I have blogged before about hold recommendations.  Surprisingly – at least to me – the statistics I get from the publisher of this blog reveal that more people have read that particular post than anything else I have written since I started this thing a few years ago.  That has to mean something, right?  So, when I saw a recent SEC settlement that involved hold recommendations, I figured it was worth looking into and giving my thoughts.

I wrote last time that the only occasion when hold recommendations have had any potential relevance was in the context of customer arbitrations, where clever attorneys have tried to avoid having their clients’ old – sometimes really, really old – claims dismissed under FINRA’s six-year eligibility rule by baking some vague allegations about more recent hold recommendations into the Statement of Claim.  That hasn’t changed.  I still see these all time.  For the most part, arbitrators remain unimpressed by such claims, absent some clear documentation demonstrating that there was, in fact, some explicit recommendation to hold.

But, admittedly, Reg BI potentially changes the landscape for recommendations to hold, making them something of interest both to regulators and claimants’ lawyers.  The SEC has stated that for broker-dealers, Reg BI applies both to explicit recommendations to hold and, as well, “implicit hold recommendations that are the result of agreed-upon account monitoring between the broker-dealer and retail customer.”  Indeed, that was the principal point of my prior post, i.e., the need for BDs, in light of this guidance, to disclaim, very, very clearly, any obligation to monitor customer accounts, since once a BD does that, it can avoid any potential claim – whether from a regulator or in an arbitration – that it has violated Reg BI through an alleged implicit hold recommendation.  That advice has not changed at all.  The SEC has gone to the trouble of describing a clear path to a safe harbor, and any BD that fails to follow that path does so at its own peril.

But what about dually registered RR/IARs?  This hybrid model is increasingly common, and because such individuals straddle the regulatory regimes for both BDs and IAs, it can be confusing and complicated to understand exactly what standards to which they will be held.

Let me start with some good news.  The SEC has made it very clear what it thinks:

If you are a financial professional who is dually registered (i.e., an associated person of a broker-dealer and a supervised person of an investment adviser (regardless of whether you work for a dual-registrant, affiliated firm, or unaffiliated firm)) making an account recommendation to a retail customer, whether Regulation Best Interest or the Advisers Act applies will depend on the capacity in which you are acting when making the recommendation.

Ok, good start.  But it gets even better, even clearer:

Regulation Best Interest does not apply to investment advice provided to a retail customer by a dual-registrant when acting in the capacity of an investment adviser, even if the retail customer has a brokerage relationship with the dual-registrant or the dual-registrant executes the transaction in a brokerage capacity.

Well, now we have some guidance to work with!  If you’re a BD, once you adequately disclaim your duty to monitor accounts, implicit recommendations to hold are not actionable under Reg BI.  (And, of course, we already know that they’re not actionable under FINRA’s suitability rule either, inasmuch as that rule only covers explicit hold recommendations, as FINRA has expressed many times.  See, for example, Reg Notices 12-25 and 12-55.)  If you’re a dual registrant, and you give investment advice wearing your IAR hat, rather than your RR hat – including advice that involves hold recommendations – then you are not acting under Reg BI.  This is real progress!

The problem, or at least potential problem for both dual registrants and any IAR not associated with a BD is that you’re still not out of the woods, by any means, when it comes to hold recommendations.  And that’s because while Reg BI may not present any problems, the SEC is vigorously enforcing – too vigorously, in the view of many – liability that stems from the Advisers Act.  And while the touchpoint for that liability is the inadequate disclosure of conflicts of interest, rather than the efficacy of the recommendation itself, it remains that the transaction underlying the claim is the same: a hold recommendation.

Which brings me to the SEC settlement I mentioned at the outset.  Here is the SEC’s summary of the case:

At times during the period from January 2014 through March 2019 (the “Relevant Period”), Oxbow held for advisory clients mutual fund share classes that charged fees pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“12b-1 fees”) instead of lower-cost share classes of the same funds that were available to the clients. Oxbow’s investment adviser representatives (“IARs”), as registered representatives of an affiliated broker-dealer, received 12b-1 fees in connection with these investments, but Oxbow did not adequately disclose this conflict of interest in its Form ADV brochures or otherwise.

Note the use of the word “held” here.  The case wasn’t about recommendations by Oxbow IARs to purchase the wrong share class, it was about hold recommendations.  The SEC said this very plainly later in the document: “During the Relevant Period, Oxbow advised clients to hold mutual fund share classes that charged 12b-1 fees when lower-cost share classes of those same funds were available to those clients.”  Indeed, in a footnote, the SEC explained that “[w]ith the exception of three purchases of shares of one fund in a class that charged 12b-1 fees when a lower-cost share class of the same fund was available, Oxbow did not purchase shares charging a 12b-1 fee when a lower-cost share class of the same fund was available during the Relevant Period.”  Obviously, if the problem wasn’t with purchases by Oxbow, then it had to be with the fact that Oxbow advisory customers were advised to continue to hold higher-cost share classes.

