On April 20, 2023, the U.S. Securities and Exchange Commission (SEC) published a staff bulletin on the duty of care for broker-dealers and investment advisers under Regulation Best Interest (Reg BI) and the investment adviser fiduciary standard, respectively.1 The bulletin, the third and final in a series following two bulletins published in 2022 on conflicts of interest and account-type recommendations, reflects the SEC staff’s continued focus on enforcing broker-dealers’ and investment advisers’ obligations in providing investment advice and recommendations.2 The bulletin, like the two prior, reflects an expansive view with respect to these obligations.
Following an introductory section summarizing broker-dealers’ and investment advisers’ care obligation3, the bulletin takes the form of answers and guidance in response to 20 questions posed by a hypothetical individual financial professional — although some of the questions focus on duties of firms rather than individual professionals. These questions are grouped in categories that largely reflect topics in the Reg BI adopting release4: understanding the investment or investment strategy, understanding the retail investor’s investment profile, considering reasonably available alternatives, complex or risky products, and recommendations or advice by dual registrants.
As a whole, the answers in the bulletin emphasize that the duty of care when making recommendations is ongoing and dynamic, may often require documentation of compliance, and cannot be waived or transferred. Certain noteworthy staff comments are summarized below.5
Substantive Similarity of Reg BI Duty of Care and Investment Adviser Fiduciary Duty
In both the introduction and a response to a question about whether the Reg BI duty of care or the investment adviser fiduciary duty applies to a dual registrant, the staff state that the obligations under Reg BI and the investment adviser fiduciary standard are “substantially similar.” This is consistent with the entire bulletin, which purports to “reiterat[e] the standards of conduct for broker-dealers and investment advisers in addressing their care obligations” and cites to both the Reg BI adopting release and the SEC’s Fiduciary Interpretation6 throughout. Despite a discussion in Question 20 of the facts-and-circumstances analysis the staff use to determine which of the two standards applies to dual registrants, this bulletin suggests that there is no substantive difference in the two sets of obligations applicable to making investment recommendations to customers. As the response to Question 20 notes: “although the specific application of Reg BI and the investment adviser fiduciary standard may differ in some respects and be triggered at different times, in the staff’s view they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors” (emphasis added). Commentators spilled oceans of ink discussing the differences between an investment adviser’s fiduciary duty and a broker-dealer’s best interest obligation; in the end, at least for the duty of care, there does not appear to be any meaningful difference.
Analysis of Costs
The bulletin provides a very broad response to a question about how to consider investment costs when making investment recommendations. It provides a “non-exhaustive” list of potential costs that include “fees or expenses that affect an investor’s return,” costs associated with exiting a strategy, and tax costs. Financial professionals should thus consider “costs beyond the explicit costs disclosed on a trade confirmation or account statement” when making investment recommendations. This holistic approach to costs requires analysts to take into account a range of potential costs that investors may incur at different times and in different ways, including not only costs charged by an issuer (such as management fees for a mutual fund or exchange-traded fund) but also the potential costs of liquidating an investment or a strategy, rather than simply comparing explicit fees charged for different investment options.
Reasonably Available Alternatives and Limited Menus
The bulletin cautions firms offering limited product menus to investors and financial professionals working for such firms that they may not be able to make recommendations to investors in situations where they cannot offer an investment that is in the investors’ best interest. While acknowledging that Reg BI does not require an evaluation of products outside of a firm’s limited menu, the bulletin nonetheless states that “investment advisors ... should periodically consider ... whether other investment options that may better serve their clients’ interests may be available.” It also states that in some circumstances even the “most appropriate” investment alternative offered in a firm’s limited menu may not be in an investor’s best interest, and in such a circumstances the firm — or a professional working for such a firm — should not recommend any investment in the limited menu. This discussion suggests that firms offering limited product menus should be prepared to explain to the staff how they have determined that products within the menus were in a particular investor’s best interest.
