Could the Securities and Exchange Commission use its new conduct rules—Regulation Best Interest-- to apply a fiduciary duty to registered investment advisor outside businesses, like their CPA or tax preparation companies? A mortgage brokerage subsidiary? Or any other type of service or business the RIA or its partners own?

That’s the potential hellscape securities attorney Stephen Galletto, a partner with Stark & Stark’s Investment Management Practice Group in Lawrenceville, NJ, is working to help his RIA clients guard against.

Galletto says the securities practice in his firm, which works with RIAs of various sizes across the country, is actively debating how to ensure that RIAs' outside businesses don’t get caught up in the new Reg BI regulations and interpretation when they go into effect June 30, 2020.

“I think we’re in an environment where the SEC could come into a firm where much of the time it is a CPA firm and apply Reg BI. Will they subject CPA services to a fiduciary duty as well?” Galletto asked.

“What we want to create for clients is a better separation between business interests and advisory services so they do not fall into a category where everything they are doing is viewed as subject to the fiduciary standard,” he said.

The SEC said that it’s latest interpretation affirmed: “The investment advisor’s fiduciary duty is broad and applies to the entire advisor-client relationship.
 
“The Commission has previously recognized the broad-scope investment advisory relationship ...does not permit an advisor to exploit that fiduciary relationship by defrauding his client in any investment and does not require that the activity be ‘in the offer or sale of any’ security or ‘in connection with the purchase or sale of any security.’”

Galletto said he and his partners are working to anticipate where the SEC may go in terms of the application of the new standards. “We are debating how specific we want to get in terms of describing the depth and breadth and fees of services that are fiduciary services for contract purposes and those that are excluded. We are just trying to get ahead of where the SEC may go in terms of ancillary services that might be held to a fiduciary standard.

“A well-protected firm clearly states the scope of an engagement, services being rendered and the fees negotiated by the advisor and client,” Galletto said.

The “squishy” contracts he often sees could make RIAs vulnerable if the SEC begins to apply Reg BI vigorously, said the attorney who works mainly with advisor firms (as opposed to broker-dealers or dually-registered firms that are offer both brokerage and RIA services), said firms’ contracts he reviews are often “squishy,” which could make RIAs vulnerable if the SEC begins to apply Reg BI vigorously.

“Written agreements come in all sorts of shapes and sizes, but I see quite a few contracts where the terms are just not so clear,” Galletto said.

The first order of business for the SEC will be to focus on broker-dealer and hybrid firms to make sure it is clear the services being provided by brokers live up to Reg BI. But once that is figured out, Galletto said, he believes regulators will use the new package of rules on RIAs, too.

“I anticipate the SEC will use Reg BI to build higher expectations and standards in general but also as a disciplinary tool and catch-all that regulators can direct against firms for whatever the hot button of the year happens to be,” he said.

While Reg BI was created ostensibly so that investors understand the different services, fees and level of loyalty that brokers and RIAs offer, at the end of the day only advisors have been and remain fiduciaries. Brokers and dually-registered advisors were not made fiduciaries.

“On the investment advisor side [at the SEC] there seems to be a general distrust that investment advisors are actually meeting with clients, creating a plan and building a portfolio, so how dare they take that percentage point?” Galletto worried.

Elections in 2020 could also change how Reg BI is applied, he said.

“I don’t know what the outcome of the upcoming election will be, but depending on who is sitting in the Oval Office and whether Senate or House seats flip, this regulation could become the foundation piece for a heightened duty and more enforcement teeth,” Galletto said.

States that are pushing individual fiduciary regulations and legislation are also a concern for RIAs, he said.

“We have clients who are residents in multiple states, so the more layers of regulation there are, the more layers we have to peel back, the more likely we are to upset a state regulator to be functional,” he said.

“It’s one of my bigger complaints that we can’t get a unified rule,” Galletto added.

As for firms’ threats that they’ll pull out of states like Nevada if they implement tougher fiduciary standards for brokers, Galletto said, it is more likely most companies will at least take steps to comply “until there is blood in the water” from enforcement of a state rule, before making a decision about whether to leave or stay and possibly sue.

Morgan Stanley, Charles Schwab, TD Ameritrade and Wells Fargo have all threatened to stop doing business in Nevada if the state imposes a fiduciary standard on the industry. Massachusetts and New Jersey have also proposed fiduciary rules.