Category Archives: SEC

Best Interest Standard of Care for Advisors #6


best interest, fiduciary, prudent, SEC

What Does Best Interest Mean . . . In the Real World? (Part 3)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the sixth of the series about the Best Interest Standard of Care.

In my last two posts (Best Interest Standard of Care for Advisors #4 and #5), I discussed the definition of the Best Interest standard of care, with a particular focus on the duty to exercise care, skill, prudence and diligence in developing recommendations for investors. Those articles commented on the consistency in the Best Interest and fiduciary standards being developed by the SEC and several states (including New York), as well ERISA’s duty of care and duty of loyalty.

Bests #9 discussed the similarities of the standards of care and Bests #10 talked about the consideration of costs. This article focuses on considerations of the quality of the products and services and on portfolio investing.

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Best Interest Standard of Care for Advisors #5


best interest, reg BI, registered investment advisers, SEC

What Does Best Interest Mean . . . In the Real World? (Part 2)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the fifth of the series about the Best Interest Standard of Care.

My last article, Best Interest Standard of Care for Advisors #4, discussed different definitions of a “best interest” standard of care. The point of that article is that, while there may be slight differences in the wording, the rules converge to require that an advisor (and the advisor’s supervisory entity) act with care, skill, diligence and prudence to make recommendations that are in the best interest of the investor. This article discusses how the standard applies to specific circumstances.

As background, there are three parts to any best interest standard. The first is that the advisor engage in a process–carefully, skillfully, diligently and prudently–to develop the recommendation. That process is measured by an objective standard . . . what are the relevant factors that a knowledgeable professional advisor would consider and how would that hypothetical advisor evaluate those factors. The second is that the advisor act with loyalty to the investor. The advisor cannot put his interests ahead of the investor’s. The third is that the recommendation appropriately consider the investor’s profile (e.g., the needs and circumstances of the investor).

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Best Interest Standard of Care for Advisors #4


401(k), 403(b), best interest, DOL, prudent, reg BI, registered investment advisers, SEC

What Does “Best Interest” Mean? (Part 1)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the fourth of the series about the Best Interest Standard of Care.

“Best Interest” has become part of the American lexicon . . . as an aspirational goal or a demanding standard—depending on the point of view. But, what does best interest mean? It may mean different things to different people . . . and perhaps even to different regulators. However, I believe that most people would agree on the definition in this article.

As I read the guidance issued by the Department of Labor (DOL), the Securities and Exchange Commission (SEC), and New York State, there are actually two different best interests. The first is a standard of care and the second is a duty of loyalty. Of the two, the duty of loyalty is the easiest to define because, in all of the guidance it boils down to a requirement that an advisor cannot put his interest ahead of the investor’s.

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Best Interest Standard of Care for Advisors #3


401(k), 403(b), best interest, DOL, reg BI, registered investment advisers, SEC

SEC Best Interests . . . When? And What About the DOL

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the third of the series about the Best Interest Standard of Care.

The Regulatory Agendas for the SEC and DOL were recently issued. Both have plans for guidance by September of 2019, but the anticipated timing of the guidance has, by and large, been misinterpreted. To understand what I mean, read on.

The SEC’s Agenda said that Final Action on the Regulation Best Interest proposal for broker-dealers and the Interpretation of Standard of Conduct for investment advisers would be “09/00/2019.”

Similarly, the Department of Labor Agenda said that there would be a final rule on the “Fiduciary Rule and Prohibited Transaction Exemptions” with the date of “09/00/2019.”

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Best Interest Standard of Care for Advisors #2


best interest, DOL, FINRA, prudent, reg BI, SEC

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the second of the series about the Best Interest Standard of Care.

In my last post, I discuss the remarkable similarities among the SEC’s proposed Regulation Best Interest, the SEC’s proposed Interpretation for investment advisors, the DOL’s Best Interest standard of care (which is a combination of ERISA’s prudent man rule and duty of loyalty), and the New York State Best Interest standard for sales of annuities and insurance products. All of those rules require that advisors act with care, skill, prudence and diligence, and that they place the interests of the investor ahead of their own.

In the first post, I conclude that the Best Interest standard requires the following:

  • A careful and skillful professional process measured by the objective standard of a knowledgeable and experienced advisor; and
  • A duty of loyalty to the investor.

This post discusses the type of process that would satisfy the Best Interest standard for all of those rules. However, since the process is not well defined (other than in guidance under ERISA), some of the suggestions in the post may, in fact, be Best Practices. Let me define that term. “Best Practices” means that the advisor is doing more than is required by the law. While Best Interest may be required, Best Practices is not; it is voluntary. As a result, Best Practices are for advisors who desire to excel, while Best Interest is for advisors who want to be compliant.

