SEC Staff Posts Conflicts of Interest Guidance for Investment Advisers and Broker-Dealers
On August 3, 2022, the US Securities and Exchange Commission (“SEC”) staff posted a bulletin (the “Bulletin”) that, in the staff’s view, reiterates the standards of conduct for investment advisers and broker-dealers in identifying and addressing conflicts of interest under the Investment Advisers Act of 1940 (“Advisers Act”) and Regulation Best Interest (“Reg BI”) under the Securities Exchange Act of 1934 (the “Exchange Act”), respectively.1 The Bulletin is styled as a “Q&A” and covers, among other matters, identification,2 elimination, and mitigation of conflicts, as well as conflicts policies and procedures.3
Although in large part the Bulletin does in fact reiterate the standards of conduct under the Advisers Act and Reg BI, the Bulletin interestingly focuses on compensation arrangements (including wrap and similar programs) and proprietary product offerings, which, in our view, is a sign of likely forthcoming regulatory activity. Accordingly, the Bulletin is a worthwhile read for legal and compliance personnel of investment advisers (whether registered or not) and broker-dealers. Salient points and related observations from the Bulletin are summarized below:
All Investment Advisers and Broker-Dealers Have Conflicts – The Bulletin states unequivocally that all investment advisers and broker-dealers have conflicts of interest.4 Notably, the Bulletin cites as a common source of conflict a firm’s receipt of any compensation, such as, for investment advisers, receipt of a fee based on assets under management. Likewise, broker-dealers 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 the recommendation or investment advice is not in the best interest of the retail investor. For investment advisers, this presumably means that, unless a firm does not receive any form of compensation for its services (which in turn would mean that the firm would not be an “investment adviser” as defined in the Advisers Act), a conflict that needs to be eliminated, mitigated, or otherwise disclosed includes the receipt of any compensation for advisory services even if the fee is simply an asset-based fee as is common in the investment advisory industry. However, treating the mere receipt of an asset-based fee for advisory services as a conflict (for disclosure purposes or otherwise) is, in our experience, uncommon.
Conflict Elimination Generally – Echoing the messaging in the Regulation BI Adopting Release and the Fiduciary Interpretation, the Bulletin states that firms “may” find that there are some conflicts that they are unable to address in a way that will allow the firm or its financial professionals to provide advice or recommendations that are in the investor’s best interest. The staff believes that in such cases firms “may” need to determine whether to eliminate the conflict or otherwise refrain from providing advice or recommendations that could violate the obligation to act in the investor’s best interest.
Assessing Compensation-Related Conflicts – The staff believes that all firms need to address compensation-related conflicts (both at the firm and the financial professional levels) and sets out four suggestions for questions to ask when assessing those types of conflicts: (1) do the firm’s compensation practices incentivize its financial professionals to offer advice and recommendations that are not in the investors’ best interests; (2) does the basis for calculating financial professionals’ compensation have the effect of passing along firm-level conflicts to their financial professionals, such as incentivizing them to recommend or provide advice about certain products, account types, or services to investors that are most profitable for the firm; (3) do the firm’s financial professionals also receive other types of compensation or benefits, such as trips and meals paid for by a third party, that may create conflicts of interest between the financial professionals and the firm’s investors; and (4) does the firm have policies and procedures and other systems/controls in place to identify and address these conflicts.
Elimination of Compensation-Related Conflicts – The Bulletin makes clear that eliminating compensation-related conflicts (or refraining from providing conflicted advice or recommendations) could be necessary if a firm adopts a compensation or incentive program that provides significant benefits or penalties based on its financial professionals’ success or failure in meeting certain benchmarks, quota, or other performance metrics established by the firm (beyond those that are specifically prohibited under Reg BI). In the staff’s view, the greater the reward (or the more severe the reduction in compensation or other type of penalty or disincentive) to the financial professional, the greater the risk that there will be a violation. Accordingly, the staff believes that if a 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 investor’s interest, the firm “may” need to revise its incentive program to reduce5 or eliminate the conflict.
Mitigating Compensation-Related Conflicts – The Bulletin sets out a non-exhaustive list of practices that the staff believes could be used as potential mitigation methods: (1) avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales of certain products or provision of certain services; (2) minimizing compensation incentives for financial professionals to favor one type of account over another or to favor one type of product over another (e.g., products that provide third-party compensation, such as revenue sharing, proprietary or preferred provider products, or comparable products sold on a principal basis) by, for example, basing differential compensation on neutral factors; (3) eliminating compensation incentives within comparable product lines by, for example, capping the credit that financial professionals may receive across mutual funds, annuities, real estate investment trusts (“REITs”), or other comparable products across providers; (4) implementing supervisory procedures to monitor recommendations, or ongoing advice, that result in additional compensation that is near compensation thresholds or is near thresholds for firm recognition or involve products, proprietary products, or transactions that provide more compensation to the firm or its financial professionals; (5) adjusting compensation for financial professionals who fail to manage their conflicts of interest adequately and to bring any conflicts to management’s attention; (6) limiting the types of products, transactions, or strategies certain financial professionals may recommend; and (7) providing training and guidance to financial professionals on evaluating, selecting, and, as required, monitoring investments in the best interests of investors.
