Care Obligations of Broker-Dealers and Investment Advisers

08/23/2023

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The Bulletin focuses primarily on the care obligation of Regulation Best Interest (“Reg BI”) for broker-dealers and the duty of care under the Investment Advisers Act of 1940, as amended (the “IA fiduciary standard”) for investment advisers (together, “Care Obligations”).

The Care Obligations are drawn from key fiduciary principles that include the obligation to act in retail investors’ best interests and not to place their own interests ahead of those of their investors. Care Obligations generally include the following three components:

• understanding the potential risks, rewards, and costs associated with a product, investment strategy, account type, or series of transactions;
• having a reasonable understanding of the specific retail investor’s investment profile, which generally includes information the retail investor may disclose in connection with the recommendation or advice; and
• having a reasonable basis to conclude that the recommendation or advice provided is in the retail investor’s best interest.

The Bulletin states that whether a recommendation or advice satisfies the Care Obligations is an objective evaluation, which turns on the facts and circumstances of the particular recommendation or advice and the investment profile of the retail investor at the time the recommendation is made or the advice is provided. While Reg BI and the IA fiduciary standard remain distinct obligations, the Bulletin suggests equivalence between the Care Obligations under both standards.

The Bulletin focuses on the following five criteria:
 

1. Understanding the Investment or Investment Strategy

   Investment advisers, broker-dealers and their financial professionals need to understand the investments and investment strategies on which they are advising before advising or recommending them to their retail investors. They need to understand the potential risks, rewards and costs of the investments or investment strategies so they have a reasonable basis to conclude that the recommendation or advice is in the retail investor’s best interest. The following non-exhaustive factors should be considered in evaluating an investment’s or strategy’s potential risks, rewards and costs: objectives of the investment, ongoing costs, key characteristics and risks, likely market performance, expected returns and payout rates, unusual features, and the role of the investment strategy within the context of the investor’s actual or anticipated investment portfolio.
   
   Where there is an ongoing monitoring obligation, the reasonable investigation will require continued analysis after purchase of the investment and over the course of the relationship.
   
   While cost is not the only consideration, it is a factor that firms and financial professionals must consider when providing a recommendation or advice to a retail investor. The “total potential costs” should be evaluated, including, “commissions, markups or markdowns, and other transaction costs; sales loads or charges; advisory or management fees; other fees or expenses that may affect a retail investor’s return…; trading and other costs associated with an investment strategy…; costs of exiting an investment or investment strategy…; any relevant tax considerations; and the likely impacts of those costs over the retail investor’s expected time horizon.” In other words, an analysis of costs should include costs beyond the explicit costs disclosed on a trade confirmation or account statement.
   
   Among firm duties under their Care Obligations is to provide their financial professionals with sufficient information and training so that they understand the investments and investment strategies they recommend or on which they advise. Financial professionals cannot satisfy their own Care Obligations solely by relying on the efforts of others at their firm.
    

2. Understanding the Retail Investor’s Investment Profile

   Obtaining and evaluating information about the retail investor's “investment profile” is a critical step to satisfying a firm’s Care Obligations. Firms and their financial professionals should make reasonable efforts to collect this information, with the reasonableness of the effort dependent on the specific facts and circumstances of the particular situation. Firms also must have a reasonable basis to believe that their recommendations or advice are not based on materially inaccurate, incomplete, or outdated information about the retail investor.
   
   Among other things, firms should seek to obtain and consider the investor's “financial situation… and needs; investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objective and financial goals; and any other information the retail investor may disclose” in connection with the recommendation or advice. Broker-dealers generally must periodically attempt to update customer account information and investment advisers generally must update an investor’s investment profile in order to maintain a current understanding of the client’s objectives and adjust the advice to reflect any changed circumstances.
   
   If investor information is unavailable despite reasonable diligence to obtain it, firms should carefully consider whether they have a sufficient understanding about the retail investor to evaluate if a recommendation or advice is in that retail investor’s best interest. Without sufficient information, firms generally should decline to provide recommendations or advice until they obtain necessary investor information.
    

3. Considering Reasonably Available Alternatives

   A “key component” of satisfying the Care Obligations of broker-dealers and investment advisers is consideration of alternatives that are reasonably available to achieve an investor’s objective. Indeed, it would be difficult for firms and their financial professionals to form a reasonable basis to believe a recommendation or advice is in its investor’s best interest without considering alternatives. What constitutes reasonable consideration of available alternatives will depend on facts and circumstances. Firms should have a “reasonable process for establishing and understanding the scope of reasonably available alternatives” that should be considered as part of satisfying their Care Obligations. Consideration of reasonable alternatives should begin early in the process of formulating recommendations and providing advice, and should not be done as a “retrospective exercise.”
   
