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SEC Warns Firms Not to Neglect Conflicts of Interest

Regulatory Compliance

The Securities and Exchange Commission is warning broker-dealers and investment advisers that they need to take ongoing steps to identify and eliminate conflicts of interest, noting that all firms have them in some form.  

Under the Regulation Best Interest for broker-dealers and the fiduciary standard for investment advisers under the Investment Advisers Act—both of which are drawn from key fiduciary principles that include an obligation to act in a retail investor’s best interest—the SEC notes that a conflict of interest is 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.” 

As such, the staff believes that identifying and addressing conflicts should not be merely a “check-the-box exercise,” but rather a robust, ongoing process that is tailored to each conflict, the SEC says in the 17-page staff bulletin released Aug. 3. Consequently, the SEC advises that firms should review their business models and relationships with investors to address conflicts of interest specific to them. 

Released in Q&A form, the staff bulletin includes 13 questions and answers addressing how firms should identify, eliminate and mitigate conflicts of interest, as well as addressing potential conflicts with respect to product menus and disclosing conflicts. The staff advises that the bulletin should be read in conjunction with Reg BI, as well as specific Commission releases discussing Reg BI and the IA fiduciary standard, among other sources. 

This is the second staff bulletin issued in the last several months. In March, the SEC issued a bulletin providing views on how broker-dealers and investment advisers can satisfy their obligations to retail investors when making account recommendations—particularly with respect to dually registered or affiliated firms, as well as dually licensed financial professionals.

Identifying Conflicts

As background, the bulletin explains that, in addition to satisfying the duty of loyalty and care obligations, investment advisers must also implement policies and procedures designed to prevent violations by the adviser and its supervised persons under the Advisers Act, as well as identify all conflicts of interest associated with recommendations to retail customers under Reg BI.  

To that end, the SEC affirms that broker-dealers are expected to identify conflicts on an ongoing basis and periodically review their policies and procedures for compliance with Reg BI. What’s more, under the Advisers Act, the Commission has stated that investment advisers, as part of designing their written compliance policies and procedures, should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations. “Investment advisers also must review, no less frequently than annually, the adequacy of such policies and procedures and the effectiveness of their implementation,” the staff bulletin advises. 

Moreover, to demonstrate compliance under Reg BI and the IA fiduciary standard, the staff suggests that firms should consider documenting the measures they take to address and monitor conflicts.

Mitigation

As to whether a firm has satisfied its obligations once the firm identifies and discloses its conflicts to retail investors, the staff advises that disclosure alone does not satisfy the obligations and that certain conflicts must be addressed through mitigation. “Where such conflicts cannot be effectively addressed through mitigation, firms may need to determine whether to eliminate the conflict or refrain from providing advice or recommendations that are influenced by that conflict to avoid violating the obligation to act in a retail investor’s best interest in light of the investor’s objectives,” the SEC advises.  

Moreover, the SEC reminds that even if conflicts are addressed sufficiently, under both Reg BI and the IA fiduciary standard, firms and their financial professionals can provide recommendations or advice only when they have a reasonable basis to believe that the recommendation or advice is in the retail investor’s best interest.

Addressing what factors are relevant to a firm’s approach to mitigating conflicts of interest, the staff explains that the appropriate mitigation measures will depend on the nature and significance of the incentives provided to the firm or its financial professionals and a firm’s business model. In the staff’s view, those factors may include:

  • the sources of the firm’s compensation, revenue or other benefits (financial or otherwise), whether or not it receives them directly from the retail investor;
  • the extent to which a firm’s revenues vary based on the type of account, products (including but not limited to share classes recommended), services recommended or AUM;
  • whether or not the firm or its affiliates recommend or provide advice about proprietary products; and 
  • the extent to which the firm uses incentives to encourage financial professionals to recommend or provide advice about accounts or investment products that are more profitable for the firm. 

Product Menus

As to whether a firm needs to address conflicts concerning a recommendation or advice that is limited to a menu of certain products, the staff answers in the affirmative, noting that a firm’s product menu can have a “significant impact” on the conflicts of interest present in its business model. 

“The staff believes that firms should carefully consider how their product menu choices—which could include limitations such as offering only proprietary products (i.e., any product that is managed, issued, or sponsored by the firm or any of its affiliates), a specific asset class, or products that pay revenue sharing or feature similar third-party arrangements—comply with the firm’s obligations to act in the best interest of retail investors when providing investment advice and recommendations and to disclose conflicts,” the bulletin states. 

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