By Stephen Wilkes and Seth Gaudreau
On April 26, 2023, the U.S. Securities and Exchange Commission (“SEC”) published a Staff Bulletin (the “Bulletin”) reiterating the care obligation standards of conduct for broker-dealers and investment advisers when providing investment advice and recommendations to retail investors under Regulation Best Interest (“Reg BI”) and the Investment Advisers Act of 1940 (“IA Fiduciary Standard”), respectively. Similar to earlier bulletins from the Staff, the Bulletin is styled as a Q&A and focuses on compliance with firms’ and financial professionals’ care obligations when forming a reasonable belief that their investment advice and recommendations are in the retail investor’s best interest. The Bulletin addresses the care obligations’ three overarching and intersecting components:
- understanding the potential risks, rewards, and costs associated with an investment or investment strategy,
- having a reasonable understanding of the specific retail investor’s investment profile, and
- having a reasonable basis to conclude that the recommendation or advice provided is in the retail investor’s best interest.
The Staff also address recommendations or advice involving complex or risky products and dual registrants and the “heightened scrutiny” that should be applied by firms and financial professionals. The “heightened scrutiny” for recommendations or advice involving complex or risky products may present challenges and uncertainty for certain types of investors and increased due diligence.
Understanding the Investment or Investment Strategy
The Staff’s first Q&A expresses its view, that firms and their investment professionals need to understand the investments and investment strategies in order to form a reasonable basis that the recommendation or advice is in a retail investor’s best interest.
In the Staff’s view reasonableness depends on the facts and circumstances of the specific terms and features of an investment or investment strategy. The Bulletin provides a non-exhaustive list of factors, “that may be relevant to consider as part of evaluating the potential risks, rewards, and costs of an investment or investment strategy.” These factors are not only relevant at the start of the relationship but should be considered on an ongoing basis. Further, firms and financial professionals need to consider the overall potential costs, including direct and indirect costs that could be borne by the retail investor. Recommending the lowest cost option does not inherently satisfy the care obligation and both firms and financial professionals need to consider costs beyond those disclosed on a trade confirmation or account statement. These includes aspects of potential costs, such as: commissions, markups or markdowns, and other transaction costs; sales loads or charges; advisory or management fees; other fees or expenses that may affect a retail investor’s return (such as Rule 12b-1 fees, other administrative and service fees, revenue sharing, and transfer agent fees); the trading and other costs associated with an investment strategy (such as the need to continually buy and sell options or futures contracts or pay margin interest, daily rebalance fees, and any structural features of the investment that could magnify investor losses); the costs of exiting an investment or investment strategy (such as deferred sales charges or liquidation costs); any relevant tax considerations; and the likely impacts of those costs over the retail investor’s expected time horizon.
Financial professionals cannot satisfy their own care obligations by solely relying on a firm’s approved list of investments. Financial professionals are responsible for understanding an investment or investment strategy before they advise or recommend an investment or investment strategy.
Understanding the Retail Investor’s Investment Profile
Under the Staff’s view, in order to form a reasonable basis belief that a particular investment or investment strategy is in the best interest of a particular retail investor, both firms and their financial professionals need to make a reasonable effort to ascertain a retail investor’s “investment profile.” The investment profile needs to be complete, up-to-date, and materially accurate and should contain a retail investor’s financial situation, investment objectives, and other information and characteristics of that retail investor. 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. The Staff provides a non-exhaustive list of considerations, such as: the investor’s financial situation (including current income) and needs; investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objective and financial goals; and any other information the retail investor may disclose in connection with the recommendation or advice.
An investment profile is not a once-and-done exercise and firms will need to make a reasonable effort to ascertain whether the investor’s investment profile has changed and to ensure that they have sufficient information to make a recommendation or provide advice in the retail investor’s best interest. The Staff believes firms and investment professionals should generally decline to provide recommendations or advice until they obtain the necessary investor information.
In addressing a retail investor’s tax status, the Staff believes that a firm and its financial professionals should consider whether the tax-advantaged option covered by their recommendation or advice is in the best interest of the retail investor based on the retail investor’s investment profile. Various tax advantage and strategies are factors that should be considered but do not alone provide a reasonable belief that a particular recommendation or particular advice would be in the retail investor’s best interest.