In my view, a combination of Best Interests and Best Practices suggests that advisors should use the following process:

  • Gather the information that is relevant to providing Best Interest advice. (“Relevant” means the information that is necessary to develop a recommendation that is appropriate for the investor. A synonym in this circumstance would be “material” information. If information about the needs and circumstances of the investor could affect the recommendation, then it is material and relevant).
  • Consider the types of investments (and insurance products) and strategies that are appropriate for the investor based on the analysis of the investor’s profile (that is, based on analysis of the relevant information). In effect, this step is the formulation of a strategy for the investor based on the products and services available to the advisor. While there may be some flexibility if the advisor only has access to limited types of products, that flexibility is limited, in the sense that any recommendation will still be measured by the Best Interest standard of care.
  • Select the particular investments, insurance products and services that will be recommended to the investor, that is, that will populate and implement the investment strategy. As the SEC said in its proposed guidance, while cost and compensation are not the only factors to be considered, their significance is enhanced under the SEC proposals. In other words, they are major considerations. Another obvious important consideration is the quality of the product. That includes the “management” of the product, for example, the investment advisor for a mutual fund, the investment manager for an investment service, and the insurance company issuing an annuity contract or life insurance policy.

I suspect that, if an advisor gets into trouble because of his or her recommendations, it will be the result of an inappropriate (and perhaps unsuitable) strategy, excessive costs and compensation, or inferior quality of the “manager” of the product.

That begs the question of, how does an advisor demonstrate a Best Interest process? Other than for the DOL and ERISA plans, there is not a requirement to maintain documentation of the process. However, it probably goes without saying that a well-documented process is good risk management (and, for that matter, that a well-documented process is likely to be a prudent process).

In the next year or two, the SEC may enhance its guidance to further define the processes that are needed to satisfy its Best Interest standard. More certainly, though, the SEC, FINRA, DOL and New York State regulators will, in due course—perhaps over the next three years or so—begin their enforcement activities. Unfortunately, it’s possible that we may see “regulation by enforcement,” meaning that the holes in the guidance are filled in by the enforcers, rather than the regulators.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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

 

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Best Interest Standard of Care for Advisors #1


best interest, BICE, prudent, SEC

What is the Best Interest Standard of Care?

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the first of the series about the Best Interest Standard of Care.

For this inaugural article, let’s talk about the meaning of “Best Interest.”

There are at least four Best Interest standards. (While “best interest” can also refer to management of conflicts of interest, this article is about the best interest standard of care.)

  • ERISA’s best interest standard of care for plan sponsors and fiduciary advisors for private sector retirement plans. (While ERISA doesn’t literally have a best interest standard—because the Best Interest Contract Exemption was vacated by the 5th Circuit Court of Appeals, that best interest standard was a combination of ERISA’s prudent man rule and duty of loyalty which, of course, are still in the law. As a result, I will use the term to refer to the combination of ERISA’s prudent man rule and duty of loyalty.)
  • The SEC’s proposed best interest standard for broker-dealers in its Regulation Best Interest.
  • The best interest standard in the SEC’s proposed “Interpretation” for investment advisers.
  • The New York State Best Interest standard for recommendations of life insurance policies and annuity contracts.

Let’s look at how each of those are defined.

  • The ERISA Best Interest Standard for Retirement Plans (copied from the Best Interest Contract Exemption):

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.

  • The SEC’s Proposed Best Interest Standard for Broker-Dealers:

The best interest obligation . . . shall be satisfied if: The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence 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 and rewards associated with the recommendation; . . .

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

  • The SEC’s Proposed Best Interest Standard for Investment Advisers:

The SEC proposal did not include a definition of best interest. However, the SEC proposal reaffirms that investment advisers are fiduciaries for their clients and includes the best interest standard as a part of the RIA fiduciary duty. It seems inconceivable that the best interest standard for investment advisers would be lower than that same standard for broker-dealers. And, since the SEC uses the same label—“best interest”—for both investment advisers and broker-dealers, the likelihood is that the standard is the same. (In some ways, though, those best interest rules are different, for example, the RIA best interest standard applies to a much wider range of advice and includes monitoring.)

  • The New York State Best Interest Standard:

The producer, or insurer where no producer is involved, acts in the best interest of the consumer when . . .

the producer’s or insurer’s recommendation to the consumer reflects the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use under the circumstances then prevailing. Only the interests of the consumer shall be considered in making the recommendation. The producer’s receipt of compensation or other incentives permitted by the Insurance Law and the Insurance Regulations is permitted by this requirement provided that the amount of the compensation or the receipt of an incentive does not influence the recommendation; and . . .

