On April 20, 2023, the SEC published a staff bulletin in a question-and-answer format to reinforce the standards of conduct owed by broker-dealers and Registered Investment Advisers (RIAs) when they are giving investment advice and making recommendations to retail investors. The bulletin focused on the Care Obligation imposed by Regulation Best Interest (“Reg BI”). The Care Obligation obligates broker-dealers to exercise reasonable diligence, care, and skill when making recommendations to retail customers. Reg BI’s Care Obligation dictates that broker-dealers establish, maintain and enforce written policies and procedures that are reasonably designed to achieve compliance with the regulation.
The bulletin also reiterated the duty of care owed under the Investment Advisers Act of 1940, which is referred to as the “IA fiduciary standard.” Collectively, the bulletin referred to Reg BI and the IA fiduciary standard as “care obligations.”
Reg BI for broker-dealers and the IA fiduciary standard for investment advisers both are drawn from key fiduciary principles that include an obligation to act in the retail investor’s best interest and to avoid placing their own interests ahead of the investor’s. By complying with their care obligations, firms and their financial professionals are able to 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 differ in some ways, they usually produce substantially similar results regarding the ultimate responsibilities owed to retail investors.
These care obligations include three elements:
- Understanding the potential risks, rewards, and costs connected to a product, investment strategy, account type, or series of transactions.
- Having a reasonable understanding of the retail investor’s investment profile; and
- Based on their understanding of the first two elements and after considering reasonably available alternatives, firms and financial professionals must have a reasonable basis to conclude that the recommendation or advice provided is in the retail investor’s best interest.
Firms and financial professionals must determine whether a recommendation or advice satisfies the care obligations. They must conduct an objective evaluation that is based upon the facts and circumstances of the specific recommendation or advice, as well as the investment profile of the retail investor at the time the recommendation is made or when the advice is given. When adopting and implementing reasonably designed policies and procedures governing their care obligations, broker-dealers and investment advisers should tailor them to their specific business models and their relationships with retail investors.
The bulletin’s answers to questions will help firms and their financial professionals to comply with Reg BI. These answers will also guide investment advisers and will help them satisfy their duty of care under the IA fiduciary standard.
Understanding the Investment or Investment Strategy
1) Do I need to understand the investment or investment strategy I am advising on or recommending?
Yes. It is no surprise that RIAs, broker-dealers, and their financial professionals need to understand the investments and investment strategies on which they provide advice and recommendations. This obligation requires firms and financial professionals to develop a sufficient understanding of the potential risks, rewards, and costs of the investment or investment strategy, so they have a reasonable basis to believe they are acting in a retail investor’s best interest. Without this understanding, firms and their financial professionals cannot have a reasonable basis for believing that their recommendation or advice aligns with a retail investor’s investment profile.
2) What factors should firms and financial professionals consider to develop such an understanding of an investment or investment strategy?
As part of their care obligations, broker-dealers, RIAs, and their financial professionals must develop an understanding of the investment or investment strategy in order to form a reasonable basis for making recommendations or providing advice to retail investors. What is reasonable depends upon the facts and circumstances, as well as the specific terms and features that a firm or financial professional would need to understand about the investment or investment strategy under consideration.
The bulletin provided a non-exhaustive list of the important 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 include:
- the goals of the investment or investment strategy such as exposure to a specific market sector;
- the initial and ongoing costs of the investment or investment strategy such as potential costs like redemption fees;
- the investment or investment strategy’s key characteristics and risks such as liquidity needs;
- the investment or investment strategy’s likely performance in different market and economic conditions;
- the expected returns, expected payout rates, and potential losses of the investment or investment strategy;
- any special features of the investment or investment strategy such as tax advantages or guaranteed payments; and
- the role of the investment or investment strategy in the retail investor’s actual or anticipated investment portfolio.
Where there is an ongoing monitoring obligation, firms and their financial professionals must continue their analysis throughout the course of the relationship.
3) Are costs always a relevant factor to consider when recommending or providing advice on investments or investment strategies?
Yes. While costs should certainly be a consideration, firms, and financial professionals cannot satisfy their obligations by simply recommending the lowest-cost option. Nevertheless, firms and their financial professionals must always consider cost as a factor when making a recommendation or giving advice to a retail investor. The firm and its financial professionals should consider the total potential costs when evaluating whether the recommendation or advice is in a retail investor’s best interest, including direct and indirect costs paid by the retail investor. For example, when determining whether an investment or investment strategy is in the investor’s best interest, the firm and its financial professionals should consider the following non-exhaustive list of potential costs to the extent they are relevant:
- Commissions;
- Markups or markdowns, and other transaction costs;
- Sales loads or charges and advisory or management fees;
- Other fees or expenses that may affect a retail investor’s return such as Rule 12b-1 fees;
- Trading and other costs associated with an investment strategy such as the need to continually buy and sell options or to pay margin interest;
- Costs of exiting an investment or investment strategy such as deferred sales charges or liquidation costs;
- Any relevant tax considerations; and
- The likely impact of those costs over the retail investor’s expected time horizon.
