The Forgotten Aspects of Reg BI

By now you know that the SEC Commissioners have passed, by a 3-1 margin, the new Reg. BI Rule, which has somehow metastasized into four proposals: 34-86031- The Broker-Dealer Standard of Conduct; IA-5248 – Commission Interpretation Regarding Standard of Conduct for Investment Advisors; IA-5249 – Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Advisor; and the overlooked 34-86032 – CRS Relationship Summary; Amendments to Form ADV

In all, the rule covers, by my count, just over 1,370 pages—most of it, frankly, fluff. 

The media coverage has mostly focused on the fact that the SEC fell short of imposing a fiduciary standard on all who purport to provide investment advice, despite calling the broker-dealer regulatory requirements a “best interest” standard.    They’ve compared what Reg BI “best interest” obligations with traditional suitability standards, and found no material differences.

Those are certainly setbacks to the fiduciary advisor world.  But Reg BI is fundamentally a disclosure rule, which means that fiduciary advisors (and, of course brokers) will have to meet new disclosure requirements.  That’s what I want to focus on here: what, exactly, are you going to have to disclose that you didn’t have to before Reg BI went into effect?

Reg BI in a Nutshell

To my mind, the SEC gave away its real intentions pretty early, when it announced (pages 9-10 of the original proposal) that its goal was to protect the broker-dealer model and “choice” for the consumer:

“Our goal in designing proposed Regulation Best Interest is to enhance investor protection, while preserving, to the extent possible, access and choice for investors who prefer the “pay as you go” model for advice from broker-dealers, as well as preserve retail customer choice of the level and types of advice provided and the products available.”

And on page 38-39 you get more of the same:

“We believe that such investors may prefer a commission-based brokerage relationship over a fee-based account.”

Thus, I was a bit surprised to discover, on pages 171-172, that brokers and BDs and wirehouse reps would be prohibited from using the term “advisor” to describe themselves and their services:

“We are proposing to restrict any broker or dealer, and any natural person who is an associated person of such broker or dealer, when communicating with a retail investor, from using as part of its name or title the words “adviser” or “advisor” unless such broker or dealer is registered as an investment adviser…” 

As you’ll see shortly, brokers are not required to tell prospects that they are not allowed to call themselves ‘advisors,’ and there seems no restriction in calling themselves “wealth managers,” or “vice presidents of investments.”  But you might, if you’re marketing against the brokerage office up the street, tell your prospect to ask them if they actually serve as “advisors.”  If they come up with a different term, ask the question again, recognizing that they are, by SEC regulation, not allowed to call themselves what you are free to call yourself.

Form and Substance

But what about the actual disclosures?  Here (final rule link:, the SEC made substantial modifications, and I think it’s fair to say that whenever any substantial party raised an objection, the Commission executed an immediate strategic retreat.  This is good for advisors (less complicated paperwork, less clumsy wording from the SEC which really has a misleading effect), but even better for the brokerage firms (they can devise their own wording, which I would bet will be extremely slick while telling the investor less than meets the eye).  The original disclosure language that the SEC has written out for brokers, which they were required to give to their clients, under Form CRS, said, in relevant part:

“We must act in your best interest and not place our interests ahead of yours when we recommend an investment or an investment strategy involving securities. When we provide any service to you, we must treat you fairly and comply with a number of specific obligations.”

In its modified proposal, the SEC abandoned this required wording—and that, in this case, is a very good thing.  No sane compliance attorney would have allowed a brokerage firm to put that language on client communications, so the SEC was proposing to do it for them under a safe harbor. 

Now brokers and advisors must use their own language to provide a four pages or less “relationship summary” whose heading the SEC has helpfully written for you: “What investment services and advice can you provide me?” (page 87 of 34-86032 – CRS Relationship Summary; Amendments to Form ADV—and all future references will be to this part of the rule.)

Your disclosure will start by summarizing the brokerage or investment advisory services that you provide, and any material limitations on those services. (page 92).  Advisors might say they offer financial planning and asset management services.  Broker-dealer reps must, somewhere here, state that they buy and sell securities, but the SEC decided not to require them to say that they are engaged in a sales relationship.  In my mind, this was a huge concession to the brokerage lobbyists.

You will also have to disclose whether you have account minimums, and to explain whether or not you monitor retail investors’ investments, and how frequently.  You must disclose whether you accept discretionary authority, and whether there are any limitations on that authority—and broker-dealer reps may (but are not required to) state whether they accept limited discretionary authority. (various places, but see page 94 and thereafter)   If the firm offers non-discretionary services, then it must disclose that the investor makes final decisions—and you can bet the brokerage firms will use this language to the hilt.  (Your honor, it may look like I sold all sorts of garbage and crap to my customer, but notice in the disclosure form where it is clearly disclosed that the investor makes all final decisions on purchases and sales.)

