Regulation Best Interest: An Overview of the Requirements

The SEC has issued its final Regulation Best Interest (Reg BI), Form CRS Regulation, RIA Interpretation and Solely Incidental Interpretation. I am discussing the SEC’s guidance in a series of articles entitled “Best Interest Standard of Care for Advisors.”

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The SEC’s Reg BI establishes a best interest standard of care for investment recommendations to retail customers by broker-dealers and their registered representatives. In addition, Reg BI requires new disclosures and mitigation of advisor’s financial conflicts of interest. The SEC also issued an Interpretation of the Standard of Conduct for Investment Advisers, which clarified the SEC’s position on a number of issues related to the fiduciary standard and conflicts of interest for RIAs. There were two other pieces of guidance: the Form CRS Regulation (which requires a simplified front-end disclosure by broker-dealers and investment advisers); and the Solely Incidental Interpretation for limited discretion and monitoring of accounts by broker-dealers.

My last two posts, Best Interest for Advisors #9 and #10, focused on the requirement in Reg BI that a recommendation to a retail customer must include consideration of the cost of the investment or strategy. I started with that issue because I believe that it will be highly impactful over the long run. However, this article starts at the beginning . . . an overview of the changes made by Reg BI. In the release to the final regulation, the SEC explained Reg BI’s requirements (applicable on June 30, 2020):

“When making a recommendation, a broker-dealer must act in the retail customer’s best interest and cannot place its own interests ahead of the customer’s interests (hereinafter, ‘‘General Obligation’’). The General Obligation is satisfied only if the broker-dealer complies with four specified component obligations. The obligations are:

  1. Providing certain prescribed disclosure before or at the time of the recommendation, about the recommendation and the relationship between the retail customer and the broker-dealer (‘‘Disclosure Obligation’’);
  2. Exercising reasonable diligence, care, and skill in making the recommendation (‘‘Care Obligation’’);
  3. Establishing, maintaining, and enforcing policies and procedures reasonably designed to address conflicts of interest (‘‘Conflict of Interest Obligation’’), and
  4. Establishing, maintaining, and enforcing policies and procedures reasonably designed to achieve compliance with Regulation Best Interest (‘‘Compliance Obligation’’).

In each of those four areas the SEC has imposed heightened requirements on broker-dealers, which will in turn impact advisors. This article now looks at one of those “Obligations”—the duty of care. The Care Obligation is described, in part, as:

Care obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to: . . . Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer; . . .

I highlighted four parts of the regulatory section for emphasis and discussion.

First, the broker-dealer and advisor must act with “reasonable diligence, care, and skill” to develop the recommendation. That is similar to the DOL’s prudent man rule for fiduciaries, which requires care, skill, diligence and prudence. The SEC dropped the word “prudence,” but then went on to say that “diligence, care, and skill” has the same meaning as if the word “prudence” was included. In other words, from the SEC’s perspective, the standard is similar to the prudent man rule applied on a transactional basis (that is, applied at the time of the recommendation of covered transactions). This standard—which the SEC says is based on fiduciary principles-would require a process of gathering information about the investor, and consideration the available account-types and investments (including factors such as costs and risk), appears to be very much like the prudent process required by ERISA for retirement plan recommendations. For this part of the Obligations, the focus should be on the process used by the advisor and the broker-dealer.

The second part is that the recommendation must be in the “best interest” of the retail customer. However, it’s not possible to determine what is “best”, and unfortunately the SEC didn’t define that standard (other than to say that it didn’t require selection of the single best investment). Based on my review of the full Reg BI rule and release, I believe that its meaning is similar to “prudent”, in the sense that, if a rigorous process is followed to identify the superior alternatives and reasonable costs, a number of qualifying options (e.g., mutual funds) can be identified as being “prudent,” that is, in the best interest of the customer. However, if the number of alternatives examined for this purpose is limited, it may be that the process will reveal than none of the limited group can be recommended under the best interest standard, even though some of the limited group are better than the others.

The third part is about the “retail customer’s investment profile and the potential risks, rewards and costs”. While the process requires a diligent, careful and skillful analysis of the relevant information, the retail customer’s profile is starting point for the information that needs to be considered in the process. Once the needs and circumstances of the retail customer have been identified based on the profile, the advisor needs to consider the account-types and investments that are reasonably available for that customer, and factors such as costs, risk and rewards of the alternatives based on the particular customer’s needs and circumstances.

The last part is that the broker-dealer and the advisor cannot put their interests ahead of the retail customer’s. This is, unfortunately, something that can be easily identified after the fact, but hard to describe before the fact. A violation could result from recommending mediocre proprietary mutual funds or recommending higher compensating alternatives when comparable options are available to the investor at a lower cost.

Concluding Thoughts

The Care Obligation will increase the legal standard for recommendations to retail customers by broker-dealers and advisors. But, for those advisors who have focused on providing good advice to their customers, and used high quality and reasonably priced investments, there will be little change in how they do business. In that case, the burden will fall primarily on the broker-dealer to develop best interest processes, policies and procedures, and supervisory practices.

