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Given the ongoing regulatory scrutiny and enforcement action, now is the time to reassess your approach to standards of conduct, ensuring conflicts of interest arising from your business models or relationships with investors are adequately managed.
The SEC recently issued a Staff Bulletin focusing on standards of conduct for Broker Dealers and Investment Advisers Conflicts of Interest, which has been a key area of interest for the past few years, with the SEC and FINRA including Regulation Best Interest (Reg BI), Fiduciary Duty and Form CRS on their respective examination priorities letters for 2022.
Under current rules focused on creating transparency, eliminating or minimizing conflicts of interest with clients, both Broker Dealers and registered investment advisers (RIAs) have an obligation to always act in the investor’s best interest.
The SEC has published several no-action letters, Staff Bulletins, Compliance Guidance and Risk Alerts regarding this topic since 2019 and this latest Staff Bulletin comes a few weeks after their first enforcement case. You can find a timeline of activities here.
In June, the SEC brought a Reg BI enforcement case against broker dealer Western International Securities, Inc. and five brokers. According to the complaint, the firm and its brokers violated the Best Interest Obligation when they recommended and sold $13.3 billion in high-risk and unrated bonds to retirees and retail investors. The retail investors had moderate risk tolerance and the bonds sold were not suitable to them. The bonds were recommended without appropriate due diligence, care and without a reasonable basis to believe the investments were in the customer’s best interest.
What the regulator expects from you
Broker-dealers and RIAs are required to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with the regulation. The firms’ Code of Ethics, Compliance Manual or Written Supervisory Procedures (WSP) should embody your fiduciary principles and duties established in accordance with the standards of conduct expectations.
Policies should also cover business risks and create a “robust, ongoing process that is tailored to each conflict”, which should be documented alongside approaches to mitigate. Firms must:
1. Identify Conflicts of Interest
Firms must adopt forms to identify, map, eliminate or minimize, and monitor any Conflicts of Interest relating to employees. Robust controls are only as good as the data the Compliance team has access to. To identify conflicts, the team should rely on a conflict of interest questionnaire, an outside business activities questionnaire combined with robust controls to understand personal investments (including private and public companies). These questionnaires and controls should be adopted to all relevant employees and new hires.
It is expected that conflicts will be identified and handled in a timely manner, with a “culture of compliance” empowering employees to raise future conflicts for evaluation.
Employees should be required to update their information promptly, in case of any material changes, and submit any possible new information or investments that would create a possible conflict of interest. Possible and future conflicts should also be escalated to the Chief Compliance Officer for evaluation.
Conflicts of interest can also arise through gifts or entertainment, where employees may receive benefits such as trips, meals, events or conferences paid for by a third party. These benefits may influence the employee to take decisions or recommendations that would place its interests ahead of the investor’s interests, with employees required to disclose and request approval for gifts and entertainment received.
Employees should be trained upon joining the firm, and on an annual basis regarding the conflicts of interest policy, how to identify, report and how to maintain updated books and records of all conflicts.
Conflicts of interest are not restricted to individuals, as firms may create conflicts based on their business models. A firm’s conflict may appear through compensation arrangements (e.g. fees, bonuses or commissions), where there is a financial incentive to recommend investments that could benefit the firm but not be in the client’s best interest.
Firms should review the following items, reinforced by the recent Staff Bulletin:
- Compensation, revenue and other benefits paid to employees and to other companies;
- Compensation, revenue and other benefits received by other companies;
- Commissions related to recommendations regarding proprietary products; and
- Commissions across different profitable products recommended.
If an RIA has a 12b-1 fee arrangement (revenue sharing in connection with mutual funds), the compensation is considered a conflict of interest and must be disclosed on Form ADV Part 2A.
Conflicts may be found as a spouse may work for a public company, a member of the household could be a judge/regulator, or a financial dependent is investing in a private tech company that will be acquired by a public company. A complete questionnaire would assist Compliance to identify these conflicts.
2. Disclosure obligations
Firms are required to identify and disclose any material conflicts of interest. While RIAs can disclose those conflicts through Form ADV Part 2A, broker dealers are required to disclose conflicts prior to, or at the time of, making a recommendation to a client.
