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SEC Regulation Best Interest - Reasonable Care

Posted by Jack Duval

Sep 14, 2018 8:12:46 AM

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This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

Knowing the Client and the Investment

As I’ve written previously, a Registered Representative must know both the client and the investment in order to make a Best Interest recommendation under the proposed SEC rules.  (This is also true under the existing FINRA Suitability Rule 2111.)

Under RBI, the SEC addresses this directly, writing: [1]

... we believe acting in the best interest of the retail customer would require a broker-dealer to have a reasonable basis to believe that a specific recommendation is in the best interest of the particular retail customer based on its understanding of the investment or investment strategy under proposed paragraph (a)(2)(ii)(A), and in light of the retail customer's investment objectives, financial situation, and needs.  (Emphasis added)

Additionally, the SEC believes the principals that underlie the RBI requirements are the same as those under the DOL’s Best Interest Standard (which was a fiduciary standard):

We believe that the principles underlying our proposed best interest obligation as discussed above, and the specific Disclosure, Care, and Conflict of Interest Obligations described in more detail below, generally draw from underlying principles similar to the principles underlying the DOL's best interest standard, as described by the DOL in the BIC Exemption.[2]  (Emphasis added)

Although RBI does not impose a fiduciary duty, the SEC refers to the DOL Rule (as well as obligations under RBI) regarding how Registered Representatives will be held to a prudent expert standard:

(The DOL Rule) defines advice to be in the "best interest" if the person providing the advice acts "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with the such (sic) matter would use... without regard to the financial or other interests" of the person.[3]

Further, the proposed Disclosure Obligation, Care Obligation and Conflict of Interest Obligations described in more detail below, establish standards of professional conduct that, among other things, would require the broker-dealer to employ reasonable care when making a recommendation.[4]  (Emphasis added)

Reasonable Care

An important question, then, is what constitutes “reasonable care”?  (I am here only focusing on the reasonable care obligation concerning investments, not those regarding the obligation to know the client.)

At a minimum, reasonable care requires the Registered Representative to undertake an analysis of the potential recommended investments to express her investment thesis and choose one that is in the best interest of the client.

In short, reasonable care requires that the Registered Representative do her homework.  Additionally, the diligence undertaken will need to be evidenced in writing so that it can be supervised, and for the broker’s own protection, should litigation ensue.

Choosing Between Investments

The SEC has provided guidance on the analysis of investments in RBI, writing: [5]

We reiterate that we recognize that it may be consistent with a retail customer's investment objectives - and in many cases, in a retail customer's best interest - for a retail customer to allocate investments across a variety of investment products, or to invest in riskier or more costly products, such as some actively managed mutual funds, variable annuities, and structured products.

However, in recommending such products, a broker-dealer must satisfy its obligations under proposed Regulation Best Interest.  Such recommendations would continue to be evaluated under a fact specific analysis based on the security or investment strategy recommended in connection with the retail customer's investment profile, consistent with the proposed best interest obligation.  (Emphasis added)

Fact Specific Analysis

The “fact specific analysis” is a new requirement and, as mentioned above, will need to be evidenced for each recommendation and supervised by the broker-dealer (“BD”).

The SEC mentions variable annuities as an example of a “more costly product”.  A fact specific analysis would need to show that a variable annuity was in the client’s best interest after accounting for those costs and compared to other available options.  For most variable annuities, this will be exceedingly difficult.

In a typical variable annuity contract the client is charged two to four percent per year in total fees.  These consist of asset management fees, mortality and expense fees, administrative fees, and riders.  Academic literature has shown a typical death benefit guaranteeing the principal to be worth between one and 10 basis points per year.[6]  However, most variable annuity contracts charge 100 to 125 basis points for the guarantee.

Such a high markup is very difficult to justify (as are all the other fees).

The advantage of tax-deferred growth inside a variable annuity is overwhelmed by these extremely high fees and the net investment returns will likely never overcome them when compared to a similar allocation into index funds, which typically distribute no capital gains.

Furthermore, most variable annuities require the sacrifice of liquidity, a risk that is completely uncompensated.[7]

In order to justify the recommendation of a variable annuity under RBI, a Registered Representative would have to show, in a fact specific analysis, how it is in her client’s best interest to buy the variable annuity versus a similar allocation in index funds.

I have yet to see such an analysis and am highly skeptical that one could pass the prudent expert standard.

The Importance of Costs

The SEC recognizes the importance of costs when undertaking a fact specific analysis, writing:[8]

… we emphasize that the costs and financial incentives associated with a recommendation would generally be one of many important factors...

