The Securities and Exchange Commission in 2019 issued significant new rules and interpretations addressing the standards of conduct for broker-dealers, in the form of Regulation Best Interest,¹ and the standards of conduct for investment advisers (together with broker-dealers, firms), in the form of the Commission Interpretation Regarding Standard of Conduct for Investment Advisers under the Investment Advisers Act of 1940 (IA Fiduciary Standard).² While the current SEC Chair, Gary Gensler, has not placed agency action regarding the standards of conduct on his agenda, he has expressed a desire to “get the best out of best interest.”³ In this regard, he has “asked [the] Divisions of Investment Management, Trading and Markets, Examinations, and Enforcement to help ensure that investment professionals live up to these obligations.”⁴ In response, the Staff has issued two bulletins, one in March addressing account recommendations and one in August addressing conflicts of interest. The Staff also recently stated that it anticipates publishing a third bulletin, addressing care obligations, sometime this winter.

Because each bulletin reflects Staff views only and was not approved by the SEC, it is not intended to create any new or additional obligations or to amend or alter the law. Rather, each bulletin’s stated purpose is to “assist firms and their financial professionals with addressing conflicts of interest such that they comply with their obligations to provide advice and recommendations in the best interest of retail investors.” However, firms may wish to consider this guidance in light of continued focus on Regulation Best Interest and the IA Fiduciary Standard by the SEC's Divisions of Examination and Enforcement and, the Financial Industry Regulatory Authority, in the case of broker-dealers.

This Dechert OnPoint discusses the August bulletin address conflicts of interest (Bulletin).⁵

Background

Regulation Best Interest

Regulation Best Interest requires broker-dealers and their associated persons to act in the best interest of their retail customers at the time of making recommendations to these customers or their legal representatives, regarding any “securities transaction or investment strategy involving securities (including account recommendations)” and to place the interests of the retail customers ahead of the financial or other interests of the broker-dealer and its associated persons. Regulation Best Interest consists of four component obligations: the disclosure obligation; the care obligation; the conflict of interest obligation; and the compliance obligation.

Under the conflict of interest obligation, a broker-dealer must have in place and enforce written policies and procedures that are reasonably designed to identify, and, at a minimum disclose, all conflicts of interest associated with recommendations to retail customers. In the case of conflicts of interest that create incentives for associated persons to place their or the broker-dealer’s interest ahead of a retail customer when making recommendations, the broker-dealer also must mitigate such conflicts. However, in the case of any sales contests, sales quotas, bonuses or non-cash compensation that are based on the sales of specific securities or types of securities within a limited period of time, such practices must be eliminated.

IA Fiduciary Standard

The IA Fiduciary Standard provides that an investment adviser’s fiduciary duties consist of a duty of care and a duty of loyalty, which, taken together, require an adviser to act in the best interest of its clients at all times. The SEC has stated that the duty of care includes: the duty to provide advice that is in the client’s best interest (which includes suitability obligations); the duty to seek best execution where the adviser has the responsibility to select broker-dealers to execute client trades; and the duty to provide advice and monitoring over the course of the adviser/client relationship. The duty of loyalty requires an adviser to “eliminate or make full and fair disclosure of all conflicts of interest which might incline [it] – consciously or unconsciously – to render advice which is not disinterested such that a client can provide informed consent to the conflict.”

Identifying Conflicts of Interest

Under both Regulation Best Interest and the IA Fiduciary Standard, firms must identify conflicts of interest and address them appropriately. The Bulletin notes that all firms have “at least some” conflicts of interest with retail investors, and states that such interests include economic incentives to recommend certain products, services or account types over others, based on the revenue that the firm would receive from such recommendations. The Bulletin further notes that a firm’s conflicts of interest will depend on a variety of factors, including “a firm’s business model” and, in order to act in a retail investor’s best interest as required by Regulation Best Interest and the IA Fiduciary Standard, a firm must deal with conflicts to prevent the firm or its financial professionals from “providing recommendations or advice that places their interests ahead of the interests of the retail investor.” Examples of what the Staff believes are common sources of conflicts of interest include:

• Compensation, revenue or other benefits (financial or otherwise) to the firm or its affiliates, for the services provided to retail investors;

• Compensation, revenue or other benefits (financial or otherwise) to financial professionals from their firm or its affiliates;

• Compensation, revenue or other benefits (financial or otherwise) to the financial professionals resulting from other business or personal relationships the financial professional may have, relationships with third parties that may relate to the financial professional’s association or affiliation with the firm or with another firm (whether affiliated or unaffiliated), or other relationships within the firm; and

• Compensation, revenue or other benefits (financial or otherwise) to the firm or its affiliates resulting from the firm’s or its financial professionals’ sales or offer of proprietary products or services, or products or services of affiliates.

