Six Ways Regulation Best Interest Falls Short of a Fiduciary Standard

with No Comments

On June 5th, 2019, the Securities and Exchange Commission (SEC) released their final draft of Reg BI, or “Best Interest” as it is called. Unfortunately,¬†Regulation Best Interest does not have your best interests at heart. I am absolutely certain that broker-dealers will take great advantage of the term to confuse and attract clients to their sub-par-standard service model.

A fiduciary is held to the highest legal and ethical standards for the property entrusted to your care. Any random person who acts as an executor or as a trustee or under a power of attorney is considered a fiduciary and held to the fiduciary standard.

However, the SEC is allowing financial professionals to hide in a lower legal requirement, not meet a fiduciary standard, and call it “Best Interest.”

Here are six ways that Regulation Best Interest falls short of the fiduciary standard.

1. Best Interest is not a fiduciary standard.

The SEC states plainly, “We have declined to subject broker-dealers to a wholesale and complete application of the existing fiduciary standard under the Advisers Act because it is not appropriately tailored to the structure and characteristics of the broker-dealer business model (i.e., transaction-specific recommendations and compensation).”

Instead, it should be said that the entire broker-dealer business model of sales recommendations is not tailored to providing the objective financial advice that consumers deserve.

2. Best Interest is rules-based.

The SEC admits, “We do not believe that any rulemaking governing retail investor-advice relationships can solve for every issue presented.” They understand that¬†there are no such things as “fiduciary rules.” And yet, they have still tried to solve the issue with additional rules rather than adopting the principles-based model of the fiduciary standard.

This rules-based methodology is one of the weaknesses of regulatory agencies in the United States.

3. Best Interest is full of conflicts of interest.

The SEC admits, “We do not intend for our standard to require a broker-dealer to provide conflict-free recommendations.”

The wording with Regulation Best Interest was very carefully chosen, but the average consumer will not understand the difference. Regulation Best Interest uses the language that the interests of the broker-dealer “not be put ahead of” the interests of the consumer. This is different than giving advice “without regard to” the broker-dealer’s interests. Broker-dealers are not required to “put aside” their own interests.

The SEC carefully worded their regulation to imply that broker-dealers can keep their interests and conflicted advice so long as they do not put it ahead of the interests of the retail customer. The SEC plainly states that they rejected the wording that broker-dealers provide advice “without regard to” their own interests.

A fiduciary standard on the other hand includes the loyalty obligation which requires advice be given “without regard to the advisor’s interests.”

4. Best Interest is temporary.

Being a fiduciary requires ongoing responsibilities. The duty of care and the duty to monitor includes the duty to provide advice and monitoring at a frequency that is in the best interest of the client according to the scope of the relationship.

A broker-dealer’s relationship with a client stems from a sales-like transaction and Regulation Best Interest requires no ongoing responsibilities. There is no duty to monitor a customer’s account or provide any additional advice after a sale has been made.

5. Bad behavior is merely disclosed not eliminated.

The SEC suggests, “The enhancements contained in Regulation Best Interest are designed to improve investor protection by enhancing the quality of broker-dealer recommendations.” But nothing in the regulation requires broker-dealers to actually improve the quality of their recommendations. Disclosure, rather than elimination, is all that is required of conflicts of interest. And so long as all the alternatives within your system gouge clients equally you are allowed to pick from among them freely.

Again, the SEC suggests, “These actions are designed to help retail customers better understand and … make an informed choice [and] … provide clarity.” Yet nothing in the regulation will have any of these effects because disclosures written to obscure the truth will succeed in obscuring the truth.

6. The added record keeping requirements only hurt smaller fiduciary firms.

The SEC states, “In addition to adopting Regulation Best Interest, we are also adopting the record-making and record keeping requirements largely as proposed, with certain explanations and clarifications regarding the scope of these requirements and the extent to which new obligations have been created.”

Most consumers think that requiring firms to have additional record keeping is harmless. It is not.

In a massive broker-dealing firm, all the record keeping and regulatory filings are done by a team of corporate lawyers. The overhead is minuscule when compared with the vast army of commission-based salespeople posing as advisors each of whom does not need to worry about such content. Additionally, the disclosure text written by these lawyers is the backbone of their compliance and therefore the heart of their defense if they are ever challenged.

In a smaller fiduciary firm, staff is working under a principles-based fiduciary standards. Time and effort is spent on whatever helps the client achieve their goals. Regulatory paperwork and record keeping is largely irrelevant to the task of meeting the fiduciary standard. No amount of paperwork will exonerate you if you are not fulfilling the fiduciary standard that you are subject to.

At Marotta Wealth Management, I serve as the Chief Compliance Officer (CCO) and am responsible for all of the old and new obligations created by SEC lawyers. It was my responsibility to write our ADV Part 2 when they added that requirement. It is my responsibility to complete our ADV Part 1 filing with the SEC each year and update our ADV Part 2 as necessary. It will be my responsibility to compose the newly created ADV Part 3 Form CRS Relationship Summary as that is rolled out in the near future. Each of these documents requires annual updating with information unimportant to the decision clients make when choosing our firm.

Our ADV Part 2 required months of work when it was first crafted. First, it required understanding what the SEC was asking to be disclosed. Next, it required research to understand why they considered these questions worth asking. Then, it required drafting an explanation that both educated consumers as well as answered the question regarding our firm. Finally, it required extensive editing to reduce the reading level as much as possible. The result is a 27 page document written at a 9.8 Flesch Kincaid Grade level. (Compare this to the latest March 2019 ADV Part 2 for the Ameriprise Financial Planning Service CRD# 6363 which reads at a 19.3 Flesch Kincaid Grade level.)

The expertise required to be an excellent Chief Compliance Officer may not overlap with the expertise required to be an excellent fee-only fiduciary advisor. It is like requiring your doctor to be good at malpractice legal defense. Yes, they will learn something. Yes, the fields are related. However, it may still end up being a waste of time.

Photo by Thomas Bonometti on Unsplash

Follow David John Marotta:

President

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)