Reg Bi bulletin mentions alternatives to risky, complex investments

Look for alternatives to crypto, other risky plays: 5 takeaways from SEC Reg BI bulletin

April 21, 2023 4:53 PM

Brokers need to carefully consider alternatives before recommending cryptocurrencies, asset-backed securities and other risky and complex products.

And if they're at a firm that also happens to be a registered investment advisor, they need to make sure they are charging their clients in a way that serves their interests.

Those are two big takeaways from a staff bulletin the Securities and Exchange Commission began circulating on Thursday. The SEC, which oversees large parts of the wealth management industry, issued the bulletin as the last of three guidance documents it planned to circulate following the adoption of Regulation Best Interest for the broker-dealer industry in June 2019.

This time, the SEC is calling to attention to what it calls the duty of care, a responsibility to look out for clients' best interests using a reasonable understanding of their objectives. The previous two bulletins dealt with account recommendations, including 401(k) rollovers, and avoiding conflicts of interest.

The SEC's general goal is to shed light on brokers' obligations under Regulation Best Interest, which is often characterized as weaker than the fiduciary duties governing financial advisors' conduct. But both standards call on financial planners to look out for their clients' best interests, to eliminate conflicts of interest as much as possible and to disclose any unavoidable conflicts.

SEC officials said Thursday there is one big difference. Regulation Best Interest, or Reg BI for short, applies only at the time that a broker is recommending an investment or helping to complete a transaction for an investor. The fiduciary standard applies throughout an advisor's entire relationship with clients.

The SEC has so far brought one enforcement case under Reg BI and the Financial Industry Regulatory Authority, the brokerage industry's self-regulator, has initiated only a few more. Regulators have said they are planning to get stricter about Reg BI violations this year.

SEC officials said Thursday the latest staff bulletin is a further indication of what advisors and brokerages need to do if they want to stay on the right side of the law. Here are some of their tips:

There is an alternative

When the SEC was adopting Reg BI, one of the biggest changes the regulator noted was a requirement for brokers to seriously consider alternatives to any investment they are planning to recommend. Before Reg BI, brokerage representatives were safe to put forward investment strategies they merely deemed "suitable," even if they hadn't taken the time to compare them with other options.

Now brokers join advisors in having to weigh the pros and cons of alternatives. In its staff bulletin, the SEC said planners should start their reviews at the outset of their work on a particular investment strategy and not undertake them retroactively to justify a choice that's already been made.

They also expect breadth. It most likely will not be enough to look merely at the different class shares offered by a particular mutual fund, for instance, and then recommend the one that seems best for a client. Rather, advisors should be looking at all the different types of investments that are on offer through their firms.

Mark Quinn, the director of regulatory affairs at the broker network Cetera Financial Group, said firms should strongly consider adopting formal procedures spelling out what advisors and brokers have to do to meet their obligation to compare different investment options.

He said Cetea has turned for help in this regard to the financial technology company CapitalROCK. It offers an automated system called RightBRIDGE to review various investment options and determine which are likely to be in clients' best interests.

"Maybe at a small firm, there's no need for something like this," Quinn said. "But at a large firm with hundreds and hundreds of mutual funds and annuities and everything else, I don't see how you can manage without a more defined process."

The SEC said there is no requirement to document why particular choices were made but recommended advisors and brokers do so anyway.

"In the staff's view, 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," according to the bulletin.

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Heightened scrutiny

There's nothing in Reg BI or the fiduciary standard that says brokers and advisors can't recommend complex and possibly obscure products to clients. Cryptocurrencies and other digital assets, derivatives, private funds, asset-backed securities and assets bought using borrowed money — on margin — are all fair game.

But, before planners suggest any of these to clients, they need to subject them to what the SEC deems "heightened scrutiny." This in part means they need to go to even greater lengths than they normally would to understand the risks and possible benefits of any complex product they're considering. The mere fact that investors express interest in crypto doesn't necessarily mean an advisor or broker would be justified in putting their money in Bitcoin or some other digital asset.

