Best Interest Standard of Care for Advisors #30

Regulation Best Interest: Best Interest and Suitability-How They Differ (Part 1)

Regulation Best Interest (Reg BI) imposes a “best interest” standard of care on broker-dealers for their recommendations of securities and investment strategies to retail customer. That raises the question, what does best interest mean and how does it differ from suitability? That’s a hard question without an easy answer. Even the SEC acknowledges in the adopting release for Reg BI that:

“Specifically, recognizing that a facts and circumstances evaluation of a recommendation makes it difficult to draw bright lines around whether a particular recommendation would meet the Care Obligation, the Commission is providing further interpretations and guidance on how a broker-dealer could have a ‘reasonable basis to believe’ that a recommendation is in the best interest of its retail customer and does not place the broker-dealer’s interest ahead of the retail customer’s interest, as well as circumstances when we believe that a broker-dealer could not have such a reasonable belief.”

While the SEC’s language suggests that concrete examples will follow, that is not the case. Instead, the examples tend to be general and principles-based, such as:

“The customer-specific component of the Care Obligation will rest on whether a broker-dealer had a reasonable basis to believe that the recommendation was in the best interest of the particular retail customer at the time of the recommendation, based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation, and did not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer.”

As the bolded language says, the SEC requires that four factors be considered in developing a recommendation for a retail customer:  the customer’s investment profile, potential risks and rewards, and costs. That tells us that a broker-dealer and its representatives must always consider those factors. And, as a practical matter, one approach for compliance might be to have a defined process for gathering the information, evaluating it in light of the retail customer’s investment profile, and making a recommendation that bears a reasonable relationship to the information and that is in the best interest of the investor.

However, that still leaves a lot of grey. The one factor, though, that has the most clarity (in the sense that it can be most easily measured) is the requirement to consider “cost.”

The SEC emphasized that change from the suitability rules by saying:

“Regulation Best Interest is designed to improve investor protection by:

  • Requiring broker-dealers to have a reasonable basis to believe that recommendations are in the retail customer’s best interest, which enhances existing suitability obligations by: . . . expressly requiring consideration of cost in evaluating a recommendation as part of the Care Obligation; . . .”

It is important to note, though, that differences in cost can be offset by differences in product features and benefits. In other words, while cost is an important factor, it is not the only factor to be considered. However, the SEC’s elevation of cost as a factor in Reg BI is an important change from the old suitability rules.

Here is one example. (My next post will provide additional examples.)

Example 1: A broker-dealer offers two S&P 500 index funds with essentially no differences except that one has a 50 basis point expense ratio and the other has a 75 basis expense ratio. While it is theoretically possible that some difference in features or benefits could justify the additional cost, no examples come to mind in this case. Remember, the issue is whether it would be in the best interest of a retail investor to recommend the more expensive 75 bps version.

In this example, there are two identical investments. The only difference, from the customer’s perspective, is that one is more expensive than the other, meaning that the return for the customer will be lower. (Remember, we are assuming that the investments are identical except for their costs.)

One might argue that the broker-dealer and its advisor should be able to recommend the more expensive option if it pays more compensation and if the additional compensation is reasonable. However, the adopting releases for the proposed and final Reg BI focus on the best interest of the customer. As a result, the likely interpretation of Reg BI is that the lower cost alternative should be recommended, assuming that the investment is otherwise identical.

The elevation of cost as a factor is one of the major changes in Reg BI. It should not be discounted. Cost needs to be considered in the development of every recommendation under Reg BI.

Next month’s article will have additional examples.

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

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