On April 20, 2023, the staff of the Securities and Exchange
Commission (the “SEC”) published an FAQ-style
bulletin1 that provides guidance on the care obligations
of broker-dealers and investment advisers in providing investment
advice and recommendations to retail investors. The bulletin
emphasizes the importance of complying with the Care Obligation of
Regulation Best Interest (“Reg BI”) for broker-dealers
and the duty of care enforced under the Investment Advisers Act of
1940, as amended (the “IA fiduciary standard”) for
investment advisers (together, the “care obligations”).
The care obligations are drawn from key fiduciary principles,
including an obligation to act in the retail investor’s best
interest and not to place the fiduciary’s interests ahead of
the investor’s interest.
The care obligations generally include the following three
components:
- understanding the potential risks, rewards, and costs
associated with an investment or investment strategy, - having a reasonable understanding of the specific retail
investor’s investment profile, and - having a reasonable basis to conclude that the recommendation
or advice provided is in the retail investor’s best
interest.
The evaluation of whether a recommendation or advice satisfies
the care obligations is an objective evaluation based on the facts
and circumstances of the particular recommendation or advice and
the investment profile of the particular retail investor at the
time the recommendation is made or when the advice is provided.
The bulletin is intended to assist firms and their financial
professionals in meeting their care obligations to provide advice
and recommendations in the best interest of retail investors. The
bulletin should be read in conjunction with other relevant sources,
including Reg BI and the specific SEC releases discussing Reg
BI2 and the IA fiduciary standard3.
While the bulletin focuses primarily on advisers and
broker-dealers interacting with retail investors, many of the
points of focus highlighted in the bulletin, including an emphasis
on evaluation of the costs of certain products and the need for
“heightened scrutiny” of more risky or complex
structures, appear focused on alternative investment products,
including non-traded business development companies
(“BDCs”) and registered tender offer and interval fund
products that have increased in popularity over the past several
years. As a result, the bulletin and the staff views that it
describes also likely will impact the marketing of alternative
investment regulated fund products to high-net-worth investors
through traditional financial adviser and broker-dealer
channels.
I. Understanding the Investment or Investment Strategy
Under the care obligations, investment advisers, broker-dealers,
and their financial professionals need to understand the
investments and investment strategies on which they advise or which
they recommend to retail investors. To have a reasonable basis to
believe that their advice or recommendation is in the retail
investor’s best interest, they must develop a sufficient
understanding of the potential risks, rewards, and costs of the
investment or investment strategy.
The non-exhaustive list of factors that firms and financial
professionals need to consider to develop such an understanding of
an investment or investment strategy include:
- its objectives,
- costs (including direct and indirect costs),
- key characteristics and risks,
- likely performance in different market and economic
conditions, - expected returns,
- expected payout rates,
- potential losses,
- any special or unusual features, and
- its role within the context of the investor’s actual or
anticipated investment portfolio.
Where there is an ongoing monitoring obligation, the reasonable
investigation also requires continued analysis after the purchase
of the investment and over the course of the relationship.
While costs should not be the only consideration, firms and
financial professionals must always consider costs as a factor when
providing advice or recommending an investment to a retail
investor. The total potential costs should be evaluated, including
direct and indirect costs, commissions, markups or markdowns, sales
loads or charges, advisory or management fees, other fees or
expenses that may affect a retail investor’s return, and the
trading and other costs associated with an investment strategy. In
the staff’s view, an analysis of costs should include costs
beyond the explicit costs disclosed on a trade confirmation or
account statement. Accordingly, certain alternative investment
products, including non-traded BDCs and registered tender offer and
interval funds, may face greater scrutiny as a result of their
typically higher fees and expenses when compared to mutual funds or
exchange-traded products.
Firms should provide financial professionals with sufficient
information and training to understand the investments and
investment strategies they recommend. While care obligations apply
at both a firm and individual level, financial professionals cannot
solely rely on the efforts of others at their firm to satisfy their
own care obligations and must personally understand the investment
or investment strategy.
II. Understanding the Retail Investor’s Investment
Profile
The bulletin discusses the importance of understanding an
investor’s “investment profile” to satisfy care
obligations. An investment profile refers to information about the
retail investor, which a financial professional should make
reasonable efforts to ascertain. To establish a reasonable
understanding of the investor’s profile, information such as
their financial situation, investments, assets and debts, tax
status, age, investment time horizon, risk tolerance, and financial
goals should be considered. The information is not exhaustive, and
additional or different factors may be considered.
Broker-dealers and advisers must have sufficient information to
make recommendations or provide advice, and the profile may need to
be updated regularly to comply with their respective obligations.
If the investor’s information is unavailable, broker-dealers
and advisers should carefully consider whether they have a
sufficient understanding of the investor to provide recommendations
or advice. The tax status of the investor or account is also an
important consideration when selecting or providing advice on a
particular investment or investment strategy relative to other
options.
III. Considering Reasonably Available Alternatives
The bulletin suggests that investment advisers, like
broker-dealers, should consider reasonably available alternatives
when providing investment advice to retail investors. In the
staff’s view, what constitutes a reasonable consideration of
available alternatives will ultimately depend on a particular
investor’s profile and the nature and circumstances of the firm
(including a firm’s use of open architecture frameworks and
limited investment menus). A reasonable recommendation process
should include guidelines for the firm’s financial
professionals that define the scope of alternatives that should be
considered and the factors that should be weighed. Moreover, the
process of considering available alternatives should start early
when formulating a recommendation, rather than being a
retrospective exercise.
