Would SEC’s best interest standard apply to hybrid advisers?

One of the fiduciary investment advice industry’s most respected minds is interpreting the Security and Exchange Commission’s proposed best interest standard as not applying to dually registered broker-dealers.

Michael Kitces, director of wealth management at Pinnacle Advisory Group and the publisher of Nerd’s Eye View at Kitces.com, says the proposed best interest standard of care, and new disclosure and conflict mitigation requirements, would only apply to stand-alone broker-dealers.

“In practice, the entire (Regulation Best Interest) framework applies only to standalone broker-dealers that provide recommendations to retail customers, and not the majority of brokers operating as dual-registered or hybrid advisors,” writes Kitces on his website.

Of the nearly half-million investment representatives in the country, nearly 70 percent work for firms dually registered with FINRA and the SEC, according to data Kitces sites from the SEC. Only 31 percent are registered at stand-alone broker-dealer firms.

“All of these Best Interest standards are a moot point for the majority of brokers who won’t be subject to them anyway because they claim to give advice while wearing their RIA hat, and then take off the RIA hat, put on their broker-dealer suitability hat, and continue with business as usual,” said Kitces in an email.

In its proposal, the SEC says, “dual-registrants would be required to comply with Regulation Best Interest only when making a recommendation in their capacity as a broker-dealer.” The regulation would not apply to investment recommendations made on advisory accounts, which are governed by a fiduciary standard of care.

But Kitces doubts dually-registered brokers would need to avail themselves of the proposed best interest standard.

“It leads to the question ‘when would a broker-dealer be making a recommendation in their capacity as a broker-dealer?’” said Kitces.

“The answer is ‘never’,” he added. “Why on earth would any broker-dealer possibly ever want to? The SEC is already granting them a clear safe harbor to avoid ever needing to face Reg Best Interest – as long as you say all the advice occurred when you were wearing your RIA hat, you never have to deal with Regulation Best Interest wearing your broker-dealer hat for implementation.”

Dually registered brokers are allowed to distinguish brokerage customers that pay commissions on investments from advisory clients, who typically pay an annual fee on assets under management.

The trend of dual registration gained considerable momentum over the past decade, after an SEC rule that would have allowed brokers to charge advisory fees outside of the fiduciary standard was overturned in an appellate court.

For fiduciary adviser purists, dual registration is an apostasy that has given cover for conflicted advice under the guise of a fiduciary standard of care.

“Even the SEC literally calls them ‘dual-hatted’ advisors, explicitly recognizing that means there is a point where they take the fiduciary RIA hat off, and put the brokerage suitability hat on,” said Kitces.

The effect of the new standard will be dually registered brokers using their registered adviser hat as a safe harbor, says Kitces. Standalone brokers will be able to spin up a corporate RIA subsidiary, and dual-register their representatives in order to avoid the best interest obligation on brokerage clients.

But that will have little impact on mitigating conflicts of interest, thinks Kitces.

“It’s hard to see how being dual-registered will clean up questionable brokerage product sales,” he said. “If that was the case, it should have already cleaned up questionable transactions.”

The proposed best interest standard does raise brokers’ existing suitability standard, acknowledged Kitces.

“It’s a somewhat higher standard that is designed to not actually apply to anyone,” he said. “It’s a red herring.”

The SEC noted the controversy over dual registration in its proposal.

“The Commission recognizes that making the determination of whether a dual registrant is acting in the capacity of a broker-dealer or an investment adviser is not free from doubt, and this issue has existed for dual-registrants prior to the proposal of Regulation Best Interest,” regulators write.

When factoring whether an investment recommendation was made in an advisory or brokerage capacity, the SEC considers the type of account, how the account was described to customers, and the type of compensation, “with no one factor being determinative.”

New disclosure requirements “will help clarify the capacity in which a dual-registrant is acting,” the SEC says.

Regulators are seeking comment on whether further clarification is needed for investors with both brokerage and advisory accounts.