Brokerage firms will also have to disclose if their reps are limited in what they can recommend (sell), and describe those limitations (i.e., only proprietary products or products that offer revenue-sharing payments for shelf space).  There appears to be no requirement to disclose if the firm is pushing certain products over others.

Then there’s this (page 108): “In a change from the proposal we are requiring firms to provide specific references to more detailed information about their services that, at a minimum, include the same or equivalent information to that required by the Form ADV Part 2A Brochure.”  A link to your ADV on your website would appear to be sufficient.

At the end of this section, the SEC has helpfully supplied a list of questions that must be included by both brokerage firms and advisors:

Advisors: “Given my financial situation, should I choose a brokerage service?  Why or why not?”

Brokers: “Given my financial situation, should I choose an investment advisory service?  Why or why not?”

All: “How will you choose investments to recommend to me?”

All:  “What is your relevant experience, including your licenses, education and other qualifications?  What do those qualifications mean?”

Interestingly, the SEC dropped the requirement to describe how often the retail investor can expect you to communicate with him or her.

Fee disclosures

This brings us to the next section, which must be titled: “What fees will I pay?”  (page 122). Firms will summarize their fees and costs for brokerage and investment advisory services, how frequently those fees are assessed and the conflicts of interest they create.  Brokerage firms must describe transaction-based fees, while advisor would describe their asset-based or fixed fees.

It will be interesting to see how diligently the brokerage firms adhere to the requirement (page 130) to disclose “custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product-level fees.”  Will the broker have to disclose that he’s charging an asset management fee, and then putting client money into proprietary funds or separately-managed accounts that slip some of their management fees into the brokerage firm’s back pocket?  (The reader is advised not to hold your breath.)  A few pages later, we are told that annuity surrender fees should be disclosed.  That would be at least a mild breeze of fresh air.

The SEC will require your disclosure document to include (page 133): “You will pay fees and costs whether you make or lose money on your investments.  Fees and costs will reduce any amount of money you make on your investment over time.  Please make sure you understand what fees and costs you are paying.” 

And the SEC has written what I believe to be a very naive “conversation starter” to go in the back of this section:

All: “Help me understand how these fees and costs might affect my investments.  If I give you $10,000 to invest, how much will go to fees and costs, and how much will be invested for me?”  (Only upfront costs?  Really?)

I worry a little bit about a provision on page 42 of the final report, which says “firms may omit or modify required disclosures or conversation starters that are inapplicable to their business, or specific wording required by the financial instructions that is inaccurate.”  Who is going to decide?  Do I trust the brokerage firms to make that call?

Conflicts of interest

That brings us to the “standard of conduct” disclosure, which the SEC will require to be titled “What is your legal obligation to me?” In passing, I felt like the SEC totally gave the game away when it stated (page 145) about some commentators: “Others believed that retail investors are unlikely to understand the difference between “best interest” and “fiduciary”…” But wait.  I thought ‘best interest’ was equivalent to the fiduciary standard.  It’s clear that even the SEC doesn’t think so.

The SEC will require your disclosure form—and brokerage firms’—to include the question: “How might your conflicts of interest affect me, and how will you address them?”  (page 151)  The final rule (page 156) says that the disclosure must include specific information about proprietary products, third-party payments, revenue sharing and principal trading.

I see some hope here that brokerage firms might be required to talk about the deep conflicts built into the revenue model, but experience tells me the reality will disappoint.  Meanwhile, advisors with an AUM revenue model will have more to disclose than advisors who charge fixed quarterly fees or by the hour.

Another required question (page 166): “How do your financial professionals make money?”  The final draft says that the firm must disclose “whether financial professionals are compensated based on facts such as: the amount of client assets they service; the time and complexity required to meet a client’s needs; the product sold (i.e. differential compensation); product sales commissions; or revenue the firm earns from the financial professional’s advisory services or recommendations.” If your advisory team is paid a salary, this would seem pretty straightforward.  But what about the owner of the firm—is he or she not compensated based on number of clients, number of assets, etc.?  I can envision needing legal help with this one.

Disciplinary history

Finally, the “disciplinary history” section, which provides (a victory for advisory firms) “firm-specific” disclosures.  So even if a Merrill Lynch broker has a clean disciplinary record, the fact that the firm has a file long enough to qualify as a rap sheet is what gets disclosed.

Here’s the required heading (page 171): “Do you or your financial professionals have legal or disciplinary history?”  This is a ‘yes’ or ‘no’ question, alas, which means that brokerage firms are not required to disclose the tens or hundreds millions of dollars they paid out to regulators and customers for things they neither admitted nor denied.  But the form does have to include directions to the website to allow the consumer to research the firm and its financial professionals. 

