Investment advisors and brokers must compile a client profile and understand the investment strategies they recommend if they want to meet the requirements of Regulation Best Interest’s care obligation, the Securities and Exchange Commission said in a new staff bulletin yesterday.\

The agency urged both firms and professionals to develop a sufficient understanding of the potential risks, rewards and costs of each investment or investment strategy to ensure that the recommendation or advice would be in a retail investor’s best interest, the agency said.

“Without this understanding, firms and their financial professionals cannot have a reasonable basis to believe that their recommendation or advice aligns with a retail investor’s investment profile in a way that satisfies their obligations to make a recommendation or provide advice that is in the specific investor’s best interest,” the SEC said.

According to the regulator, the factors firms and their advisors and brokers must understand include:

  • Investment or investment strategy objectives, such as whether an investment is designed to provide income, principal protection or growth, and what markets it exposes investors to;
  • Key characteristics of the investment strategy and how factors such as liquidity or volatility may impact performance;
  • How different market and economic conditions may impact the investment;
  • The expected returns, payout rates and potential losses investors are likely to experience;
  • Special or unusual features of the investment or investment strategy (such as tax advantages or guaranteed payments); and
  • How the investment or investment strategy works within the context of the retail investor’s actual or anticipated investment portfolio.

Costs are always a relevant factor to consider when recommending or providing advice on investments or investment strategies, the SEC said.

“While costs should not be the only consideration, and a firm or financial professional cannot satisfy its obligations simply by recommending the lowest cost option, the firm and financial professional must always consider cost as a factor when providing a recommendation or advice to a retail investor,” according to the bulletin.

In the staff’s view, the firm and financial professional should consider the total potential costs, including direct and indirect costs, that could be charged to a retail investor, also including commissions, markups or markdowns, transaction costs, sales loads or charges, advisory or management fees, and all transaction fees and possible penalties. 

Advisors and brokers cannot rely solely on their firm’s approved list of investments for retail investors when providing advice, the SEC also made clear. 

The SEC said “financial professionals cannot satisfy their own care obligations by solely relying on the efforts of others at their firm. Rather, they remain responsible for personally understanding an investment or investment strategy before they recommend or provide advice with regard to that investment or investment strategy.”

The agency didn’t not prevent brokers and advisors from recommending complex or risky products, but said that they must establish “a reasonable basis to believe the complex or risky product is in the best interest of the retail investor.”

On the “know your client” front, the agency also made clear that an advisor’s and broker’s obligation to gather information for the investor’s investment profile is not a “one and done” exercise.

“The staff believes that you generally should seek to obtain and consider, without limitation: the investor’s financial situation (including current income) and needs; investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objective and financial goals; and any other information the retail investor may disclose to you in connection with the recommendation or advice,” according to the bulletin. 

Overall, a check-the-box process for fulfilling the care obligation is unlikely to work, the agency said. 

“Whether a recommendation or advice satisfies the care obligations is an objective evaluation, turning on the facts and circumstances of the particular recommendation or advice and the investment profile of the particular retail investor at the time the recommendation is made or when the advice is provided,” according to the SEC.