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SEC Provides Further Guidance in its Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflict of Interest

by | Aug 24, 2022 |

By Stephen Wilkes and Seth Gaudreau

The U.S. Securities and Exchange Commission (“SEC”) recently published a Staff Bulletin (the “Bulletin”) providing further fiduciary standards guidance for broker-dealers and investment advisers under Regulation Best Interest (“Reg BI”) and the Investment Advisers Act of 1940 (“IA Fiduciary Standard”), respectively.  Like an earlier bulletin from the Staff (see the May 29, 2022 SEC Staff Bulletin found here), the Bulletin is styled as a Q&A and focuses on standards of conduct that are “drawn from key fiduciary principles that include an obligation to act in a retail investor’s best interest and not to place their own interests ahead of the investor’s interest.”

The Bulletin defines conflict of interest, under Reg BI and the IA Fiduciary Standard, as an interest that might incline a broker-dealer or investment adviser- consciously or unconsciously -to make a recommendation or render advice that is not disinterested. The Staff further states that firms need to take a proactive approach that is not only robust and ongoing but is tailored to each conflict and not merely a “check the box” exercise.

The Bulletin provides a summary of the conflict of interest rule under Reg BI and the IA Fiduciary Standard.  The Staff’s Q&As focus on the following topics: Identifying Conflicts of Interest, Mitigating Conflicts of Interest, Product Menus, and Disclosing Conflicts of Interest.  Below are the key takeaways from each section.

Identifying Conflicts of Interest

The Staff’s first Q&A expresses its view that “[a]ll broker-dealers, investment advisers, and financial professionals have at least some conflicts of interest with their retail investors.”  The Staff feels that the economic incentives for firms and financial professionals to recommend various products and services that may not be in a retail investor’s best interest create substantial conflicts of interest.  The Staff also clarifies that under Reg BI not only must broker-dealers establish, maintain, and enforce written policies and procedures reasonably designed to identify all conflicts of interest, they must also identify conflicts of interest on an ongoing basis.

The Bulletin provides two nonexhaustive lists of best practices, which should be used under a firm’s “culture of compliance” to identify common sources of conflicts of interest, and further identifies steps firms can use to mitigate such conflicts of interest. Firms should review these lists in tandem and identify areas of concern that they may need to address.

Further, disclosures alone do not satisfy the obligation to act in the retail investor’s best interest and those conflicts should (or must) be mitigated or eliminated, if they conflict with the firm’s and the financial professional’s obligation to act in a retail investor’s best interest in light of the investor’s objectives.

Eliminating and/or Mitigating Conflicts of Interest

Reg BI “requires broker-dealers to have written policies and procedures reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses, and noncash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.”  Under the IA Fiduciary Standard, conflicts of interest must be fully and fairly disclosed to allow a client to provide informed consent; if such informed consent cannot be obtained, then the conflict needs to be eliminated.  The Bulletin provides a generalized example that  firms with compensation and incentive programs, based on benchmarks, quotas, or other performance metrics, whose benefits (or conversely, the drawbacks) are seen to influence a financial professional’s decision regarding a retail investor’s interests, will be scrutinized by the SEC.  The Staff, has concerns that the level of rewards (or conversely, the penalties) associated with these programs calls into question whether they comply with Reg BI and the IA Fiduciary Standard. Firms should consider whether such programs need to be reduced or eliminated.

The Staff feels that conflict of interest mitigation measures need to be specific to the nature and significance of the specific incentives provided to the firm or its financial professionals under a firm’s business model. The Bulletin provides a nonexhaustive list of potential factors that need to be considered.

The Bulletin addresses conflicts of interest concerning compensation arrangements, and lists various best practices that may lead to conflict of interest identification and potential mitigation methods.  A key to the factors and mitigation methods, according to the Staff, is that “[a]lthough industry practice may be a useful guide, the sufficiency of any mitigation of conflicts of interest is not assessed by comparison to industry practice alone.” Firms need to be able to demonstrate periodic review and testing of policies and procedures that are reasonably designed to disclose, mitigate, or prevent conflicts that impact a firm’s or financial professional’s ability to place the retail investor’s interest ahead of its own.  The Staff further states that, “it may be difficult for a firm to demonstrate compliance with the applicable standard of conduct without documenting the measures it takes to mitigate conflicts of interest and any such periodic assessment of its policies and procedures undertaken by the firm.”

Product Menus

The Bulletin specifically addresses “Product Menus” and the conflicts of interest that may arise from advice and recommendations that are limited to a certain menu of products, which may include proprietary products, a specific asset class, or products that pay revenue sharing or feature similar third-party arrangements.  The Staff feels that firms should consider establishing a review process for the products they offer (or that are offered by an affiliate).  Broker-dealers not only need to identify and mitigate any conflicts associated with such products, under Reg BI they also need to identify and disclose any material limitations placed on the securities or investment strategies.  The Staff views the example of the product review process it provided as equally applicable to limitations placed on investment strategies and investment advisers.

Disclosing Conflicts of Interest

The Staff reiterates its position that disclosures cannot be a simple “check the box” exercise.  Specific conflicts need to be disclosed in “plain English” and tailored to a firm’s business models and compensation structures, as well as to the different products offered.  The Staff warns that generalized disclosures that a conflict “may” exist is not a sufficient disclosure where a conflict exists.  In cases where the nature and extent of the conflict make it difficult to convey the material facts or effects of the conflict, then it cannot be fully and fairly disclosed and a firm should consider mitigation or elimination of the conflict.  The Staff further provided best practices and a nonexhaustive list of examples that need to be disclosed, at a minimum, when conflicts concern compensation or other benefits, including compensation or other benefits from proprietary products and third party compensation.  A firm’s obligation to act in a retail investor’s best interest is not satisfied by the disclosure of the existence and/or the potential effects of a conflict of interest

In the final Q&A, the Staff reiterates that “addressing conflicts is not a ‘set it and forget it’ exercise” and firms need to monitor conflicts of interest over time and periodically assess the adequacy and effectiveness of their policies and procedures to ensure compliance with Reg BI and the IA Fiduciary Standard.  They further state the importance of documenting the measures a firm has taken to address and monitor conflicts of interest, in order to show that the firm and its financial professionals are not placing their interests ahead of retail investors.

Key Themes to Consider

  • The SEC is reiterating standards of conduct for handling conflict situations under the Investment Advisers Act of 1940 and Reg BI – and focusing on compensation and proprietary products as examples. This may be a shot across the bows to highlight upcoming future activity by the SEC.
  • Conflicts must be identified and monitored – then mitigated if not eliminated pursuant to a robust set of written policies and compliance procedures.
  • Compensation conflicts are subject to a broad view, and not necessarily purely sales- related.
  • Limited menu product offerings and proprietary products should be governed by established product review processes.
  • Finally, the staff bulletin provides a roadmap to the informal thinking and insights that underlie official SEC guidance – and should be compared carefully with existing policies and procedures to identify potential weaknesses or areas for improvement.