By Joe Sisti and Patrick M. Dennis
Reg BI – The Care Obligation
In this episode, Oyster experts discuss the Regulation Best Interest (Reg BI) Care Obligation and factors to consider when making recommendations, “Reasonable Available Alternatives,” account selection and rollover recommendations.
Welcome to this week serving of Oyster Stew, a mix of financial services, commentary and insight. Each week we’ll discuss what is happening in the industry based on what we see as we work with regulators and clients. We hope you come away with the knowledge and tools to help you make the best decisions for your firm’s future. You can learn more about Oyster Consulting and the value we can add to your firm by going to our website, www.oysterllc.com.
Patrick Dennis: 0:33
All right , this is Patrick Dennis with Oyster Consulting. I am here today with Joseph Sisti and Bob Tuch, both of whom are senior consultants with Oyster. This is the third in a series of five podcasts that Oyster is doing in connection with Reg BI, and, if you haven’t had a chance, you can go back and listen to the other podcasts. Reg BI is relatively complicated. There’s a lot to it. The first couple of times you read through it, you may not get that or understand how complicated are all of the things you need to do. But we’re here today to talk specifically about the Care Obligation, which is one of the four obligations under Reg BI. So with that, I’ll let Bob talk about the summary of the requirements for the Care Obligation and we’ll go from there.
Bob Tuch: 1:34
Thank you. Patrick. Reg BI contains a general requirement that applies to broker-dealer personnel when they make recommendations to retail customers. This general requirement imposes a standard of care when t here’s a recommendation of any securities, transaction or investment strategy involving securities. When broker-dealer personnel make these recommendations, they must act in the best interest of the retail customer at the time of the recommendation without placing the financial or other interests of the firm or the firm’s representatives ahead of the interests of the customer. This standard of care must also be met when broker-dealer personnel make account recommendations, including recommendations to r ollover or transfer assets in a workplace retirement plan to an IRA, and recommendations to take a plan distribution. And finally, the standard of care must also be adhered to in connection with implicit hold recommendations that result from agreed upon account monitoring to supplement this general standard of care requirement. Reg BI imposes additional obligations in the form of a Disclosure Obligation, the Care Obligation that we’ll be addressing in some detail today, a Conflicts of Interest Obligation that requires policies and procedures that are reasonably designed to identify, disclose and manage conflicts of interest, and finally a Compliance Obligation that requires written policies and procedures designed to achieve compliance with reg BI. With that general overview in mind, let’s focus on the Care Obligation. The Care Obligation requires broker-dealer personnel to exercise reasonable diligence, care and skill to achieve the following when making recommendations to retail customers: First, understand the potential risks, rewards and costs associated with the recommendation and have a reasonable basis to believe that their recommendation could be in the best interest of some of the firm’s retail customers. Next, have a reasonable basis to believe that their recommendation is in the best interest of a particular retail customer based on that customer’s investment profile and the potential risks, rewards and costs associated with the recommendation, and refrain from placing the financial or other interests of the firm or from representatives ahead of the interest of the customer. And finally, having a reasonable basis to believe that a series of recommended transactions, even if they are all in the customer’s best interest when viewed in isolation, is not extensive and is in the customer’s best interest when taken together in light of a customer’s investment profile, and does not place the financial or other interests of the firm over the interest of the customer.
Patrick Dennis: 4:30
Thanks for that. Bob, would you mind giving us a little bit more detail on the important factors to keep in mind when you’re talking about the Care Obligation under reg BI?
Bob Tuch: 4:41
Sure. First, let me mention that the best interest standard doesn’t necessarily require the lowest cost option. While cost is clearly a very important factor that always needs to be taken into consideration, it is not the only one. Here are a few more things to keep in mind. What constitutes reasonable diligence, care and skill will vary depending on all relevant factors to be considered. Firms should consider reasonably available alternatives as part of having a reasonable basis to believe that a recommendation is in the best interest of a retail customer. Next, the SEC has no intent to limit or foreclose recommendations of complex or more costly products or strategies when there’s a reasonable basis to believe that these recommendations could be in a retail customer’s best interest . A quick example here: a firm may have a retail customer who expresses an interest in having exposure within a certain asset class. It may result in having a portfolio of securities that are somewhat complex or have limited liquidity. If the customer demonstrates a good understanding of the risks involved and has a strong desire to own these, recommendation of particular securities within the desired asset class could very well meet the best interest standard. Another important consideration is taking a risk-based approach when deciding whether or not to document an evaluation of a recommendation and the basis for the particular recommendation . This could take place, for example , when the recommendation is of a complex product or where a recommendation may seem inconsistent with a customer’s investment objective on its face. When a firm determines not to obtain or analyze one or more of the factors specifically identified in the SEC’s definition of retail customer investment profile, the firm should document it’s determination that a factor is not a relevant component of a customer’s investment profile in light of t he facts and circumstances related to the particular recommendation. And finally, when recommending that a customer open an IRA account, or rollover assets to an IRA account, rather than keeping assets in or moving assets to a workplace retirement plan, firms should consider a variety of factors. We’ll have more on that later.