Customer Profile and Tax Status
The bulletin devotes several questions to explaining financial professionals’ obligation to understand their customers’ investor profiles. In the responses to these questions, the staff emphasize that a financial professional must understand an investor’s financial situation and goals in order to know whether a recommendation is in that investor’s best interest. This obligation requires that financial professionals have up-to-date information about investors (Question 6) and also that in situations where financial professionals lack investor profile information sufficient to evaluate the merits of investment options for an investor, they should decline to make any recommendation. (Question 7) If a financial professional makes a recommendation notwithstanding missing some investor profile information, the staff suggest that the professional “consider documenting” why the unavailable or uncollected information is not relevant to the recommendation.
The bulletin also devotes several paragraphs to responding to a question (Question 8) about the role of a retail investor’s tax status in understanding a retail investor’s investment profile. The bulletin states that a financial professional will need an understanding of an investor’s tax status not only when the professional or investor “identifies a goal with tax implications” but also when providing advice “on a particular investment or investment strategy relative to other options” to which tax considerations are relevant. The bulletin’s examples of situations in which tax considerations are relevant show that the staff understand “tax status” to include not just a customer’s tax bracket but also (at least) information about where a customer pays taxes; one example given is “whether an out of state 529 plan is in the best interest of a customer who lives in a state that offers tax benefits for investing in the home state’s plan.” The examples are also broad enough to suggest that wherever a tax-advantaged investment is considered as a reasonably available alternative, the financial professional should have an understanding of the investor’s tax status in order to evaluate the appropriateness of this alternative.
Taken together, these comments warn financial professionals to exercise caution when they do not know a customer’s tax status or other potentially sensitive information such as a customer’s investments at other firms. The staff may not find it sufficient for a financial professional to provide a disclaimer that the customer should seek tax advice elsewhere and to then make a recommendation of an investment or investment strategy absent application of information about the customer’s tax status.
Documentation of Compliance
The bulletin suggests that documenting the evaluation of reasonably available alternatives, while not required, is beneficial: “[I]n the staff’s view, it may be difficult for a firm to demonstrate compliance with its obligations to retail investors, or periodically assess the adequacy and effectiveness of its written policies and procedures, without documenting the basis for certain recommendations.” The bulletin states that such documentation is particularly valuable when a conflict of interest exists or an investment appears inconsistent with an investor’s objectives. This guidance is in tension with the Reg BI adopting release, which stated that “broker-dealers or their associated persons are not required to prepare and maintain documentation regarding the basis for each specific recommendation, including an evaluation of a recommended securities transaction or investment strategy against similar available alternatives.”6 Practically, while not documenting analysis of alternatives may be permissible, the staff appear to suggest that this will make it more difficult to defend a firm’s or financial professional’s analysis in exams or enforcement actions. Documenting analysis of alternatives may thus be particularly helpful in situations where the staff are most likely to be concerned about a recommendation — where there is a conflict of interest, the product appears inconsistent with an investor’s documented goals or tax status, or a product is complex or risky.
Broker dealers and investment advisers should review the staff’s comments in this bulletin and prepare for aggressive and broad application of the care obligation by the staff. While each analysis of whether an investment is in an investor’s best interest will depend on the unique facts and circumstances of the investor and investment, the bulletin suggests that firms would be wise to have in place policies and procedures — including documentation of analysis of reasonably available alternatives for certain types of investments at least in some circumstances — that allow them to explain how they meet their care obligations in connection with each recommendation.
3 The regulation BI or fiduciary duty of care obligation arises in the context of investment advice or investment recommendations provided to clients, and may have indirect impact on private fund managers to the extent their funds are sold through such intermediaries, although private fund managers have no direct duty of care to fund clients.
4 Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031, 84 FR 33318 (June 5, 2019).
5 To date, the SEC and the Financial Industry Regulatory Authority have brought only a handful of enforcement actions for violation of Regulation BI, and none of these cases has specifically addressed the duty of care.
6 Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. 5248, 84 FR 33669 (June 5, 2019).