SEC Publishes Staff Bulletin on the Standards of Conduct for Broker-Dealers and Investment Advisers Making Account Recommendations to Retail Investors
The staff of the Securities and Exchange Commission issued further guidance this spring in a bulletin (Bulletin)1 interpreting the standard of conduct for broker-dealers under Regulation Best Interest2 and investment advisers (together with broker-dealers, firms) under the Investment Advisers Act of 1940 (IA Fiduciary Standard)3 when making account recommendations to retail investors. Because the Bulletin reflects only staff views and was not approved by the SEC, it is not intended to create any new or additional obligations or to amend or alter the law. Rather, the Bulletin is intended to “assist firms and their financial professionals with considering reasonably available alternatives and cost, addressing conflicts of interest, and adopting and implementing reasonably designed policies and procedures when making account recommendations.”
Regulation Best Interest
Regulation Best Interest requires broker-dealers and their associated persons to act in the best interest of their retail customers at the time of making recommendations regarding any “securities transaction or investment strategy involving securities (including account recommendations)” and to place the interests of the retail customers ahead of the financial or other interests of the broker-dealer and its associated persons. Regulation Best Interest consists of four component obligations: the disclosure obligation, the care obligation, the conflict of interest obligation, and the compliance obligation.
IA Fiduciary Standard
The IA Fiduciary Standard provides that an investment adviser’s fiduciary duties consist of a duty of care and a duty of loyalty, which, taken together, require an adviser to act in the best interest of its clients at all times. The duty of care consists of three components: the duty to provide advice that is in the client’s best interest (which includes suitability obligations); the duty to seek best execution; and the duty to provide advice and monitoring over the course of the adviser/client relationship. The duty of loyalty requires an adviser to eliminate, or to disclose fully and fairly all conflicts of interest for the purpose of obtaining informed consent.
ERISA and IRA-Related Developments
The development and adoption of Regulation Best Interest followed the adoption and later invalidation of an amended fiduciary rule (Amended ERISA Rule) under ERISA. After a long and circuitous process, the Amended ERISA Rule was finalized by the Department of Labor in 2016, on what constitutes “investment advice” to employee benefit plans and (among other things) IRAs (together with ERISA plans, Plans). The Amended ERISA Rule dramatically expanded ERISA’s reach, affecting the way that a number of financial institutions structured and offered products and services both to ERISA and non-ERISA customers. In 2017, the United States Court of Appeals for the Fifth Circuit struck down the Amended ERISA Rule, including the related new and amended ERISA class exemptions that had been issued in connection with the issuance of the applicable underlying regulation.4
Eventually, in 2020, in light of the return of the “investment advice” regulation to its 1975 pre-amendment form (1975 ERISA Rule) that resulted from the judicial elimination the Amended ERISA Rule and related exemptions, the DOL issued Prohibited Transaction Class Exemption (PTCE) 2020-025, so as to allow those that were concerned about possible fiduciary status or that actively wanted to pursue fiduciary status to be able to proceed without violating ERISA’s self-dealing prohibitions. In the preambles to the proposed and final versions of PTCE 2020-02, the DOL discussed the five-part test for determining whether advice is the “investment advice” that is contained in the 1975 ERISA Rule. The preambles were widely seen as significantly expanding the scope of (although do not in any way amend) the 1975 ERISA Rule, particularly as applied to rollover solicitations.
Account (including Rollover) Recommendations
Under both Regulation Best Interest and the IA Fiduciary Standard, account recommendations to retail investors must be in the retail investor’s best interest and not put the interests of the firm ahead of the retail investor. “Account recommendations” include recommendations of securities account types generally (e.g., to open an IRA or other brokerage account), as well as recommendations to roll over or transfer assets from one type of account to another (e.g., a workplace retirement plan account to an IRA). Firms and their personnel must have a reasonable basis to believe that a recommendation is in the best interest of the retail customer at the time the recommendation is made, based on that retail customer’s investment profile, as well as the potential risks, rewards and costs associated with the recommendation. The Bulletin states that a firm’s limited account offerings cannot alone be used as a basis for a recommendation; rather such limitations need to be disclosed to the retail investor and considered when making a recommendation. The staff’s emphasis on the relevance of limited account offerings (which may well reflect historical SEC thinking) may raise additional considerations for firms whose financial professionals may be limited in their availability to offer products because of license limitations.
The SEC noted that for rollovers, firms should consider additional relevant factors when making such recommendations, such as: “costs; level of services available; features of the existing account, including costs; available investment options; ability to take penalty-free withdrawals; application of required minimum distributions; protection from creditors and legal judgments; and holdings of employer stock.” The staff also noted that it would find it difficult to take the view that a firm’s recommendation of a retirement account rollover was in the best interest of a retail investor (or consistent with the IA Fiduciary Duty), if the firm had not considered alternative options (including leaving the investor’s funds in his or her existing retirement account, if an available option).
