Best Interest Standard of Care for Advisors #34

Regulation Best Interest: Best Interest and Suitability—How They Differ (Part 5)

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.

My last post (#33) and this one take a slightly different approach; these articles focus on circumstances where the compensation paid to broker-dealers and their financial professionals increases the cost of the recommended investments. For example, that could be a higher compensating share class of a mutual fund or an annuity with a higher commission. The point of these two articles is that the recommendation of those products invokes the heightened consideration of costs under the Reg BI Care Obligation (as explained in the first three articles in this series), and also implicates a requirement to mitigate incentives for financial professionals of broker-dealers (under the Reg BI Conflict of Interest Obligation).

My last post discussed the requirement to mitigate incentives that might incline a financial professional to make recommendations that are in the best interest of the professional, rather than the best interest of the investor. It also looked at how the SEC explained the concept of mitigation. This article provides a more concrete definition of mitigation by quoting and commenting on several of the examples given by the SEC in the Adopting Release for Reg BI.

Before looking at the examples, though, it’s important to note that these are just examples. The SEC made that clear by explaining“[W]hile not required elements, the Commission believes the following non-exhaustive list of practices could be used as potential mitigation methods for firms to comply with (a)(2)(iii)(B) of Regulation Best Interest….”  Stated differently, these examples will work to mitigate the specified incentives, but broker-dealers may mitigate these incentives using other, or a combination, of techniques (for example, training and supervision may work in some cases, but reduction of compensation differentials may be appropriate in others)

The Adopting Release provides a number of examples, including these:

  • Avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;

Comment: As a financial professional approaches a production level (or asset level) that would incrementally increase his or her compensation, the sales recommendations or account-type recommendations could possibly be mitigated by heightened supervision of the recommendations. If the thresholds significantly increase compensation (e.g., a significant increase in compensation on additional sales or a “waterfall” arrangement where compensation on prior sales increase retroactively), the expectations of the supervision and other mitigation practices will be heightened. On the other hand, where there are more thresholds and each one has smaller increases, the mitigation practices may not need to be as robust.

  • Eliminating compensation incentives within comparable product lines by, for example, capping the credit that an associated person may receive across mutual funds or other comparable products across providers;

Comment:  As an example, broker-dealers may limit mutual funds on their platform to those that pay identical front-end loads and trailing 12b-1 fees. In that case, there will not be a need to mitigate compensation for recommendation decisions among those mutual funds because compensation will not vary based on which fund is recommended. The SEC’s example is slightly different than that because it suggests that, regardless of the load or trail that the broker-dealer receives, the broker-dealer could “levelize” the compensation paid to financial professionals, thereby eliminating the need to mitigate any incentive effect of recommending one mutual fund over another.

  • Minimizing compensation incentives for employees to favor one type of account over another; or to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis, for example, by establishing differential compensation based on neutral factors;

Comment: This SEC example is different than the preceding one because this relates to mitigation as between different types of investments. For example, how would a broker-dealer mitigate the incentive effect if a financial professional earns more compensation for selling a variable annuity than for selling mutual funds? The SEC’s example focuses on the work of the financial professional relative to the compensation in the sense that, if the compensation differentials are based on “neutral factors” (such as the amount of work involved), that could mitigate the incentive effect. In my experience, though, some broker-dealers are focusing instead on their internal processes for supervising the sales of annuities (e.g., is an allocation to guaranteed income consistent with the retail investor customer provide and therefor in the best interest of the investor).

  • Implementing supervisory procedures to monitor recommendations that are: Near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products or transactions in a principal capacity; or, involve the roll over or transfer of assets from one type of account to another (such as recommendations to roll over or transfer assets in an ERISA account to an IRA) or from one product class to another;….

Comment: I highlighted the language about rollovers because it is a good example of a situation where the only mitigation technique (that I can think of) is for the broker-dealer to have a well-designed process for developing recommendations and where adherence to that process (for gathering and evaluating data) is closely supervised. If the participant doesn’t roll over, the financial professional typically won’t make any money; but, if the rollover recommendation is accepted, the financial professional will earn commissions from the rollover IRA. In that case, the incentive can’t be managed by eliminating (or reducing) the compensation differential. It’s an all or nothing proposition. In cases like that, the pressure is on the broker-dealer to have a well-designed process for the development of the recommendation and then to supervise that the approach is properly applied.

Concluding thoughts:

The Reg BI Obligations for Care and Conflicts of Interest are connected at the hip because the conflict of interest (“compensation”) is often embedded in the cost of the recommendation and cost must be considered under the Care Obligation. A financial professional must consider cost to the investor in making a recommendation, which could mean that the recommendation of a higher-cost investment would violate the Care Obligation (which is placed on both the broker-dealer and the financial professional) and the Conflict of Obligation to mitigate the compensation incentive of the financial professional (which is imposed on the broker-dealer).

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.