This analysis should consider far-reaching financial implications for the retail investor.
4) 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. The bulletin advised that firms should generally help to ensure that their financial professionals have sufficient information and training to understand the investments and investment strategies they give advice on or recommend. Nevertheless, financial professionals cannot satisfy their own care obligations by solely relying on their firm. Financial professionals remain responsible for personally understanding an investment or investment strategy before they recommend or give advice pertaining to that investment or investment strategy.
Understanding the Retail Investor’s Investment Profile
5) 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 its financial professionals should make reasonable efforts to learn about the retail investor. Obtaining and evaluating information about the retail investor’s investment profile is a critical requirement. Those efforts to collect information must be reasonable. Firms and their financial professionals must also have a reasonable basis for believing that their recommendation or advice is not based on materially inaccurate, incomplete, or outdated information about the retail investor.
To establish a reasonable understanding of the retail investor’s investment profile, firms, and their financial professionals should seek to obtain and consider the investor’s financial situation, investments, assets, debts, marital status, tax status, age, investment time horizon, liquidity needs, risk tolerance, investment experience, investment objectives, and financial goals. They must also understand any other information the retail investor may disclose to them.
6) Is gathering information for the retail investor’s investment profile a once-and-done exercise?
No. Broker-dealers and investment advisers may need to update the investor’s investment profile to comply with their respective obligations. Generally, broker-dealers should make a reasonable effort to ascertain information regarding an existing retail investor’s investment profile where they know or have reason to believe, that the customer’s investment profile has changed. Similarly, investment advisers must update the client’s investment profile in order to maintain an understanding of the client’s objectives and should tweak the advice to reflect any change in circumstances.
7) What do I do if investor information is unavailable?
Where investor information is unavailable despite reasonable efforts to obtain it, firms and financial professionals should carefully consider whether they have a sufficient understanding of the retail investor in order to evaluate if any recommendation or advice offered is in the person’s best interest. Without that information, firms and financial professionals will not be able to form a reasonable belief that a recommendation or advice is in a retail investor’s best interest. The bulletin suggested that firms and financial professionals should usually decline to provide recommendations or advice until they obtain the necessary investor information. When firms and their financial professionals do move forward, they should document why they believe this information is not relevant in view of the facts and circumstances surrounding the particular recommendation or advice.
8) As discussed above, tax status is part of the retail investor’s investment profile. What does it mean to consider the investor’s tax status when providing recommendations or advice?
There are many investments and investment strategies where a primary feature may be a tax advantage for the investor such as section 529 plans and tax loss harvesting. Where a retail investor or a financial professional identifies tax-related goals, SEC staff said they should consider whether the tax-advantaged option covered by their recommendation or advice is in the best interest of the retail investor. Nonetheless, SEC staff opined that the existence of a tax advantage alone would not provide a reasonable belief that a recommendation or particular advice would be in the retail investor’s best interest.
Considering Reasonably Available Alternatives
In the Reg BI Adopting Release, the SEC made clear that a broker-dealer generally should consider reasonably available alternatives to determine whether it has a reasonable basis to believe that a recommendation is in the best interest of its retail customer. Investment advisers must also consider reasonably available alternatives when selecting or recommending investments for their clients.
9) 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. Consideration of reasonably available alternatives should begin early in the process of formulating a recommendation or providing advice rather than as a retroactive exercise undertaken after the fact.
10) How should firms approach developing a process to identify the scope of reasonably available alternatives that financial professionals should evaluate?
The bulletin warned that firms should have a reasonable process for identifying the scope of reasonably available alternatives that their financial professionals should consider. Although the specific steps may vary, as a general matter, the process of developing a recommendation or advice should begin by considering a broader array of investments or investment strategies that are generally consistent with the retail investor’s investment profile. Firms and their financial professionals should then narrow the choices to a smaller universe of potential investments or investment strategies that is more focused on meeting the best interest of a particular retail investor.
11) My firm operates with an open architecture framework. Do I have to evaluate every alternative available through my firm?
Financial professionals do not necessarily need to evaluate every possible alternative available through the firm. On the other hand, the SEC staff believes that financial professionals would still need to evaluate a range of potential alternatives that is sufficient to form a reasonable basis to believe a recommendation or advice is in the best interest of the retail investor.
12) My firm has a limited menu of investments. Do I have to consider all of them when evaluating reasonably available alternatives?
It depends. A financial professional associated with a firm that has only a limited menu of investments should be familiar with all of them. However, certain investments on that limited menu that can be made available to retail investors may be inconsistent with an individual retail investor’s investment profile. Nevertheless, a firm and its financial professionals cannot rely on a limited menu to justify recommending an investment or providing advice that does not satisfy the obligation to act in a retail investor’s best interest. Investment advisers engaged in providing ongoing investment advice should periodically consider whether the investment options they make available to their clients are sufficient to meet their best interests. Firms with a limited investment menu should have a reasonable process, tailored to their particular business model and investments, for considering reasonably available alternatives.
