Over the next several months The Leaders Group will be introducing the new policies, procedures, forms, disclosures and technology that will help meet the obligations under Regulation Best Interest (Reg BI). The U. S. Securities and Exchange Commission released the final rule June 5, 2019 with a compliance date of June 30, 2020.
Reg BI has four main components:
- Disclosure Obligation -to disclose material facts about the relationship and recommendations that are being made, the capacity of the financial professional, fees, services, conflicts and information on the products they are selling.
- Care Obligation – exercise reasonable diligence, care, and skill when making recommendations to customers.
- Conflicts of Interest Obligation – conflicts must be identified, and to the extent possible, eliminated. Those that cannot be eliminated must be disclosed and mitigated.
- Compliance Obligation – policies and procedures must be established, maintained and enforced.
The SEC did not define best interest, but The Leaders Group is defining best interest as putting the customer’s interests above our own. To us, that means recommendations made for the customer are prudent, and not influenced by compensation, or any self-interest. In this article, the care obligation will be explored.
Under the Care Obligation, you must exercise reasonable diligence, care, and skill when making a recommendation to a customer:
- To understand the potential risks, rewards, and costs associated with recommendation, and to have a reasonable basis to believe that the recommendation could be in the best interest of at least some customers;
- To have a reasonable basis to believe the recommendation is in the best interest of a particular customer based on that customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the interest of you and the broker-dealer ahead of the interest of the customer; and
- To have a reasonable basis to believe that a series of recommended transactions, even if in the customer’s best interest when viewed in isolation, is not excessive and is in the customer’s best interest when taken together in light of the customer’s investment profile.
What does the first component of the Care Obligation require?
You must exercise reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with the recommendation.
What would constitute reasonable diligence, care, and skill will vary depending on, among other things, the complexity of and risks associated with the recommended security or investment strategy and your familiarity with the recommended security or investment strategy.
While every circumstance will be specific to the situation, and the recommended security or investment strategy, you generally should consider important factors such as:
- the investment strategies:
- investment objectives;
- characteristics of the product (including any special or unusual features);
- volatility; and
- likely performance in a variety of market and economic conditions;
- the expected return of the security or investment strategy; and
- any financial incentives to recommend the security or investment strategy.
What does the second component of the Care Obligation require?
You must consider the risks, rewards, and costs in light of the customer’s investment profile and have a reasonable basis to believe that the recommendation is in that particular customer’s best interest and does not place your interest ahead of the customer’s interest.
The customer’s investment profile is defined to include, but is not limited to the customer’s:
- other investments;
- financial situation and needs;
- tax status;
- investment objectives;
- investment experience;
- investment time horizon;
- liquidity needs;
- risk tolerance; and
- any other information the customer may disclose to the broker in connection with a recommendation
What does the third component of the Care Obligation require?
When recommending a series of transactions, you must have a reasonable basis to believe that the transactions taken together are not excessive, even if each is in your customer’s best interest when viewed in isolation. The requirement applies irrespective of whether you exercise actual or de facto control over a customer’s account.
What would constitute a “series” of recommended transactions would depend on the facts and circumstances and would need to be evaluated with respect to a particular customer.
You should consider reasonably available alternatives, if any, in determining whether you have a reasonable basis for making the recommendation.
What specific factors should be considered when making account type recommendations, or recommendations to open an IRA, or to roll over assets into an IRA?
With respect to account type recommendations, you should generally consider:
- the services and products provided in the account;
- the projected cost to the customer of the account;
- alternative account types available;
- the services requested by the customer; and
- the customer’s investment profile.
When making recommendations to open an IRA, or to roll over assets into an IRA, you should consider a variety of factors including, but not limited to:
- fees and expenses;
- level of services available;
- available investment options;
- ability to take penalty-free withdrawals;
- application of required minimum distributions;
- protections from creditors and legal judgments;
- holdings of employer stock; and
- any special features of the existing account.
Are there special considerations when recommending securities or investment strategies that are complex or risky?
When recommending securities or investment strategies that are complex, you should take particular care to make sure you understand the terms, features, and risks – as with the potential risks, rewards, and costs of any security or investment strategy – in order to establish a reasonable basis to recommend the product to customers. Also, you must weigh the potential risks, rewards, and costs of the particular product or investment strategy, in light of the customer’s investment profile.
When recommending potentially-high risk products, such as penny stocks or other thinly-traded securities, you should generally apply heightened scrutiny to whether such investments are in your customer’s best interest.
Is a representative required to recommend the lowest-cost security or investment strategy?
While you must understand and consider costs when making a recommendation, it is only one important factor among many factors. You would not satisfy the Care Obligation by simply recommending the least expensive security without further analysis of the other factors and the customer’s investment profile.
For example, depending on the facts and circumstances, you may be able to recommend a more expensive security or investment strategy if there are other factors about the product or strategy that reasonably allow you to believe it is in the best interest of your customer, based on that customer’s investment profile.
Many factors will need to be considered when making a recommendation under Reg BI, and next we will look at all the disclosures that we will need to make.
Contact Jane Riley for more information:
Chief Compliance Officer