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Reg BI: The Care Obligation and Reasonable Alternatives

Post on: March 20, 2020 | Chris Rohde | 0

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As broker-dealers prepare to implement policies to comply with the SEC’s Regulation Best Interest (Reg BI), one requirement they should be cognizant of is the requirement under the Care Obligation to consider reasonably available alternatives prior to making a recommendation.


Care Obligation Basics

Previously, brokers were only required to analyze whether a recommended investment was “suitable” for their investor, however, the Care Obligation increases the standard of conduct for broker-dealers. Now brokers must also analyze whether the security is in the best interest of the investor. The Care Obligation requires brokers to “exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.” This new requirement brings registered representatives at broker-dealers closer to the standard that IARs are held to under the fiduciary rule.

To exercise reasonable diligence, care, and skill, a broker should:

  • understand the potential risks, rewards, and costs associated with the recommendation of an investment.
  • have a reasonable basis to believe that the investment is in the best interest of a particular investor based on their investment profile and the potential risks and rewards associated with the investment.

Best Interest Analysis

With the release of Reg BI, the SEC provided some details on the type of diligence they are expecting. Reasonable basis suitability requires a broker to develop a sufficient understanding of any security they may recommend by examining factors such as:

  • The objectives of the recommended investment.
  • The characteristics of the investment, including liquidity, volatility, and any special or unusual features.
  • The likely performance of the investment in a variety of market and economic conditions.
  • The financial incentives to recommend the security.

To this the SEC adds as an explicit requirement that a broker consider the cost of the security to the customer, which is not a required consideration under the current suitability rules. The SEC does, however, make it clear that high cost is not disqualifying. A broker-dealer could recommend a more expensive security, or investment strategy, if other factors about the security lead the broker to believe that the recommendation of that security is in the best interest of the customer. All of these factors are extremely important to evaluate for any security, but especially important to review for complex or risky products, including different alternative securities.

After evaluating the security itself, a broker next needs to determine whether a recommendation of the security (or investment strategy) is in the best interest of the particular customer. In order to do this, a broker needs to understand the customer’s investment objectives, financial situation, and needs. Finally, a broker may not place the broker-dealer’s interests ahead of the clients'. This requires the broker and the broker-dealer firm to have a firm grasp on the conflicts of interests and ensure that they are not putting their interests, such as higher compensation or other fees, ahead of the interest of the customer.

To meet these requirements, a broker needs to create a Customer Investment Profile containing comprehensive information about the investor including:

  • Biographical data
  • General financial situation
  • Current investments and previous investment experience
  • General and specific investment objectives
  • Specific needs for this investment
  • Tax status
  • Time horizon
  • Liquidity needs

This and any other relevant information is generally gathered from the customer, and a broker may rely on this information, barring any red flags.

Reasonably Available Alternatives

In addition to the above elements of the standard of care under Reg BI, brokers must evaluate “reasonably available alternatives.” To be clear, this requirement is not addressing the broad category of “alternative investments” that we often write about on our blog. Rather, “reasonably available alternatives” refers to other investments similar to whatever specific investment a broker is recommending. For example, before recommending a mutual fund, a broker should consider the merits of other available mutual funds.

The SEC makes clear that this requirement does not mandate that firms, or brokers, recommend the cheapest alternative or that a broker must evaluate every possible alternative to the security being recommended, as broker-dealers often have limited menus of products available to them. Those limitations must be disclosed under the Disclosure Obligation of Reg BI. While the SEC acknowledged that it does not expect brokers to be able to offer every security available, broker-dealers would be wise to consider additional products not currently available to their representatives as a means to address this requirement.  

When evaluating reasonable alternatives in making a recommendation, reps should consider the individual investor’s customer investment profile, the investments and services available from their firm to recommend, and other specific limitations on the investments themselves (such as requiring the investor to be accredited or have certain liquidity requirements).

For example, if a broker has an investor looking to conduct a 1031 Exchange into a DST product, in addition to considering cost, risk tolerance, and other general factors, the rep should consider the available DST products in light of leverage, location, time horizon, asset class, income needs, and stability. This may lead to the conclusion that there are only a few DSTs that meet the requirements, and further that the best option for the investor’s needs may in fact be the one that has a higher cost.

As broker-dealers consider how to comply with the consideration of reasonable alternatives requirement, perhaps it is an opportunity for them to expand their product menu in order to present recommendations from a more comprehensive alternative product selection. For example, “alternative investments” as an asset class; inclusive of securities such as Direct Participation Interests in Real Estate, Oil and Gas, Non-traded REITs, Opportunity Zone Funds, syndicated DSTs, and many others, may be worthy options to take into account as firms seek to meet Reg BI's reasonable alternatives requirement. These securities are not directly correlated to the performance of the larger market.  This attribute alone may be one way that a broker-dealer could comply with the SEC's guidance for brokers to consider when complying with the Care Obligation—particularly investment objective, volatility, and performance in a variety of market and economic conditions. There is significant risk to these products, and broker-dealers adding them to their menu should do the required due diligence on the products and conduct training for their reps prior to authorizing the sale of such products.


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About author

Chris Rohde

Chris serves as Associate Corporate Counsel at WealthForge where he advises on an array of areas, including both federal and state securities laws, broker-dealer law, general corporate law matters, and cybersecurity.
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