Furthermore, the SEC states clearly that when choosing among identical securities, RBI requires the less expensive security be recommended:[9]

Thus, where, for example, a broker-dealer is choosing among identical securities available to the broker-dealer, it would be inconsistent with the Care Obligation to recommend the more expensive alternative for the customer…

If a broker-dealer recommends a more expensive security or strategy over another reasonably available alternative offered by the broker-dealer, they must have a reasonable basis to believe the higher cost is justified and that the recommendation is in the customer's best interest.

A key word in the quote above is “identical”.  Very few investments are likely to be identical in the literal sense.  However, many are certain to be highly comparable with differences that are essentially trivial.  For instance, in the variable annuity example, a large cap blend sub-account inside the variable annuity is likely to be highly comparable to an S&P 500 Index fund.

A simple correlation analysis would almost certainly reveal that the differences were small, as would an analysis of the holdings and the sub-accounts active share.  Indeed, most funds (or sub-accounts) in the same size and style category are likely to be close to identical, although none would likely meet the literal meaning of “identical”.

The more comparable two investments are, the more important it will be to choose the less expensive option.  For products that have insurance or other features such as principal protection, an additional analysis of the costs, liquidity, guarantor risk, and other factors will be required.

Importantly, the case of identical investments isn’t the only standard the SEC sets out, indeed, it is only a special case.

Comparable Product Factors

The SEC has provided guidance on what a BD must consider when undertaking their fact specific analysis for comparable products or strategies offered by the firm:[10]

While every inquiry will be specific to the broker-dealer and the investment or investment strategy, broker-dealers may wish to consider questions such as: 

  • Can less costly, complex, or risky products available at the broker-dealer achieve the objective of the product?
  • What assumptions underlie the product, and how sound are they? What market or performance factors determine the investor’s return?
  • What are the risks specific to retail customers? If the product was designed mainly to generate yield, does the yield justify the risk to principal?
  • What costs and fees for the retail customer are associated with this product? Why are they appropriate?  Are all of the costs and fees transparent?  How do they compare with comparable products offered by the firm?[11]
  • What financial incentives are associated with the product, and how will costs, fees and compensation relating to the product impact an investor’s return?
  • Does the product present any novel legal, tax, market, investment, or credit risks?
  • How liquid is the product? Is there a secondary market for the product?

As described above, the broker-dealer's diligence and understanding of the risks and rewards would generally involve consideration of factors, such as the costs; the investment objectives and characteristics associated with a product or strategy (including any special or unusual features, liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), as well as the financial and other benefits to the broker-dealer.

Fact Specific Analysis Supervision

Perhaps most important is that Registered Representatives will have to undertake their fact specific analysis before the recommendation is made.  As discussed above, that analysis would need to be in writing and show how the recommendation is in the client’s best interest and comports with all their particular facts and circumstances, including risk tolerance and investment objectives.

If there was no analysis, or the analysis was deficient, then the recommendation would likely fail to meet the RBI standard (or might only meet it by chance) and would certainly have failed to have been supervised.

The requirement of a fact specific analysis will necessitate additional supervisory systems and oversight, and BDs will need to implement policies and procedures to make sure they comply with RBI.

__________

Notes:

[1]           SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed September 12, 2018.

at 141.

[2]           Id. at 58.

[3]           Id. at 108.

[4]           Id. at 59.

[5]           Id. at 147.

[6]           Mose Arye Milevsky and Steven E. Posner; The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds; The Journal of Risk and Insurance, 2001; Vol. 68; No. 1, 93-128.  Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.178.1519&rep=rep1&type=pdf;  Accessed September 12, 2018.

[7]           Many variable annuities allow the withdrawal of up to 10 percent of the original investment on a penalty-free basis every year.  However, withdrawals above that amount often have eight to 10 percent penalties in the first year and decline each year after that.

            Typically, investors in illiquid investments such as hedge funds and private equity funds demand an illiquidity premium of three percent per year for the loss of liquidity.  Variable annuities provide no such return premium.  Indeed, because of their fee structure, they are likely to return three percent less than the benchmark each year.

[8]           RBI at 147.

[9]           Id. at 148.

[10]         Id. at 139-40 and 143.

[11]         An interesting question arises about firms that only offer one type of product, such as insurance carriers that only sell insurance or variable products.  I will address this in later posts.

 

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Topics: FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, fiduciary obligations, prudent expert standard, Securities Exchange Commission, Regulation Best Interest, Reasonable Care, Fact Specific Analysis

SEC Regulation Best Interest - The Prudent Expert Standard

Posted by Jack Duval

Aug 23, 2018 9:38:27 AM

Accelerant SEC Regulation Best Interest - Logo 

As discussed in my previous posts, SEC Regulation Best Interest (“RBI”) will require broker-dealers and their agents to put the best interests of their clients first.  What is less well understood is that RBI will also impose a prudent expert standard on Registered Representatives.