Christine Lazaro, the director of the Securities Arbitration Clinic at St. John's University in New York, said the bulletin is the first statement she has seen from the SEC explicitly stating that alternatives to risky and complex products don't have to be perfect matches.

"We often see complex products that are being hyped for their potential income while basically ignoring the risk," she said. "This says you should also be considering products that might have less income but also substantially less risk."

Before recommending a risky and complex investment, according to the SEC, advisors and brokers should make sure their clients state some sort of identifiable investment goal that can be met only through that sort of product. It also said planners should avoid risky investments unless they've determined their clients have the wherewithal to shoulder potential losses.

Above all, according to the bulletin, "the staff believes firms should consider whether lower risk or less complex options can achieve the same investment objectives."

Profiling

For many advisors and brokers, the SEC's bulletin will make some seemingly obvious points. Do they need to have a thorough understanding of any investment they're recommending? Yes. Should they have an equally thorough understanding of their clients' needs and investing goals? Check there, too.

But the SEC's bulletin goes a step further and lays out some specific questions advisors and brokers need to be asking. With investments, do they understand the goals behind a particular investment strategy? Is it, for instance, meant to provide income, and is it designed to be held for a long or short term? What are the strategies and risks and how is it likely to perform in differing market conditions?

The SEC said the cost of an investment always has to be taken into account, although it is not the only consideration that matters. Advisors always have to weigh the benefits of a particular investment against commissions and other transaction fees, tax implications, costs associated with leaving a particular investment strategy and expenses their clients may have to bear.

The SEC also says brokers and advisors can't simply rely on lists of investment options compiled by others at their firm. Every planner is personally responsible for vetting any product or strategy they plan to put before clients.

Know thy client

The bulletin lays out similar questions brokers and advisors should be asking themselves about investors if they want to make sure they're fulfilling their duty of care. For every one of their clients, planners should be drawing up what the SEC deems investment profiles.

Many of the questions advisors should be asking are fairly obvious. What are a particular client's income, debts, marital status, investment goals, tax status and expected retirement age? Beyond that, the SEC recommends taking into account considerations like a person's preferred investment strategy. Is a given client a buy-and-hold long-term investor or someone who's interested in more frequent trading? Do clients prefer making their own investment decisions or are they happy to entrust that to an advisor or a broker?

The SEC cautions that compiling an investment profile is not a one-and-done exercise. Brokers who have repeat customers and advisors are both under an obligation to make sure their understanding of clients' financial situations is up to date.

Lazaro said the bulletin makes it clear that brokers and advisors are obliged to ask questions if they discover seeming inconsistencies in their clients' investment goals. If an investor who previously showed a low tolerance for risk suddenly expresses interest in day trading, planners can't simply ignore the change and proceed as if nothing happened.

"If there's a conflict in the investment profile, they have to find some way to reconcile it," Lazaro said.

The SEC's bulletin also takes up what planners should do if they can't obtain what they deem essential information about an investor. In such cases, the regulator said, it's better to walk away than make a recommendation that may prove not to be in the client's best interest.

Careful with those two hats

The SEC's bulletin also offers special advice for firms that are dually registered as both broker-dealers and investment advisors. Hybrid and dually registered wealth managers have become increasingly common in recent years, in part because having both sides of the business can present investors with more choices.

The SEC recommends planners at such firms always ask themselves if clients would be better served by making a particular investment through a brokerage account or an advisory account. Both have their pros and cons.

"For example, a retail investor whose objective is to buy and hold a long-term investment may be better off paying a one-time commission to a broker-dealer for the purchase of that investment rather than paying an ongoing advisory fee merely to hold the same investment," according to the bulletin.

Conversely, clients who want to engage in frequent trading may be better off paying an annual fee rather than commissions on every single transaction. Either way, a planner's foremost duty is to be upfront about if they're acting as a broker or an advisor with any given investment and to make sure clients know how they'll be charged.