Bates Research | 08-18-22
SEC Staff Offers Additional Guidance on BD and IA Conflicts of Interest
On August 3, 2022, SEC staff issued new guidance addressing conflicts of interest under the Regulation Best Interest (“Reg BI”) standard for broker-dealers and the fiduciary standard for investment advisers. While the staff bulletin states clearly that the guidance is intended only to be a reflection of internal views on the subject, its tone, comprehensiveness (replete with numerous examples), and even its pragmatic question-and-answer format warrant careful attention. From the outset, the bulletin advises broker-dealers and investment advisers to “review their business models and relationships with investors to address conflicts of interest specific to them.” That would entail thoroughly reviewing a firm’s practices and procedures on all things that might create a conflict of interest, and then making adjustments consistent with this guidance. Here’s an overview.
Core Principles under Reg BI and the Fiduciary Standard
The guidance reaffirms the basic principles that underlie the different standards required of broker-dealers and investment advisers. The SEC defines a “conflict of interest” under both standards as “an interest that might incline a broker dealer or investment adviser – consciously or unconsciously – to make a recommendation or render advice which is not disinterested.”
Under Reg BI, broker-dealers owe four duties to retail clients: disclosure, care, conflicts of interest and compliance. (For a detailed discussion of Reg BI requirements and firm compliance, see Bates’ White Paper). The bulletin reiterates that the duties on conflicts of interest under Reg BI require that broker-dealers who make recommendations to retail clients have written policies and procedures reasonably designed to (1) identify and disclose, or eliminate, all conflicts of interest; 2) identify and mitigate conflicts by associated persons; (3) identify and disclose securities investment strategies that may place the interest of the broker-dealer ahead of the interest of the retail customer; and (4) identify and eliminate certain “sales contests, sales quotas, bonuses, and non-cash compensation.” These requirements to identify, mitigate and eliminate conflicts exist under the other Reg. BI duties (compliance and disclosure) as well as in the care obligation, which requires a broker dealer to have “a reasonable basis to believe that each recommendation or series of recommendations made is in the best interest of the particular retail customer and does not place their financial or other interests ahead of the interest of the retail customer.”
For investment advisers, the bulletin reaffirms the core obligations under the fiduciary standard, including the duties of loyalty and care. Under the former, staff describe the obligation to eliminate conflicts of interest and make full and fair disclosures so that clients can give informed consent. Under the latter, they reiterate that investment recommendations must be in the client’s best interest, grounded in a “reasonable understanding of the client’s objectives." Also emphasized is the importance of written policies and procedures and recordkeeping, without which “it would be difficult for an investment adviser to demonstrate how it complies with its fiduciary obligations.”
New Guidance on Conflicts of Interest
The new bulletin includes an examination of the practical issues arising from these duties. This guidance is organized around (i) identifying conflicts, (ii) eliminating conflicts, (iii) mitigating conflicts and (iv) disclosing conflicts. While the guidance differentiates obligations under the two standards where applicable, the focus is directly on how to achieve these four compliance objectives.
Identifying Conflicts: Have An Ongoing Process and Procedure
The SEC acknowledges that all broker-dealers and investment advisers “have at least some conflicts of interest with their retail investors,” but that the “nature and extent” of these conflicts varies, often related to a firm’s business model. The bulletin lists various examples of conflicts stemming from arrangements on compensation, revenue or other benefits to the firm or its affiliates.
The bulletin emphasizes the importance of having ongoing processes and procedures to identify conflicts. The expectation is that broker-dealers develop, maintain, and periodically review policies and procedures to identify conflicts on an ongoing basis. Investment advisers must also identify “other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations.” They also note that disclosure of a conflict alone is not enough to satisfy the best interest or fiduciary obligations.
Broker-dealers and investment advisers may have to eliminate a conflict if it prevents them acting in the best interest of the retail investor. As to broker-dealers, Reg BI explicitly requires written policies and procedures “reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.” Investment advisers are warned that, if the “nature and extent” of the conflict makes it difficult for the adviser to provide full and fair disclosure, and if the conflict cannot be mitigated, the adviser should eliminate the conflict or refrain from providing the advice or recommendation. Based on several examples, the bulletin concludes that if a particular practice incentivizes a “financial professional to place the firm’s or the financial professional’s interest ahead of the retail investor’s interest, the firm may need to revise its incentive program to reduce or eliminate the conflict.”
