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What is a Stockbroker’s “Due Care” Obligation Under Regulation Best Interest (Reg. BI)?

We introduced the new U.S. Securities & Exchanges Commission (SEC) Regulation Best Interest (Reg. BI) just after it went into effect and summarized the four obligations now being imposed upon broker-dealers and their associated persons with respect to any post June 30, 2020 securities-related recommendations, namely:

  1. Disclosure: to provide disclosures about the type of relationships they will have with their customer before or at the time of any recommendations.
  2. Due Care: to exercise reasonable diligence, care, and skill in making the recommendation.
  3. Conflicts: to establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest, preferably to avoid or mitigate them; and if they cannot be avoided, to make sure they are disclosed to the retail customer in a way the customer will understand the conflict and appreciate its impact on the recommendation.
  4. Compliance: to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg. BI.

We promised to elaborate further upon them, so we will start with perhaps the most important obligation to investors, and that is the “Due Care” obligation.

Under the “Due Care” obligation, a stockbroker is required to exercise reasonable diligence, care, and skill when making any recommendations to any retail customers, including what type of investment strategy to employ or type of account to open at the brokerage firm. In the past, all a stockbroker needed to do was have a reasonable explanation as to why a particular recommendation to buy, sell, or hold a particular security or continue with an investment strategy was “suitable” for a client; that is, match the client’s supposed investment objectives and risk tolerance, net worth, liquid net worth, tax status, time horizon, etc. with the new account form, usually made up by the stockbroker.

But under Reg. BI, the stockbroker’s exercise of “Due Care” is now judged by the “fiduciary” standard; all of the elements of the “Due Care” analysis include a consideration of whether the recommendation is in the “best interest” of the retail customer. According to the SEC, a stockbroker must now exercise reasonable diligence, care, and skill to:

  1. Understand potential risks, rewards, and costs associated with recommendation, and have a reasonable basis to believe that the recommendation could be in the “best interest” of at least some retail customers;
  2. Have a reasonable basis to believe the recommendation is in the “best interest” of a particular retail customer based on that retail customer’s investment profile; the potential risks, rewards, and costs associated with the recommendation; and that the recommendation does not place the interest of the broker-dealer ahead of the interest of the retail customer; and
  3. Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s “best interest” when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.

The reasonable diligence, care, and skill requirement will vary depending on, among other things, the complexity of and risks associated with the recommended security or investment strategy and the broker-dealer’s familiarity with the recommended security or investment strategy.

As before with respect to the first prong of the old “suitability rule” (whether the investment or strategy is suitable for at least some investors), the broker-dealer and stockbroker are both required to consider important factors such as:

  1. The security’s or investment strategy’s:
    1. Investment objectives;
    2. Characteristics (including any special or unusual features);
    3. Liquidity;
    4. Volatility; and
    5. Likely performance in a variety of market and economic conditions;
  1. The expected return of the security or investment strategy; and
  2. Any financial incentives to recommend the security or investment strategy.

This inquiry is the “minimum” the SEC believes to be necessary to develop a sufficient understanding of the security or investment strategy and to be able to reasonably believe that it could be in the best interest of at least some retail customers.

Next, the SEC has said stockbroker’s making any recommendation must consider the risks, rewards, and costs in light of the retail customer’s investment profile and have a reasonable basis to believe that the recommendation is in that particular customer’s best interest and does not place the broker-dealer’s interest ahead of the customer’s interest. The retail customer’s investment profile has long been defined to include, but is not limited to, the retail customer’s:

  1. Age;
  2. Other investments;
  3. Financial situation and needs;
  4. Tax status;
  5. Investment objectives;
  6. Investment experience
  7. Investment time horizon;
  8. Liquidity needs;
  9. Risk tolerance; and
  10. Any other information the retail customer may disclose to the broker in connection with a recommendation

In our opinion, the key point being made by the SEC in its interpretation of Reg. BI is that the stockbroker must not simply match the character of the recommendation with the retail customer’s profile, but consider all of the risks, rewards, and costs of the recommended investment, strategy, or account, and be reasonably certain the recommendation is in the “best interest” of that particular customer. In addition, the stockbroker must not place his/her interest in the recommended transaction, strategy, or account type (to maximize commissions or fees, or to avoid the risk of loss by dumping unwanted inventory, etc.) ahead of retail customers.

The last component of the “Due Care” Obligation is more applicable to investment strategies and/or account type selection. In this regard the SEC has stated:

When recommending a series of transactions, you must have a reasonable basis to believe that the transactions taken together are not excessive, even if each is in your customer’s best interest when viewed in isolation. The requirement applies irrespective of whether you exercise actual or de facto control over a customer’s account.

This element of the “Due Care” obligation obviously is targeting the reasonableness of trading strategies; that is, whether excessive trading in any particular account might constitute the form of investment fraud commonly known as “churning.” In its comments, the SEC has made it clear that the element of “control” that had to be proven before Reg. BI is no longer relevant to whether the stockbroker has violated Reg. BI. The old “churning” analysis is now simply whether excessive trading in an account is in that retail customer’s “best interest” and not the stockbroker’s best interest, which it is almost all of the time.

The SEC guidance on Reg. BI is that the stockbroker not only consider whether the recommendation of a particular investment, strategy, or account is in the “best interest” of the retail customer, but that he/she must consider the universe of investments, strategies, and accounts offered by the broker-dealer and whether another type of investment, strategy, or account offered at that broker-dealer would be in that customer’s “best interest” instead of the one recommended. This would require the stockbroker to conduct a review of such reasonably available alternatives that is reasonable under the circumstances, which will depend on the facts and circumstances at the time of the recommendation.

In summary, the “Due Care” obligation requires that the broker-dealer recommending products to its salesforce to sell to retail customers, and stockbrokers in recommending investments, investment strategies, and/or particular type of accounts, do something more than just provide a prospectus to a customer and match the investor’s profile with the description of the investment or strategy described in the prospectus or the firm’s marketing materials. The broker-dealer and stockbroker must consider multiple factors and be reasonably certain the recommendation is in the “best interest” of the customer and not their own “best interest.”

Contact Us for a Free Initial Consultation With Experienced FINRA Arbitration Attorneys

If you have any questions about Reg. BI or any recommendation you may have received from your broker-dealer or stockbroker, The Law Offices of Robert Wayne Pearce, P.A. has highly experienced lawyers who have successfully handled many managed account cases and other securities law matters and investment disputes in FINRA arbitration proceedings. We will work tirelessly to secure the best possible result for you and your case. Attorney Pearce and his staff represent investors across the United States on a CONTINGENCY FEE basis which means you pay nothing - NO FEES-NO COSTS - unless we put money in your pocket after receiving a settlement or FINRA arbitration award.

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For dedicated representation by an attorney with over 40 years of experience and success in structured product cases and all kinds of securities law and investment disputes, contact the firm by phone at 561-338-0037, toll free at 800-732-2889, or via e-mail.

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