Reg BI turns 2, but not everyone is celebrating

Over the years, some have become convinced Reg BI is a significant step up from brokers’ previous suitability standard. Others remain skeptical that it’s tough enough to curb broker conflicts.

After almost two years, there’s no consensus on whether the broker standard of conduct is working, and proponents and skeptics of the measure continue a fervent debate over whether it can deliver on its investor protection promises.

There’s not even agreement on the exact age of Regulation Best Interest. The SEC promulgated the final regulation in June 2019. The measure went into force as scheduled in June 2020 in the middle of the coronavirus pandemic because the agency wanted to keep one of its top regulatory priorities on track.

The measure prohibits brokers from putting their interests, such as maximizing compensation, ahead of their customers’ interests, such as getting the best return on their investments. It was the centerpiece of a package that also included a disclosure document called the client relationship summary — or Form CRS — and a Securities and Exchange Commission staff interpretation of Investment Advisers Act of 1940 that governs investment advisers.

Reg BI is within a month of either its second or third birthday, depending on whether its advent is assumed to be promulgation in 2019 or its implementation in 2020. Over the years of its existence, some have become convinced it’s a significant step up from brokers’ previous suitability standard. Others remain skeptical that it’s tough enough to curb broker conflicts.

If there’s any agreement among market participants, regulators and experts, it’s that it’s too early to make a final judgment on Reg BI.

“There’s a lot more work to be done in the industry,” said Ohio Securities Commissioner Andrea Seidt. “We as regulators have a lot more work to do to make sure firms are going in the right direction.”

The SEC has not yet weighed in with a major enforcement case. Its first piece of Reg BI guidance — a staff bulletin about the appropriate steps to take in account recommendations — emphasized that cost is an important consideration but did not break new ground.

Two years after implementation, the debate over whether Reg BI is, in fact, protecting investors continues with as much fervor as the debate over whether it would protect investors did in the years leading up to its promulgation.

Investing in Compliance

“Yes, it is working,” said Mark Quinn, director of regulatory affairs at Cetera Financial Group.

Cetera has made major investments of time and money — a “seven-figure expenditure” — to comply with Reg BI, Quinn said. For instance, the firm has implemented technology that helps brokers compare an array of potential recommendations based on historical return, risk and cost to satisfy the Reg BI requirement that they assess alternatives.

The difference in the level of analysis now compared to before Reg BI “is dramatic,” Quinn said. “It’s a much more robust process.”

Quinn said Cetera also has levelized compensation for investments such as variable annuities and non-traded real estate investment trusts to remove incentives that might steer brokers to a particular product.

An investor advocate has a different view.

“I haven’t seen any meaningful changes in [brokerage] business practices based on my review of Reg BI disclosures,” said Micah Hauptman, director of investor protection at the Consumer Federation of America. “Given that, it’s not clear recommendations and advice have improved in a meaningful way.”

During the run-up to Reg BI, investor advocates argued that Reg BI wasn’t as strong as fiduciary duty in ensuring that advisers acted in clients’ best interests. But Reg BI proponents point to the SEC staff bulletin that equates Reg BI with the fiduciary standard, stating that they “yield substantially similar results” in responsibilities to retail investors.

“They certainly think it’s a strong standard and that it’s working,” said Kevin Carroll, managing director and associate general counsel at the Securities Industry and Financial Markets Association.

Putting Reg BI and fiduciary duty on the same plane sets off Knut Rostad, president of the Institute for the Fiduciary Standard. He took umbrage at an SEC answer on a set of frequently asked questions about Form CRS that discouraged investment advisers from using the term “fiduciary” on the document.

“The SEC rationale for Reg BI and Form CRS has evolved from raising the broker standard and helping investors see that advisers and brokers differ to seeking to lower the adviser standard and helping investors view advisers and brokers alike,” Rostad said. “This is becoming a pass/fail grading system. There’s no such thing as superior work anymore.”

The SEC did not respond to a request for an interview with Gary Gensler, the agency’s chairman.

Room for Interpretation

One reason that opinions diverge is that there’s so much room for interpretation when it comes to implementing and complying with Reg BI.

The regulation is principles-based. It is meant to ensure that a brokerage’s customers and an investment advisory firm’s clients essentially receive the same protections even though brokers operate under Reg BI and advisers adhere to fiduciary duty. But Reg BI doesn’t provide specific rules brokers must follow.