I have highlighted language in each of the definitions. My purpose is to emphasize how similar the standards are. All of the Best Interest standards seem to require a process. That is, how can an advisor be careful, skillful, prudent and diligent without engaging in a process? In my view, there are several steps to that process. The first is determining the needs and circumstances of the investor; the second is evaluating the investment or insurance strategies in light of those needs; and the third is a consideration of the costs and quality of the investment and insurance products that are being considered. The gathering and analysis of that relevant information must be done carefully and skillfully based on a hypothetical knowledgeable and experienced advisor. In other words, the standard is not the ability of a particular advisor, but instead the industry expectations of professional advisors. The evaluation and performance of the advisor is based on that objective standard.

In addition, each of the definitions requires that an advisor place the interests of the investor ahead of the interests of the advisor. The Best Interest standard imposes a duty of loyalty on the advisor.

“Best Interest” does not mean that an advisor must pick the best investment or insurance product. However, it does impose a higher duty than suitability in the development of recommendations, and it may prove to be more demanding than many people expect. It does mean that quality and costs are more significant considerations than they are under the suitability standard.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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

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Moving from Angles to Bests


Announcement, broker-dealers, DOL, prudent, registered investment advisers, SEC

Now that I have completed 100 articles about interesting Angles on birth –and death–of the DOL’s Fiduciary Rule, and the birth of an SEC best interest standard for broker-dealers and RIAs, I am going to start on a new series. The new series, rather than being titled “Angles,” will be called “The Bests.”

So, from now on, my articles—maybe the next 100—will focus on two “bests”—the SEC’s best interest standard and best practices for advisors and plan sponsors.

I figure that the SEC’s best interest rules will be developed and implemented over the next year or two, giving me a wealth of materials for new articles. But, I don’t want to be limited to that. I think that it’s important to talk about best practices for retirement plans and retiree investing and withdrawing, with a focus on helping participants to and through retirement—accumulation and decumulation.

With this introduction of the new series, the articles will begin after the Labor Day break.

Enjoy the dog days of summer . . . family vacations, baseball games and barbeques!

Fred Reish

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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

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Interesting Angles on the DOL’s Fiduciary Rule #100


BICE, broker-dealers, DOL, FINRA, registered investment advisers, SEC

Investment Advisers and the SEC’s Interpretation of Their Duties: Part II

This is my 100th article about interesting observations—or “angles”—concerning the Department of Labor’s Fiduciary Rule and the SEC’s “best interest” proposals.

Part I of this post discussed the application of the SEC’s best interest standard to recommendations to participants to take distributions and rollover to IRAs. It also discussed the apparent requirement for a thoughtful and professional process to develop the recommendation. However, it reserved for this post, Part II, the factors to be considered in that process.

The RIA Interpretation lists a number of factors to consider in the best interest process. However, most of them apply to investment recommendations, rather than advice about distributions. But a few are helpful. For example, the costs of investments and services and consideration of the investor profile are relevant factors.

Under Reg BI, though, the SEC is a little more helpful. For example, Reg BI says that an advisor should engage in a careful, skillful, diligent and prudent process. Reg BI also refers to FINRA Regulatory Notice 13-45 in several places. That Regulatory Notice requires that the information about the important factors (see below) be gathered and considered in light of the investor profile. While the Regulatory Notice says that the rollover recommendation must be suitable in light of these factors, the RIA Interpretation and Reg BI add that the recommendation must be in the “best interest” of the participant and that the interests of advisors and their firms cannot supersede those of the participant.

Although vacated by the 5th Circuit, the DOL’s Best interest Contract Exemption (BICE) described a prudent process, using language similar to the SEC’s proposed Reg BI . . . care, skill, prudence and diligence. In addition, the DOL’s BICE also said that information needed to be gathered about the relevant factors and those factors should be evaluated in light of the needs and circumstances of the participant. In other words, the SEC’s proposals and the DOL’s vacated rule are remarkably similar on rollover recommendations.

In sum, I think that it’s fair to say that, in order for the SEC’s best interest standard to be satisfied, an advisor (of a broker-dealer or an RIA) must engage in a process where the advisor gathers, and carefully and professionally considers, the relevant information. That process would need to satisfy the best interest and loyalty standards.

