Best Interest Standard of Care for Advisors #31

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Regulation Best Interest: Best Interest and Suitability—How They Differ (Part 2)

Regulation Best Interest (Reg BI) imposes a “best interest” standard of care on broker-dealers for their recommendations of securities and investment strategies to retail customers. That raises the question, what does best interest mean and how does it differ from suitability?

While the discussion in this article is based on the Reg BI best interest requirements for broker-dealers, the SEC has also imposed a best interest standard on investment advisers.  As a result, investment advisers should also be attentive to these issues.

As I explained in Part 1 of this article (Best Interest Standard of Care for Advisors #30), that’s a hard question without an easy answer. However, based on the SEC’s discussion in the Adopting Release, I have developed examples that illustrate where best interest appears to impose a more demanding standard than suitability. These examples are based on the Reg BI requirement that broker-dealers and their associated persons consider costs in the development of every recommendation. While costs are not the only factor to be considered, the SEC says that they are now a more important factor in the development of recommendations.

We are adopting the Care Obligation largely as proposed; however, we are expressly requiring that a broker-dealer understand and consider the potential costs associated with its recommendation, . . . and have a reasonable basis to believe that the recommendation does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer. Nevertheless, we emphasize that while cost must be considered, it should never be the only consideration. Cost is only one of many important factors to be considered regarding the recommendation and that the standard does not necessarily require the ‘‘lowest cost option.’’ Relatedly, we are emphasizing the need to consider costs in light of other factors and the retail customer’s investment profile.

The SEC’s approach requires that cost be considered as an important factor in the context of the retail customer’s investment profile. The consideration of costs and other relevant factors indicated by that profile should be done in a manner that is in the investor’s best interest. In some cases, though, a greater emphasis on costs would be warranted. In my last post, I gave the example of two S&P index funds. This article gives additional examples.

Example 2: A broker-dealer offers two share classes of a particular mutual fund. One share class has an expense ratio of 150 bps and the other has an expense ratio of 100 bps. If the front end load is the same for both, the SEC and FINRA would likely take the position that a recommendation of the 150 bps share class was not in the best interest of the retail customer. Since these are two share classes of the same mutual fund, there would ordinarily not be any differences in features or characteristics that would provide greater value (i.e., best interest) to the retail customer to offset the differences in cost.

Example 3: There are two similar mutual funds in the same investment category managed by different managers. The expense ratio of one is 150 bps and the other is 100 bps. All other things being equal, it could be argued that the one with the 100 bps expense ratio appears to be in the best interest of the retail investor. Of course, in many cases “all other things” are not equal. The issue here is whether the advisor has evaluated the differences between the mutual funds and justifiably determined that the more expensive version is better for the investor than the less expensive version. In my view, where the cost differences are relatively minor, and where there are differences between the investments, the professional judgment of an advisor will generally be respected. However, as the cost differential gets larger, the need to justify the difference increases. And, to make an obvious point, where the cost of an investment seems out of line (and particularly if the higher cost is largely attributable to compensation to the advisor and the broker-dealer), broker-dealers should be prepared for challenges to those recommendations (and should consider documenting the reasons for the justification of the higher cost investments).

Here are two approaches that broker-dealers could consider to manage the cost issue for recommendations of mutual funds. The first is to limit the funds that can be offered by their advisors. That’s not to suggest a major restriction, but instead to suggest a review of the funds offered through the broker-dealer to limit the line up to those that are commercially competitive in terms of cost. The second is for advisors to have a defined process for recommending mutual funds that considers cost, as well as qualitative considerations.  For example, that process could be documented through software that evaluated mutual funds (and their costs) and proposed asset allocations based on the retail customer’s investment profile.

My next post, the third in this series, will provide additional examples.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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