Patrick Dennis: 7:16
Thanks Bob. That was great to hear about the important things that people should keep in mind when they’re making these recommendations. And now I want to turn it over to Joe, if you don’t mind. Joe, could you talk to us about the factors that registered reps should consider when making a recommendation to a retail client?
Joe Sist: 7:33
Sure. Patrick. I think the first factor to consider when making a recommendation is that the recommendations you’re thinking of suggesting to your retail customers must not only be suitable for that customer, but come July 2020, recommendations must be in the best interest of that customer. So, what does that mean and how do you comply with the rule? Well, the SEC has listed a number of important factors to consider based on the retail customer’s investment profile. However, we know deciding whether or not to recommend a security or investment strategy entails much more than just considering a customer’s investment profile. As Bob mentioned earlier, we think broker-dealers should take a risk-based approach and they should document the basis for their recommendations in those situations where the securities or strategies are not aligned with the customer’s investment profile. So with that being said, some factors may carry more or less weight depending on whether the registered representative feels they have a reasonable basis for determining if a recommendation is in the customer’s best interest. There really has been a lot written on the rule already, but the guidance doesn’t provide an exhaustive list of factors to consider. You’re not checking boxes here, so I think there’s a lot of flexibility for firms to consider when trying to adopt their policies and procedures to fit their business and comply with the rule. I really want to emphasize the importance of analyzing enough information to have a reasonable basis for believing that a recommendation is in the customer’s best interest. Broker-dealer s should consider factors included in the customer’s investment profile, of course including risk tolerance and investment time horizon, but they should also realize that cost is clearly a focus of the rule and of the regulators. There are multiple factors that can be used to make a reasonable decision, and cost definitely should be one of them. I also think that having a complete updated customer investment profile on file should also be considered. While that may not be an issue for many broker-dealers, it clearly should be a focus for others. I would also note the guidance suggest that specific post-trade exception reports be created by compliance to identify specific trades for review with a focus on the Care Obligation. The key here is that there really is a lot for broker-dealers to consider in the months ahead. Policies and procedures will have to be created or amended. Post-trade exception reports will have to be created, training for associated persons, as suggested. All of this aligned with the risk-based approach to documenting recommendations where appropriate.
Patrick Dennis: 10:11
So Joe, it sounds like, as we’ve always heard or were frequently reminded in terms of regulatory obligations, is that documentation is key. Is that appropriate here as well?
Joe Sist: 10:26
It definitely will be, but most certainly in those instances where the recommendation is not aligned with the client’s investment profile. I think that’s a critical feature of this. I wouldn’t say that every single recommendation needs to be documented, but those that don’t clearly align, or where there’s some question, I would recommend that.
Patrick Dennis: 10:45
Thanks Joe. Let me ask you this. What kind of alternatives are available or suitable for clients? When you’re talking about, you know, one of the things is reasonably available alternatives, how do you make that determination?
Joe Sist: 10:59
Well, I think it’s important that broker-dealers spend some time evaluating the available product offerings at the firm to determine whether what is available gives their registered representatives a reasonable basis to make a recommendation in the best interest of their customers. It’s important to understand that having reasonably available alternatives does not mean that a broker-dealer has to evaluate every possible alternative out there. The goal of the rule is not to ask registered representatives to recommend the single best of all possible alternatives. That wouldn’t be fair to anyone. But instead, I think the broker-dealers should ensure that their registered representatives understand the potential risks, the rewards, the costs associated with a given recommendation. And one that is selected from the group of reasonably available alternatives. So what does this mean to you and your firm? Well, every broker is different. So the short answer is it means different things to different firms. I think some of the factors that should be considered are the firm’s customer base, the investment and services available to the registered representatives and any other products, specific limitations on certain investments that may apply to their customers. Finally, I think part of the firm’s training for associated persons should include helping them understand the products and investment strategies available, each of which that should be evaluated as reasonably available alternatives before making a recommendation to their retail customers.
Patrick Dennis: 12:34
Thanks, Joe. I think one of the things that we ought to remind folks is, while the reasonably available alternative standard is one factor, when you’re looking at the States and various States, particularly in New Jersey, Massachusetts, depending on where Nevada goes with this , their standards essentially require you to use or to select the best of the reasonably available alternatives. More on that later, but frankly, it’s just something that folks need to keep in mind and we’ll see where the States come out on this. Joe, can you give us your thoughts on how to go about or how to make the right account selection or recommendation to clients in this context?