But, what are the relevant factors? The leading guidance on that question is found in FINRA Regulatory Notice 13-45 and the DOL’s vacated BICE (including a FAQ issued by the DOL). Boiled down to the essence, those materials say that advisors must consider, at the least, the investments, services and expenses in the plan; the investments, services and expenses for the proposed rollover IRA; and information about the participant (for example, financial objectives, needs, and risk tolerance). It would also be permissible to consider other factors, such as participant preferences, outside assets, other family investments, and so on.

While BICE has been vacated, it likely reflects the DOL’s current thinking about a prudent process and, as a result, could be applied by the DOL to situations where fiduciary advisors make recommendations of distributions and rollovers. (See DOL Advisory Opinion 2005-23A.) Also, since the DOL has the most experience with plan distributions, FINRA and the SEC may defer to the DOL’s thinking in this area. And, while the FINRA Regulatory Notice only covers recommendations by broker-dealers and their advisors, I doubt that the standard for RIAs would be lower than the standard for broker-dealers.

As a result, investment advisers should develop processes for gathering and considering information about the investments (and fees, costs and services) available to the participant in the plan, and compare them to similar information for a proposed IRA, in light of the investment profile of the participant.

And, keep in mind, as I mentioned in Part I of this article, the SEC’s Interpretation RIA reflects current SEC thinking. This is not something to be put off for the future.

NOTE: This article discusses rollover recommendations to participants in participant directed plans. The issues for “pooled” plans are different. In particular, the analysis for defined benefit plans can be more complex.

NOTE: While the DOL’s vacated Fiduciary Rule would have applied to private sector, ERISA-governed retirement plans, the SEC’s guidance applies to participants in all plans, including government plans.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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

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Interesting Angles on the DOL’s Fiduciary Rule #99


broker-dealers, DOL, registered investment advisers, SEC

Investment Advisers and the SEC’s Interpretation of Their Duties: Part I

This is my 99th article about interesting observations concerning the Department of Labor’s (DOL) Fiduciary Rule and the SEC’s “best interest” proposals.

The SEC labeled its interpretation of the standard of care for RIAs (the “RIA Interpretation”) as a proposal. However, in that proposal, the SEC explained that the RIA Interpretation was based on the SEC’s current understanding of the duties of investment advisers. More specifically, the SEC described the RIA Interpretation as reaffirming and clarifying the RIA fiduciary rule: “. . . we believe it would be appropriate and beneficial to address in one release and reaffirm—and in some cases clarify—certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”

As a result, investment advisers should treat the RIA Interpretation as governing guidance and should make sure that they are complying with the duties explained in the RIA Interpretation.

This article discusses some of those duties and compares them to the DOL’s vacated fiduciary rule and the SEC’s proposed Regulation Best Interest (“Reg BI”) for broker-dealers.

The RIA Interpretation says that all advice to all clients is fiduciary advice and, therefore, subject to the RIA duty of care and duty of loyalty. (There are several duties of care, but this article focuses on the best interest standard of care. There is also a duty of loyalty, which, for example, covers the disclosure requirements for RIAs.) To juxtapose the RIA duties with Reg BI, broker-dealers also have a best interest standard of care, but only for recommendations to “retail customers” about securities or strategies involving securities. Other recommendations by broker-dealers are not covered by the best interest standard.

With regard to the DOL, when the 5th Circuit Court of Appeals vacated the Fiduciary Rule, the old fiduciary regulation was revived. That regulation imposes a 5-part test for fiduciary status. (Note that the 5-part test only applies to non-discretionary investment advice. Whenever an advisor has discretion over assets in a plan, a participant’s accounts or an IRA, the advisor is automatically a fiduciary under a separate part of the regulation. And the DOL’s definition of discretion is very broad.) One of the 5 “parts” is that the advice must be given on a “regular basis,” meaning that a one-time recommendation would not cause a person to be a fiduciary. As a practical matter, the 5-part test is usually satisfied by the services typically offered by investment advisers to plans, participants’ accounts and IRAs. In addition, it is a functional test. As a result, where representatives of broker-dealers regularly make recommendations to those qualified accounts (and satisfy the other 4 parts), representatives and broker-dealers will be fiduciaries, even if they do not think they are.

To understand how those rules operate, let’s look at several scenarios involving recommendations of plan distributions and rollovers.

Under the DOL’s 5-part test, an advisor who recommends a distribution and rollover would not ordinarily be a fiduciary. However, there is an exception. Where the advisor is a fiduciary to a plan, and makes a recommendation to a participant in that plan to take a distribution and roll over to an IRA with the advisor, the DOL will consider the advisor (either a broker-dealer or RIA) to be a fiduciary for that purpose. See DOL Advisory Opinion 2005-23A.

