*Yes, I am old, Yes, I used to love listening to the late Keith Jackson call college football games. I miss his “whoa Nelly” calls.

As the debate over the SEC’s proposed Regulation Best Interest (Reg BI) rages on, people have increasingly asked me what I think will happen. The SEC is obviously going to propose Reg BI in some form. I expect various legal actions to be filed attempting to stop the implementation. In the end. I expect at least one court to rule that Reg BI violates the SEC’s express mission statement, to protect and promote investors’ interests, and is therefore unenforceable. Just my opinion.

Lot of moving parts behind that opinion, but all supported by existing law. First, the SEC’s stated purpose is to enact rules and regulations that protect investors, not broker-dealers. Reg BI adopts a number of positions that arguably advance the interests of broker-dealers and their representatives at the cost of investors.

The clearest example of this is Reg BI’s adoption of a disclosure rule regarding conflicts of interest rather than a strong absolute prohibition of selling when conflicts of interest exist. Making matters even worse is the failure of the SEC to offer and require a clear and understandable standardized format for such disclosures of conflicts of interests.

Another obvious problem with Reg BI is the SEC’s to define the core concept, best interests. While one could argue that such an oversight was deliberate to further protect the investment industry, I would suggest that there are two potential ways that investors may be able to overcome such tactics.

At least for the present time, FINRA’s rules would still apply. Often overlooked is FINRA’s requirement with regard to the other “F” word-“fair dealing.” Fortunately, NASD/FINRA and SEC enforcement decisions provide valuable guidance in defining fair dealing and what constitutes a violation of the requirement.

The Scott Epstein enforcement decision (Exchange Act Release No. 34-59328) is the decision most cited in connection with FINRA’s fair trading/fair treatment requirement (FINRA Rule 2111, Supplementary Material -.01). The panel noted that FINRA and the SEC have consistently stated that a registered representative’s “recommendations must be consistent with his customer’s best interests.”

Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA rules, with particular emphasis on the requirement to deal fairly with the public. The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.

OK, so we have the rule. But what does it mean and what constitutes a “fair dealing” violation by a broker-dealer or stockbroker? Epstein was accused of engaging in “switching,” or recommending the sale and subsequent purchases of mutual funds for the primary purpose of generating commissions for him and his broker-dealer. In ruling that Epstein was guilty of all charges, the SEC panel justified its decision by stating that

Epstein’s recommendations served his own interests by generating substantial production credits, but did not serve the interests of his customers. Epstein abdicated his responsibility for fair dealing when he put his own self-interest ahead of the interests of his customers.

So, the fair dealing requirement incorporates the same “best interest” standard, one based on broker/adviser’s putting his/her financial interests ahead of the customer’s financial interests. Seems simple enough, but how would one prove this.

Anyone who follows me on social media or on one of my blogs knows that I am a staunch advocate of using cost-efficiency to prove securities violations involving fair dealing, suitability and/or a duty of prudence. After all, Sections 90 of the Restatement (Third) of Trusts, otherwise known as the Prudent Investor Rule, establishes several prudence standards.

Since broker-dealers and stockbrokers often recommend actively managed funds, the key comment to Section 90 is comment h(2), which essentially states that recommending or using actively managed mutual funds is imprudent unless the funds are cost-efficient, that is their anticipated returns cover the fund’s extra costs and risks. As the Comment to Section 7 of the Uniform Prudent Investor Act states, “wasting beneficiaries’ money is imprudent.”

Based on the research of numerous noted and well-respected investment experts, the evidence overwhelmingly states that most actively managed mutual funds are cost-inefficient, that they fail to cover their investment costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.¹

Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.²

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.³

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance…. [the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.⁴

This would certainly seem to make the justification of a recommendation of an actively managed mutual fund more questionable unless the financial adviser can show that the fund(s) in question are cost-efficient relative to other comparable investment options, including comparable index funds.

