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Regulation Best Interest: Financial Professionals’ New Rules

SEC with handshake in background

  |  By Curtis Glovier

The Securities and Exchange Commission (SEC) has adopted a new package of rules, referred to as Regulation Best Interest or Regulation BI, that are “designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers.”

So, why were these new rules approved, and what do they mean for investors? Here is a closer look at Regulation Best Interest.

Why did the SEC pass Regulation BI?

The term financial advisor is often used loosely to refer to professionals who offer financial advice. But financial advisors affiliated with a broker-dealer follow a different model than those affiliated with a Registered Investment Advisor (RIA). In the broker-dealer model, advisors are paid to sell financial products, like stocks and bonds, to investors. In the registered investment adviser model, advisers are paid to provide investment advice and financial planning. (This article provides an in-depth look at the differences between the two.)

Given these roles, regulators have held broker-dealers and investment advisers to two different standards of care—the suitability standard and the fiduciary standard. Because investment advisers offered advice, they were considered to be fiduciaries, and they were required to work in the best interest of the client. Broker-dealers were held to the lower suitability standard and were required to recommend products to an investor that they deemed to be “suitable”—even if those investments were not the lowest cost or the best suited for an individual.

But over time, the lines between broker-dealers and investment advisers blurred, and in 2016, the Department of Labor (DOL) finalized a fiduciary rule that would have required all financial advisors who received compensation for providing investment advice to clients with IRAs and 401(k)s to act in their clients' best interest. But following a legal challenge, the U.S. Fifth Circuit Court of Appeals struck down the rule in 2018.

What is Regulation Best Interest?

In the absence of the DOL Fiduciary Rule, the SEC moved forward with efforts to review broker-dealer standards, and the result is Regulation Best Interest.

Regulation BI goes beyond the suitability standard for broker-dealers by stating that broker-dealers must act in the “best interest” of their retail clients. They must recommend financial products that are in their customers’ best interests and clearly identify any potential conflicts of interest they have with those products. They must also disclose any financial incentives they receive for selling those products, and they may not put their financial interests ahead of a retail client’s interests when making recommendations. 

However, broker-dealers are still not considered fiduciaries. While they must act in the best interest of a client, Regulation Best Interest does not define the term “best interest,” nor does it hold them to the higher fiduciary standard of investment advisers.

What are Regulation BI’s new obligations?

Regulation BI includes four new obligations that broker-dealers must meet when working with retail clients:

  • Disclosure Obligation: Broker-dealers must disclose all fees, costs, and conflicts of the products and services they provide.
  • Care Obligation: Broker-dealers must exercise reasonable diligence when making a recommendation to a client. They must understand the investment’s risks and rewards, and they are required to consider costs when making a recommendation. However, broker-dealers are not required to recommend the cheapest option.
  • Conflict-of-Interest Obligation: The broker-dealer must have and enforce written policies and procedures designed to identify and—at a minimum—disclose or eliminate conflicts of interest. The policies and procedures must:
    • Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest, or the interests of the firm, ahead of the client’s interest;
    • Prevent material limitations on offerings—such as a limited product menu or offering only proprietary products—from causing the firm or its financial professional to place his or her interest or the interests of the firm ahead of the client’s interest; and
    • Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.
  • Compliance Obligation: This obligation requires that broker-dealers produce written policies that ensure they comply with Regulation Best Interest.

How do the rules apply to IRAs?

Broker-dealers must comply with these new rules when dealing with retirement plans, including recommending IRA rollovers. As the SEC states in its rule, the decision to roll over a 401(k) into an IRA may be one of the most significant financial decisions a retail investor could make. That means a broker-dealer must now assure a rollover is in the best interest of a client.

Broker-dealers will need to consider a client’s investment profile when recommending an IRA rollover, as well as a variety of factors related to IRAs, such as fees, available investment options, and required minimum distributions. As the rule states, “we caution broker-dealers not to rely on, for example, an IRA having ‘more investment options’ as the basis for recommending a rollover.”

What does Regulation BI mean for self-directed investors?

The rule becomes effective 60 days after it is published in the Federal Register, but the Compliance Date (the date brokers-dealer and their representatives must begin complying with the new requirements of Regulation BI) will be June 30, 2020.. As of that date, a client should expect to receive a relationship summary when they start working with a broker-dealer or investment adviser. This summary must include a range of information, including services being offered, fees being charged, conflicts of interest, and whether the firm and its financial professionals have a history of disciplinary action. The summary must be produced in a Q&A format, so investors can easily compare summaries among advisors.

In addition, while broker-dealers and investment advisers must act in the “best interests” of clients, “best interest” still means different things for broker-dealers and investment advisers. Investment advisers are considered fiduciaries and are required by the SEC to:

  • Provide undivided loyalty and utmost good faith
  • Avoid misleading clients
  • Provide full and fair disclosure of all material facts when offering investment advice. These are facts that "a reasonable investor would consider to be important."
  • Avoid all conflicts of interest or disclose any potential conflicts of interest that may exist

As a self-directed investor, you and your financial advisor are responsible for evaluating the merits of all investments that you decide to own in your IRA. Self-directed IRA custodians like PENSCO review deals solely for administrative feasibility—custodians do not evaluate the merits of deals and cannot offer advice.

Given this, it’s important to find a financial advisor or investment adviser you can trust and that you understand the type of investment advice they will provide—advice in your best interest or advice held to a fiduciary standard. Asking questions upfront and understanding how a potential advisor will review investments and be compensated can help form the basis of a successful and long-term advisor-client relationship.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.

PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.