For instance, Reg BI requires that brokers disclose and avoid or mitigate conflicts of interest. But 10 brokerages may have 10 different approaches for addressing conflicts — and each may think that it is doing so correctly.

“Mitigation of conflicts is much more of an art than a science,” Quinn said.

Under Reg BI, brokers are required to consider reasonably available alternatives to the product and strategy recommendations they make. They’re not forced to go with the lowest-cost option, but the regulation certainly implies that they must explain why they didn’t so.

But brokers are usually confident that they’re doing right by their customers.

“There’s always a rationale about why that recommendation was in the client’s best interest if you ask the registered representative,” said Bao Nguyen, a principal in risk advisory services at Kaufman Rossin.

The SEC is applying a principles-based rule to a brokerage industry that traditionally has been transactions-oriented.

Reg BI is about establishing the right process for delivering investment advice, and that may not have immediately sunk in with brokerages that focus on sales, said Fred Reish, a partner at Faegre Drinker Biddle & Reath.

Reg BI “is improving the disclosures and the quality of services, but it is slower than the SEC might have anticipated,” Reish said. “There’s a culture clash between the standard of are and the culture of some organizations. That’s why it will take a while to fully integrate for all broker-dealers. It has to get into the fabric of the culture.”

Stepping up

Brokerages are stepping up their efforts to satisfy Reg BI, Nguyen said. Initially, there was a tendency to use off-the-shelf compliance products. Now, brokerages are putting in place compliance systems that are molded around their business model.

“They’re implementing a more detailed process of supervision around Reg BI as opposed to just embedding the regulatory language in their policies and procedures,” said Nguyen, a former Finra examiner and chief compliance officer.

But supervision is exactly where firms are falling short, Seidt said. She chairs the Reg BI implementation committee of the North American Securities Administrators Association, the organization for state securities regulators.

Last November, NASAA released a report that concluded Reg BI hasn’t curbed the sale of complex, costly and risky products — such as private securities, variable annuities, nontraded REITs and leveraged or inverse ETFs — that provide a revenue boost for brokers but can harm their customers.

“They’ve made disclosing them better,” Seidt said. “I don’t think we’ve seen any progress from firms in moving away from harmful compensation conflicts. They need to stop layering their incentives because every additional incentive increases the likelihood that the firm is going to place its financial interests ahead of the customer’s.”

The brokerage industry has disputed NASAA’s assertions.

“We’re not seeing those exam findings out of the SEC or Finra,” Carroll said.
How Reg BI is supposed to work is captured in the tension over the sales of complex products. State regulators say the measure hasn’t curbed brokers’ appetite to push the investments. But Carroll said Reg BI wasn’t designed to stop such recommendations.

“Complex products are appropriate and in the best interest of some number of retail clients,” he said. “Whether it’s in the best interest of [other] retail customers is where the Regulation Best Interest rubber meets the road.”

How brokerages handle complex products under Reg BI is an area where there’s room for improvement, Nguyen said. He’s noticed that many firms don’t track such transactions, even though both Finra and the SEC have focused on them.

“I’m surprised more firms don’t keep a record of the complex products they’ve sold and why it’s in a customer’s best interest [in order to] demonstrate compliance with Regulation Best Interest,” Nguyen said.

While the Reg BI package was being drafted, Form CRS was criticized by the financial industry and investor advocates. It’s a two-page document for advisers and brokers and four pages for dual registrants that outlines a firm’s services, fees, conflicts of interest, disciplinary history and other information. It must be filed with the SEC and made available to retail investors on a firm’s website.


Now that Reg BI is in force, Form CRS continues to cause consternation. The SEC has conducted several enforcement cases against firms that missed CRS deadlines or failed to file it. The agency also has released guidance warning firms that it has found that the document can be dense and inaccurate.
Quinn said Form CRS is helpful but said there is room for improvement.

“There may be additional work to do for firms to make it more digestible for investors,” Quinn said. He noted that only so much information can be conveyed in four pages and said Cetera Financial Group offers a supplementary conflicts disclosure that runs about 30 pages.

The work-in-progress theme will continue for Reg BI, perhaps even through future anniversaries.

“I’ve been surprised at how much work it’s taken for organizations to make changes to be in compliance with the principles-based best interest standard in Reg BI,” Reish said.

To read the full article please visit InvestmentNews.

Bao Nguyen, CAMS, CFE, CRCP, is a Risk Advisory Services Principal- Broker-Dealer & RIA Leader at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.