There are three broad obligations to RBI:[1]

  • Disclosure;
  • Care, and;
  • Conflicts of Interest.

The Prudent Expert Standard

I am here focusing on the Care Obligation, which the SEC has described as:

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:[2]

  • Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
  • 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; and
  • Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. (Emphasis added)

While RBI does not establish a fiduciary obligation, the SEC is clear that it views the duty to exercise reasonable diligence, care, skill, and prudence as similar to a fiduciary duty, writing:[3]

Under Regulation Best Interest, as proposed, a broker-dealer’s duty to exercise reasonable diligence, care, skill and prudence is designed to be similar to the standard of conduct that has been imposed on broker-dealers found to be acting in a fiduciary capacity.  (Emphasis added)

The “reasonable diligence, care, skill, and prudence” language, as well as the process of understanding “potential risks and rewards”, applying that understanding to the retail customer’s investment profile, and evaluating a series of recommended transactions, all necessitate coming to an expert opinion.

Indeed, coming to an expert opinion will be the only way the Care Obligation can be fulfilled.

The SEC points to the prudent expert standard in RBI, writing:[4]

We believe that the principles underlying our proposed best interest obligation as discussed above, and the specific Disclosure, Care, and Conflict of Interest Obligations described in more detail below, generally draw from underlying principles similar to the principles underlying the DOL’s best interest standard, as described by the DOL in the BIC Exemption

The BIC Exemption’s best interest Impartial Conduct Standard would require (as here relevant) that advice be in a retirement investor’s best interest, and further defines advice to be in the “best interest” if the person providing the advice acts “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with the (sic) such matters would use… without regard to the financial or other interests” of the person..  (Emphasis added)

The SEC believes the principles underlying RBI are consistent with those of the DOL rule.  The DOL language of “a prudent person acting in a like capacity and familiar with such matter” is the prudent expert standard.  Thus, that is the standard that should apply to Registered Representatives making recommendations to retail customers.

Furthermore, the SEC refers to RBI as establishing “standards of professional conduct”:[5]

… the proposed Disclosure Obligation, Care Obligation and Conflict of Interest Obligations described in more detail below, establish standards of professional conduct that, among other things, would require the broker-dealer to employ reasonable care when making a recommendation.  (Emphasis added)

Knowing the Investment and the Client

As with the FINRA Suitability standard, the registered representative must know both the investment and the client in order to meet the Best Interest standard.  The SEC makes this clear in RBI, writing about:

Knowing the investment

Without establishing such a threshold understanding of its particular recommendation, we do not believe that a broker-dealer could, as required by Regulation Best Interest, act in the best interest of a retail customer when making a recommendation…[6]

Knowing the customer

A broker-dealer that makes a recommendation to a retail customer for whom it lacks sufficient information to have a reasonable basis to believe that the recommendation is in the best interest of that retail customer based on the retail customer’s investment profile would not meet its obligations under the proposed rule.[7]

Anyone arguing that the prudent expert standard will not apply under RBI will need to overcome the SEC’s own language, the shingle theory,[8] as well as what will likely be a mountain of advertising and marketing material from the broker-dealer extoling its expertise.[9]  Furthermore, there will be the matter of the CRS Relationship Summary, which will affirm the BDs adherence to the securities law and regulations (including RBI and all the attendant obligations) and will nowhere disavow the firm’s expertise with investments.[10]

Supervisory Implications of the Prudent Expert Standard

Under RBI, broker-dealer supervisors will be tasked with making sure their registered representatives know both their clients and the investments recommended.  In theory, they are doing this already.  However, RBI, by requiring recommendations in the client’s best interest (instead of being merely suitable) will necessitate more work and documentation around knowing the investment.

I will discuss this in more detail in my next post.

__________

Notes:

[1]       SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed August 23, 2018.

[2]       Id. at 404-5.

[3]       Id. at 134.

[4]       Id. at 58 and footnote 108.  Also see, Accelerant blog post: The DOL Fiduciary Rule – Prudent Expert Standard; Available at: http://blog.accelerant.biz/blog/the-dol-fiduciary-rule-prudent-expert-standard; Accessed August 23, 2018.

[5]       Id. at 59.

[6]       Id. at 137.  This language also exits in FINRA RN 12-25 at Q22.  “Brokers cannot fulfill their suitability responsibilities to customers… when they fail to understand the securities and investment strategies they recommend.”

[7]       Id. at 145.

[8]       The “shingle theory” goes back to a 1943 Second Circuit decision, Charles Hughes & Co., Inc. v. SEC (139 F.2d 434; 2d Cir. 1943).  As Louis Loss wrote: “the theory was that even a dealer at arms’ length implicitly represents when he or she hangs out a shingle that he or she will deal fairly with the public.”  Fundamentals of Securities Regulation, Fourth Edition; Louis Loss and Joel Seligman; Aspen Publishers (New York); 2004; 1063.  Of course, RBI makes the relationship similar that of a fiduciary, which is far higher than one of “arms’ length”.

