04.26.22

SEC Adds More Meat to ‘Retail Standards’ Stew

by: Rich Blake

The list of new rule proposals coming from the U.S. Securities and Exchange Commission (SEC) keeps getting longer. The SEC has floated rules for distributing private funds, managing cybersecurity risks, making climate-related disclosures, investing in special purpose acquisition companies and referencing credit ratings and executing swaps – and that's just in the past few weeks.

Meanwhile, the agency at the end of March released its highly anticipated "2022 Examination Priorities" report. In it, the SEC underscored just how busy the Division of Examinations was last year. Some 3,040 examinations took place in 2021, an increase of 3% over 2020.

But for investment advisory teams, there was an even more crucial trove of compliance material recently published by the SEC. It came out at the end of March: a bulletin regarding specific parts of the financial advisory conduct rules known as Regulation Best Interest ("Reg BI") and also touching on some other rules tying into investment advisers’ (IA) fiduciary responsibility (which becomes all the more complicated when contrasted with the best interest standard as applied to broker-dealer representatives).

But what bears emphasis is how, at last, the SEC bulletin has "fleshed out what firms should consider in documenting two key components of a best interest recommendation," said securities lawyer Ben Marzouk, Partner, Eversheds Sutherland.

Those key components being, according to Marzouk, “cost” and “reasonable available alternative."

The Long and Winding Road

Approved in 2019, implemented one year later during the height of the pandemic, Reg BI has been debated and parsed, lambasted and heralded. It's been called overkill by some industry members, and some critics characterize the care standards catch-all as toothless.

Last May, then newly appointed SEC Chair Gary Gensler seemed to hint that the agency was possibly going to take a fresh look at the rules possibly set with an eye toward updating or augmenting it; meanwhile, Gensler also vowed to not only enforce it but to "get the most out of it."

The SEC issued its “Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors” on March 30, 2022.

Note that the phrase "Reg BI" is not used. The shorthand name for the specific topic to which the bulletin pertained, as the SEC noted, was "retail standards."

However, keep in mind one of the main elements of the Reg BI rules package was the “Commission Interpretation Regarding Standard of Conduct for Investment Advisers.”

A Convergence of Standards

Sandra Dawn Grannum of the law firm Faegre Drinker Biddle & Reath LLP hasgiven the new bulletin a thorough review in the context of Reg BI (as it pertains to conduct standards for Investment Advisers, or IA’s) while also considering previous guidance connected with related issues, such as when the SEC launched its initiatives aimed at making sure typical Main Street investors were not steered into more expensive mutual fund share classes.

Along the way, the SEC issued a FAQ, “Regarding Disclosure of Certain Financial Conflicts of Interest Related to Investment Adviser Compensation.” 

Grannum has tracked what she calls a "developing convergence" of the Reg BI and IA fiduciary standards as they apply to retail investors.

While the SEC retail standards bulletin does not suggest any updates to Reg BI, it does signal, Grannum explained, that the SEC staff will interpret these two sets of regulations as requiring similar efforts by firms when it comes to managing their conflicts of interest regarding recommendations to retail investors.

Two Key Components

The SEC issued its retail standards guidance in the form of an FAQ. As noted, two key components were fleshed out.

Here's one big question for starters: Are costs always a relevant factor to consider when making account recommendations?

Short answer: Yes.

Longer answer: "Yes, you must always consider cost as a factor when making an account recommendation," the SEC said. "While Reg BI and the IA fiduciary standard do not always obligate you to recommend the least expensive type of account, both require you to have a reasonable basis to believe that the account recommendation is in the retail investor’s best interest and does not place your or your firm’s interests ahead of the retail investor’s interest.”

Another big question: Do I need to consider reasonably available alternatives when making account recommendations?

Yes again.

"Under both Reg BI and the IA fiduciary standard, you may recommend an account to a retail investor only when you have a reasonable basis to believe that the account is in the retail investor’s best interest. For example, if you are a dually licensed financial professional, you need to make a best interest evaluation that takes into consideration the spectrum of accounts you offer (i.e, both brokerage and advisory accounts are subject to any eligibility requirements, such as account minimums).

“Moreover, you cannot recommend an account that is not in a retail investor’s best interest solely based on your firm’s limited product menu or arising from limitations on your licensing. Any limitations on account types considered, in the staff’s view, are material facts that should be disclosed (along with other relevant material facts, including services, fees and conflicts of interest) to retail investors.”