Here are some best practices to mitigate those risks.

The Securities and Exchange Commission’s Regulation Best Interest (Reg BI), effective June 30, 2020, imposes a general obligation that is satisfied when four obligations are met:

• The Disclosure Obligation;
• The Care Obligation;
• The Conflict of Interest Obligation; and,
• The Compliance Obligation.

The SEC’s Small Entity Compliance Guide for Reg BI provides a good general overview of these obligations.

This article highlights the obligations and litigation risks posed by the Care Obligation as well as recommended best practices to mitigate those risks.

Under the Care Obligation, broker-dealers and associated persons (advisors) must exercise reasonable diligence, care and skill when making a recommendation to a retail customer in order to:

• Understand the potential risks, rewards and costs associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some customers;
• Have a reasonable basis to believe the recommendation is in the customer’s interest based upon the customer’s investment profile and the potential risks, rewards and costs associated with the recommendation, and does not place the broker-dealer’s interests ahead of the customer’s interests; and
• Have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the customer’s best interest when taken together in light of the customer’s investment profile.

The Care Obligation imposes duties on broker-dealers and advisors that exceed current suitability requirements by requiring that:

• Recommendations be in the best interest of the customer and not place the broker-dealer’s interests ahead of the customer’s interests;
• Costs be considered when making the recommendation; and
• The obligations relate to a series of recommended transactions regardless of whether a broker-dealer exercises actual or de facto control over a customer’s account.

See SEC Release No. 34-86031 at 253-254. Also, “a broker-dealer should consider ‘reasonably available alternatives’ as part of having a ‘reasonable basis to believe’ that the recommendation is in the Customer’s best interest.

Reg-BI’s Care Obligation “enhancements” over existing suitability requirements are areas of additional litigation risk, and include, whether:

• The broker-dealer or advisor exercised the required “reasonable diligence, care, and skill” to meet the Care Obligation;
• The recommendation was in the best interest of the customer;
• The broker-dealer or Advisor put their interests ahead of the customer’s interests; and
• The firm had reasonable policies and procedures to ensure compliance with these requirements.

An additional litigation risk involves whether a broker-dealer or advisor adequately considered the potential costs associated with a recommendation, which includes both the costs associated with the security’s initial purchase, and “any costs that may apply to the future sale or exchange of the security, such as deferred sales charges or liquidation costs.” Although potential costs are not dispositive, they must always be considered.

Reg BI’s requirement that “broker-dealers must weigh the potential risks, rewards, and costs of a particular security or investment strategy in light of” the customer’s investment profile adds another dimension of litigation risk. The investment profile must include the customer’s “age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information” the customer may disclose. “Broker-dealers must obtain and analyze enough customer information to have a reasonable basis to believe that the recommendation is in the best interest” of the customer.

The SEC’s position that a “broker-dealer should consider ‘reasonably available alternatives’ as part of having a ‘reasonable basis to believe’” that the recommendation is in the customer’s best interest adds additional risk. Although Reg BI does not require an evaluation of every possible alternative or the recommendation of the “best” alternative, disputes may arise over whether there was an appropriate assessment of reasonably available alternatives and over the adequacy of the supervision of this obligation.

Good contemporaneous documentation will be a key strategy for avoiding increased liability under Reg BI because whether the recommendation is in the customer’s best interest and did not place the broker-dealer’s interests ahead of those of the customer will be “based on information reasonably known” to the advisor “at the time the recommendation is made.”

Because disputes over the recommendation will often occur years later when circumstances have changed and memories have faded, comprehensive contemporaneous documentation of the information known at the time of the recommendation as well as the analyses of costs, reasonably available alternatives, and other best-interest factors done prior to the recommendation will be key to defending the claim and mitigating exposure.

Although not required, the SEC notes that “broker-dealers may wish to consider documenting the basis for determining that the recommendation” is in the customer’s best interest “when it is not evident from the recommendation itself.”  This documentation will be particularly important if the recommended security costs more than the alternatives or results in greater remuneration to the firm or advisor.

Reprinted with permission from the May 1, 2020 edition of the ThinkAdvisor © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.