There are those that suggest that comparing actively managed funds to less expensive index funds is inherently unfair. However, if we accept that the guiding principle is the protection of investors and putting their financial best interests first, then the only thing that matters is the comparative cost-efficiency of the funds under consideration.

The concept of comparing actively managed funds to comparable index funds has the support of two well-respected investment icons, Nobel Laureate William S. Sharpe and Charles D. Ellis.

‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’⁵

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!⁶

By adopting cost-efficiency as the preliminary and primary standard in addressing both FINRA’s fair trading rule and the prudence under Reg BI’s duty of care, the court and the parties would only have to answer one simple two-part question:

At the time that the financial adviser selected a particular actively managed fund to recommend:
(a) was the actively managed mutual fund cost-efficient in comparison to other comparable available funds, including index funds, and
(b) did the actively managed mutual fund further the SEC mission statement of properly protecting investors’ best interests?”

If an actively managed fund is cost-inefficient relative to a comparable index fund, or if a comparable index fund was not even considered, I am not sure how one can argue in good faith that the actively managed fund is in any customer’s best interests  Since financial advisers typically receive commissions in connection with sales of actively managed funds, you would be looking at an Epstein-like situation, where the financial adviser would profit financially, while the customer would actually be losing money relative to comparable cost-efficient investment options.

At the end of the day, we hold these truths to be self-evident:

1. prudent investors do not knowingly invest in cost-inefficient investments, and
2. recommending cost-inefficient investments to customers is not fair dealing/fair treatment.

Going Forward
As I stated earlier, if the SEC adopts Reg BI as currently written, I do not believe that it will withstand judicial scrutiny. The obvious issue that I would expect opponents of Reg BI to address is why the SEC did not just adopt the fiduciary standard set out in the Investment Advisor Act of 1940. I would provide the protection investors need and provide one uniform standard.

The SEC has tried to justify the adoption of a much lenient suitability standard on the grounds of wanting to provide investors with a choice of how they receive investment advice. With all due respect, that argument is simply “disingenuous double talk.” If I was a judge in any of these cases challenging Reg BI, I would quickly point out to the counsel that the choice of a standard of prudence in no way prohibits the business model chosen by the investment industry. It simply requires a certain level of conduct from broker-dealers and financial advisers in carrying out their business model.

The SEC’s mission statement makes their primary mission the protection of investors. In opting for a suitability standard, the SEC has deliberately chosen the weaker of two options. Again, if I were a judge hearing one of the promised challenges to Reg BI, I am asking the SEC why the less protective suitability standard was really chosen, as it definitely seems to favor the investment industry at the expense of public investors.

Another issue that I would address is the noticeable absence of any express fair dealing require such as set out in FINRA’s rules. The SEC would probably answer that such a requirement is implicit in the definition of “best interests,” but then again that should raised the issue of why Reg BI does not define “best interest” at all.

The absence of an express fair dealing requirement in Reg BI is also troubling given FINRA’s statement that it might just adopt Reg BI as well. What is unclear is whether that FINRA would eliminate its express fair dealing requirement as part of such a move, arguably eliminating a key investor protection measure.

If Reg BI were to survive all legal challenges, the question would be whether the plaintiff’s bar would argue fair dealing and prudence based upon a cost-efficient standard. Given the evidence cited herein, the adoption of such a standard would seemingly simplify the argument of such legal actions. The only question would be whether an actively managed fund’s incremental costs exceed the fund’s incremental returns relative to a comparable index fund. The strategy would also seemingly impose an extremely difficult evidentiary burden on the investment industry, given the extra costs and risks typically associated with actively managed funds relative to index funds.

Chairman Clayton has recently announced that the release of Reg BI may be sooner than later. Actual implementation would obviously be significantly delayed if the promised challenges to Reg BI do occur, especially given the expected appeals by the losing party. Something leads me to believe that these cases are going to be “doozeys” for legal eagles.

Notes
1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
2. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997)
5. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm
6. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”                     available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c

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This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.