Your financial advisor is looking out for your best interest, right? In theory, yes. But up until recently, some financial advisors could legally steer you into investments that would line their pockets too. A rule from the Securities and Exchange Commission (SEC), implemented mid-2019, addresses that issue by defining new standards of care, specifically for investment brokers. That rule is known as Regulation Best Interest or Reg BI.
The SEC rolled out Reg BI to address a discrepancy in the standards of care that brokers and Registered Investors Advisors (RIA) must legally follow. Under the old rules, broker recommendations for financial products had to pass the suitability test — meaning all recommended products or strategies must be a good fit for the client’s situation. But if there was more than one “suitable” option, the broker was free to push the one that paid higher commissions. RIAs, on the other hand, are held to the higher standard of fiduciary care. The fiduciary standard requires advisors to act in good faith and prioritize the clients’ interests above their own.
The challenge with having different standards for brokers vs. RIAs is that it creates confusion and inconsistency for clients. This can potentially be harmful if a client is recommended an option that’s not in their best interest, or if the broker simply chooses not to inform the client of an option because they don’t have a legal requirement to do so. For example, a broker may not recommend a life settlement because they are unfamiliar with this option and don’t have a legal requirement to notify their client of it, even though it’s in the client’s best interest to be aware of all their assets and liquidity options.
Before Reg BI, both investment brokers and RIAs would call themselves financial advisors, so you might have no idea which standard of care applies to you. Read on to learn how to find out if your advisor is a broker or an RIA, what protections Reg BI offers you, and what limitations Reg BI has relative to the stricter fiduciary care standard.
Regulation Best Interest Summary
Reg BI applies specifically to broker-dealers and their representatives. Broker-dealers are financial institutions that trade securities for themselves but also on behalf of its clients. Fidelity Investments, Charles Schwab, and TDAmeritrade are three large, U.S.-based broker-dealers. When a broker-dealer representative buys stock for you in your account, he or she is acting as your broker. The dealer role happens when the institution makes trades for itself.
Brokers often get paid by way of commissions for selling products and securities. This naturally creates a conflict between what’s best for the broker and what’s best for you as the client. Reg BI aims to limit that conflict by defining a broker’s obligation to you and mandating disclosures, so you better understand the fees you’re being charged.
Impact of Regulation Best Interest for Financial Advisors
Reg BI has two main functions. First, it specifies that only RIAs working under the fiduciary standard can call themselves advisors. This should help delineate the difference between RIAs who must work in your best interest, and brokers who follow the lesser standard defined in Reg BI.
Second, Reg BI defines your broker’s obligations to you and other clients. The overriding obligation is that your broker must work in your best interest. Under that umbrella, your broker must also fulfill four specific obligations.
1. Disclosure Obligation
For all recommendations, your broker must provide, in writing, an explanation of the recommendation and its risks. The broker must also define his or her responsibilities with respect to that recommendation and disclose any conflicts of interest.
As a simple example, let’s say your broker advocates an investment strategy that involves frequent trading to pursue gains on short-term market trends. Your broker would have to explain this strategy and the risks involved. You would also expect your broker to outline how he or she will monitor your account and what measures will be in place (such as stop-loss orders) to mitigate your risk. If your broker earns commissions on every trade, that would also be disclosed as a conflict of interest.
2. Care Obligation
Under the Care Obligation, your broker must “exercise reasonable diligence, care, and skill when making a recommendation.” That means your broker should deeply understand the risk/reward trade-off of the recommendation and reasonably believe the proposed strategy will benefit you.
For example, it wouldn’t be reasonable for a broker to recommend an all-equity portfolio if you are risk-averse or intend to retire next year. Your broker’s recommendations must be justifiable considering your financial situation, age, liquidity needs, risk tolerance, and investment experience.
3. Conflict of Interest Obligation
The Conflict of Interest Obligation applies to broker-dealer institutions. At the corporate level, broker-dealer institutions must design and enforce internal policies to manage conflicts of interest between their employees and clients.
An example of a Reg BI policy would be a company-wide ban on bonuses associated with selling certain securities. Incentivizing employees for selling a specific security goes against the spirit of Reg BI — because it encourages brokers to push that security, regardless of whether it’s a good fit for the client’s investment strategy.
4. Compliance Obligation
The Compliance Obligation also applies only to the institution. Broker-dealer institutions must design and enforce internal policies that support compliance with Reg BI. That might include structured compliance training workshops and refresher courses along with processes for monitoring compliance and handling any violations.
In the name of transparency, Reg BI also requires brokers and RIAs to provide clients with a general disclosure called Form CRS, or client relationship summary. Form CRS summarizes the firm’s set of services along with the associated standard of care. This document should also disclose all costs, fees, conflicts of interest, and whether the firm has any history of disciplinary action against it.
Limitations of Regulation Best Interest
Reg BI is intended to protect you and add transparency to your relationship with your broker. But the rule has its critics. Some say Reg BI doesn’t go far enough, and that the SEC should enforce the stricter fiduciary standard on brokers. Others argue that the Reg BI disclosure requirements may be more confusing than helpful. The thinking is that many clients won’t read or understand their Reg BI disclosures. That could create an opportunity for firms to hide conflicts of interest within dense, fine-print documents that are casually handed to clients without explanation.
Consumer Expectations of Financial Advisors as a Result of Reg BI
Despite the criticism, Reg BI does raise standard of care provided by brokers. Even if you don’t understand every disclosure, your broker is still obligated to act in your best interest, which wasn’t the case before Reg BI. This only affects you, of course, if you’re working with a broker (and not an RIA) today. If you’re not sure whether your professional is a broker or RIA, you can ask directly or reference the CRS.
You’d ask the same question if you’re in the market for a financial professional. You’ll want to know upfront what the professional’s role is and what standard of care will apply.
Going forward, brokers can better fulfill Reg BI obligations by expanding their expertise to a broad variety of financial strategies, products, services, and securities. One example is our life settlement exchange which can help clients on two sides of the life settlement transaction. Clients with unwanted life insurance can sell those policies for high cash proceeds. And high-net-worth clients can enrich their portfolios with a low-risk asset that’s not correlated to the stock market.