Why Regulation Best Interest Should Be Jettisoned

As we know, a square peg cannot--and never will--fit in a round hole, especially within the parameters of the nonfiduciary business model. The reason is that an 800-pound gorilla (that is, broker/dealers, insurance companies, and others) always plants itself between nonfiduciaries (that is, registered representatives, insurance agents, and others) and their customers. As a result, nonfiduciaries cannot ever rise to the standard of being a fiduciary.

In this business model, nonfiduciaries must pay off the Big Chimp first and make him happy before he will step aside and allow them to sell products to their customers. In the nonfiduciary business model, the interests of the Chimp must always come first because legally he is the only entity in that model to whom nonfiduciaries owe fiduciary duties and their financial allegiance.

Here’s a schematic of the business model that nonfiduciaries must follow:

Nonfiduciary stockbrokers/insurance agents → Big Chimp broker/dealers/insurance companies → customers.

That translates to:

The nonfiduciary business model → generates inherent conflicts of interest because of fiduciary duties owed by a nonfiduciary to the Big Chimp → which allows a nonfiduciary to engage (whether knowingly or unknowingly) in avaricious conduct at the expense of their customers → which creates built-in disincentives for customers get the best deal → which results in nonfiduciaries and their customers being on different sides of the table, which is directly contrary to fiduciary conduct.

Think of that. The interests of the Chimp must always come first before those of the customers of nonfiduciaries. This model flies in the face--and makes a mockery--of Regulation Best Interest (Reg BI), which was issued by the U.S. Securities and Exchange Commission on June 5 (and which will go into full effect on June 30, 2020). In a nutshell, this is why nonfiduciaries can never truly place the interests of their customers ahead of their own--whatever Reg BI may say. The business model followed by nonfiduciaries is simply incompatible with Reg BI, which is why I have always likened it to trying to fit a square peg into a round hole.

The masterminds at the SEC--guided by the evident heavy hand of such industry insiders as the Securities Industry and Financial Markets Association--came up with the idea of implementing a series of disclosures in order to convert nonfiduciaries into “fiduciaries” without actually calling them fiduciaries. This effort, achieved by using the legal term “best interest” and applying it in a bogus context to turn what is nonfiduciary into fiduciary, doesn’t work for obvious reasons. The best proof of this is that there’s no fiduciary duty of loyalty present in Reg BI.

This duty, the most fundamental, underlying fiduciary duty of all, is absent because its inclusion in Reg BI would have actually turned nonfiduciaries into fiduciaries. But the SEC/industry-insider nexus couldn’t allow that, so the duty of loyalty wasn’t included in Reg BI. The duty of loyalty is what separates a fiduciary from a nonfiduciary. The Big Chimp could never abide that.

Instead, the SEC chose to equate this most ancient of fiduciary duties to a series of written disclosures. (The SEC should be utterly ashamed for treating any fiduciary duty, especially this one, with such disregard and obvious contempt, reducing it to a technicality.) According to a number of academic studies, though, few investors ever bother to read the impenetrable legalese of disclosures. And when they do, even fewer can demonstrate a knowing understanding of them. Of course, the potent forces that promote the nonfiduciary business model know all this, which is why Reg BI is so chock-full of disclosures--and even such ever so helpful “conversation starters.”

It’s bad enough that the SEC has, via the required disclosures in Reg BI, attempted to convert nonfiduciaries into fiduciaries in all but name only. But, perhaps even worse, it has also trashed the fiduciary standard and what it means to be a fiduciary under the Investment Advisers Act of 1940.

Until the SEC's issuance of Reg BI, a Registered Investment Advisor firm, as a fiduciary under the '40 Act, was required to try to avoid conflicts of interest and make full disclosure of all material conflicts of interest. But now, in language snuck into a footnote to Reg BI, an RIA is required to try to avoid conflicts of interest or make full disclosure of all material conflicts of interest. This simple change of one word from "and" to "or" has helped eviscerate the difference between what it means to be a fiduciary (or not) under the '40 Act.

Will Market Forces Eventually Toss Nonfiduciaries on the Ash Heap of History? When I read about states such as Nevada, Massachusetts, and New Jersey attempting to establish their own fiduciary standard for stockbrokers and the like--and the threats directed their way by certain trade associations and brokerage firms--someone I had known in years past came to mind.

Katharina was a word processor at a firm where I practiced law back in the olden days. She was from Germany. We got to talking one day in my office, and she said that, while swimming across a river to escape East Germany, she had been shot. The bullet had gone into the back of her knee and had come out the front, shattering her kneecap. That was, she explained, why she limped.

She told me that she had to flee because she just couldn’t live under the control of East German authorities and the explicit (and especially implicit) threats that they used to maintain power. Since she reckoned that the system wasn’t going to change anytime soon, she had to seek a different life in a different system that valued freedom and liberty.

Far be it from me to compare outfits like certain industry trade associations and brokerage firms with East German border guards. To some extent, though, the analogy is apt. The totalitarian system of East Germany ran on threats, and sometimes they were carried out with deadly effect. Certain industry brokerage firms have reportedly threatened (nonphysically, of course) the CFP Board of Standards that they will no longer allow their registered representatives to sport the CFP designation if the board goes ahead with implementing its new fiduciary standard. Such firms have also purportedly threatened authorities in states considering the adoption of the fiduciary standard that they will pull all of their registered representatives from such states if they proceed with adopting such a standard.

When a system can be maintained only through physical or nonphysical threats, then it would seem to me to be an unsustainable one ultimately--especially in a free society.

The Need to Litigate Reg BI Out of Existence As noted, the Big Chimp legally demands fealty from nonfiduciaries at (oftentimes great) financial expense to their customers. It's a zero-sum game: The more the Chimp demands from a customer, the less the customer (often unknowingly) has to invest under the nonfiduciary business model.

Of course, it’s a zero-sum game under the fiduciary business model as well. But in that model, there are certain built-in protections for fiduciary clients, such as (1) the legal requirement demanded of a fiduciary that it follow the duty of loyalty which creates, (2) a brake on any voracious, revenue-maximizing conduct on the part of a fiduciary, (3) the absence of the Big Chimp demanding its (often voracious) cut, and (4) ongoing monitoring of investments (compared with temporary monitoring required of a nonfiduciary under Reg BI that ends once a sales transaction is complete).

As noted in last month’s column, the nonfiduciary business model--enshrined in spades in Reg BI--is the Mother of All Conflicts of Interest in the investment world. From it, many other conflicts inherent in the nonfiduciary business model flow. No amount or kind of disclosures in Regulation BI can change that central reality--whatever the number of pages of regulations issued by the SEC.

Which is why, in my view, some body with the appropriate standing should sue the SEC forthwith in order to jettison Reg BI for the great mistake it is. In 2007, the Merrill Lynch Rule was slapped down by a federal appeals court in Financial Planning Association v. SEC. The court held that the SEC overstepped its bounds by attempting to negate a long-standing federal statute--the '40 Act--through its regulatory rule-making.

My belief is that the SEC has committed even greater transgressions in the case of Reg BI. In addition to getting rid of Reg BI, declaratory relief should be sought in any lawsuit to actually require the SEC to vigorously enforce the clear divide between fee-receiving fiduciary RIAs and commission-receiving nonfiduciary broker/dealers under the ’40 Act.