to act in the best interest of their clients as well.

The bad news

Here’s the bad news. Critics are complaining Reg BI does not clearly define what “best interest” is and that the rules are too weak.

That’s the reason the rule passed on a 3-1 vote, with the lone Democrat dissenting.

From the outset, many investor advocates wanted a uniform set of rules that applied to both financial advisors and broker/dealers, one that would make both fiduciaries required to act in the best interests of their clients. The advisory community (Wall Street) has fought against this, arguing that earlier versions would invite an avalanche of lawsuits and restrict the ability of Americans to receive investment advice.

So instead of a uniform set of rules, we have two sets: a “fiduciary” rule for investment advisors and a “Best Interest” rule for broker-dealers.

While not perfect, there is reason to believe that the new Reg BI is an improvement over prior regulations, particularly concerning broker/dealers.

The broker-dealer community has faced criticism on several fronts. First, some believe they continue to place their clients into investments that are not suitable for them (putting a widow who should have relatively safe investments into a high-risk technology fund, for example), and that some broker-dealers routinely engage in trading their client’s portfolio solely to generate commissions without improving the portfolio, a practice known as “churning,” or only offered proprietary products that benefited the investment firm or that they failed to recommend the lowest-cost mutual fund or ETF.

Does the new Reg BI do anything to reduce these practices? I think they do.

First, there are disclosure obligations about the capacity in which the broker is acting, fees, the type and scope of services provided, and conflicts.

But there is more. There are standards of care that must be exercised. The broker-dealer must be able to articulate the risk, rewards, and costs of what they are doing for the client, and they must make a recommendation in the retail customer’s best interest.

Finally, the conflict of interest requirement mandates that broker/dealers must develop policies that identify and mitigate conflicts of interest, like suitability and churning.

With that said, I do understand the point of critics.  Without a clear definition of what constitutes “best interest,” the rules can still be slippery.

For example, it doesn’t specifically require brokers to routinely recommend the lowest cost funds. Cost is one factor among several that can be considered.

That’s why it’s likely the SEC will gradually develop standards for what constitutes “best interest.” They will have some time: Reg BI does not come into effect until June 2020.

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