Best Interest Standard of Care for Advisors #9

Regulation Best Interest: The Focus on Costs (Part 1)

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.”

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. Reg BI also 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. In addition, 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.

The SEC’s release for the proposed Reg BI described “cost” as being a more important consideration than it is under the suitability standard. However, in the final Reg BI, the significance of “cost” was elevated even further. That was accomplished by moving “cost” from the release discussion to the actual regulation. In relevant part, the Reg BI Care Obligation now reads:

Care obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to:

. . . Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer; . . . [Emphasis added.]

Think about that. When Reg BI applies on June 30, 2020, every broker-dealer recommendation to retail customers must include consideration of the cost of the investments or investment strategies. As explained by the SEC:

We are incorporating “costs” in the rule text . . . of Regulation Best Interest as a relevant factor that, in addition to risks and rewards, must always be understood and considered by the broker-dealer prior to recommending a particular securities transaction or investment strategy involving securities to a particular retail customer. [Emphasis added.]

That doesn’t mean that broker-dealers need to recommend the lowest cost option or even that cost will always be the predominant factor. But it does mean that the process for developing the recommendation must include consideration of cost as a relevant factor. And, practically speaking, it means that broker-dealers will need to justify higher cost recommendations by identifying other factors that outweigh the higher cost.

The requirement in Reg BI to exercise reasonable diligence, care and skill suggests a process. Based on my reading of Reg BI and the release language, there are two steps to the process. The first is to determine which of the broker-dealer’s types of accounts is in the best interest of the customer based on the customer’s investment profile. That would include an assessment of the various account types—brokerage accounts, third party asset managers, etc.—and a determination about which is in the best interest of the customer. The second step is to select investments within the account type that are in the best interest of the customer. That would include both the particular investments and the asset allocation. In considering the account types, investments and investment strategies to recommend, the process must include consideration of the costs.

The analysis of cost will include both the product cost and the compensation cost. For example, if a broker-dealer or its advisor is considering several individual variable annuities, the cost would include the commissions and trails paid to the broker-dealer, as well as the other costs associated with a variable annuity. Or, if the recommended strategy was a portfolio of mutual funds, the analysis would include the commission (front-end load) and the trailing 12b-1 fees, as well as other costs in the mutual funds (e.g., the investment adviser’s fees for managing the fund). In either case, if the more expensive alternative is recommended, a broker-dealer would need to reasonably believe that there were features that offset the difference in costs.

As that suggests, other factors may outweigh the cost differences. As the SEC explains:

A broker-dealer could recommend a more expensive security or investment strategy if there are other factors about the product that reasonably allow the broker-dealer to believe it is in the best interest of the retail customer, based on that retail customer’s investment profile. Similarly, a broker-dealer could recommend a more remunerative security or investment strategy if the broker-dealer has a reasonable basis to believe that there are other factors about the security or investment strategy that make it in the best interest of the retail customer, in light of the retail customer’s investment profile.

In relying on that explanation, though, broker-dealers should consider whether to document the process, and the offsetting factors, in order to demonstrate compliance.

The key is for broker-dealers to have processes for their advisors to make those evaluations. That involves decisions about how to do that analysis (e.g., software and databases for mutual fund selection and allocation), training, policies and procedures, and supervision . . . all of which must be put in place before June 30, 2020. Broker-dealers need to be working on this now. The starting point is to understand the new rules and what they require.

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.