The staff also notes that, although there is no requirement for
firms to document the evaluation of reasonably available
alternatives, “it may be difficult for a firm to demonstrate
compliance with its obligations to retail investors, or
periodically assess the adequacy and effectiveness of its written
policies and procedures, without documenting the basis for certain
recommendations.” The staff emphasized that such documentation
may be particularly important where a recommendation seems to
conflict with an investor’s investment objectives or poses
conflicts of interest for the firm or financial professional.
IV. Special Considerations: Complex or Risky Products
Firms and financial professionals should apply “heightened
scrutiny” when considering whether a complex or risky product
is in a retail investor’s best interest. Examples of risky or
complex products 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. The staff recommends that firms
establish procedures specifically designed to address
recommendations, or advice about, complex or risky products. This
includes due diligence processes, appropriate training and
supervision, evaluating reasonably available alternatives
(including lower risk or less complex options), and documenting the
process and reasoning behind the particular recommendation or
advice. While many alternative investment products in the
registered fund space may fall outside the scope of what the staff
considers “complex” or “risky,” the lack of
clear bright lines for when “heightened scrutiny” would
apply could cause some uncertainty with respect to its
applicability to regulated fund products such as non-traded BDCs or
other non-traded registered fund products that may use significant
leverage or derivatives as a material portion of their investment
process.
V. Special Considerations: Recommendations and Advice by Dual
Registrants
Whether Reg BI or the IA fiduciary standard applies to a dually
registered firm and/or financial professional depends on a facts
and circumstances analysis, including factors such as the type of
account, how the account is described, the type of compensation,
and the extent to which the firm or financial professional
disclosed to the customer or client the capacity in which they were
acting. The staff caveats 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. Ultimately, both the Reg BI and the IA fiduciary
standard yield similar results in terms of the responsibilities
owed to retail investors.
Dually registered firms and dually licensed financial
professionals have an obligation to consider whether an investment
or investment strategy is more appropriate for a retail
investor’s brokerage account or advisory account when providing
recommendations or advice. This process should include
consideration of the difference in reasonably expected total costs
depending on whether the investment or investment strategy is held
in the retail investor’s brokerage or advisory account,
including account-level costs such as commissions, advisory fees on
assets under management, or tax consequences over the expected life
of the investment. The financial professional should have a
reasonable basis to believe that the recommendation or advice is in
the best interest of the retail investor and not based on
materially inaccurate or incomplete information.
Key Takeaways
While the bulletin and similar guidance are not “a rule,
regulation or statement” of the SEC and have “no legal
force and effect,” broker-dealers and investment advisers
should consider the guidance in light of the SEC’s increased
focus on care obligations. The SEC’s 2023 exam priorities
advised that the SEC will continue to prioritize examinations of
broker-dealers and investment advisers to ensure that retail
investors are receiving recommendations in their best interests. In
this regard, the SEC notes that broker-dealers and
dually-registered investment advisers are an area of continued
interest, as are affiliated firms with financial professionals that
service both brokerage customers and advisory clients.
Broker-dealers and investment advisers would be well-served to take
note of staff recommendations in the bulletin, particularly with
respect to implementing and documenting appropriate processes for
advising retail investors. Additionally, when adopting and
implementing reasonably designed policies and procedures regarding
their care obligations, broker-dealers and investment advisers
should tailor those policies and procedures, taking into
consideration their particular business models and relationships
with retail investors.
Separately, sponsors of existing or proposed alternative
investment regulated fund products, including non-traded BDCs and
registered tender offer and interval funds, should consider whether
their investment strategy and structure may cause their regulated
fund products to be viewed as “complex” or
“risky,” and therefore subject to heightened scrutiny.
Similarly, such sponsors may wish to consider updating offering
documents and other marketing materials to address potential
concerns regarding the aggregate fees and expenses of such
alternative investment regulated fund products, along with the
other key factors highlighted by the staff in the bulletin. In
particular, while the bulletin could lead to greater scrutiny of
certain non-traded BDCs and registered tender offer and interval
fund products by both advisers and broker-dealers seeking to invest
client assets, it also may provide an opportunity for certain
sponsors to differentiate their alternative investment products to
those retail advisers and broker-dealers by addressing the points
discussed in the bulletin.
Footnotes
1. Staff Bulletin: Standards of Conduct for
Broker-Dealers and Investment Advisers Care Obligations (Apr. 20,
2023), available at SEC.gov | Staff Bulletin [1]: Standards of Conduct
for Broker-Dealers and Investment AdvisersCare
Obligations.
2. Exchange Act rule 15l-1; Regulation Best Interest: The Broker-Dealer
Standard of Conduct, Exchange Act Release No. 86031, 84 FR
33318, 33320-21 (June 5, 2019).
3. Commission Interpretation Regarding Standard of
Conduct for Investment Advisers, Investment Advisers Act
Release No. 5248, 84 FR 33669, 33669 n.7, 33672 (June 5,
2019).
SEC Staff Issues Bulletin On The Care Obligations Of Advisers And
Broker-Dealers To Retail Investors
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