The Bulletin also states:
Where investor information is unavailable despite [the representative’s] reasonable diligence, the staff believes [the financial institution] should carefully consider whether [it has] a sufficient understanding of the investor to evaluate if any account recommendation is in that investor’s best interest. The staff believes [the institution] will not be able to have a reasonable belief that an account recommendation is in an investor’s best interest under Reg BI or the [the Advisers Act] fiduciary standard without sufficient information about the retail investor and therefore should generally decline such account recommendations until [the institution obtains] the necessary investor information. To evaluate any recommendation to transfer assets out of an employer’s [P]lan, or between individual retirement accounts, you would need to obtain information about the existing [P]lan, including the costs associated with the options available in the investor’s current [P]lan.
This language may raise a question (at least regarding rollovers) as to whether the staff believes one can make a recommendation without obtaining requisite information about a Plan. If so, the DOL’s approach in this regard as it relates to rollovers under PTCE 2020-02 might be less restrictive than the SEC’s. The DOL in the preamble to the final version of PTCE 2020-02 noted that firms should use Plan-related information under certain existing regulatory requirements.6
Factors to Consider
The Bulletin discusses the factors a firm should take into consideration before making an account recommendation. Noting that an investor’s investment profile and account characteristics should be taken into account, the staff noted in the Bulletin that the following information should be considered about the retail investor:
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 to [the firm] in connection with an account recommendation. The staff also believes that [firms] should consider, without limitation, the retail investor’s: anticipated investment strategy (e.g., buy and hold versus more frequent trading); level of financial sophistication; preference for making their own investment decisions or relying on advice from a financial professional; and the need or desire for account monitoring or ongoing account management.
Other factors that the staff suggested for consideration when making a recommendation are “the services and products provided in the account (including ancillary services provided in conjunction with an account type, account monitoring services, etc.); the projected costs to the retail investor; alternative account types available; and whether the account offers the services requested by the retail investor.” The staff further noted that a firm should obtain and evaluate “enough information about the retail investor to have a reasonable basis to believe the account recommendation is in the best interest of that retail investor and that [the firm’s] recommendation is not based on materially inaccurate or incomplete information.” If such information is not available to firms after “reasonable” diligence, the staff indicated that a firm must evaluate whether it has sufficient information to provide an account recommendation in the investor’s best interest, or otherwise decline to provide a recommendation. It is noted that the reference to “any other information the retail investor may disclose to you” could give rise to several difficult interpretative and operational challenges, including in conversations relating to rollovers.
While neither Regulation Best Interest nor the IA Fiduciary Standard requires a firm to recommend the least expensive account offering for a retail investor, both regimes require that a firm have a reasonable basis to determine that the costlier account is in the best interest of the retail investor. The Bulletin notes that a recommendation of a more expensive account should be based on an examination of the facts and circumstances of the retail investor. The staff’s emphasis on cost arguably echoes the DOL’s view that, in the context of rollover recommendations “the fees and expenses associated with both the Plan and the IRA” should be considered in PTCE 2020-02.
Retail Investor Preference
The Bulletin also discusses retail investor preference. The staff noted that a firm would not satisfy its requirements under Regulation Best Interest or the IA Fiduciary Standard, as applicable, simply by following the preferences of a retail investor. According to the staff, a retail investor’s preference should be taken into account, but a firm also needs to consider the investment profile of the investor and reasonably available alternatives, in order to be able to act in the best interest of the investor when making a recommendation. Nevertheless, if the retail investor ultimately directs the firm to open an account that conflicts with the recommendation, the Bulletin states that the firm can proceed with such a request.
These statements arguably suggest that the SEC’s view is that even if a client expresses a given preference, an institution still would need to make a recommendation covered under Regulation Best Interest based on a finding of best interest based on the applicable facts and circumstances. The Bulletin does not appear to go so far as to ignore completely the importance of client preferences, but, to the contrary, the Bulletin indicates that client preferences are indeed factors that should be considered. For example, the Bulletin states that a financial representative should focus on whether or not clients have a “preference for making their own investment decisions or relying on advice from a financial professional” and “the client’s need or desire for account monitoring or ongoing account management.” Nevertheless, the SEC arguably may be suggesting that a client’s expressed preference by itself – short of a specific direction – is insufficient to offer a recommendation without the independent “best interest” determination by the representative.
More Investment Options and Products and Services
In a footnote to the Bulletin, the staff states: “[t]he Commission has cautioned broker-dealers not to rely on an IRA having ‘more investment options’ as ‘the’ basis for recommending a rollover.” The Bulletin further states: “[t]he existence of special features or other potential benefits would not alone support a reasonable belief that an account recommendation is in an investor’s best interest.”
The staff’s language arguably suggests that broker-dealers who rely on “more investment options” as “the” basis for a recommendation will need additional bases to support the recommendation. The same may also be the case for “special features” that may be offered at the institution.
Documentation for Account Recommendations and Conflicts of Interest
The Bulletin goes further than prior SEC statements regarding the need for firms to document the basis for an account recommendation.7 According to the staff, in the case of certain recommendations, the absence of documentation regarding the basis for the account recommendation might make it “difficult for a firm to assess periodically the adequacy and effectiveness of its policies and procedures or to demonstrate compliance with its obligations to retail investors.”