What the SEC does not illuminate in the settlement, however, is whether these hold recommendations were explicit or implicit.  But, that may be because, frankly, it doesn’t matter.  We know from the guidance that the SEC published in connection with the promulgation of Reg BI that if you “[i]f you have agreed to perform account monitoring services, then Regulation Best Interest applies even where you remain silent (i.e., an implicit hold recommendation).”  It makes logical sense that if you have a statutory (rather than a contractual) obligation to perform these same account monitoring services, i.e., because you are an IA or an IAR, the conclusion would be the same: you are potentially liable for implicit hold recommendations.  Of course, IAs and IARs do have that statutory obligation, given that they have a fiduciary duty to their clients.

So there’s the point.  Three people make an implicit recommendation to hold (i.e., they remain silent about an existing investment); one is an RR associated solely with a BD, one is a dually registered RR/IAR, and one is just an IAR.  Only the first guy is safe, under any standard.  The second guy may be safe, depending on which of his two hats he was wearing.  The third guy, on the other hand, will have to defend his recommendation under Reg BI, and faces potential liability if it is determined not to have been appropriate.

Confusing?  Yes.

One last observation, an important one.  As I noted above, the gist of the Oxbow case is not that it violated its fiduciary duty by making inappropriate hold recommendations, but, rather, by not disclosing to its clients “all material facts,” including “full and fair disclosure that is sufficiently specific so that they could understand the conflicts of interest concerning Oxbow’s advice about investing in different classes of mutual funds and could have an informed basis on which they could consent to or reject the conflicts.”  That violation, putting aside whether or not you agree with the SEC’s take-no-prisoners approach to 12b-1 fee disclosures, would have existed whether or not Oxbow made hold recommendations, or, if it did, whether or not they were appropriate.

Disclosure cases do not require the SEC to prove that any client ever actually relied on the disclosures and proceeded to make a trade; hell, it doesn’t matter whether anyone ever even read the disclosures! They are either sufficient, or they’re not.  The challenge is simply figuring out how to disclose these conflicts of interest with sufficient detail to satisfy the SEC.  And that is really hard.  Some guidance exists,[1] but, for the most part, it has not only come after the fact, but comes in the form of disciplinary actions that the SEC has taken, which is hardly the best way to go about helping industry members.  No surprise that one of FSI’s 2020 Advocacy Priorities is “Regulation by Enforcement.”  Its website says: “Last year, we spoke out about the increasing trend of regulation by enforcement, particularly by the SEC. We continue to oppose enforcement activity that is based on staff guidance or creates new requirements without going through the formal rulemaking process.”  Hear hear!


[1] See, for example, this 2019 FAQ from the SEC, which suggests that at least the following must be disclosed about share class conflicts:

  • The existence and effect of different incentives and resulting conflicts.
    • The fact that different share classes are available and that different share classes of the same fund represent the same underlying investments.
    • How differences in sales charges, transaction fees and ongoing fees would affect a client’s investment returns over time.
    • The fact that the adviser has financial interests in the choice of share classes that conflict with the interests of its clients.
  • The nature of the conflict.
    • For example, whether the conflict arises: (a) as a result of differences in the compensation the adviser and its affiliates receive; or (b) from the existence of any incentives shared between the adviser and the clearing broker or custodian (such as offsets, credits, or waivers of fees and expenses).
    • Whether there are any limitations on the availability of share classes to clients that result from the business of the adviser or the service providers that the adviser uses. These may include, for example:
      • Limitations that a fund or the adviser’s clearing broker or custodian imposes (for instance, where a custodian’s platform only makes certain share classes available or a fund or platform has minimum investment requirements); and
      • Limitations that the adviser imposes (for instance, by type or class of clients, advice, or transactions).
    • Whether an adviser’s practices with regard to recommending share classes differs when it makes an initial recommendation to invest in a fund as compared to: (a) when it makes recommendations regarding whether to convert to another share class; or (b) when it makes recommendations to buy additional shares of the fund. For example, the adviser could consider disclosing its practices for reviewing, in conjunction with its periodic account monitoring, whether to convert mutual fund investments in existing or acquired accounts to another share class.
  • How the adviser addresses the conflict.
    • The circumstances under which the adviser recommends share classes with different fee structures and the factors that the adviser considers in making recommendations to clients.
      • For example, where the adviser would bear the cost of a transaction fee, how the adviser evaluates the differences between, on the one hand, a share class with a 12b-1 fee but no transaction fee and, on the other, a share class of the same fund with a transaction fee and, on the other, a share class of the same fund with a transaction fee but no 12b-1 fee.
    • Whether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction (e.g., with regard to clients whose accounts are subject to the Employee Retirement Income Security Act of 1974 or clients with individual retirement accounts).