July 9, 2019


SEC ruling on the broker-dealer standard of conduct

The financial crisis of 2008 put the financial services industry under significant scrutiny. While the biggest headline grabbers were overleveraged investment banks and practices around mortgage origination, retail investment services also underwent additional regulatory oversight. Specifically, Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act directed the Securities and Exchange Commission (SEC) to rule on the obligations, actions, and standards of brokers, dealers, and investment advisers.

The legislation requiring a ruling came about because the sentiment among average Americans is that their interactions with the investment world tended to benefit those working in the investment world more so than themselves. These feelings were not unfounded. In the 80s and 90s, almost all “retail” (individuals purchasing for their own accounts, not part of a larger group) investing happened through brokers and the only fund offerings were high-cost actively managed accounts. Between advisory fees, sales loads, fund fees, trading commissions, and custodial fees, the cost of investing was often in excess of 3%.

In the last two decades, we have seen a dramatic increase in the use of low-cost index funds and movement towards independent, fee-only fiduciary advisors. This has been a win for investors as it has lowered the cost of investing and improved the quality of service.

On June 5, 2019, roughly a decade after the passage of Dodd-Frank, the SEC issued its ruling.

The SEC’s June ruling focused on brokers and their interaction with retail investors. Previously, brokers were required to use products that were “suitable” or ones the broker reasonably believed were appropriate in terms of the client’s financial needs, objectives and unique circumstances. Now, brokers must adhere to a “Best Interest” standard which according to the SEC’s rule means “acting in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interest of the retail customer.” On the surface that sounds great and not very different from the “Fiduciary Standard” advisory firms must adhere to. However, the SEC ruling notes there are “key differences between Regulation Best Interest and the Advisers Act Fiduciary Standard.”

Rockbridge is registered with the SEC under the Investment Advisers Act of 1940 and has always been held to the Fiduciary Standard required by that Act. The Fiduciary Standard has substance behind it. As fee-only fiduciary advisors, we aren’t allowed to put our financial interests ahead of our clients. If we were to purchase for a client, a product with a sales load or a trailing commission, and accept that commission, the client could sue us and would win because we broke the Fiduciary Standard. The current suitability standard for brokers does not provide the same protection to investors and the New Best Interest standard doesn’t get into specifics on how it will be different.

The irony from a business perspective is that Rockbridge benefits from the poor actions of brokerage firms. Acting as a fiduciary is a differentiator that more and more people are searching for as investors become more educated. We are hopeful the trend continues as brokerage firms in Syracuse are still many times larger than local registered investment advisory firms.

To be fair to brokerage firms, low balance accounts aren’t generally profitable which is why many fee-only fiduciaries have minimums in the $100,000 to $500,000 range. For those who have little knowledge of finance and would otherwise pick a stock or sit on cash, being charged 5% up front with an ongoing fund fee of 1% isn’t a bad option, as long as the broker doesn’t churn the account or provide bad advice that benefits the broker in the short-term at the sacrifice of the investor’s long-term financial well-being.

In addition to changing the language from “suitable” to “best interest,” the ruling also puts restrictions on sales contests. No longer can brokerage firms hold contests for sales of specific securities though more general contests are still allowed. The ruling also puts further emphasis on disclosing fees being charged and conflicts of interest.

We’ll have to wait to see how the new “best interest” standard is implemented for brokers. We work in the industry and can’t determine what, if any, impact the new ruling will have. It will probably take years of arbitration and court cases, further definitions and rulings, and more legal precedent until we know its full impact. If it effectively becomes a Fiduciary Standard without the ongoing advice obligation, that will be great for retail investors. If it becomes a new name for the suitability standard, then brokerage firms will win as the status quo continues. An ominous sign is that large brokerage companies were supportive of the ruling while consumer advocacy groups (who sought an extension of the Fiduciary Standard) opposed it.

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