The DOL’s position applies to all types of ERISA-governed plans, including 401(k)s, 403(b)s, cash balance plans, profit sharing plans and pension plans. (While most private sector plans are covered by ERISA, government plans are not. In addition, some private sector plans are not, for example, one-person plans and most church plans.)

With regard to RIAs, the SEC said, in its RIA Interpretation, that recommendations of plan distributions and rollovers would be fiduciary advice, subject to the best interest standard of care. Since the SEC RIA Interpretation applies to all recommendations to all clients, an investment adviser would be held to the best interest standard of care for distribution and rollover recommendations to all plans (even if not ERISA covered), including 401(k)s, 403(b)s, cash balance plans, pension plans and profit sharing plans.

Under the proposed Reg BI, a broker-dealer’s rollover recommendation to a participant in a participant-directed plan would also be subject to the best interest standard of care. That is because the recommendation to take a distribution necessarily includes a recommendation to liquidate the investments inside the participant’s account. In other words, it is a securities recommendation. However, it appears to me that a recommendation to take a distribution from a cash balance or pension plan would not involve a securities recommendation and, therefore, would not be subject to the best interest standard. Similarly, a recommendation to take a distribution from a “pooled” defined contribution plan, such as a profit sharing plan, may not involve a securities recommendation, since the participant does not have any authority to determine which investments are sold to finance the distribution.

In both cases—RIAs and broker-dealers, the recommendation about how to invest the money in the rollover IRA would be covered by the SEC’s best interest standard. (However, while RIAs would have an ongoing duty to monitor the account, broker-dealers do not. The duty to monitor could be modified by the agreement. For example, RIAs can contract to not monitor, while broker-dealers can agree to monitor.)

Now that we know which rollover recommendations are subject to the best interest standard, there are two remaining questions. The first is, what is the best interest standard? The second is, what does the best interest standard require for distribution recommendations?

Those two questions will be answered in Part II of this Angles.

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #98


broker-dealers, DOL, prudent, SEC

Regulation Best Interest: Consideration of Cost and Compensation

This is my 98th article about interesting observations concerning the Department of Labor’s fiduciary rule and the SEC’s “best interest” proposals.

The SEC’s Regulation Best Interest (Reg BI) proposes a number of major changes to the governance of broker-dealers. For example, it imposes a best interest standard of care on recommendations of securities transactions and it requires that material conflicts of interest involving financial incentives be eliminated or, alternatively, disclosed and mitigated. Based on the SEC’s examples of mitigation, it appears “real” mitigation is expected and not just existing practices with more disclosure.

There are other significant changes. For example, there is an increased focus on the costs and compensation related to recommended securities transactions and investment strategies. The SEC’s discussion explains that:

“[O]ur proposed interpretation of the Care Obligation would make the cost of the security or strategy, and any associated financial incentives, more important factors (of the many factors that should be considered) in understanding and analyzing whether to recommend a security or an investment strategy.” [Emphasis added.]

The SEC’s position is that both the costs of recommended securities or strategies and the associated compensation (that is, the financial incentives) will be more important factors than they have been in the past.

The SEC goes on to explain its position on costs:

“We preliminarily believe that, in order to meet its Care Obligation, when a broker-dealer recommends a more expensive security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost of the security or strategy is justified (and thus nevertheless in the retail customer’s best interest) based on other factors (e.g., the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), in light of the retail customer’s investment profile.” [Emphasis added.]

In addition, the SEC explained its position on compensation:

“When a broker-dealer recommends a more remunerative security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that—putting aside the broker- dealer’s financial incentives—the recommendation was in the best interest of the retail customer based on the factors noted above, in light of the retail customer’s investment profile.”

The two quotes (which are together in a single paragraph in Reg BI) may appear to conflict with each other. However, they are consistent and coherent if they are interpreted as follows: a broker-dealer will need to justify recommending a higher-cost investment (over another reasonably available, but lower-cost alternative). However, if there are two similar investments (including costs), but one pays the broker-dealer (and the financial advisor), more than the other, and it is better for the investor, then it could be recommended under the best interest standard. The inverse of that, though, is that the higher cost (and higher compensating) alternative cannot be recommended unless there are different characteristics and features that justify the cost.

The SEC’s best interest will require that a broker-dealer be diligent, careful, skillful, and prudent—which suggests a process—and that the process result in an investment that is in the best interest of the investor, with a greater emphasis on cost and compensation.

For those of you who work with retirement plans, you will recognize that the process, and the factors to be considered, are similar to ERISA’s prudent process requirement.

The proposals under Reg BI are significant and will, if finalized, require changes in the operations, including supervision, of broker-dealers.

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

 

 

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