Like many others, I was eager to review the final version of the SEC’s Reg BI. As an attorney, I was anxious to see whether “prudence” was still expressly set out in Reg BI’s Care Obligation. As many had predicted, the SEC removed the term from the final version of the regulation and offered a disingenuous excuse for not including “prudence” in the final version of the regulation.

Had “prudence” been left in Reg BI’s final version, it would have had disastrous consequences for the variable annuity industry. Moshe Milevsky’s famous study, “The Titanic Option,”¹ essentially showed that variable annuities will never be able to pass any true fiduciary standard due to the inequitable nature of the “inverse pricing” methodology used by most variable annuity issuers in calculating a variable annuity’s annual M&E fees.

I am on record as stating that I believe that Reg BI will be vacated by the courts if actions are filed contesting the regulation. My opinion is based largely on the fact that several former SEC economists wrote a scathing review of the Reg BI. The courts often give significant weight to the opinions of former executives within a governmental agency.

My opinion is also based on the fact that the SEC did not define “best interest,” the key concept behind the regulation. While Chairman Clayton offered what I consider to be yet another disingenuous explanation for not defining “best interest,” I do believe that various key SEC and NASD/FINRA enforcement decisions that offered insights into the term “best interest,” such as the Scott Epstein² and Wendell D. Belden³  decisions, could be used to identify “best interest” violations.

The final issue that I have with Reg BI is the fact that, in my opinion, it is totally inconsistent with the SEC’s mission statement-to protect investors-and unnecessarily protective of Wall Street’s interests at investors’ expense. The courts have consistently stated that the purpose of securities laws is to protect investors, not brokers.

In Hirshberg & Norris v. SEC, the court dealt with an analogous situation where the appellee broker-dealer essentially argued that the federal securities laws and regulations were enacted to protect broker-dealers rather than the investing public. The court quickly rejected the appellant’s argument, stating that

To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protections of the broker-dealer rather than the protection of the public….On the contrary, it has long been recognized by the federal courts that the investing and usually naïve public needs special protection in this specialized field. We believe that the Securities Act and the Securities Exchange Act were designed to prevent, among other things, just such practices and business methods as have been shown to have been indulged in by the petitioner in this case.⁴

Time will tell whether Reg BI can successfully run the judicial gauntlet.

Reg BI’s “Hidden Agenda”
In reading through Reg BI, I did find the SEC’s frequent reference to the importance of “efficient” advice and strategies interesting, especially the need to factor in the costs of such advice and strategies.

A rational investor seeks out investment strategies that are efficient in the sense that they  provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility. From the discussion above, an efficient investment strategy may depend on the investor’s utility from consumption, including: (4) the cost to the investor of implementing the strategy.⁵

The efficiency of a recommendation to a retail customer may depend on: (1) the menu of securities transactions and investment strategies the broker-dealer or its associated persons considers and makes available to the retail customer; (2) the return distribution and the costs of these securities transactions and strategies;…⁶

An inefficient recommendation may lead to various results for the retail customer, including inferior investment outcomes, such as risk-adjusted expected returns that are lower relative to other similar investments or investment strategies.⁷

Reg BI’s acknowledgment of the importance of cost-efficiency in terms of investment recommendations is consistent with the Restatement (Third) of Trust’s position regarding cost-efficient in investing. Section 90, comment h(2) essentially states that the recommendation of cost-inefficient actively managed mutual funds is imprudent.

Several years ago I created a metric, the Active Management Value Ratio (AMVR). The AMVR is based on the research of investment icons such as Charles D. Ellis and Burton L. Malkiel. The AMVR allows investors, investment fiduciaries and attorneys to evaluate the cost-efficiency of actively managed mutual funds. Further information about the AMVR and the calculation process, click here.

Going Forward
Whether Reg BI survives judicial scrutiny or not, financial “advisers” of all types need to recognize the importance of investment costs and the potential liability issues associated with same. Costs matter.

With Reg BIs’ recognition of the importance of factoring in cost-efficiency, one has to wonder if the cost-efficiency issue will include the consideration of the growing issue of closet index/shadow index funds. Canada and Australia have recently recognized the closet indexing issue and are considering new regulations to address the problem.

Based on recent information provided by the Morningstar Investment Research Center, domestic U.S. large-cap funds have an average expense ratio of 106 basis points and average trading costs of 73 basis points, using the funds’ average turnover ratio of 61 percent and John Bogle turnover/trading cost conversion metric. So these funds essentially start out 180 basis points in the hole compared to comparable passive/index funds.

The only way that actively managed funds can hope to make up this difference in costs is through higher returns. However, research has shown that many domestic funds, especially large-cap funds, have shown a trend of high R-squared correlation numbers in order to reduce the potential loss of customers due to significant differences in returns from comparable passive/index funds. So by “hugging” the indices, the actively managed funds may reduce variances in returns, but the significant difference in fees remains, effectively reducing investors’ returns.

Costs and cost-efficiency matter. Both the Restatement (Third) of Trusts and now Reg BI acknowledge that fact. At some point, financial advisers need to do the same and adjust their practices accordingly, or continue to face increasing liability exposure.

Notes
1. Moshe A. Milevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Death Benefit in Variable Annuities and Mutual Funds,” J. of Risk and Insurance, Vol. 68, No. 1 (2001)
2. Scott Epstein, Exchange Act Release 34-59328 (2009)
3. Wendell D. Belden, Exchange Act Release 34-47859 (2003)
4. Hirshberg & Norris v. SEC, 177 F.2d 228, 233 (1949)
5. Regulation Best Interest, Exchange Act Release 34-86031, 378 (2019)
6. Regulation Best Interest, Exchange Act Release 34-86031, 380 (2019)
7. Regulation Best Interest, Exchange Act Release 34-86031, 383-84 (2019)

Copyright © 2019 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.