The Bulletin cautions, however, that depending on the circumstances, other mitigation measures may be necessary or, in some instances, it may not be possible to mitigate the conflict of interest (i.e., elimination is required). The Bulletin also cautions that staying within the bounds of prevailing industry practice will not insulate a firm from a potential violation: “Although 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. In the staff’s view, periodic review and testing of policies and procedures is necessary to ensure the on-going adequacy and effectiveness of a compliance program.”6
Compensation-Related Conflict Disclosures – The staff believes that facts disclosed regarding a compensation-related conflict should, at a minimum, include (1) the nature and extent of the conflict; (2) the incentives created by the conflict and how the conflict affects or could affect the recommendation or advice provided to the investor (e.g., if the availability of products that can be recommended to the investor is limited as a result of the financial professional only recommending products from certain preferred providers); (3) the source(s) and scale of compensation for the firm and/or financial professional; (4) how the firm and/or financial professional is compensated for, or otherwise benefits from, their recommendation or advice (for example, revenue sharing or other compensation related to cash sweep programs) and what, if any, additional benefits they may receive (for example, cost reductions, merchandise, gifts, or prizes); and (5) the nature and extent of any costs or fees incurred, directly or indirectly, by the investor as a result of the conflict.
Proprietary Products – The staff believes that firms should carefully consider how their product menu choices (such as offering only proprietary products, a specific asset class, or products that pay revenue sharing or feature similar third-party arrangements) comply with the firm’s obligations under relevant standards of conduct. In the staff’s view, firms should consider establishing product review processes for the products they offer (or that are offered by an affiliate), which could include (1) identifying and mitigating the conflicts of interest associated with the product, such as payments for inclusion on a firm’s menu of products offered (sometimes referred to as shelf space); (2) declining to recommend or provide advice with regard to a product where the firm cannot effectively mitigate the conflict; (3) evaluating the use of “preferred lists”; (4) restricting the investors to whom certain products may be recommended; (5) prescribing minimum knowledge and/or training requirements for financial professionals who may provide recommendations or advice with regard to certain products; and (6) conducting periodic product reviews to identify potential conflicts of interest and evaluate whether the measures addressing conflicts are working as intended (and further to modify those measures or product selections accordingly).7
Regarding disclosure of the conflicts related to proprietary products, the Bulletin offers a list of facts that, in the staff’s view, should be disclosed at a minimum: (1) whether the firm or an affiliate manages, issues, or sponsors the product; (2) whether the firm, its financial professionals, or an affiliate could receive additional fees and compensation related to that product; (3) 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 (4) the extent to which financial professionals receive additional compensation, have quotas to meet, or qualify for bonuses or awards based on their sale of proprietary products.
Ongoing Monitoring – Importantly, the Bulletin states that identifying and addressing conflicts is not a “set it and forget it” exercise. In this regard, the staff encourages firms to monitor conflicts over time and periodically assess the adequacy and effectiveness of their policies and procedures (particularly in light of events that develop or information received over time). As examples of how such information might be obtained, the staff cites supervision (e.g., exception testing of recommendations) and the actual experience of the firm. This staff view is expected and consistent with prior guidance.
Demonstration of Compliance – The Bulletin states that in order to demonstrate compliance with applicable standards of conduct, in the staff’s view, a firm should consider documenting the measures it takes to address and monitor conflicts of interest. The Bulletin also makes this point when discussing mitigation.
The idea that registrants bear the burden of proving their compliance by the creation of appropriate documentation is not new. The staff’s statements are also consistent with the fairly recent proposal to require registered investment advisers to document their annual compliance reviews.8
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A prudent course of action for any investment adviser or broker-dealer would be to review the Bulletin and compare the staff’s messaging with the firm’s current practices and conflict inventories. If you have any questions about the Bulletin or conflicts of interest more generally, including practical considerations, or would like to discuss any of these topics, please do not hesitate to reach out to Leslie Cruz, Stephanie Monaco, Adam Kanter, or Steffen Hemmerich.
1 See generally, Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. 5248, 84 FR 33669 (June 5, 2019) (“Fiduciary Interpretation”); Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031, 84 FR 33318 (June 5, 2019) (“Reg BI Adopting Release”).
2 The Bulletin includes a number of suggested steps to identify conflicts: define conflicts in a manner that is tailored to the firm’s business (including conflicts related to the firm, its financial professionals and affiliates) and understandable by personnel; define conflicts in a manner that covers all aspects of advice/recommendations (e.g., account recommendations; allocation of investments among accounts; allocation of investment and IPO opportunities; and cash management services); establish a process to identify conflicts, both initially and on an ongoing basis (including periodic testing of policies and procedures); and provide for appropriate training programs for personnel (covering conflicts, identification of conflicts (and related roles and responsibilities), and escalation of identified conflicts).
3 Although the Bulletin focuses on retail investors, the staff is quick to point out that an investment adviser’s fiduciary duty applies equally to all advisory clients (whether retail investors or otherwise).
4 Over the years, we have seen some investment advisers make affirmative statements to the contrary in their advertisements and other communications (e.g., “we are conflict-free!”).
5 Presumably, this reference to reducing the conflict (and the above reference to “significant” benefits or penalties) is related to the Bulletin’s discussion of mitigation.
6 The staff believes this review should include a periodic assessment of whether a firm’s policies and procedures are reasonably designed to disclose and mitigate, as necessary, the impact of conflicts. In the staff’s view, 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. See also Demonstration of Compliance below.
7 The staff notes that under Reg BI, 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 those limitations. In the staff’s view, the product review processes described above could equally apply to limitations placed on investment strategies and investment advisers. For example, a dual registrant acting in its advisory capacity 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. The staff then states that investment advisers “therefore should consider addressing any such circumstances in which their advice will be similarly limited.”
8 See Private Fund Advisers; Documentation of Registered Adviser Compliance Reviews, Investment Advisers Act Release No. 5955, 87 FR 16886 (Mar. 24, 2022).