The SEC understands that there are circumstances where a disclosure alone cannot mitigate a conflict of interest and the adviser must seek to avoid that conflict or, at a minimum, make full and fair disclosure of all material conflicts of interest.
For RIAs following previous SEC FAQs, conflicts of interest disclosures in Form ADV Part 2A must be factual and disclose actual conflicts, rather than using the term “may”, with the Investment Advisers Act stating:
“Disclosure that an adviser “may” have a particular conflict, without more, is not adequate when the conflict actually exists. For example, we would consider the use of “may” inappropriate when the conflict exists with respect to some (but not all) types or classes of clients, advice, or transactions without additional disclosure specifying the types or classes of clients, advice, or transactions with respect to which the conflict exists. In addition, the use of “may” would be inappropriate if it simply precedes a list of all possible or potential conflicts regardless of likelihood and obfuscates actual conflicts to the point that a client cannot provide informed consent.”
3. Duty of Care / Fiduciary Duty
Given the firms obligation to protect and prioritize client/investor interests ahead of any other commission, investment decision or personal interests, the Care Obligation under Reg BI requires every broker-dealer and their associated persons to have a reasonable basis to believe that each recommendation is made in the best interest of the client. RIAs must observe the fiduciary standards, which combines the duty of loyalty (eliminate conflicts and disclose remaining ones) and the duty of care, providing investment advice in the client’s best interest.
RIAs should also review specific guidance on allocation policies, as the SEC has addressed investment allocation policies, where advisers are required to adopt rigid allocation policies as per the Investment Advisers Act:
“When allocating investment opportunities, an adviser is permitted to consider the nature and objectives of the client and the scope of the relationship. An adviser need not have pro rata allocation policies, or any particular method of allocation, but, as with other conflicts and material facts, the adviser’s allocation practices must not prevent it from providing advice that is in the best interest of its clients.”
Firms should also review their Compliance function, evaluating whether headcount, capacity, structures and processes are robust enough to keep identifying, mitigating, addressing and disclosing current and future conflicts of interest.
What you should do now?
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- Review your Code of Ethics, Compliance Manual and WSPs regarding Conflicts of Interest. Conflicts should be defined in the firm’s policy and examples where conflicts can arise should be listed, such as account recommendations, allocation of investments among accounts, allocation of investments opportunities among investors; cash management services or financial incentives to employees.
- Review the process to identify, map and mitigate conflicts of interest. For example, how do you identify conflicts arising from new product development? A new products committee including compliance representation can help manage this.
- Review compensation, revenue, commissions and other benefits (financial or otherwise) related to incentive sales, appraisals, client retentions, new clients. This should also include company-to-company commissions, such as 12b-1 fees. A product menu and its incentives would assist the conflicts mapping process.
- Have a centralized repository of conflicts of interest and request an annual attestation to confirm its accuracy. Conflicts may arise at the individual or firm level.
- Review all disclosures (e.g. Form ADV Part 2A) and compare to the repository conflict of interest.
- Review the Annual Compliance Meeting / Code of Ethics Annual Training to confirm it addresses conflicts or interest procedures. As part of periodic policy reminders and training throughout the year, conflicts of interest should be featured as a key topic.
Our conflicts of interest mapping template
We’ve been supporting firms to manage their approach to standards of conduct; including assessing, managing and mitigating conflicts and potential conflicts of interest. We’ve also produced a conflicts of interest mapping tool, providing an easy way for firms to capture and understand potential conflicts at a firm or employee level.
Additional resources
- August, 2022 – Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest
- March, 2022 – Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors
- March, 2022 – SEC 2022 Examination Priorities
- February, 2022 – FINRA 2022 Report on FINRA’s Examination and Risk Monitoring Program
- December, 2020 – No-Action Letters: Securities Industry and Financial Markets Association
- August, 2020 – Frequently Asked Questions on Regulation Best Interest
- April, 2020 – Risk Alert: Examinations that Focus on Compliance with
Regulation Best Interest - September, 2019 – Regulation Best Interest: A Small Entity Compliance Guide (September 9, 2019)
- June, 2019 – Commission Interpretation Regarding Standard of Conduct for Investment Advisers