13) 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. Nevertheless, that alternative may still not be in the best interest of the particular retail investor in view of their investment profile. Therefore, one possible outcome of this 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 its financial professionals would not satisfy their care obligations if they recommend or advise any of those investments or investment strategies to the retail investor.
14) Does every investment or investment strategy have a reasonably available alternative?
The bulletin recognized that product innovation, particularly in the realm of complex products, has resulted in the development of products and features that make them unique. However, SEC staff expressed the opinion that even products that are not identical may still be comparable to each other for purposes of identifying them as reasonably available alternatives. For example, if a retail investor’s investment objectives include exposure to a particular market sector, firms should consider a range of products that offer similar exposure and are consistent with the investor’s investment profile.
15) 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. Firms and their financial professionals 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 for believing that a recommendation or advice is in a retail investor’s best interest. Therefore, they would need to understand the potential risks, rewards, and costs associated with those reasonably available alternatives.
16) Should firms document the evaluation of reasonably available alternatives?
Although there is no requirement to create and maintain this documentation, a firm will find it difficult to demonstrate compliance without it. This could include documentation that the firm and its financial professionals considered reasonably available alternatives. Documentation is vitally important where a particular recommendation appears to be inconsistent with a retail investor’s investment objectives on its face and/or raises conflicts of interest for the firm or the financial professional.
Special Considerations: Complex or Risky Products
17) Can it be consistent with a financial professional’s care obligations to recommend, or provide advice about, a complex or risky product?
Yes. Neither Reg BI nor the IA fiduciary standard prohibits recommendations of, or advice about, complex or risky products to retail investors where the financial professional has established a reasonable basis to believe they are in the best interest of the retail investor. These products may not be in the best interest of a client unless there is an identified, short-term, customer-specific trading objective. Firms and their financial professionals should consider whether less complex, less risky, or lower-cost alternatives can achieve the same objectives for their retail customers. Generally, they should apply “heightened scrutiny” to decide whether a risky or complex product is in the retail investor’s best interest.
18) What does it mean to apply heightened scrutiny in the context of recommending, or providing advice about, a complex or risky product?
Certain products are more complex or have additional risk features. As a result, it may be more difficult for firms and their financial professionals to develop an understanding of the terms, features, and risks of those products in order to have a reasonable basis to believe that they are in the best interest of retail investors. Products requiring heightened scrutiny might include inverse or leveraged exchange-traded products, penny stocks, and crypto-currency.
In addition to developing an understanding of the product, firms, and their financial professionals should obtain information about the retail investor to substantiate why a complex or risky product would be in the retail investor’s best interest.
19) What procedures should a firm consider implementing to address complex or risky product recommendations or advice?
A firm’s written policies and procedures should be tailored to the firm’s business model. Those policies and procedures might articulate the due diligence process for complex or risky financial products to ensure that they are evaluated by qualified and experienced firm personnel. In addition, firms should consider establishing procedures for evaluating reasonably available alternatives to complex or risky products they give advice about or recommend.
Special Considerations: Recommendations and Advice By Dual Registrants
20) I am a dually licensed financial professional working at a dually registered firm, and some of our retail investors have both brokerage and advisory accounts with us.
20(a) How do I know which standard applies when providing advice and recommendations to such investors?
A facts and circumstances analysis is required to determine 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. Among other factors, the SEC considers 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. 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. This disclosure of capacity may not be conclusive if the facts and circumstances suggest the financial professional was, in fact, acting in a different capacity.
20(b) Do I need to consider whether a brokerage or advisory account is more appropriate for an investment or investment strategy when providing recommendations or advice to a retail investor of a dually licensed financial professional?
Yes. Dually registered firms and dually licensed financial professionals have an obligation to reasonably believe the recommendation or advice they provide regarding account type is in the retail investor’s best interest. Furthermore, where a retail investor holds both brokerage and advisory accounts, a dually registered firm or dually licensed financial professional should consider whether a recommendation of an investment or investment strategy is better suited for the investor’s brokerage or advisory account.
Takeaways
Although the staff bulletin does not have legal force or effect, does not alter or amend applicable law, and creates no new or additional obligations for any person, broker-dealers and RIAs should make every effort to follow the guidance in it. The staff bulletin is expressly limited in scope to the duties owed by a broker-dealer or investment adviser, including their financial professionals when providing recommendations or investment advice to retail investors. As an example, it does not address the duty to seek best execution of clients’ transactions.
RIAs should always make certain that their recommendations and advice are not based upon materially inaccurate or incomplete information. In advisory contracts and client communications, RIAs should encourage clients to notify them immediately if their financial circumstances change.
The SEC’s bulletin is available here. https://www.sec.gov/tm/standards-conduct-broker-dealers-and-investment-advisers
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.
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