The Bulletin notes that firms are expected to identify conflicts of interest and that, under Regulation Best Interest, broker-dealers are required to create, maintain and enforce “written policies and procedures reasonably designed to identify all conflicts of interest associated with recommendations to retail customers.” The Staff also reminds firms that, under the Investment Advisers Act, investment advisers are required to identify conflicts of interest as part of designing their compliance policies and procedures. Further, the Staff urges all firms to stress a “culture of compliance” and to review policies and procedures periodically.

In terms of identifying conflicts of interest, the Bulletin suggests that firms consider whether their policies and procedures:

• Define conflicts in a manner that is relevant to the firm’s business and in a way that enables appropriate personnel (including compliance professionals) to understand and identify conflicts of interest;

• Define conflicts in a manner that includes conflicts that arise across the scope of advice or recommendations associated with the relationship with the retail investor;

• Establish a process to identify the types of conflicts that the firm and its financial professionals may face and how such conflicts might impact advice or recommendations;

• Provide for an ongoing and regular, periodic process to identify conflicts associated with the firm’s business; and

• Establish, and publish internally or otherwise communicate, training programs regarding conflicts of interest.

Eliminating Conflicts of Interest

The Staff believes that there are particular circumstances where a conflict of interest should be eliminated. Regulation Best Interest requires that “sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time” be eliminated. The Bulletin notes that investment advisers are required to “fully and fairly” disclose any conflicts of interests in a manner that allows a client to provide informed consent, and that, without informed consent, the Staff believes that such a conflict should be eliminated. Where a conflict of interest prevents a firm or its financial professionals from providing advice or recommendations that are in a retail investor’s best interest, the Bulletin states that conflict should be eliminated or the firm should not provide the advice or recommendation.

Mitigating Conflicts of Interest

One of the Staff’s goals in publishing the Bulletin appears to be encouraging firms to address conflicts through elimination or mitigation rather than disclosure. Accordingly, the Bulletin urges firms to mitigate conflicts where possible. The Bulletin notes that mitigation measures for conflicts “depend on the nature and significance of the incentives provided to the firm or its financial professionals and a firm’s business model.”⁶ Where mitigation of a conflict of interest cannot be achieved, the Staff encourages firms to consider eliminating the conflict altogether or refraining from making a recommendation or providing the advice.

The Bulletin reminds firms that if conflicts of interest relating to compensation and incentive programs arise, firms need to consider whether such arrangements “could cause their financial professionals (either consciously or unconsciously) to provide advice or make recommendations that place the interests of the firm or the financial professional ahead of the retail investor’s interests.” The Staff also noted that firms should adopt measures to mitigate conflicts of interest in relation to the compensation of financial professionals, providing a “non-exhaustive list” of mitigation methods.⁷ In addition, the Bulletin expresses the Staff’s belief that firms should not rely solely on industry practice for mitigation of conflicts, but also should conduct periodic reviews and tests of their policies and procedures to ensure continuing efficacy of their respective mitigation abilities and compliance programs. The Bulletin reminds firms that conflicts of interests must be addressed at both the firm and financial professional levels.

Product Menus
The Bulletin states that, where a firm has provided recommendations or advice limited to a menu of certain products, this can create conflicts of interest. The Staff further encourages firms to “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…” The Bulletin reminds broker-dealers that under Regulation Best Interest, such limited product offerings should be disclosed, and further asserts that this process of identifying and disclosing related conflicts “could equally apply” to investment advisers.

Disclosing Conflicts of Interest

Under both Regulation Best Interest and the IA Fiduciary Standard, conflicts of interest must be disclosed. In the Bulletin, the Staff reminds firms that such disclosure should allow a retail investor “to make a more informed decision about a recommendation, and, in the case of investment advisers, provide informed consent to the conflict of interest.” Under Regulation Best Interest, broker-dealers must “fully and fairly disclose all material facts relating to a conflict of interest that might incline the firm or its financial professionals to make a recommendation or provide advice that is not disinterested.” The Bulletin states that investment advisers also must make “full and fair disclosure of all conflicts of interest which might incline an investment adviser consciously or unconsciously to render advice which is not disinterested such that a client can provide informed consent to the conflict.” The Staff believes that disclosure should be in “plain English” and tailored to the particulars of a firm. The Staff also highlights that conflicts-of-interest disclosure should refrain from using the word “may” where such conflict actually exists, noting that the SEC would consider such disclosure insufficient. Where disclosure cannot describe a conflict fully and adequately, the Staff asserts that such conflict should be mitigated or eliminated, stressing the importance of disclosing compensation and incentive arrangements for firms and their financial professionals. The Bulletin includes the Staff’s view of what information should be disclosed, which includes:

• The nature and extent of the conflict;

• The incentives created by the conflict and how the conflict affects or could affect the recommendation or advice provided to the retail investor (e.g., where the availability of product that can be recommended to the retail investor is limited as a result of the financial professional recommending only products from certain preferred providers);

• The source(s) and scale of compensation for the firm and/or financial professional;

• How the firm and/or financial professional is compensated for, or otherwise benefits from, their recommendation or advice (e.g., through revenue sharing or other compensation related to cash sweep programs) and what, if any, additional benefits they may receive (e.g., cost reductions, merchandise, gifts or prizes); and

• The nature and extent of any costs or fees incurred, directly or indirectly, by the retail investor as a result of the conflict.

