By John Filar Atwood
The SEC has released a staff bulletin that provides guidance on the standards of conduct required of broker-dealers and investment advisers when making account recommendations for retail investors. The bulletin, which was praised by Chair Gary Gensler, is intended to assist firms and their professionals with considering reasonably available alternatives and cost, addressing conflicts of interest, and adopting and implementing policies and procedures when making account recommendations.
Reg BI vs. IA fiduciary standard. The bulletin considers both Regulation Best Interest (Reg BI) for broker-dealers and the Investment Advisers Act (IA) fiduciary standard for investment advisers, which it notes are drawn from the same fiduciary principles including an obligation to place a retail investor’s best interests ahead of the firm’s own interests. Although the application of Reg BI and the IA fiduciary standard may differ slightly and be triggered at different times, the SEC staff believes they yield substantially similar results in terms of the responsibilities owed to retail investors.
The bulletin states that whether a professional follows Reg BI or the IA fiduciary standard depends upon the capacity in which he or she is acting, but notes that the antifraud provisions of the IA may apply to investment advisers in connection with current and prospective clients. As a result, in many cases both Reg BI and the IA apply as a professional considers an account recommendation.
The bulletin clarifies that an investment professional must disclose his or her capacity under both Reg BI and the IA fiduciary standard when making a recommendation. If the professional has not established the capacity in which he or she is acting, the staff states that both standards apply and the professional should disclose to the investor that he or she is acting in both capacities.
In the bulletin the staff reiterates that investment professionals must consider reasonably available alternatives when making account recommendations. If a professional is dually licensed, then he or she must make a best interest evaluation taking into consideration all accounts the firm offers, both brokerage and advisory. The staff added that a professional cannot recommend an account that is not in a retail investor’s best interest solely based on the firm’s limited product menu or arising from limitations on the professional’s licensing. These limitations must be disclosed to retail investors, the staff stated.
Best interest factors. The staff addresses in the bulletin what factors a professional should consider when deciding if an account recommendation is in a retail customer’s best interests. The factors to be considered should include the retail investor’s financial situation and needs, investments, assets and debts, marital status, tax status, age, and investment time horizon. In addition, liquidity needs, risk tolerance, investment experience, investment objectives, and financial goals should be considered.
The staff further recommends that investment professionals weigh a customer’s anticipated investment strategy, level of financial sophistication, preference for making their own investment decisions or relying on advice from a financial professional, and the need or desire for account monitoring or ongoing account management. If insufficient information is available about a potential customer, the staff believes investment professionals should decline account recommendations until they obtain the needed information.
Costs. The staff states in the bulletin that costs are always a relevant factor when making an account recommendation. Reg BI and the IA fiduciary standard do not always obligate an investment professional to recommend the least expensive type of account, the staff notes, but they both require that the professional have a reasonable basis to believe that the account recommendation is in the retail investor’s best interest.
If a professional recommends a higher cost account, he or she must have a reasonable basis to believe the recommendation is nonetheless in the retail investor’s best interest based on other factors and in light of the particular situation and needs of the investor. The bulletin points out that the Commission has pursued enforcement actions against investment advisers for recommending higher-cost products to clients when similar, lower-cost products were available.
The staff outlines some of the kinds of costs that should be considered such as account fees, commissions and transaction costs, tax considerations, and indirect costs like those associated with payment for order flow and cash sweep programs. The staff notes that the cost of an account may also include fees associated with the investment products that are available through the account, such as management fees, distribution and servicing fees, and the costs of investing in funds, including front-end and back-end fees.
Investor preference. The bulletin indicates that if a retail investor expresses a preference for a particular type of account, making an account recommendation on the basis of that preference would not satisfy the standards. The staff believes that a retail investor may not fully understand what the differences between brokerage and advisory accounts are in terms of costs and available products and services. Accordingly, an investment professional should consider reasonably available alternatives and recommend an account he or she believes is in the retail investor’s best interest. The staff added that if a customer ultimately directs the investment professional to open an account that is contrary to his or her recommendation, the professional is not required to refuse the investor’s direction.
Best practices. The bulletin includes examples of practices that can help firms avoid conflicts of interest with respect to account recommendations. They include: (1) avoiding compensation thresholds that disproportionately increase compensation through openings of certain account types; (2) adopting policies and procedures reasonably designed to minimize or eliminate incentives, including both compensation and non-compensation incentives, for employees to favor one type of account over another; (3) implementing supervisory procedures to monitor recommendations that involve the rollover or transfer of assets from one type of account to another; and (4) adjusting compensation for financial professionals who fail to adequately manage conflicts of interest associated with account recommendations.