On August 3, 2022, the SEC published a Staff Bulletin, which discussed investment advisers’ and broker-dealers’ conflicts of interest. The Staff Bulletin offered guidance on how firms can identify, eliminate, mitigate, and disclose those conflicts of interest. The guidance focused on the fiduciary standard for investment advisers under the Investment Advisers Act of 1940 (IA fiduciary standard) and Regulation Best Interest (Reg BI), which applies to broker-dealers. The Staff Bulletin used a Frequently Asked Questions (FAQs) approach to provide this guidance.
The Staff Bulletin defined a conflict of interest as one that might motivate a broker-dealer, investment adviser, or financial professional to make a recommendation or to give advice that is not disinterested. Firms and financial professionals can be motivated, consciously or unconsciously, to act in a manner that is contrary to the best interest of the investor.
According to the Staff Bulletin, the IA fiduciary standard and Reg BI are drawn from key fiduciary principles, which include an obligation to act in the retail investor’s best interest and to avoid placing their own interests ahead of the client’s. An investment adviser’s fiduciary applies to all advisory clients, whether or not they are retail investors. In contrast, Reg BI only applies when a broker-dealer is making a recommendation to a retail investor.
Reg BI policies and procedures
To satisfy Reg BI, broker-dealers must comply with the rule’s four obligations governing:
- Conflicts of interest; and
When making recommendations to retail customers, broker-dealers are required to establish, maintain, and enforce written policies and procedures that are reasonably designed to:
- Identify, disclose, or eliminate all conflicts of interest associated with a recommendation;
- Identify and mitigate conflicts of interest at the associated person level;
- Identify and disclose any material limitations imposed on the securities or investment strategies that may be recommended to a retail customer, as well as any conflicts of interest that go hand-in-hand with them;
- Prevent those limitations and related conflicts of interest from causing the broker-dealer, or a natural person who is an associated person of the broker-dealer, to make recommendations that place the interest of the firm or the natural person ahead of the retail customer’s best interest; and
- Identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or certain types of securities within a limited time frame.
RIA policies and procedures to address conflicts of interest
Registered Investment Advisers (RIAs) must adopt and implement policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act and the rules thereunder. Ideally, those policies and procedures will prevent breaches of the IA fiduciary standard.
When designing their written compliance policies and procedures, RIAs should first identify their conflicts of interest, as well as any compliance factors that create risk exposure for the firm and its clients. No less than annually, RIAs must review the adequacy of those policies and procedures and the effectiveness of their implementation.
Policies and procedures are not a set-it and forget-it exercise. A well-conceived compliance program should be flexible enough to adjust to known variables in operations and business activities. It should also establish processes to monitor the program’s effectiveness and to pivot or be updated when it becomes necessary to do so. It is critical that firms have a process to address new compliance risks and challenges. Reasonably designed policies and procedures that address conflicts may become inadequate based on subsequent events or the firm’s experiences.
Disclosure of conflicts of interest
Disclosures should be designed to permit retail investors to make more informed decisions regarding recommendations. In relation to RIAs, these disclosures allow retail investors to give informed consent to the specific conflict of interest.
The Staff Bulletin encouraged RIAs and broker-dealers to identify their conflicts of interest and address them in their policies and procedures. Firms should take steps such as:
- Defining conflicts in a manner that is relevant to the firm’s business model;
- Define conflicts in a manner that includes those that arise across the scope of advice or recommendations associated with the retail investor relationship;
- Establish a process to identify the types of conflicts that the firm and its financial professionals may face and how those conflicts might impact advice or recommendations;
- Provide for an ongoing and regular, periodic process to identify conflicts associated with the firm’s business model; and
- Establish training programs regarding conflicts of interest.
Training programs can be published internally or otherwise communicated.
Where appropriate, RIAs and broker-dealers should eliminate conflicts of interest. Firms may find that there are some conflicts that they cannot address in a way that will allow them or their financial professionals to provide advice or recommendations that are in the retail investor’s best interest. In those cases, firms may need to determine whether to eliminate the conflict or refrain from providing advice or recommendations that could be influenced by it.
When broker-dealers and RIAs are providing advice or recommending proprietary products to retail investors, firms should disclose conflicts of interest such as:
- Whether the firm or an affiliate manages, issues, or sponsors the product;
- Whether the firm, its financial professionals, or an affiliate could receive additional fees and compensation related to that product;
- Whether the firm prefers, targets, or limits its recommendation or advice to proprietary products or only those proprietary products for which the firm or an affiliate could receive additional fees and compensation; and
- The extent to which financial professionals receive additional compensation or have quotas to meet to qualify for bonuses or awards based on their sale of proprietary products, such as mutual funds, annuities, or real estate investment trusts.
