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Stockbrokers Must Now Act in Their Customers’ Best Interests

June 30, 2020 Blog
  • SEC Regulation “Best Interest” Is In Effect
  • Reg BI Imposes a Fiduciary Duty On Stockbrokers
  • Brokers Must Put Their Customers’ Interests First

Change is coming to the roughly 300,000 stockbrokers and financial advisers who sell Mom and Pop investors financial services and products. A new industry rule, Regulation Best Interest or “Reg BI” goes into effect on Tuesday, June 30.

Reg BI requires brokers making investment recommendations to put the financial or other interests of their customers ahead of their own and disclose any so-called “conflicts of interest”.

In other words, brokers now owe a fiduciary duty to put their customers’ interests first.

This is a huge change. Prior to the new rule, stockbrokers only needed to follow an industry standard called “suitability”; in essence, brokers had to make suitable or appropriate investment recommendations.

That standard was far too porous and gave brokers and brokerage firms far too much room for bad behavior and advice. The old “suitability” standard meant that brokers could offer high fee, proprietary products so long as they were considered to be suitable.

The best-interest obligation for brokers has far more stringent standards.

First, it requires brokerage firms to disclose any material facts relating to the scope and terms of the relationship with the customer, as well as all material conflicts of interest related to their investment recommendations.

Second, the rule has a “duty of care” obligation; that means brokerage firms must have a reasonable basis to believe that the recommendation is in the best interest of the customer.

Next, it requires brokerage firms to identify and disclose conflicts of interest and to prevent them.

Finally, firms must work under a compliance obligation, meaning that securities houses adopt policies and practices to meet the guidelines of Reg BI.

Why did this take so long?

The reason why is simple: brokerage firms for decades have pushed their own proprietary products which have greater fees and costs to customers, ahead of less costly alternatives. The old way of doing business under the suitability standard was simply far more profitable.

A case in point is UBS’s Yield Enhancement Strategy, known as YES. The firm recently sold $6 billion worth to their high net worth clients. YES is a complex investment strategy that seeks to generate returns through the sale and purchase of S&P index options. It does not require a cash investment but rather uses a so-called release, or lending to clients on margin, using a customer’s existing stock or bond portfolio as collateral for the strategy.

UBS created a point of sale conflict of interest by paying advisors much more to sell YES than the other products. The UBS YES product was also far riskier than its competitors. Unfortunately, this was not adequately disclosed to investors.

As volatility soared from the end of 2018 to now, YES suffered outsized losses resulting in customers exiting the strategy in droves.

The YES debacle is the type of conflict of interest which Reg BI seeks to prohibit. The “duty of care” provision of the rule requires that all reasonably available product alternatives be considered when a financial advisor makes a recommendation.

Firms must now change their technology and compliance procedures to make sure that they are conforming with the new rule.

It’s about time that Wall Street firms adhere to the standard business practice of putting customers’ interests ahead of their own.