A key component of the SEC’s proposal designed to address investor confusion about their advisory relationships is the Form CRS Relationship Summary – though the proposals length is a daunting start. How does the CRS deal with conflicts of interest?
Conflicts of Interest
The SEC acknowledges that investment advisers, broker-dealers and their financial professionals have incentives to put their interests ahead of the interests of their retail investor clients and customers, and that while federal securities laws do not preclude broker-dealers or investment advisers from having conflicts of interest that might adversely affect the objectivity of the advice they provide, firms and financial professionals have obligations regarding their conflicts. Consequently, the proposal contemplates that firms would be required to disclose conflicts relating to:
- financial incentives to offer to, or recommend that the retail investor invest in, certain investments because (a) they are issued, sponsored or managed by the firm or its affiliates, (b) third parties compensate the firm when it recommends or sells the investments, or (c) both;
- financial incentives to offer to, or recommend that, the retail investor invest in certain investments because the manager or sponsor of those investments or another third party (such as an intermediary) shares revenue it earns on those products with the firm; and
- the firm buying investments from and selling investments to a retail investor for the firm’s own account (i.e., principal trading).
The proposal notes that under Regulation Best Interest, broker-dealers would be “required to establish, maintain and enforce written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendation,” as well as to disclose, in writing, all material conflicts of interest that are associated with the recommendation.
That said, the SEC is not here proposing to require or permit the relationship summary disclosure to include specific information about all of the conflicts of interest that are or could be present in a firm’s relationship with retail investors. Indeed, the proposal’s authors “believe that requiring an exhaustive discussion of all conflicts in the relationship summary would make the relationship summary too long for its intended purpose…” and commented that since conflicts of interest are already reported on Form ADV Part 2, “a more exhaustive discussion of conflicts by investment advisers would be duplicative…”.
Moreover, they note that Regulation Best Interest will require a written disclosure of all “material conflicts of interest” associated with a recommendation to a retail customer. In the CRF, the SEC is instead proposing to require “specific information about conflicts of interest related to financial incentives for recommending or selling proprietary products or products offered by third parties, and from revenue sharing arrangements.”
However, with regard to conflicts of interest, the proposal says that a firm would be required to state, as applicable, that it has a financial incentive to offer or recommend to the retail investor certain investments because: (a) they are issued, sponsored or managed by the firm or the firm’s affiliates, (b) third parties compensate the firm when it recommends or sells the investments, or (c) both. The proposal also contemplates requiring examples of the types of investments associated with each of these conflicts, and that revenue-sharing arrangements be disclosed by stating that the firm has an incentive to offer or recommend the retail investor to invest in certain investments because the manager or sponsor of those investments or another third party (such as an intermediary) shares with the firm revenue it earns on those investments.
The questions on the conflict of interest section begin on page 110 and run through page 115.
The “Additional Information” section is where the SEC proposes to place information on where retail investors can find more information about the firm’s disciplinary events, services, fees and conflicts, facilitating “the layered disclosure that the relationship summary provides.”
Ultimately, the SEC notes that “…requiring firms to state the existence of disciplinary events, provide specific questions for retail investors to ask, and provide information on where retail investors can find more information, would cause more retail investors to seek out this information…”.
And the additional information questions begin on page 122 and run through 126.
About This Series
This is the third in our ongoing series of posts analyzing the Form CRS. The other installments in the series are: