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

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.

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."

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.