Best Interest Standard of Care for Advisors #26

Regulation Best Interest: Recommendations of Account Types (Part 2)

The SEC has issued its final Regulation Best Interest (Reg BI), Form CRS Rule, 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.”

In my last post (Best Interest for Advisors #25), I discussed the SEC guidance for broker-dealers and investment advisers on recommendations of account types. The article explained that investment advisers are subject to the best interest standard for recommending account types (since July of last year) and broker-dealers will be subject to the new best interest rules for recommending account types (beginning June 30 of this year).

The focus of the article, though, was to define what an account type was. As the article explained, “account type” is to be interpreted very broadly and includes many programs and accounts that may not obviously be considered types of accounts. As a result, the first compliance step for broker-dealers and investment advisers is to identify all of the account types they offer. Then those firms can develop the processes for their advisors to consider the types of accounts (and compare different types of accounts) offered by the firm . . . in light of the investor’s needs. (The rules apply to retail customers of broker-dealers and all clients of investment advisers.)

As Reg BI explains for broker-dealers (and as the RIA Interpretation would apply to investment advisers):

. . . Regulation Best Interest will apply to recommendations by a broker-dealer of a securities account type. Thus, the Care Obligation will require a broker-dealer to have a reasonable basis to believe that a recommendation of a securities account type (e.g., brokerage or advisory, or among the types of accounts offered by the firm) is in the retail customer’s best interest at the time of the recommendation and does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.

As a result, an advisor with a broker-dealer must consider the account types available at the broker-dealer and determine which one or ones are in the best interest of the particular retail customer. If no account type is appropriate for that retail customer, the advisor must acknowledge that fact to the retail customer.

But, what if the advisor is a dually licensed professional with a dual registrant broker-dealer/investment adviser. The SEC address that question in the Adopting Release of Reg BI:

Where the financial professional making the recommendation is dually registered (i.e., an associated person of a broker-dealer and a supervised person of an investment adviser (regardless of whether the professional works for a dual-registrant, affiliated firms, or unaffiliated firms)) the financial professional would need to make this evaluation taking into consideration the spectrum of accounts offered by the financial professional (i.e., both brokerage and advisory taking into account any eligibility requirements such as account minimums), and not just brokerage accounts.

And, what if the broker-dealer is a dual registrant, but the advisor is only a registered representative of the broker-dealer and thus can only recommend account types available through the broker-dealer. Again, the SEC addressed that question in the Adopting Release:

Similarly, where the financial professional is only registered as an associated person of a broker-dealer (regardless of whether that broker-dealer entity is a dual-registrant or affiliated with an investment adviser), he or she would need to take into consideration only the brokerage accounts available. However, even if a broker-dealer only offered brokerage accounts, the associated person would nevertheless need to have a reasonable basis to believe that the recommended account was in the best interest of the retail customer.

But elsewhere in the Adopting Release, the SEC explained that, if the broker-dealer is a dual registrant, but the advisor can only represent the brokerage side of the house, that is a “material limitation” on the advisor’s services. The effect of a material limitation is that the broker-dealer (or the advisor) must disclose that the advisor has a material limitation on his or her services and what that material limitation is. Interestingly, both the Care Obligation and the Disclosure Obligation in Reg BI are placed on both the broker-dealer and the individual advisor, so that, if the material limitation is not disclosed by the broker-dealer, the advisor must disclose it. And the disclosure should be in writing.

The SEC says that the account type requirements are a new regulatory burden on broker-dealers. Among other things, that means that new practices, policies and procedures, and training will be required . . . and must be in place by June 30, 2020.

For investment advisers, the account type requirements are already in place. As a result, the practices for compliance should already be in place. I am concerned that some (many?) investment advisers may not be aware of this requirement.

My next article, Part 3, in this series about account types, will discuss the SEC’s views on the process required to evaluate account types and SEC examples of what the outcome of that process might look like.

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.