Best Interest Standard of Care for Advisors #33

Regulation Best Interest: Best Interest and Suitability—How They Differ (Part 4)

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 customers. That raises the question, what does best interest mean and how does it differ from suitability?

Parts 1, 2 and 3 of this series (Best Interest Standard of Care for Advisors #30, #31 and #32) explain that the difference between best interest and suitability is not easily defined. However, based on the SEC’s discussion in the Adopting Release for Reg BI, I provided five examples of where best interest appears to impose a more demanding standard than suitability. These examples focus on the Reg BI requirement that broker-dealers (and their registered representatives) consider costs in the development of recommendations. While costs are not the only factor to be considered, the SEC says that “best interest” makes cost a more important factor than it was under the suitability standard.

This article takes a slightly different approach; it focuses on circumstances where the compensation paid to broker-dealers and their financial professionals increases the cost of the recommended investments. For example, that could include a higher compensating share class of a mutual fund or an annuity with a higher commission. The point of this article is that the recommendation of those products implicates the heightened consideration of costs under the Reg BI Care Obligation (as explained in the first three articles in this series), and also implicates the requirement to mitigate incentives for financial professionals of broker-dealers (under the Reg BI Conflict of Interest Obligation).

In the Adopting Release, the SEC described the interrelationship of those Obligations in Reg BI and explained that each must be separately satisfied:

‘‘[W]here a broker-dealer is choosing among identical securities with different cost structures, we believe it would be inconsistent with the best interest obligation for the broker-dealer to recommend the more expensive alternative for the customer, even if the broker-dealer had disclosed that the product was higher cost and had policies and procedures reasonably designed to mitigate the conflict under the Conflict of Interest Obligation, as the broker-dealer would not have complied with the Care Obligation. Such a recommendation, disclosure aside, would still need to be in the best interest of a retail customer, and we do not believe it would be in the best interest of a retail customer to recommend a higher-cost product if all other factors are equal.’’

My three previous posts discussed the Care Obligation, so let’s turn to how the mitigation requirement must also be satisfied. The Reg BI Conflict of Interest Obligation provides in part:

Conflict of interest obligation. The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to:

(B) Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive for a natural person who is an associated person of a broker or dealer to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer;…

Reg BI doesn’t define ‘mitigate”, but it seems fairly obvious that it means that the incentive effect (e.g., of differences in compensation) must be reduced. But that begs the question, reduced how much?

While Reg BI does not define “mitigate”, it does define “conflict of interest:”

Conflict of interest means an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer—consciously or unconsciously—to make a recommendation that is not disinterested.

For our purposes, this seems clear enough . . . where an investment account, product or strategy pays more than an alternative, the financial professional is not “disinterested”. It is that “interest” that must be mitigated.

Fortunately, in the Adopting Release for Reg BI, the SEC further explained its view of mitigation:

By requiring that a broker-dealer establish policies and procedures reasonably designed to ‘‘mitigate’’ these conflicts of interest, we mean the policies and procedures must be reasonably designed to reduce the potential effect such conflicts may have on a recommendation given to a retail customer. Thus, whether or not a broker-dealer’s policies and procedures are reasonably designed to mitigate such conflicts will be based on whether they are reasonably designed to reduce the incentive for the associated person to make a recommendation that places the associated person’s or firm’s interests ahead of the retail customer’s interest.

The Adopting Release then discusses principles and approaches for mitigation. For example, it says:

As noted in the Proposing Release, in lieu of mandating specific mitigation measures or a ‘‘one-size fits all’’ approach, we are providing broker- dealers with flexibility to develop and tailor reasonably designed policies and procedures that include conflict mitigation measures, based on each firm’s circumstances. Reasonably designed policies and procedures should include mitigation measures that depend on the nature and significance of the incentives provided to the associated person and a variety of factors related to a broker-dealer’s business model (such as the size of the broker-dealer, retail customer base (e.g., diversity of investment experience and financial needs), and the complexity of the security or investment strategy involving securities that is being recommended), some of which may be weighed more heavily than others.

 For example, more stringent mitigation measures may be appropriate in situations where the characteristics of the retail customer base in general displays less understanding of the incentives associated with particular securities or investment strategies; where the compensation is less transparent (for example, an incentive from a third-party or charge built into the price of the product or a transaction versus a straight commission); or in a situation involving a complex security or investment strategy.

 If you are frustrated by the lack of specific guidance, that’s understandable. This language points us in a direction, but doesn’t give us a map. Fortunately, the SEC also provided examples in the Adopting Release. But that’s enough for this article. The next one will use those examples to breathe life into these general guidelines.

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.