When recommending wrap fee and separately managed account programs, firms should disclose the facts that caused the broker-dealer or RIA to recommend them. Firms should disclose material facts regarding a manager’s financial incentives, such as investing assets in share classes that provide higher compensation to the firm.
How investment advisers should handle conflicts of interest
All broker-dealers, investment advisers, and financial professionals have at least some conflicts of interest related to their dealings with retail investors. Specifically, they may have an economic incentive to recommend products, services, or account types that provide more revenue or other benefits for the firm or its financial professionals, even if those recommendations or advice are not in the best interest of the retail investor.
The nature and extent of conflicts will depend on various factors, including a firm’s business model. Firms must address conflicts in a way that will prevent them or their financial professionals from providing recommendations or advice that places their interests ahead of the interests of retail investors.
When designing their written compliance policies and procedures, RIAs should identify conflicts and other compliance factors creating risk exposure for the firm and their clients. Investment advisers also must review, no less frequently than annually, the adequacy of those policies and procedures and the effectiveness of their implementation.
Investment advisers must fully and fairly disclose a conflict of interest to clients, so they can provide informed consent. In some instances, there will be conflicts that cannot be addressed in a way that will allow the firm or its financial professionals to provide advice or recommendations that are in the retail investor’s best interest. In those cases, firms need to decide whether to eliminate the conflict or refrain from providing advice or recommendations that could be influenced by it.
In cases where the firm finds that a particular incentive practice is causing its financial professionals to place the firm’s or the financial professional’s interest ahead of the retail investor’s interest, the firm may need to revise or change its incentive program. Firms should consider their specific business model in determining how these incentives impact the conflict they are attempting to mitigate.
RIAs should establish, maintain, and enforce written policies and procedures that are reasonably designed to identify and mitigate conflicts of interest at the IAR level, such as incentives that directly affect the representative’s advice and recommendation. Those policies and procedures help to ensure that IARs dos do not violate the antifraud provisions of the federal securities laws.
A firm’s product menu can have a significant impact on the conflicts of interest present in its business model. Firms should carefully consider how their product menu choices, such as only offering proprietary products, are consistent with the obligation to act in the best interest of retail investors.
The following is a non-exhaustive list of third-party compensation incentives that may be present at RIAs and broker-dealers:
- Offering a limited product menu from which recommendations are made or advice is provided based on preferred providers or investments;
- Agreements to receive payments from a clearing broker for recommending that the adviser’s clients invest in no-transaction-fee or sales load mutual fund share classes offered on the clearing broker’s platform;
- Any agreements to receive payments, loan forgiveness, and/or expense offsets from a custodian for recommending that the firm’s retail investors maintain assets at the custodian; and
- Any arrangements where the firm is compensated by mutual funds, ETFs, or other financial products from product fees, by the products’ sponsors, or other revenue-sharing arrangements.
When recommending wrap fee and other separately managed account programs, facts that should be disclosed include those that could encourage the broker-dealer or investment adviser to recommend a wrap fee account or separately managed account. For example, firms should disclose any compensation from wrap fee program sponsors for investing client assets in the sponsors’ programs and the possibility that the investor will pay higher costs. For example, firms should consider disclosing a manager’s financial incentives to invest assets in share classes that provide higher compensation to the firm. Another financial incentive would be a manager that does not trade or rarely trades, which saves the firm from paying ticket charges or other costs.
The Staff Bulletin is available at here.
The SEC’s guidance provided clarity about what Reg BI requires and what the IA fiduciary standard requires in relation to conflicts of interest. Firms should review their business models, as well as their investor relationships, and customize their disclosures to address each conflict of interest.
Certain experts believe that combining Reg BI and the IA fiduciary standard in one Staff Bulletin might be viewed as a conflation of the two standards. They suspect that the SEC is pushing to implement a universal fiduciary standard for RIAs and broker-dealers.
All business models create conflicts of interest. RIAs must continue to tweak those disclosures as their business model changes.
The Staff Bulletin observed that it would be difficult for an RIA to demonstrate how it complies with its fiduciary obligations without books and records showing how the firm addresses conflicts of interest. However, disclosure of conflicts by itself does not satisfy the obligation to act in a retail investor’s best interest. Some conflicts are resolved through mitigation. When certain conflicts cannot be mitigated, firms may need to eliminate them or decline to provide advice in a particular area.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.