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Implications of Reg BI for Broker-Dealers and Advisors

It may seem like a commonsense approach to financial planning to act in the best interest of your clients, but the reality is, that may not always be the case.

This is because there’s a variety of different styles of planner: from broker-dealers to registered reps, the planning community comes in a variety of flavors. The key to this – and why “best interest” may seem hard – has to do with how each of these various groups earn their fees. Commissions, flat rates and hourly fees dot the landscape. And in that, investors may not fully understand what they are getting when they sign up for a certain kind of advisor.

To that end, the Securities & Exchange Commission (SEC) has unveiled a wide-sweeping new set of rules designed to limit client headaches and force advisors to act in their “best interest.”

Dubbed Reg BI, the rules are wide and have huge implications for the planning community and completely changes how some things currently work.

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Reg BI: An Overview

The process to launching a standard for the advising industry has been a long one. The early portions of the process actually started back in 2016, but the ball really got rolling during the Spring of 2018, when the SEC launched three new proposals under its “Enhance Protections and Preserve Choice for Retail Investors in Their Relationships With Investment Professionals” doctrine. The idea was a simple one: to remove conflicts and increase compliance so that broker-dealers act in their clients’ best interest.

One of the big concerns for regulators is that not all broker-dealers focus on clients’ actual needs. BD’s tend to be paid via sales commissions. Buy and sell decisions, choice of product families and overall portfolio construction can be driven solely by what a BD might earn. Most broker-dealers don’t act in an unscrupulous manner, but recent high-profile cases of “churning” and the focus on low-cost index funds have brought light to their fees.

According to the SEC, the Financial Industry Regulatory Authority’s (FINRA) suitability standard doesn’t go far enough. That standard requires that a “firm or associated person have a reasonable basis to believe a recommended transaction or investment strategy involving a security or securities is suitable for the customer.” With this policy, accountability is still light.

So, after two years of public comments and rules changes, the SEC has brought the advising community Reg BI. Starting June 30 of this year, broker-dealers and advisors will be forced to navigate the four main pieces of Reg BI – care, disclosures, conflicts of interest and compliance.

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Two Main Pieces

The actual rule is a complex nearly 1,400 page document, within which there are really two main ideas to Reg BI. First comes down to recommending suitable investments and the second comes down to disclosure rules.

Under Reg BI, broker-dealers will be forced to have a general obligation to their customers when making a recommendation of any securities transaction or investment strategy for retail customers. BD’s must “not put [their] financial interests ahead of the interests of a retail customer when making recommendations.” In a nutshell, they can’t recommend something strictly because of high fees or any benefits to themselves or their firms. Under the rules, broker-dealers must understand all the potential risks, rewards and costs; recognize a customer’s investment profile; and, show that buy/sell/transactions are not considered excessive for each client.

Much of the enforcement of this comes down to compliance. In addition to new filings from firms documenting much of the transactions and reasonings behind investment decisions, BD’s will be subjected to a new series of licensing tests. The Office of Compliance Inspections and Examinations will begin issuing a series of new exams covering the four main obligations of Reg BI: Disclosure, Care, Conflict of Interest and Compliance.

Penalties and fines will exist for firms/broker-dealers violating the rules and not acting in the best interest of their clients.

The second major piece to Reg BI is a new disclosure form called the Customer/Client Relationship Summary or Form CRS.

Given the complex nature of how consumers receive investment advice, many clients don’t actually know how they are paying for said advice. Fee disclosures can sometimes be hidden in the fine print. Form CRS seeks to eliminate this headache. The SEC has proposed an easy-to-read summary that will be provided to clients at the time advice is provided.

Form CRS will examine client/customer relationships, show services the firm offers, and highlight conflicts of interests that may arise. More importantly, the document will provide a real schedule and explain the fees/costs associated with the investment. It’ll spell out how commissions are paid per buy/sell decision, yearly management costs, etc. The form will also include some interesting side information about whether or not a firm and its financial brokers currently have any reportable legal or disciplinary history with the SEC.

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Differences for RIAs & BDs

Given the wide range of advisor types out there, Reg BI isn’t exactly the same for them all. And in fact, Regulated Investment Advisors (RIAs) actually get away with only a few issues under the rule to meet compliance.

Thanks to the fact that they are already considered “fiduciaries” and act in a client’s best interest to begin with, RIAs aren’t subjected to many of the rules pertaining to putting clients first. It’s something that they already should be doing under the fiduciary banner. For RIA’s, many of the changes come from disclosing any potential conflicts of interest. Such a situation might arise, for instance, when advisors recommend iShares ETFs, while another client owns shares of BlackRock.

These sorts of disclosures will need to be known by clients in the future and RIAs will be forced to also hand out CRS forms to clients.

For those advisors under a broker-dealer model, get ready for a complete overhaul of the business model. While the rules are designed to keep RIAs and BDs separate choices for consumers, the implication of the rules are vast on the BD side. And many are not prepared to meet the changes. A recent Morningstar survey showed that at least 1/3 of BDs were unsure if their firm had taken “any proactive steps to address their product lineup in light of Regulation Best Interest (Reg BI) compliance.” That’s a huge issue given how much the new rules affect the broker-dealer industry.

Another wild card are those dual-registered advisors. That is, those who are both registered reps of a broker-dealer and an RIA. According to the SEC, Reg BI would only apply to the BD side of the business and not when the advisor was acting under the RIA side. This can create another set of compliance rules and additional costs for advisors. It may push decisions to switch solely from one side to the other.

The Bottom Line

In the end, Reg Best Interest is a wide-sweeping rule that we’ve only quickly covered. But the real gist are the expanding rules that advisors of all stripes must adhere to in order to act in the best way for their clients. Through new compliance issues, tests and disclosures, the hope is to level the playing field and reduce retail investor gripes about the advising industry.

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May 05, 2020