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The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

Regulation Best Interest: The Focus on Costs (Part 2)

The SEC has issued its final Regulation Best Interest (Reg BI), Form CRS Regulation, RIA Interpretation and Solely Incidental Interpretation. I am discussing the SEC’s guidance in a series of articles entitled “Best Interest Standard of Care for Advisors.”

______________________________________________________________________

The SEC’s Reg BI establishes a best interest standard of care for investment recommendations to retail customers by broker-dealers and their registered representatives. In addition, Reg BI requires new disclosures and mitigation of advisor’s financial conflicts of interest. The SEC also issued an Interpretation of the Standard of Conduct for Investment Advisers, which clarified the SEC’s position on a number of issues related to the fiduciary standard and conflicts of interest for RIAs. There were two other pieces of guidance: the Form CRS Regulation (which requires a simplified front-end disclosure by broker-dealers and investment advisers); and the Solely Incidental Interpretation for limited discretion and monitoring of accounts by broker-dealers.

In my last article in this series, I pointed out that the SEC has explicitly included the consideration of costs in the text of Reg BI and stated that broker-dealers must consider costs for every recommendation (beginning on Reg BI’s compliance date of June 30, 2020). That doesn’t mean that the lowest-cost investment or investment strategy must be recommended (e.g., where the customer’s investment profile indicates that a more expensive alternative would be better serve the investor), but it does mean that costs must be part of that analysis, and that higher-cost alternatives must be justified by the retail customer’s investment profile. Picking up with where the last article left off, here is the SEC’s thinking:

The Care Obligation under Regulation Best Interest includes an explicit requirement to consider the cost of a recommendation. If this causes broker-dealers and their associated persons to more carefully consider cost in relation to other factors, compared to the baseline, it should reduce the incidence of recommendations of higher cost investments from a set of reasonably available alternatives that achieve the retail customer’s objective. [In addition, if] the explicit requirement to consider the cost of a recommendation encourages broker-dealers and their associated persons to more carefully consider cost, compared to the baseline, the final rule makes it less likely that a broker-dealer or its associated persons could have a reasonable basis to believe such investments are in the retail customer’s best interest because it would be difficult to have such a belief for investments that are identical beyond their costs. Therefore, including cost as a required factor in Regulation Best Interest should enhance the efficiency of recommendations to retail customers relative to the baseline.

Comment: There are two important points in that statement. First, the SEC makes it clear that costs will always be a consideration. Second, the SEC addresses different share classes of mutual funds by saying that, if the only difference in an investment is the cost, it is difficult to see how the higher cost share class would be in the best interest of the customer. If there was any remaining doubt about that issue, that should resolve it.

The SEC also took an expansive view of what constitutes a cost (that must be considered):

This would include, for example, both costs associated with the purchase of the security, as well as any costs that may apply to the future sale or exchange of the security, such as deferred sales charges or liquidation costs.

Comment: The SEC’s point is that all costs associated with the recommended security or strategy must be considered in the analysis of the alternatives considered for recommendation to a customer. That would include, for example, any surrender charges for annuities; the carrying costs of any investments; and any costs associated with the sale, redemption or liquidation of an investment, strategy or other product. While the SEC does not require that the process be documented, broker-dealers and advisors should particularly consider documenting the considerations examined (and how they were weighed) when recommending higher-cost products, where lower-cost options are available and are also aligned with the retail customer’s investment profile. The fact that the process does not need to be documented does not mean that the recommendation won’t have to be justified in the future.

One example of a process that would satisfy the SEC’s Care Obligation, and would provide the substantiation to support compliance, would be to use credible software systems (i) to establish the asset allocation for the retail customer based on the customer’s investment profile and (ii) to select the mutual funds from among the available investments to populate the asset classes in the allocation model. The system should be designed to appropriately weigh costs relative to the quality of the mutual funds, based on the prevailing standards used by the investment community. That is, the software would have a rational basis for considering both qualitative and quantitative factors and assign values to those factors. While this approach may not apply to all types of investments (and some advisors may believe that it impedes on their value proposition), it is a “clean” example of how compliance and substantiation can be satisfied in an efficient manner.

Finally, the SEC explained that broker-dealers must always consider three factors in formulating recommendations . . . cost plus two more . . . and those must align with the retail customer’s investment profile:

We believe that while the factors that a broker-dealer should understand and consider when making a recommendation may vary depending upon the particular product or strategy recommended, cost—along with potential risks and rewards—will always be a relevant factor that will bear on the return of the security or investment strategy involving securities.

While the starting point for a broker-dealer and its advisers to develop a recommendation for a retail customer is to gather and consider the information for the customer’s profile, the analysis has to include the cost and potential risks and rewards for the investor. And the SEC is explicitly elevating the significance of the costs, as compared to its role in the suitability analysis.

Concluding Thoughts

Broker-dealers need to be making decisions about how to comply with the requirements in Reg BI. That’s the first step…making decisions about how to do business in light of the changes that will apply on June 30, 2020. But, of course, it not possible to make decisions without knowing the rules and the options. So, learning about the changes is critical. Once that is done, the next step will be to develop the practices that will support those decisions. Once that is done, the work on policies and procedures, supervision and training can begin. There is a lot to be done by June 30, 2020.