Considering Reasonably Available Alternatives
The SEC has made it clear that the consideration of reasonably available alternatives is an inherent aspect of making a “best interest” recommendation. Further, the Staff views Reg BI and its statements about broker-dealers with respect to consideration of reasonably available alternatives as a useful framework for investment advisers to consider in satisfying their care obligations when providing investment advice.
The consideration of reasonably available alternatives should be undertaken early in the process and not after the firm or financial professional has already formulated its recommendation or advice. In the context of mutual funds, reasonably available alternatives goes beyond just a share class consideration and investments and investment types that are reasonably available to investors through the firm should be considered to determine whether they could achieve the investor’s investment objectives. As part of their care obligations firms need to have and implement on an ongoing basis, a reasonable process for establishing and understanding the scope of such reasonably available alternatives. The Staff states that, “[a]though the specific steps may vary, as a general matter the staff believes the process of developing a recommendation or advice should begin by considering a broader array of investments or investments strategies that are generally consistent with the retail investor’s investment profile, and then narrowing to a smaller universe of potential investments or investment strategies as the analysis is more focused on meeting the best interest of a particular retail investor.” This process should include policies and procedures that firms’ investment professionals are trained on. Specifically, firms and their financial professionals need to address the scope of alternatives that should be considered and the factors that need to considered in order to establish a reasonable basis to believe that their recommendation or advice is in the retail investor’s best interest.
The Staff also addressed responses for firms with open architecture and alternatively, a limited menu of investments. The Bulletin addresses the different considerations firms and financial professionals should undertake dependent on the scope of the investments available to investors.
The scope of alternative investments and investment strategies that might be considered will depend on the facts and circumstances, including 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. The unique features and benefits of alternatives considered do not need to be an exact match, so long as the risks, rewards and costs associated with the alternatives recommendation or advice is reasonably consistent with the retail investor’s best interest and the investor’s investment profile.
As with most aspects of a recommendation or advice 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.”
Special Considerations: Complex or Risky Products
Although there is nothing in Reg BI or the IA Fiduciary Standard that prohibits the recommendation of, or advice about, complex or risky products, the Staff states that firms and financial professionals 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. The SEC believes that complex or risky products would require a “heightened scrutiny.” These products include, inverse or leveraged exchange-traded products, investments traded on margin, derivatives, crypto asset securities, penny stocks, private placements, asset-backed securities, volatility-linked exchange-traded products, and reverse-convertible notes. The heightened scrutiny includes additional information such as, whether the retail investor has an identified, investor-specific trading objective that is consistent with the product’s description in its prospectus or offering documents, and/or has the ability to withstand heightened risk of financial loss. These are not determinative, firms and their financial professionals must still have a reasonable basis to believe that, based on the overall relevant facts and circumstances, the investment is in a retail investor’s best interest.
A firm’s due diligence process around these products should be ongoing and its policies and procedures should be specifically designed to address recommendations of, or advice about, complex or risky products.
Special Considerations: Recommendations and Advice by Dual Registrants
As with most determination whether Reg BI or the IA Fiduciary Standard applies to a dual registrant will depend on a facts and circumstances analysis, with no one factor being determinative. The Staff addresses certain factors they may use to determine the applicable standards but also states that although the standards “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” and that “[r]egardless of the firm’s or financial professional’s capacity, [it] should obtain and evaluate enough information about the retail investor and the investment or investment strategy being recommended to have a reasonable basis to believe a recommendation or advice is in the best interest of that retail investor and that [the] recommendation is not based on materially inaccurate or incomplete information.” These considerations include considerations around whether a brokerage or advisory account is appropriate.
Conclusion and Considerations
Firms should evaluate their policies and procedures to ensure the firm’s and its financial professionals’ compliance with the Staff’s recommendations in the Bulletin. Firms should focus on appropriate processes for implementing and documenting recommendations and advice that it and its financial professionals provided to retail investors. Firms that recommend or advise on complex or risky products for retail investors should particularly take note of the Staff’s recommendations regarding these products.
The care obligation is an objective evaluation turning on the facts and circumstances of the particular recommendation or advice and the investment profile of the particular retail investor at the time the recommendation is made or when the advice is provided. While the Bulletin is not “a rule, regulation, or statement of the Commission” broker-dealers and investment advisers may wish to consider this guidance (and the previous guidance) in light of continued focus on the Reg BI and the IA Fiduciary Standard when reviewing their policies and procedures, their business models and their relationships with retail investors.