The Bulletin notes that where firms are providing advice regarding, or recommending, proprietary products, the Staff would expect additional information about these arrangements to be disclosed.⁸ Where a firm or its financial professionals receive compensation from a third party, the Staff would expect such compensation arrangements to be disclosed. In addition, the Bulletin states that where a firm is recommending a wrap fee program or other separately managed account, additional disclosures (including how such accounts are managed and the facts that “encourage the broker-dealer or investment adviser to recommend a wrap account or separately managed account”) should be disclosed.⁹

The Bulletin asserts that disclosure of conflicts of interest alone is not sufficient to satisfy a firm’s obligation to act in the best interests of a retail investor and that firms should periodically review the “adequacy and effectiveness of their policies and procedures” and disclosure.

Conclusion

While the Bulletin expressly states that it “is not a rule, regulation, or statement of the SEC,” and “has no legal force or effect,” broker-dealers and investment advisers may wish to consider this guidance in light of continued focus on the Regulation Best Interest and the IA Fiduciary Standard by the SEC’s Divisions of Examination and Enforcement and, in the case of broker-dealers, by the Financial Industry Regulatory Authority.

Footnotes

1) Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318 (2019).

2) Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 84 Fed. Reg. 33669 (2019).

3) SEC Chair Gary Gensler, “Investor Protection in a Digital Age”, Remarks Before the 2022 NASAA Spring Meeting & Public Policy Symposium (May 17, 2022).

4) Id.

5) Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest (2022). For a discussion of the March bulletin, please refer to Dechert OnPoint, SEC Publishes Staff Bulletin on the Standards of Conduct for Broker-Dealers and Investment Advisers Making Account Recommendations to Retail Investors.

6) In the Bulletin, the SEC lists the following factors to consider with respect to conflict of interest mitigation:

• The sources of the firm's compensation, revenue or other benefits (financial or otherwise), and whether or not the firm receives these 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;
• 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;
• The extent to which the compensation of financial professionals varies based on the investment product recommended (e.g., variable compensation for similar securities);
• The nature of the payment structure for financial professionals (e.g., whether retrospective, the steepness of the increases between levels);
• The size or structure (e.g., broker-dealer, investment adviser, or dual registrant) of the firm or if the firm’s financial professionals are dually licensed or engage in activities outside of the firm;
• Whether the firm shares dually licensed financial professionals with affiliates or third parties;
• The retail investor base (e.g., diversity of investment experience, total assets, and financial needs); and
• The complexity of the security or investment strategy involving securities that are recommended.

7) This additional information includes:

• Avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales of certain products or provision of certain services;
• 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) – for example, by basing differential compensation on neutral factors;
• Eliminating compensation incentives within comparable product lines – for example, by capping the credit that financial professionals may receive across mutual funds, annuities, real estate investment trusts (REITs), or other comparable products across providers;
• Implementing supervisory procedures to monitor recommendations or ongoing advice that results in additional compensation that: is near compensation thresholds; is near thresholds for firm recognition; or involves higher compensating products, proprietary products, or transactions that provide more compensation to the firm or financial professional;
• Adjusting compensation for financial professionals who fail to manage their conflicts of interest adequately or bring any conflicts to management's attention;
• Limiting the types of products, transactions or strategies certain financial professionals may recommend; and
• Providing training and guidance on evaluations to financial professionals

8) This additional information includes:

• Whether the firm or an affiliate manages, issues or sponsors the product;
• Whether the firm, its financial professionals or an affiliate could receive additional fees and compensation related to that product;
• Whether the firm prefers, or targets or limits its recommendation or advice to, proprietary products or only to those proprietary products for which the firm or an affiliate could receive additional fees and compensation; and
• 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 (such as mutual funds, annuities or REITs).

9) The Bulletin states that these factors include: compensation from wrap fee program sponsors (including affiliates) for investing client assets in the sponsors' programs; and the possibility that the investor will bear higher costs by participating in the wrap fee program than in other types of accounts. Firms also should consider the scope of the relationship with respect to the account and whether there is an obligation or agreement to monitor the account and, as applicable, disclose any incentive for the firm to not migrate infrequently traded wrap fee accounts to brokerage or non-wrap advised accounts.