On Aug. 3, 2022, the Securities and Exchange Commission (SEC) issued a staff bulletin addressing investment advisers and broker-dealers with guidance on identifying and handling conflicts of interest with investors. The staff answered common questions about addressing conflicts of interest and how to satisfy the fiduciary standard under the Investment Advisers Act of 1940 (“IA fiduciary standard”). In this blog post, we highlight key takeaways and best practices from the bulletin, specifically as they apply to investment advisers.
Advisers have an obligation to act in their clients’ (retail investors’) best interests at all times, as part of their fiduciary responsibility. Below we discuss the key elements of the 17-page staff bulletin, “Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest.”
A conflict of interest is defined as “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.” For financial firms, there is rarely a way to conduct business and completely avoid all conflicts with retail investors. Accordingly, the importance of documenting all steps taken to identify, mitigate and disclose conflicts of interest is paramount.
Identifying conflicts of interest
While the SEC staff provides a set of non-exhaustive steps for advisory firms to identify conflicts of interest, it’s important to note that all policies and procedures should be adjusted to the firm’s particular business practices. Conflicts related to an investment adviser’s business, professionals and affiliate entities should be described in plain language to ensure appropriate personnel can identify and understand them. An additional measure is to provide firm personnel with examples of various situations in which conflicts could occur.
We cannot emphasize enough the need for firms to establish clear policies and procedures for identifying conflicts and ensure employees are properly trained to follow through with the processes in place. Within these written procedures, firms should detail how they will continue to work to address conflicts as the business evolves. Firms should routinely review their processes, advice and recommendations to ensure their efforts are effective as intended.
Eliminating and mitigating conflicts of interest
The staff bulletin also provides clarity on a common misconception about disclosures, noting that disclosing a conflict of interest to the retail investor is not by itself enough to comply with the IA fiduciary standard. Instead, advisers must also determine if they can eliminate certain conflicts, and, if that is not possible, they must decide if the advice could be influenced by the conflict. In that case, the investment adviser should refrain from giving advice so as to avoid violating its obligation to act in the retail investor’s best interest.
The staff shares an example to demonstrate this type of circumstance. When a firm’s compensation model or incentive program provides significant benefits or penalties based on the adviser’s success or failure to meet predetermined performance metrics. `The concern here lies in whether the adviser is placing its own interests before those of its clients.` As a best practice, firms should evaluate their compensation practices and carefully consider the conflicts that could come about. And beyond typical compensation, the bulletin also advises firms to address conflicts associated with incentives from other types of benefits, such as trips or meals paid by a third party, or compensation for sales of specific products or services.
The SEC staff reiterates that a financial firm’s obligation to act in the clients’ best interest includes addressing conflicts at both the firm and financial professional level.
Providing adequate disclosures
For an adviser to provide a full and fair disclosure, they should describe, at a minimum:
- The nature of the conflict.
- The incentives created by the conflict and how the conflict affects or could affect the
recommendation or advice. - The source(s) and scale of compensation for the adviser and firm.
- If and how the adviser or firm is compensated for their recommendation or advice (e.g., revenue sharing)
- Fees incurred, directly or indirectly, by the retail investor as a result of the conflict.
We recommend chief compliance officers (CCOs) and all advisory firm principals carefully review the staff bulletin and the IA fiduciary standard. Firms can also act now by reviewing their business practices, policies and procedures, and relationships with each of their clients to identify and address conflicts of interest.