Bates Research | 05-05-23
SEC Bulletin Offers Staff’s Views on Standards of Conduct for Investment Advisers and Broker-Dealers When Addressing Care Obligations: What You Need to Know
In a 20-question and answer format, the SEC staff offered its latest guidance[i] on the obligations and duties of care expected of broker-dealers and investment advisers toward their retail clients. The April 24, 2023, Bulletin honed in on the “care obligations” under both the broker-dealer Regulation Best Interest (Reg BI) standard and under the investment adviser fiduciary standard emphasizing that the two standards are derived from the same principles and “yield substantially similar results in terms of the ultimate responsibilities owed to retail investors.” In this regard, the SEC guidance narrows the differences between the two. Here is the latest.
Two Standards or One?
Core commonalities between the two standards include three “overarching and intersecting components,” according to SEC staff. These components are (i) understanding key elements of the investment product or investment strategy (such as risks, rewards and costs); (ii) regularly updating and understanding the retail customer’s investment profile; and (iii) offering the investor reasonable investment alternatives in their best interest based on (i) and (ii). Staff asserted repeatedly that evaluating whether a recommendation or advice meets the standard is an “objective evaluation, turning on the facts and circumstances.”
Investment Products and Strategies
Staff stressed the importance of understanding investment products, asserting that a broker or adviser will not have a reasonable basis for making a recommendation in the best interest of the investor without such an understanding. Indeed, the Staff reiterated that understanding the firm’s investment products and/or strategies is both a Firm responsibility and the personal responsibility of the representative/advisor. The Staff said that the professional remains on the hook, even where the firm has “compiled an approved list of investments for retail investors.” Relevant factors to understanding these products and strategies may—depending on the facts—include understanding the strategic objectives, (e.g., income, principle preservation or growth); all fees and costs associated with the investment (e.g., commissions, markups, sales loads or charges, advisory or management fees; administrative and service fees, revenue sharing, and transfer agent fees); risks (e.g. potential losses, volatility, margin calls, early repayments); performance expectations (in light of economic conditions); and, special features of the investment (e.g., tax impact).
The Bulletin reminds broker-dealers and advisers to fully understand the investor’s profile, and to continue to obtain updated information. They gave examples of investor information that should be collected, including but not limited to the investor’s “financial situation; [other] investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objective[s] and financial goals;” and, depending on the circumstances, additional information such as “level of financial sophistication; preference for making their own investment decisions … and need or desire for account monitoring or ongoing account management.” They also warned brokers and advisors against providing recommendations or advice without the necessary investor profile (or to document why such information may not be relevant under the circumstances).
The Staff made clear that broker-dealers and investment advisers cannot satisfy their duty of care to retail investors if they have not considered “alternatives that are reasonably available to achieve the investor’s investment objectives.” (Staff noted that the SEC has brought enforcement actions against advisers for failing to consider available alternatives when recommending investments.)
The guidance also includes a recommendation that firms implement a process for “establishing and understanding the scope of such reasonably available alternatives,” which should include “evaluation of alternatives prior to investment and consideration of alternative investments throughout the investment period.” Such a process could include a broad array of investments “consistent with the retail investor’s investment profile, and then narrowing to a smaller universe of potential investments or investment strategies.”
Further, the staff said the process should be tailored to the firm’s business model and incorporated into the firm’s policies and procedures. Staff considered an example, however, of a firm that uses an "open architecture framework" business model, with hundreds, or thousands, of product alternatives. In such cases, they said, “a financial professional does not have to evaluate every possible alternative available through the firm.” The staff used this example to describe how facts and circumstances might affect a review of a firm’s alternative available investment policy.
The staff also noted that recommending the "most appropriate" option from a limited menu of investments would not necessarily satisfy an investment professional’s care obligations. Similarly, investment products that are "not identical may still be comparable" as alternative investment options. These examples reinforce the staff’s view that “the scope of alternative investments and investment strategies that might be considered will depend on the facts and circumstances, including but not limited to the nature of the firm’s business, the retail investor’s investment profile, the scope of its relationships with its customers and clients, and the reasonable availability of alternative investments or investment strategies.”
Finally, while the staff acknowledged that documentation of the professional’s evaluation is not specifically required, it would be difficult for a firm or professional to demonstrate compliance of all its obligations without having some documentation of the basis for recommendations. They said that such documentation “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.”
Complex or Risky Products
Notwithstanding the above, the Bulletin advised that complex or risky products—usually subject to “heightened scrutiny”—may be consistent with a client’s investment profile, and trading objective, but that the broker-dealer or adviser “should consider whether less complex, less risky or lower cost alternatives can achieve the same objectives for their retail customers as part of their overall reasonable basis analysis.” They encouraged firms recommending complex or risky products to (i) establish policies and procedures “outlining the[ir] due diligence process” in order to “help ensure that these products are assessed by qualified and experienced firm personnel; (ii) establish training and supervision procedures “to help ensure financial professionals understand the features, risks, and costs of a complex financial product; and (iii) establish procedures for evaluating reasonably available alternatives with “lower risk or less complex options,” if it would achieve the same objectives.
Staff weighed in on whether the Reg BI or the fiduciary standard is applicable for dual registrants. First, they said that the answer depends on facts and circumstances including the account type, considerations 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.” Second, they suggested that a dually registered firm should consider whether a recommendation is better suited for the investor’s brokerage account or advisory account. And finally, Staff remarked that, regarding duty of care, either result would be otherwise substantially similar “in terms of the ultimate responsibilities owed to retail investors.”
Many investment advisers have effectively tuned out at the mention of Reg BI, thinking it doesn’t apply to them. Based on the Staff Bulletin, both investment advisers and broker-dealers would be wise to take a strong look at how they evaluate and document the advice and recommendations they give to their clients.
[i] SEC Bulletin footnote 1 states: “This staff bulletin and other staff documents (including those cited herein) represent the views of the staff of the Securities and Exchange Commission (“Commission”) and are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the content of these documents and, like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create no new or additional obligations for any person.”
How Bates Can Help
Bates Group’s Compliance team helps firms navigate and achieve compliance with Reg BI and Form CRS, including:
- Disclosure obligations
- Duty of care obligations
- Conflicts of interest obligations
- Additional compliance obligations
We can assist you with:
- Developing and reviewing Reg BI Client Relationship Summary (“Form CRS”)
- Conflicts of interest assessment
- New product approval processes
- Drafting new policies and procedures
- Training for compliance and sales professionals on how to comply with Reg BI and Form CRS
- Litigation support
- Reg BI expert testimony