Regulation Best Interest: The Focus on Costs (Part 2)

The SEC has issued its final Regulation Best Interest (Reg BI), Form CRS Regulation, RIA Interpretation and Solely Incidental Interpretation. I am discussing the SEC’s guidance in a series of articles entitled “Best Interest Standard of Care for Advisors.”

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The SEC’s Reg BI establishes a best interest standard of care for investment recommendations to retail customers by broker-dealers and their registered representatives. In addition, Reg BI requires new disclosures and mitigation of advisor’s financial conflicts of interest. The SEC also issued an Interpretation of the Standard of Conduct for Investment Advisers, which clarified the SEC’s position on a number of issues related to the fiduciary standard and conflicts of interest for RIAs. There were two other pieces of guidance: the Form CRS Regulation (which requires a simplified front-end disclosure by broker-dealers and investment advisers); and the Solely Incidental Interpretation for limited discretion and monitoring of accounts by broker-dealers.

In my last article in this series, I pointed out that the SEC has explicitly included the consideration of costs in the text of Reg BI and stated that broker-dealers must consider costs for every recommendation (beginning on Reg BI’s compliance date of June 30, 2020). That doesn’t mean that the lowest-cost investment or investment strategy must be recommended (e.g., where the customer’s investment profile indicates that a more expensive alternative would be better serve the investor), but it does mean that costs must be part of that analysis, and that higher-cost alternatives must be justified by the retail customer’s investment profile. Picking up with where the last article left off, here is the SEC’s thinking:

The Care Obligation under Regulation Best Interest includes an explicit requirement to consider the cost of a recommendation. If this causes broker-dealers and their associated persons to more carefully consider cost in relation to other factors, compared to the baseline, it should reduce the incidence of recommendations of higher cost investments from a set of reasonably available alternatives that achieve the retail customer’s objective. [In addition, if] the explicit requirement to consider the cost of a recommendation encourages broker-dealers and their associated persons to more carefully consider cost, compared to the baseline, the final rule makes it less likely that a broker-dealer or its associated persons could have a reasonable basis to believe such investments are in the retail customer’s best interest because it would be difficult to have such a belief for investments that are identical beyond their costs. Therefore, including cost as a required factor in Regulation Best Interest should enhance the efficiency of recommendations to retail customers relative to the baseline.

Comment: There are two important points in that statement. First, the SEC makes it clear that costs will always be a consideration. Second, the SEC addresses different share classes of mutual funds by saying that, if the only difference in an investment is the cost, it is difficult to see how the higher cost share class would be in the best interest of the customer. If there was any remaining doubt about that issue, that should resolve it.

The SEC also took an expansive view of what constitutes a cost (that must be considered):

This would include, for example, both costs associated with the purchase of the security, as well as any costs that may apply to the future sale or exchange of the security, such as deferred sales charges or liquidation costs. 

Comment:  The SEC’s point is that all costs associated with the recommended security or strategy must be considered in the analysis of the alternatives considered for recommendation to a customer. That would include, for example, any surrender charges for annuities; the carrying costs of any investments; and any costs associated with the sale, redemption or liquidation of an investment, strategy or other product. While the SEC does not require that the process be documented, broker-dealers and advisors should particularly consider documenting the considerations examined (and how they were weighed) when recommending higher-cost products, where lower-cost options are available and are also aligned with the retail customer’s investment profile. The fact that the process does not need to be documented does not mean that the recommendation won’t have to be justified in the future.

One example of a process that would satisfy the SEC’s Care Obligation, and would provide the substantiation to support compliance, would be to use credible software systems (i) to establish the asset allocation for the retail customer based on the customer’s investment profile and (ii) to select the mutual funds from among the available investments to populate the asset classes in the allocation model. The system should be designed to appropriately weigh costs relative to the quality of the mutual funds, based on the prevailing standards used by the investment community. That is, the software would have a rational basis for considering both qualitative and quantitative factors and assign values to those factors. While this approach may not apply to all types of investments (and some advisors may believe that it impedes on their value proposition), it is a “clean” example of how compliance and substantiation can be satisfied in an efficient manner.

Finally, the SEC explained that broker-dealers must always consider three factors in formulating recommendations . . . cost plus two more . . . and those must align with the retail customer’s investment profile:

We believe that while the factors that a broker-dealer should understand and consider when making a recommendation may vary depending upon the particular product or strategy recommended, cost—along with potential risks and rewards—will always be a relevant factor that will bear on the return of the security or investment strategy involving securities.

While the starting point for a broker-dealer and its advisers to develop a recommendation for a retail customer is to gather and consider the information for the customer’s profile, the analysis has to include the cost and potential risks and rewards for the investor. And the SEC is explicitly elevating the significance of the costs, as compared to its role in the suitability analysis.

Concluding Thoughts

Broker-dealers need to be making decisions about how to comply with the requirements in Reg BI. That’s the first step…making decisions about how to do business in light of the changes that will apply on June 30, 2020. But, of course, it not possible to make decisions without knowing the rules and the options. So, learning about the changes is critical. Once that is done, the next step will be to develop the practices that will support those decisions. Once that is done, the work on policies and procedures, supervision and training can begin. There is a lot to be done by June 30, 2020.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.