The following blog was written in conjunction with InvestorCOM.
Within the last year, the SEC (Securities and Exchange Commission) has published three guidance notes on the application of Regulation Best Interest’s (Reg BI) Care Obligation and the Reasonably Available Alternative (RAA) requirement. This greater focus from regulators means investment firms have to give greater attention to doing their due diligence in the interest of their clients. In the most recent update, Staff Bulletin: Standers of Conduct for Broker-Dealers and Investment Advisers, the SEC provides much-needed guidance on how brokers-dealers and investment advisers can satisfy the SEC’s requirements.
The SEC’s Reg BI Care Obligation: Highlights from the Staff Bulletin
“This bulletin is focused primarily on the Care Obligation of Regulation Best Interest (“Reg BI”) for broker-dealers and the duty of care enforced under the Investment Advisers Act of 1940 (the “IA fiduciary standard”) for investment advisers (together, “care obligations”).
Both Reg BI for broker-dealers and the IA fiduciary standard for investment advisers are drawn from key fiduciary principles that include an obligation to act in the retail investor’s best interest and not to place their own interests ahead of the investor’s interest. Complying with their care obligations is an important aspect of how firms and financial professionals form a reasonable belief that their investment advice and recommendations are in the retail investor’s best interest. Although the specific application of Reg BI and the IA fiduciary standard may differ in some respects and be triggered at different times, in the staff’s view, they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors.”
The bulletin put out by the SEC provided clarity around key obligations and requirements, highlighted 20 questions with answers thoroughly outlining expectations from the regulator. Below, we have curated a handful of questions for our audience. To view the full bulletin and all questions and answers, visit the SEC website.
Do I need to understand the investment or investment strategy I am advising on or recommending?
Yes. Under the care obligations, investment advisers, broker-dealers, and their financial professionals need to understand the investments and investment strategies on which they provide advice and recommendations before advising on or recommending them to retail investors. This includes developing a sufficient understanding of the potential risks, rewards, and costs of the investment or investment strategy to have a reasonable basis to believe that the recommendation or advice could be in a retail investor’s best interest. Without this understanding, firms and their financial professionals cannot have a reasonable basis to believe that their recommendation or advice aligns with a retail investor’s investment profile in a way that satisfies their obligations to make a recommendation or provide advice that is in the specific investor’s best interest.
My firm has reviewed and compiled an approved list of investments for our retail investors. Can I rely solely on the firm’s review to satisfy my own obligation to understand the investment or investment strategy I am recommending or on which I am providing advice?
No. Although firms have duties under their care obligations, including a general responsibility to understand the investments or investment strategies that they are recommending or on which they provide advice, financial professionals also have this responsibility. In the staff’s view, firms should generally help ensure those financial professionals have sufficient information and training to understand the investments and investment strategies they recommend or advise on; however, financial professionals cannot satisfy their own care obligations by solely relying on the efforts of others at their firm. Rather, financial professionals remain responsible for personally understanding an investment or investment strategy before they recommend or provide advice with regard to that investment or investment strategy.
What is an “investment profile?” How does the investment profile help me satisfy my care obligation?
The term “investment profile” refers to information that the firm or financial professional generally should make reasonable efforts to ascertain about the retail investor. Obtaining and then evaluating information about the retail investor’s investment profile is a critical step to satisfying your care obligation. In order to have a reasonable basis to believe a particular investment or investment strategy is in the best interest of a particular retail investor, you must obtain and evaluate enough information about the retail investor to have a reasonable basis to believe that the recommendation or advice is in the retail investor’s best interest. The reasonableness of efforts to collect information needed about a retail investor’s financial situation, investment objectives, and other information and characteristics of that retail investor to meet this requirement depends on the specific facts and circumstances of the particular situation, including considering the nature and characteristics of the investment or investment strategy at issue. You must also have a reasonable basis to believe that your recommendation or advice is not based on materially inaccurate, incomplete, or outdated information about the retail investor.
Should I consider reasonably available alternatives when recommending or providing advice about investments or investment strategies to retail investors?
Yes. It would be difficult for firms and their financial professionals to form a reasonable basis to believe a recommendation or advice is in the retail investor’s best interest without considering alternatives that are reasonably available to achieve the investor’s investment objectives. Accordingly, the staff believes this is a key component of satisfying the care obligations of broker-dealers and investment advisers.
Can I satisfy my care obligations by simply recommending or providing advice on the “most appropriate” available option from among my firm’s limited menu of investments?
No. When considering a limited menu of reasonably available alternatives, there may be one “most appropriate” possible alternative among the limited options available, yet that alternative may still not be in the best interest of the particular retail investor in light of their investment profile. Accordingly, one possible outcome of such a process is that the firm or financial professional may conclude that no investment or investment strategy they offer is in the retail investor’s best interest. If that occurs, the firm and financial professional would not satisfy their care obligations if they recommended or advised any of those investments or investment strategies to the retail investor.
In the staff’s view, do I need to consider the risks, rewards, and costs associated with the reasonably available alternatives I have identified?
Yes. You must consider the potential risks, rewards, and costs when recommending or providing advice on investments and investment strategies in order to have a reasonable basis to believe that a recommendation or advice is in a retail investor’s best interest. Accordingly, in the view of the staff, you generally would need to understand the potential risks, rewards, and costs associated with reasonably available alternatives as part of having a reasonable basis to believe that a recommendation or advice is in the best interest of the retail investor. For example, when recommending an investment with a higher cost or higher risk as compared to reasonably available alternatives, the staff believes you should consider whether any reasonably available alternative to the investment is less costly or has lower risk that is consistent with the investor’s investment profile. Similarly, when recommending an investment based on a particular special feature or reward (such as tax advantage), the staff believes you should consider whether any reasonably available alternatives offer similar special features or rewards, in addition to considering the broader range of risks, rewards, and costs of such alternatives, in light of the retail investor’s investment profile.
Should firms document the evaluation of reasonably available alternatives?
Although there is no requirement of such documentation, in the staff’s view, it may be difficult for a firm to demonstrate compliance with its obligations to retail investors, or periodically assess the adequacy and effectiveness of its written policies and procedures, without documenting the basis for certain recommendations. This could include documentation of the consideration of reasonably available alternatives. The staff believes documentation demonstrating that the financial professional considered reasonably available alternatives can be particularly important where a recommendation may seem inconsistent with a retail investor’s investment objectives on its face and/or poses conflicts of interest for the firm or the financial professional.
How do I know which standard applies when providing advice and recommendations to such investors?
Whether Reg BI or the IA fiduciary standard applies to a particular recommendation made or advice provided by a dually registered firm and/or financial professional depends on a facts and circumstances analysis, with no one factor being determinative. The Commission considers, among other factors, the type of account, how the account is described, the type of compensation, and the extent to which the dually registered firm and financial professional made clear to the customer or client the capacity in which they were acting. In this vein, the disclosure obligations of both Reg BI and the IA fiduciary standard require a firm or financial professional to disclose to the retail investor the capacity in which the firm or financial professional is acting (e.g., broker-dealer or investment adviser). The staff caveats that the disclosure of capacity may not be determinative if the facts and circumstances suggest the financial professional was acting in a different capacity from the one disclosed.