Brokers and investment advisors must thoroughly understand products and clients’ financial needs before making recommendations, which includes having a list of alternatives they have considered, the SEC said Thursday.
That information came in a question-and-answer-style staff bulletin on “duty of care,” the third and final in a series the Securities and Exchange Commission has published on Regulation Best Interest — with a goal of making the responsibilities of brokers and advisors extremely clear.
The guidance itself seeks to inform brokers, advisors and their firms, but it's not itself any form of new regulation, an SEC official speaking on background said on a call with reporters today.
Last year the SEC issued two such staff bulletins — one just over a year ago addressed account recommendations including rollovers, and another in August covered how to manage conflicts of interest.
The 24-page document published Thursday represents one more way the regulator is trying to set expectations, potentially before it ramps up enforcement efforts around Reg BI. The bulletins are also seen as a way that SEC Chair Gary Gensler is trying to get the most use out of a regulation that was passed by his predecessor, Jay Clayton. Reg BI has now been in force for nearly three years.
The SEC official speaking today noted that a common theme among the bulletins is that complying with Reg BI and the Investment Advisers Act is not a check-the-box exercise and is one that should happen before — rather than after — recommendations are made. The SEC would not hesitate to pursue actions against individuals and firms that it sees as failing to comply, the official said.
While the Investment Advisers Act applies to all advisory clients and relations, Reg BI is triggered at the time of a recommendation to a retail customer. But the end result is similar: “In the staff’s view, they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors,” the SEC stated in the bulletin.
The SEC outlined that brokers and advisors have a duty to fully grasp the “potential risks, rewards and costs associated with a product, investment strategy, account type or series of transactions.”
Understanding an investment option should include knowing: its objectives; initial and ongoing costs; key characteristics and risks; likely performance in different market conditions; expected returns, payout rates and potential losses; unusual features; and role of the product or strategy in the investor’s overall portfolio.
The regulations don’t prevent brokers and advisors from recommending complex or risky products, the SEC noted. However, there must be “a reasonable basis to believe the complex or risky product is in the best interest of the retail investor.”
[Topic: Regulation news]
Brokers and advisors must also have “a reasonable understanding of the specific retail investor’s investment profile, which generally includes the retail investor’s financial situation (including current income) and needs; investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objectives and financial goals; and any other information the retail investor may disclose,” the SEC stated.
Part of the duty of care includes having a list of “reasonably available alternatives,” the SEC wrote. That universe of alternative investments depends on what is available through a broker or advisor’s firm, and in the case of an exhaustive “open architecture” investment menu, brokers and advisors don't need to vet every conceivable option, the regulator noted. The scope of alternatives “will depend on the facts and circumstances, including but not limited to the nature of the firm’s business, the retail investor’s investment profile, the scope of its relationships with its customers and clients and the reasonable availability of alternative investments or investment strategies,” the SEC stated.
Conversely, a limited menu of funds available through a firm does not necessarily satisfy a list of reasonable alternatives, and in such a case, a “professional may conclude that no investment or investment strategy they offer is in the retail investor’s best interest,” the bulletin read. “If that occurs, the firm and financial professional would not satisfy their care obligations if they recommended or advised any of those investments or investment strategies to the retail investor.”
The bulletin also addresses dually licensed financial professionals with clients at their firms who have both brokerage and advisory accounts. Whether Reg BI or the Investment Advisers Act applies to recommendations depends on specific circumstances, with no one factor determining that, the SEC stated. Further, the regulator noted that those professionals have a duty to consider whether brokerage or advisory accounts are more appropriate for retail investor clients.
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