A Curious Thing Happened on the Way to Implementing Regulation Best Interest
June 30, 2020, was D-Day for investment brokers, the day when they were to have implemented – or at least made a “good faith” effort to apply under the COVID-19 shutdowns – Regulation Best Interest and its companion Form Customer Relationship Summary (Reg BI and Form CRS). When adopted on 5 June 2019, the rulemaking was a huge disappointment for most retail investor protection advocates, though the SEC contended it would raise standards of care for brokers above and beyond the suitability standard they would replace. The rule was upheld late last Friday by the 2nd US Circuit Court of Appeals.
While it was unclear in 2019 whether the SEC’s new rule would improve investor advice or further muddy the distinctions between brokers and fiduciary investment advisers, few could have foreseen the monumental changes facing the brokerage industry from within its own ranks. Those changes would in many ways turn what was a significant political victory for the industry into a soul-searching industry overhaul.
Within days of the SEC’s ruling, the industry was readying itself for the new regulatory order it’d fought hard to create. No longer would brokers operate under Investment Advisers Act restrictions on giving investment advice only when incidental to their brokerage activities. The new rule had redefined “incidental” to include just about anything a broker did. Moreover, the rule’s best-interest provisions restricted brokers only from putting their own interests ahead of their clients’. It was a seemingly insignificant semantic difference from the fiduciary requirement of putting clients’ interests first, but one that amounts to a potentially gaping chasm in practice and in law.
The shifting competitive forces in the brokerage market, however, were about to intrude. Vexed by discount brokers since the end of fixed commissions in 1974, traditional brokers also had to deal with new technology-enabled entrants who were undermining the brokerage industry’s commission-based business model. Charles Schwab Corp. made the zero-commission revolution mainstream when it announced in early October its intention to offer no-commission trades. The move was quickly followed by E*Trade Financial Corp. and TD Ameritrade Holding Corp. The industry had to see the writing on the wall, and it could not have been pleased.
There is no such thing as a free lunch, of course. In the case of zero commissions, the online brokers already had ways to bolster revenues to operate profitably in the new environment they were creating. Among the most common is for discount brokers to sell clients’ orders to brokerage aggregators, who earn money on the spread between the prices they pay and what they charge. They were also piecing together revenues from requiring minimum cash balances the online brokers would invest at market-based returns while paying deposit-like low returns, as well as from pocketing the fees from lending clients’ shares to short-sellers, and from interest earned on margin loans to those same clients.
Schwab’s moves hastened not just the industry’s reassessment of its business model sans commissions but also its reconsideration of where to put its people and resources. Many have since decided the better course is to train their brokers as registration as investment adviser representatives so they could earn fees based on the value of assets they manage for clients. The coronavirus has interrupted this transition, which is the reason for the SEC’s adoption of a “good faith” implementation standard.
At the same time, the changes in market regulations were creating their own challenges for the regulators themselves. Whereas the industry previously operated under decades-old rules developed and administered by the brokerage industry self-regulator – FINRA – Reg BI was a different ball game altogether. It forced the scrapping of a rule FINRA knew intimately for an SEC-created rule the parameters of which neither the SEC nor FINRA would know. FINRA would now have to take its lead from the SEC to enforce the rule. Looking ahead, both regulators – and investors – will no doubt face challenges as firms and individuals in the industry test the limits of acceptability in the new rule.
It also is not clear where investors will emerge from this. The competitive changes will no doubt further the decades-long reduction in trading costs and product fees, which will to some extent accrue to investors. At the same time, the concurrent trend toward industry consolidation will reduce options for service providers –Schwab and TD Ameritrade announced a merger late last year – and service models.
Nevertheless, the fact that firms are transitioning toward a registered investment advisory business model cannot help but boost the standard for investment advice. Whether or not the advice of this cadre of newly minted investment advisers will be conflicted, as registered advisers they will be bound by a common law fiduciary duty that will lower the thresholds for investor claims on bad guidance. Again, a positive step for investors.
A lot has changed since the SEC introduced Reg BI and Form CRS a little more than a year ago. For supporters of a higher standard of care – or at least a clearer distinction between and more enforcement of the then-existing standards – the SEC’s decision represented a missed opportunity and one that would be difficult to revisit for several years. As this new experiment in investor care begins, there are promising signs for improvement in standards of care. Let’s hope it is not a missed opportunity.
[Editor’s note: A shorter version of this article ran in The Hill.]
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