The SEC’s Division of Examinations (Division) recently announced its priorities for the 2022 fiscal year. Not unexpectedly, as part of the Division’s focus on protecting retail investors, examinations will scrutinize whether firms are satisfying their obligations under Regulation Best Interest (Reg BI), as well as the fiduciary standard owed by Registered Investment Advisers (RIAs) pursuant to the Investment Advisers Act of 1940.
To assist RIAs and broker-dealers with meeting their obligations, the SEC issued a Staff Bulletin on March 30, 2022, dealing with the standards of conduct owed when making account recommendations for retail investors. The bulletin is presented as questions and answers that are intended to reiterate the standards of conduct applicable to RIAs and broker-dealers, which are derived from key fiduciary principles including an obligation to act in investors’ best interests. The bulletin is designed to help firms and their financial professionals with adopting and implementing reasonably designed policies and procedures that should be followed when they make account recommendations.
Dually licensed financial professionals’ obligations when recommending accounts to retail investors
The standard that financial professionals must adhere to depends upon the capacity in which they are acting, such as whether they are acting as or on behalf of a broker-dealer, an RIA, or both. In many cases, both Reg BI and the Investment Advisers Act apply to financial professionals when assessing their account type recommendations. The antifraud provisions of the Investment Advisers Act apply to investment advisers when they interact with current and prospective clients.
Under Reg BI, when making account recommendations, financial professionals must disclose all material facts pertaining to the scope and terms of their relationship with the retail investor. Where financial professionals have not yet established the capacity in which they will be acting, both standards apply. In this situation, financial professionals should disclose to investors, prior to or at the time of the recommendation, that they are acting in both capacities.
Financial professionals must consider reasonably available alternatives when making recommendations. Under both Reg BI and the fiduciary standard, financial professionals may only recommend an account to retail investors when they have a reasonable basis to believe the account is in the retail investor’s best interest. As an example, a dually licensed financial professional must make a best interest evaluation that considers both brokerage and advisory accounts, subject to any eligibility requirements such as account minimums.
Factors to consider before making an account recommendation
Financial professionals should consider the retail investor’s:
- Financial situation, including current income and needs;
- Assets and debts;
- Marital status;
- Tax status;
- Investment time horizon;
- Liquidity needs;
- Risk tolerance;
- Investment experience;
- Investment objectives and financial goals; and
- Any other information received from the investor in connection with the account recommendation.
Financial professionals should also consider retail investors’ anticipated investment strategy, financial sophistication, whether they like to make their own decisions, and the need or desire for account monitoring or management.
If the necessary information is unavailable despite reasonable due diligence, the financial professional does not have sufficient understanding to determine if the recommendation is in the client’s best interest. If so, the bulletin suggests that no recommendations be made.
Consideration of costs in account recommendations
Potential costs must also be evaluated when evaluating whether an account is in a retail investor’s best interest. The existence of special or unusual features requested by the retail investor, such as tax advantages, does not alone support a reasonable belief that an account recommendation is in an investor’s best interest. Although financial professionals are not obligated to recommend the least expensive type of account, both Reg BI and the fiduciary standard require that the account recommendation be in the retail investor’s best interest.
Retirement account rollover recommendations
Financial professionals should consider additional factors when making a rollover recommendation to ensure it is in the retail investor’s best interest. Among others, these factors would include costs, level of available services, features of an existing account including costs, available investment options, ability to take penalty-free withdrawals, application of required minimum distributions, protection from creditors and legal judgments, and employer stock holdings. Financial professionals should obtain information about an investor’s existing plan with their employer, including the costs and investment choices. Financial professionals must demonstrate that they considered the option of leaving the investor’s investments in the employer’s plan.
Investor preferences do not satisfy the standard for account recommendations
Although a retail investor’s preference should be considered, it is not sufficient to justify the recommendation of a particular account. As an example, although a retail investor may express a preference for a brokerage account during an initial conversation, he or she may not fully understand the costs, products, and services available at that point in time. Ultimately, an advisory account may be in the investor’s best interest.
Documentation to prove the basis for the account recommended
RIAs and broker-dealers are subject to record-keeping rules that may impact their obligation to document the basis for account recommendations. To comply with Reg BI, broker-dealers should establish, maintain, and enforce written policies and procedures that require documentation to demonstrate the basis for their recommendations. Similarly, RIAs must adopt and implement policies and procedures designed to prevent breaches of the fiduciary standard they owe.
Practices that can assist firms in meeting their obligations to address conflicts of interest associated with account recommendations
The bulletin provides a non-exhaustive list of practices that can help firms to meet their obligations regarding conflicts of interest associated with account recommendations. Firms should:
- Avoid compensation thresholds that disproportionately increase when certain accounts are opened;
- Adopt and implement policies and procedures that are reasonably designed to minimize or eliminate incentives for employees to favor one type of account;
- Implement supervisory procedures to monitor recommendations to roll over or transfer assets in an ERISA account to an IRA; and
- Adjust compensation for financial professionals who fail to manage conflicts of interest associated with account recommendations.
The bulletin strongly encourages firms to eliminate or mitigate any incentive that creates a risk of causing a firm or its financial professionals to place their interests ahead of the retail investor’s interest.
RIAs and broker-dealers should use this bulletin to strengthen their policies and procedures to ensure compliance with Reg BI and the fiduciary standard. Inadequate policies and procedures will cause compliance problems for firms, even if clients are not harmed.
When the SEC issues a bulletin like this, firms can expect examiners to focus on these areas in 2022 and beyond. The Division’s annual priorities publication for 2022 is another clear indication that scrutiny of Reg BI and fiduciary issues is likely to occur during an examination.
The Staff Bulletin is available here.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.