The Bulletin also provides examples of how firms can address potential conflicts of interest related to account recommendations. Practices noted by the staff include:
• Avoiding compensation mechanisms that reward the opening of certain account types over others;
• Creating and enforcing policies and procedures “reasonably designed to minimize or eliminate incentives (i.e., compensation and non-compensation) for employees to favor one type of account over another”;
• Implementing supervisory procedures to monitor account recommendations, especially for rollover recommendations; and
• Modifying compensation for financial professionals who are unable to effectively manage conflicts of interest in relation to account recommendations.
The Bulletin directs firms to pay particular attention when creating incentives that encourage an account recommendation that would “place the interests of the firm or financial professional ahead of the interest of the retail investor.” Noting its recent settled enforcement actions involving compensation incentives for financial professionals when making account recommendations8, the staff admonished firms to eliminate or mitigate any such incentives.
“Hire Me” Communications; Investment Education
A footnote to the Bulletin confirms that “Reg BI does not apply to a retail investor’s selection of an account without a recommendation by a broker-dealer, regardless of whether the retail investor also receives recommendations of transactions from the broker-dealer that are subject to Reg BI.” Implicit in this statement is the continued recognition that not all rollover conversations are necessarily recommendations. Investment education (as contemplated, for example, by DOL Interpretative Bulletin 96-1) and so-called “hire me” communications with respect to a rollover or choice of accounts do not always result in a “call to action” triggering Regulation Best Interest even where the financial institution later becomes subject to Regulation Best Interest with respect to later recommendations.
Those dealing with retirement accounts that seek to avoid fiduciary status may wish, however, to read this aspect of the Bulletin together with the DOL’s discussion in the preambles to PTCE 2020-02 of the five-part test regarding whether nondiscretionary advice is fiduciary advice under the 1975 ERISA Rule. In particular, both the preamble to proposed PTCE 2020-02 and that of the final exemption offer important color on the DOL’s current view of what may constitute investment advice under the 1975 ERISA Rule’s five-part-test.
While the Bulletin expressly states that it “is not a rule, regulation, or statement of the SEC,” and “has no legal force or effect,” broker-dealers and investment advisers may wish to consider this guidance in light of continued focus on the Regulation Best Interest and the IA Fiduciary Standard by the SEC’s Divisions of Examination and Enforcement. In addition, where retirement assets are involved, the Bulletin should be read in concert with the DOL’s authority under PTCE 2020-02.
1. Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors(2022).
2. Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318 (2019).
3. Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 84 Fed. Reg. 33669 (2019).
4. For further information about the Amended ERISA Rule and its demise, please refer to Dechert OnPoint, Department of Labor’s Fiduciary Rule.
5. For further information about PTCE 2020-02, please refer to Dechert OnPoint, Will ERISA’s Fiduciary Exemption “Rollover” to the New Administration? DOL Issues Year-End Package Relating to “Investment Advice”.
6. The DOL cited specifically to so-called Section 404(a)(5) disclosure, and separately suggested in the same preamble that institutions can use alternative data sources, such as the most recent Form 5500 or reliable benchmarks on typical fees and expenses for the type and size of Plan at issue. Furthermore, in Q&A 15 of the PTCE 2020-02 FAQs, the DOL explained that there could be circumstances in which the client refuses to provide information necessary to make a recommendation, but the broker nevertheless, under certain circumstances, could recommend the rollover. Indeed, in Field Assistance Bulletin 2021-02, the DOL noted that: financial institutions were facing meaningful challenges in obtaining and processing information in order to make a prudent recommendation; the DOL would “not enforce the specific documentation and disclosure requirements for rollovers in PTE 2020-02 through June 30, 2022” because of the “practical difficulties for financial institutions that are in the process of complying with the exemption conditions”; and “financial institutions are in the process of developing tools to comply with the rollover documentation and disclosure requirements in ... PT[C]E 2020-02 [and some] financial institutions are working with third party vendors to automate much of the documentation and analysis of rollover recommendations.”
7. See Exchange Act Rule 17a-4 (requiring broker-dealers to preserve, among other records, all communications sent or received relating to the firm’s business, including written communications with retail customers); Exchange Act Rule 17a-3(a)(35)(i) (requiring broker-dealers to keep a record of all information collected from and provided to the retail customer pursuant to Regulation Best Interest, as well as the identity of each person who is an associated person responsible for the account); and Investment Advisers Act of 1940 Rule 204-2(a)(7) (requiring investment advisers registered or required to be registered to retain all written communications related to any recommendation made or proposed to be made and any advice given or proposed to be given).
8. See In the Matter of Centaurus Financial, Inc.; In the Matter of Cowen Prime Advisors, LLC, Investment Advisers Act Release No. 5874, Investment Advisers Act Release No. 5744 (June 2, 2021), (Sept. 27, 2021); In the Matter of O.N. Investment Management Company, Investment Advisers Act Release No. 5944 (Jan. 11, 2022); In the Matter of Rothschild Investment Corp., Investment Advisers Act Release No. 5860 (Sept. 13, 2021).