   Once reasonably available alternatives have been identified that are consistent with the investor’s investment profile, firms should have a reasonable process in place for evaluating those alternatives. The process should include guidance to firm financial professionals that define the “scope of alternatives” to be considered in evaluating available alternatives. Firms and their financial professionals need to be able to evaluate a range of potential alternatives sufficient to have a reasonable basis to believe a recommendation is in the best interest of the investor.
   
   The Bulletin notes that investment advisers who are engaged in providing ongoing investment advice should “periodically” review the investment options they have recommended to a client and consider whether they are in that client’s best interest and whether other investment options may better serve their clients’ interests.
   
   When considering available alternatives, it might well be that a firm or its financial professionals conclude that no investment or investment strategy they offer is in the retail investor’s best interest. If that occurs, the firm and its financial professionals would not satisfy their Care Obligations were they to recommend or advise any of those investments or investment strategies to the retail investor.
   
   While there is no requirement that firms document the evaluation of reasonably available alternatives, the Bulletin notes that it might be difficult for a firm to demonstrate compliance with its Care Obligations without documenting the basis for certain recommendations.
    

4. Special Considerations: Complex or Risky Products

   Neither Reg BI nor the IA fiduciary standard prohibits recommendations of, or advice about, complex or risky products to retail investors where there is a reasonable basis to believe such recommendation or advice are in the best interest of the retail investor. That said, firms and financial professionals should consider whether less complex, less risky or lower cost alternatives can achieve the same objectives for their retail customers as part of their “overall reasonable basis analysis.” Moreover, firms and their financial professionals should apply “heightened scrutiny” to complex or risky products.
   
   Examples of complex or risky products where heightened scrutiny may be necessary include: “inverse or leveraged exchange-traded products, investments traded on margin, derivatives, crypto asset securities, penny stocks, private placements, asset-backed securities, volatility-linked exchange-traded products, and reverse convertible notes.”
   
   Heightened scrutiny includes (a) obtaining information about the retail investor that supports a conclusion that a complex or risky product is in that retail investor’s best interest; and (b) determining whether the retail investor has a specific trading objective that is consistent with the product’s description and/or has the ability to withstand heightened risk of financial loss.
   
   Firms that recommend complex or risky projects should establish procedures designed to address recommendations of, or advice about, those products. Procedures should include (a) a due diligence process; (b) appropriate training and supervision of financial professionals to help them better understand the features, risks and costs of complex financial products; and (c) determining whether lower risk or less complex options can achieve its same investment objectives. Firms that recommend complex or risky products should document the reasoning behind the particular recommendation.
   
   Firms that have an obligation to monitor investor accounts should establish procedures for ongoing evaluation of the complex or risky products held by retail investors to ensure they continue to be in the investor’s best interest.
    

5. Special Considerations: Recommendations and Advice by Dual Registrants

   Whether Reg Bl or the IA fiduciary standard applies to a recommendation by a dually registered firm and/or financial professional depends on facts and circumstances, including an analysis of “the type of account, how the account is described, the type of compensation, and the extent to which the dually registered firm and financial professional made clear to the customer or client the capacity in which they were acting.” The disclosure obligations of both Reg Bl and the IA fiduciary standard require a firm or financial professional to disclose to the retail investor the capacity in which the firm or financial professional is acting. However, the Bulletin points out that the “disclosure of capacity may not be determinative if the facts and circumstances suggest the financial professional was acting in a different capacity from the one disclosed.”
   
   Although the specific application of Reg Bl and the IA 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.”
   
   Dually registered firms must consider whether a recommendation of an investment or investment strategy is better suited for the investor’s brokerage or advisory account. This process should include consideration of the difference in costs, including, commissions, advisory fees on assets under management, and tax consequences over the life of the investment.
    

Conclusion

The Bulletin reiterates the seriousness of the SEC’s focus on the duties owed to retail investors – whether that duty is owed by a broker-dealer or an investment adviser. While the specific application of Reg BI (for broker-dealers) and the IA fiduciary standard (for investment advisers) may differ in some respects, they generally yield substantially similar results in terms of the ultimate responsibility for the Care Obligations owed to retail investors. To demonstrate compliance with Care Obligations, firms would be well advised to document (a) their understanding of the products they recommend or on which they advise; (b) information regarding their understanding of investor profiles and objectives; and (c) the basis for their recommendations made or advice given and their conclusion that the recommendation or advice is in the client’s best interest.


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If you have any questions regarding the Care Obligations you owe to your clients, please contact Meryl Wiener (mwiener@wbny.com or 212-984-7731), any of the undersigned, or your regular Warshaw Burstein attorney.

Frederick R. Cummings, Jr.
fcummings@wbny.com
212-984-7807

Jason Diener
jdiener@wbny.com
212-984-7797

Thomas Filardo
tfilardo@wbny.com
212-984-7806

Marshall N. Lester
mlester@wbny.com
212-984-7849

Stephen W. Semian
ssemian@wbny.com
212-984-7764

Martin S. Siegel
msiegel@wbny.com
212-984-7741

Meryl E. Wiener
mwiener@wbny.com
212-984-7731