The “yes” response that every brokerage firm will put on this disclosure form will be mitigated verbally.  The SEC (page 176) says that the broker “can make clear that a “Yes” disclosure in response to the heading question relates to the firm and other personnel… and not to them.” They can give any explanation they want about the nature of the abuses, and you can bet that brokers will be trained in how to answer this question with a sunny interpretation of the facts. 

The SEC totally punted on a proposed requirement that firms include information on how retail investors should report complaints about their investments, accounts or ‘professionals.’  But it does require a few ‘conversation starters’ (page 181) in the form of: “Who is my primary contact person?  Is he or she a representative of an investment adviser or a broker-dealer?  Who can I talk to if I have concerns about how this person is treating me?”  The disclosure form must also include a telephone number where the investor can request an updated copy of the relationship summary.

When do you deliver this document to your clients?  For brokerage firms, the earliest of any recommendation of account or securities transaction, placing an order or the opening of an account.  Advisors must deliver this information before a new account is opened or an advisory agreement is signed.  You have to re-deliver or deliver an updated version whenever you open a new account that is different from the existing account(s).

You also have to file the relationship summary with the SEC or FINRA in text-searchable format.  You can provide PDFs or paper versions to customers and clients.

Unleveling the playing field

So basically, you’re going to have to create a disclosure document, some of which has been helpfully written for you by the SEC, some of which you’re going to have to write yourself, including disclosure of compensation and conflicts of interest engrained in your business model.  It will be four pages long.  I expect us to see safe harbor guidelines and boilerplate language provided by attorneys and others, and I suspect a relatively standard template will emerge for all parties.  It’s going to be another annoying hassle.

But what will the impact be on consumers?  Will these disclosures tilt the playing field toward advisors or toward brokers?

It’s interesting to note that the SEC included a kind of sketchy economic analysis to the back of the proposal, which offered a kind of breezy summary of the onerous costs they were imposing on broker-dealers and other providers. 

But the SEC also looked at the competitive landscape, and its conclusions are revealing.  Page 316 of the original proposal notes that, despite the costs, this “best interest standard” could become a terrific sales tool for the brokerage industry:

“To the extent that retail customers perceive that the amelioration of the principal-agency conflict reinforces retail customers’ beliefs that broker-dealers will act in their best interest, retail customers’ demand for broker-dealer recommendations may increase.” 

  This is elaborated on three pages later in a VERY revealing passage:

“It may be the case… that certain retail customers base their choice between a broker-dealer and an investment adviser, at least in part, on their perception of the standards of conduct each owes to their customers. For example, there may be retail customers who prefer the commission structure of a broker-dealer, but who also prefer the fiduciary standard of conduct applicable to investment advisers… Because the proposed rule establishes a best interest standard of conduct that incorporates and goes beyond the current broker-dealer standard of conduct, broker-dealers may be better able to compete with investment advisers for those customers. To the extent that there are customers who prefer the commission structure of a broker-dealer, but who chose to use an investment adviser because of their fiduciary standard of conduct, we expect that the proposed rule will enhance competition between broker-dealers and investment advisers. (emphasis added)

Bingo!  The illusion of an enhanced standard of care, without any actual requirement that broker-dealers change their behavior, would be a boon to the brokerage industry’s ability to compete with those darned fiduciary advisors.  This is what the sales industry has wanted all along, and they got it, and the SEC is acknowledging that they got it.

This is far more nitty-gritty than you’re hearing from any of the major publications or consumer advocates.  We have been told (I think accurately) that the proposal is basically a custom-tailored sheep’s clothing for the wolves of Wall Street.  But the immediate impact is forcing advisors like you to create yet another disclosure document, which will probably have to be written by attorneys unless somebody creates a standardized template with different language covering different circumstances.  (AUM vs. quarterly flat fees, or discretionary vs. non-discretionary are some examples.)

But of course, you’ll get these documents prepared, and you’ll point out to prospects who are considering the brokerage firm up the street that the regulatory history question is meaningful, and the conflicts can be more complicated than they’ll see on the disclosure form.  My best advice, for fiduciary advisors, is to provide a fiduciary oath to clients as a supplement to the disclosure form, and invite the client to ask the broker who supposedly acts in everybody’s “best interest” to sign its clear declarative statement.  (Here’s my favorite version of the Oath:

I continue to believe that, despite the SEC’s abject retreat in the face of brokerage lobbying, fiduciary advisors are going to continue increasing their market share and Wall Street is in a long-term decline.  Even the SEC can’t prevent the grinding inexorability of market forces and consumer preference for somebody who is actually going to act in their best interests.

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