A detailed section of the guidance deals with how a firm should mitigate a conflict of interest, primarily dealing with compensation, financial incentives, and other benefits, followed by a list of factors that should be considered when mitigating a conflict. Among those are (i) the extent to which a firm’s revenues vary based on the type of account, products, and services recommended; (ii) the extent to which incentives may encourage financial professionals to recommend products that are more profitable for them or the firm; and (iii) the payment structure for financial professionals. As a result, the bulletin reiterates that firms should consider whether their compensation programs could incentivize financial professionals to make recommendations that place their interests ahead of the interests of their retail investors. The SEC is persistent in reminding firms that conflicts must be addressed at the firm level as well as at the associated person level (as required by Reg BI).
The guidance repeatedly asserts that it is important to periodically review and test policies and procedures to “ensure the on-going adequacy and effectiveness of a compliance program.” That requires documenting the ways in which the firm mitigates conflicts of interest.
Disclosing Conflicts: Use “Plain English”
The SEC warns that disclosures should not be a “check the box” exercise, rather, that disclosures “should be specific to each conflict, in ‘plain English,’ and tailored to, among other things, firms’ business models, compensation structures, and products offered at different firms.” For broker-dealers, the bulletin emphasizes full and fair disclosure of all material facts that might “incline the firm or its financial professional to make a recommendation or provide advice that is not disinterested.” Investment advisers must “make full and fair disclosure of all conflicts of interest which might incline an investment adviser–consciously or unconsciously–to render advice which is not disinterested such that a client can provide informed consent to the conflict” (emphasis added). In cases where the conflict is “difficult to disclose comprehensibly,” staff states that the firm should address it through mitigation or elimination.
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Facts to Disclose in Various Conflict Scenarios: Recommendations
Firms should disclose facts about (i) the nature and extent of the conflict; (ii) how the conflict could affect the recommendation; (iii) the source and scale of compensation; (iv) how the firm is compensated (e.g., revenue sharing, cash sweep); and (v) the costs and fees to be incurred by the investor as a result.
Proprietary Product Recommendations:
The SEC recommends disclosure as to whether the firm or an affiliate manages, issues, or sponsors the product, as well as any additional fees and compensation related to that product or incentives to sell the product, among others. In cases where conflicts arise from compensation received from third parties, staff recommends (i) disclosure of the existence and effects of third-party incentives, (including if the offering is from a limited product menu based on preferred providers, see below); (ii) any agreements with a clearing broker for products offered on their platform; (iii) agreements to maintain assets with a specific custodian; and (iv) arrangements where the firm is compensated through revenue sharing or product fees.
Managed Accounts and Wrap Fee Programs:
On conflicts arising from separately managed account and wrap fee programs, the bulletin recommends disclosing any compensation from program sponsors or affiliates, any higher costs to the investor for participating in the program, and any material facts on how the account is managed, including manager’s financial incentives, (e.g., incentives to invest assets in share classes that provide higher compensation to the firm.)
Policies and Procedures
The guidance cautions firms to be continuously and periodically monitoring for conflicts of interest as well as testing the adequacy and effectiveness of their policies and procedures. In this regard, they emphasized, it is especially important for a firm to “document the measures it takes to address and monitor conflicts of interest.”
Guidance on Product Menus
The bulletin devotes a section of its conflict of interest guidance to firms that make recommendations based on a product menu. A product menu may limit offerings to, for example, proprietary products, a specific asset class, or to products that involve revenue sharing or third-party arrangements (see above). The recommendation is for firms to
consider establishing product review processes for these menus. Such processes would, among other things, (i) identify and mitigate conflicts associated with products offered through them; (ii) evaluate the use of “preferred lists”; (iii) establish training requirements for financial professionals as to certain products; and (iv) establish periodic product reviews. The SEC notes that broker-dealers “must identify and disclose any material limitations placed on the securities or investment strategies that may be recommended to a retail customer and any conflicts of interest associated with such limitations.” Further, the guidance states that a dual registrant “should disclose any circumstances under which its advice will be limited to a menu of certain products offered through its affiliated broker-dealer or affiliated investment adviser.”
A staff bulletin of this nature should be seen as a roadmap for firms to prepare for examinations. It argues that “identifying and addressing conflicts should not be merely a ‘check-the-box’ exercise, but a robust, ongoing process that is tailored to each conflict.” The conflicts guidance shows how complex a challenge that can be. Carefully addressing each duty as applied to a broker-dealer or investment adviser business model as prescribed by these recommendations affords the best possibility to withstand SEC scrutiny. Bates will keep you apprised.
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