Joe Sist: 13:24
Sure. Come June 30th, 2020, Patrick, the Care Obligation will require broker-dealers to have a reasonable basis to believe that the recommendation is not only in the best interest of the customer, but that the specific security account type is also in the best interest of the customer. So some of the factors to consider here are the services and products provided in the account, the projected cost to the customer of the account, any alternative account types that may be available to the customer. Of course, the services specifically requested by the customer, and the customer’s investment profile. For dual registrants I think there’s some more variables here. An associated person would need to make an evaluation of the entire spectrum of account types offered and not just brokerage accounts. I think it’s pretty reasonable to assume that there may be instances where it may be in the customer’s best interest to have both a brokerage account and an advisory fee based account. For advisory accounts with this established by dual registrants, firms should also periodically review them to determine whether they remain appropriate over time. Firms should consider documenting their review to validate the appropriateness of the investment advisory services that have been provided. And in those instances where firms monitoring determines there may be an issue, firms should establish a process to potentially convert advisory back to a brokerage account. One last thing I think we should consider is that in a recent enforcement action, a large well established dual registrant was sanctioned because the monitoring process and its policies and procedures was not followed. It resulted in a significant number of reverse churning occurrences. This is certainly something I think firms should be aware of when trying to comply with this aspect of the Care Obligation.
Patrick Dennis: 15:17
We’ve learned through the reverse churning fee, in lieu of commission investigations and sanctions and all those things, that Reg BI is not going to bail you out from making sure that your clients are in the appropriate type of account, whether it’s a commission based account or a fee based account for dual registrants . And you still owe the client the obligation of giving them a best cost alternative between a commission based account and a fee based account on the investment advisory side. Correct?
Joe Sist: 15:52
Yeah, that’s true. I agree with that 100%.
Patrick Dennis: 15:55
Well with that we’d like to turn back to both Joe and Bob to talk about rollover recommendations, which is obviously an important factor in Reg BI because of the emphasis and scrutiny that accounts, IRAs and retirement accounts get. So if you guys could help us understand some of those issues, that’d be great.
Bob Tuch: 16:19
Yes. Thank you Patrick. I’ll go ahead and get us started on this. When determining how to go about enhancing your policies and procedures relating to IRA rollover recommendations, a good starting point would be FINRA Reg Notice 13-45. This notice reminded FINRA members of the options that may be available to retail customers who are participants in an employer-sponsored retirement plan , and terminate their employment. Those options include leaving the money in the former employer’s plan if permitted; rolling over the assets to a new employer’s plan if one is available and rollovers are permitted; rolling over the assets into an IRA; and, cashing out the account value. The notice indicates that these options offer advantages and disadvantages depending on desire to investment options and services, fees and expenses, withdrawal options, required minimum distributions, tax treatment, and the investor’s unique financial needs and retirement plans. We can recommend best practices in this space given our experience, including our engagements, advising firms that they’re preparing to comply with the Department of Labor’s Fiduciary Rule. Despite the fate of that rule, which was vacated in March of last year, we benefited from DOL interpretive guidance related to the evaluation of relevant factors when contemplating an IRA rollover recommendation. That evaluation process will need to be comprehensive and includes such things as obtaining relevant employer plan information, considering fees and expenses associated with the employer plan and the proposed IRA, and evaluating the level of services and the underlying investments that are available under each option.
Patrick Dennis: 18:15
Thanks Bob for that insight. So Joe, could you spend a couple of minutes and explain how Oyster can help firms deal with not only the Care Obligation, but all of the obligations and challenges put in place by Reg BI?
Joe Sist: 18:33
I’d be happy to, Patrick. I really do think there’s a lot we can do. We certainly can help them review and enhance their policies and procedures. We can help them review their product offerings for customers to help meet their needs. We can assist in evaluating reasonably available alternatives and also identifying considerations for recommending things like appropriate account types and recommending an IRA account or the rollover of assets into an IRA. Our focus here is really been on the Care Obligation, but as you know, there are other obligations out there and there are many other facets to the rule that also may require assistance. I think we are well-prepared to assist with each of those. And in discussing this topic, we clearly have highlighted some of the areas we can help with the Care Obligation.
Patrick Dennis: 19:24
Thanks Joe. I know that there are certainly a lot of other things that need to be done. Clearly one of them is identifying the conflicts of interest and making sure that you disclose all the conflicts, or remediate or eliminate the conflicts of interest, which is another area that I think we can help on. So far we’re seeing one of the bigger challenges for firms . But with that, I would like to thank both Joe Sisti and Bob Tuch for all the time and effort they put into helping us with this podcast. Once again, this is the third in a series of five podcasts dealing with Reg BI. You can certainly access the prior ones through our website and stay tuned for the upcoming podcasts on Reg BI. Thanks.