[9]       See, for instance, Merrill Lynch website of its Private Banking & Investment Group:  “Your private wealth advisor is dedicated to understanding your goals and experienced in the complexities of managing significant wealth.”  Available at: https://www.pbig.ml.com/; Accessed August 23, 2018.

[10]      SEC Form CRS Relationship Summary;  Release No. 34-83063;  IA-4888; File No. S7-08-18.  Available at: https://www.sec.gov/rules/proposed/2018/34-83063.pdf; Accessed August 23, 2018.

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Topics: FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, fiduciary obligations, prudent expert standard, Securities Exchange Commission, Regulation Best Interest

Comparing SEC Regulation Best Interest to Existing FINRA Rules

Posted by Jack Duval

Apr 27, 2018 9:30:35 AM

 

SEC Regulation Best Interest - Commissioner Kara Stein

AGENCE FRANCE-PRESSE/GETTY IMAGES US Securities and Exchange Commissioner Kara Stein.

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  The DOL Rule posts can be found here and the SEC Rule post can be found here.

The SEC's proposed Regulation Best Interest ("RBI") is remarkable in how poorly it is crafted.  Indeed, it is a disaster.

If passed in it's current form, RBI will:

  • Not create a unified fiduciary standard as it was supposed to under the Dodd-Frank Act Section 913;
  • Confuse clients as to the duties of broker-dealers compared to investment advisors, and;
  • Pass off existing FINRA Rules and interpretations as some kind of heightened standard.

Table 1:  Comparing SEC Regulation Best Interest to Existing FINRA Rules

SEC Regulation Best Interest v. Existing FINRA Rules

For a PDF of this table click here.

As can be seen above, the only thing RBI adds are the disclosures relating to the scope and terms of the relationship and material conflicts of interest.  While these are good additions, they fall far short of increasing investor protections.

Everything else in RBI already exists within the FINRA rules.

Kara M. Stein Comments

SEC Commissioner Kara M. Stein has savaged RBI in her public statement:

... does this proposal require financial professionals to put their customers' interest first, and fully and fairly disclose any conflicting interests? No.  Does this proposal require all financial professionals who make investment recommendations related to retail customers to do so as fiduciaries? No.  Does this proposal require financial professionals to provide retail customers with the best available options? No.

Commissioner Stein also points out, as have others, that nowhere in the 1,000+ pages of related documents does RBI define what "best interest" means.  Instead, the RBI states the best interest obligation will be satisfied "if the broker-dealer complies with four component requirements: a Disclosure Obligation, a Care Obligation,and two Conflict of Interest Obligations."  (96)

Thus, broker-dealers will be able to check the boxes to prove that they complied with an undefined "best interest" obligation that already exists under FINRA rules.  This can only weaken investor protection.

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Topics: FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, fiduciary obligations, erisa fiduciary expert, Securities Exchange Commission, Regulation Best Interest, fiduciary expert

SEC Regulation Best Interest

Posted by Jack Duval

Apr 20, 2018 8:18:52 AM

Accelerant SEC Regulation Best Interest - Logo 

 

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  My previous blog posts can be found here.

On Wednesday, April 18, 2018, the SEC issued a number of rule proposals designed, in theory, to "unify" the obligations of registered representatives of broker dealers with those of registered investment advisors.

It does no such thing.

Broker-dealers and their registered representatives will not be fiduciaries under Regulation Best Interest.  Investment advisors will remain fiduciaries.

Essentially, Regulation Best Interest will take many of the obligations that already exist in the FINRA Rules and Regulatory Notices and bring them under the SEC's aegis.  Indeed, the SEC stated:

As discussed herein, some of the enhancements that Regulation Best Interest would make to existing suitability obligations under the federal securities laws, such as the collection of information requirement related to a customer's investment profile, the inability to disclose away a broker-dealer's suitability obligation, and a requirement to make recommendations that are "consistent with his customers' best interest," reflect obligations that already exist under the FINRA suitability rule or have been articulated in related FINRA interpretations and case law.  (Emphasis added.  Regulation Best Interest; 10)

This means the suitability standard will remain for registered representatives with some additional language about the "best interests" of the client.  I will try to define exactly what the additional "best interest" language actually means in subsequent posts.

The SEC has released approximately 1,000 pages relating to this proposal.  You can find the three related releases here:

Release No. 34-83062; Regulation Best Interest;

Release No. IA-4889; Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation;

Release No. 34-83063; form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles.

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Topics: FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, fiduciary obligations, Securities Exchange Commission, Regulation Best Interest

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