In July 2019, the US Securities and Exchange Commission (“SEC”) issued interpretive guidance on the standards of conduct for investment advisers. The guidance outlines an investment adviser’s duty of care and loyalty as a fiduciary to its clients and specifically states that “an adviser must, at all times, serve the best interest of its clients and not subordinate its client’s interest to its own.” It further states:
“In our view, the duty of care requires an investment adviser to provide investment advice in the best interest of its client, based on the client’s objectives. Under its duty of loyalty, an investment adviser must eliminate or 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.”
Since the release of that guidance, the SEC staff have issued three “Staff Bulletins”, each of which address different standard of conduct areas in a question-and-answer format. In this Risk Management Update, we will outline the more salient areas discussed in each bulletin, provide a summary of the views expressed by the SEC staff, and include key compliance takeaways and action items for consideration.
Recommendations to Retail Investors
The first bulletin was issued in March 2022 and covers account recommendations made to retail investors. The related Q&A discusses factors to consider when making recommendations, including costs and investor preference, along with additional factors specific to retirement accounts. The staff also opines on the obligations of dually registered financial professionals when making such recommendations, the steps for addressing relevant conflicts of interest, and the maintenance of documentation that substantiates the recommendation.
Summary of Staff Views: In order to determine what type of account would be in an investor’s best interest, a financial professional must first obtain and review sufficient information about the investor. The scope of the information should include: (i) financial situation, needs, and goals; (ii) current investments; (iii) assets and debts; (iv) marital status; (v) tax status; (vi) age; (vi) time horizon; (vii) liquidity needs; (viii) risk tolerance; and (ix) investment experience, objectives, and strategy. In addition, the financial professional should understand the investor’s financial sophistication, whether they are looking to have their account fully managed vs. making their own investments decisions, and the type of investment strategy they are considering. For retirement account investors, the financial professional must examine additional factors prior to recommending both a rollover and a type of account. Without having most, if not all, of this information, the staff believe that a reasonable determination would not be able to be made and a recommendation should not be provided.
When considering types of accounts, costs must be considered, especially if the firm or financial professional receives any compensation or benefits that are tied to the account or investment product held within the recommended account. While the lowest cost account is not required to be recommended, the selection must be based on what is in the investor’s best interest.
Other factors include, but are not limited to, account characteristics, composition of investments, and potential risks and benefits. Also, investor preference can and should be considered, but cannot be the sole reason for account selection.
Both potential and actual conflicts of interest need to be considered and addressed. The main conflicts being firm incentives and compensation received by both the firm and the financial professional that are tied to types of accounts being recommended.
Last, but not least, firms are required by regulation to maintain documentation that substantiates the recommendations made to each investor.
Conflicts of Interest
This bulletin was issued in August 2022 and discusses a number of important conflicts of interest considerations. The Q&A addresses ways of identifying conflicts, circumstances and steps for eliminating and mitigating conflicts, how to address certain types of conflicts, and satisfying disclosure requirements.
Summary of Staff Views: The type of conflicts varies depending on facts and circumstances but must be identified and addressed in order to ensure that the advice being provided is in an investor’s best interest. Examples of common conflicts include the receipt of compensation received by the firm and/or its investment professionals, such as fees charged for services provided, revenue received from offering certain investment products, incentives and bonuses paid, and direct or indirect compensation received by third parties, such as gifts and/or entertainment.
Firms must establish a “culture of compliance”, which demonstrates that conflicts are taken seriously and allows and encourages financial professionals to actively identify conflicts so they can be adequately addressed. Such culture would include having processes, written policies and procedures, and a training program in place that are designed to identify, address, and continually monitor applicable conflicts.
If any conflict cannot be addressed in such a way that would ensure the recommendation or advice provided is in an investor’s best interest, then either the conflict must be eliminated, or the firm must refrain from providing the recommendation or advice.
Mitigation steps will depend on the facts and circumstances of the conflict. For conflicts pertaining to compensation arrangements, some appropriate steps include: (i) avoiding certain compensation thresholds that increase compensation based on an increase in sales of services and/or certain investment products; (ii) minimizing or eliminating compensation incentives; (iii) adjusting compensation for financial professionals that do not adequately address conflicts; (iv) limiting the types of products, transactions, or strategies that can be recommended; and (v) providing training to financial professionals.
Disclosures must be detailed enough to allow the investor to make an informed decision, which should include various facts depending on the conflict(s). It is important to note, of course, that disclosures alone do not meet the duty of care and loyalty.
Duty of Care Obligations
This is the most recent bulletin and was issued in April 2023. It is also the most extensive of the three since it addresses the obligations of firms and financial professionals under their duty of care responsibility. The areas discussed include having an appropriate understanding of the investments and strategies being recommended, factors to consider when developing such an understanding, how investment profiles can help satisfy certain duty of care obligations, looking at available investment alternatives, and considerations when recommending complex or risky investments.
Summary of Staff Views: Duty of care obligations have three “overarching and intersecting” components, which include: (i) having an understanding of the associated risks, rewards, and costs of products, investment strategies, transactions, and/or account types being recommended; (ii) having a reasonable understanding of an investor’s investment profile; and (iii) based on those understandings, along with consideration of available alternatives, concluding that the recommendation or advice is in the investor’s best interest.
For the risks, rewards, and costs of an investment or strategy, the SEC staff believes an evaluation of the key characteristics and risks, objectives, costs, performance, expected returns, special or unusual features, and the role each play in an investor’s portfolio, is necessary.
Financial professionals also have a responsibility to understand the investments and strategies they are recommending to investors, so they cannot rely solely on their firm’s efforts (i.e., selecting from the firm’s approved list without also having a personal understanding). Obtaining and evaluating, both initially and periodically, appropriate information about an investor is necessary in order to have a reasonable basis for making a recommendation and/or providing investment advice.
A reasonable consideration of alternative investments should begin when formulating a recommendation or providing advice and should involve comparing available alternatives in light of an investor’s particular circumstances. The SEC staff provided the following example:
“When a firm or financial professional is evaluating a mutual fund to recommend to a retail investor or to include in the investor’s investment portfolio, the staff likely would not view a firm as having sufficiently considered reasonably available alternatives if it merely considers different share classes of one fund. Rather, in the staff’s review, the evaluations should, for example, begin with considerations of other investments and investment types that are reasonably available to investors through the firm and could be used to achieve the investor’s investment objectives. The firm or financial professional, in the view of the staff, should conduct a comparative assessment of these alternatives in order to identify the investments or investment strategies that they reasonably believe are in the retail investor’s best interest.”
To develop a process for identifying available alternatives, an evaluation should begin with looking at a wide variety of investments or strategies that are consistent with an investor’s investment profile and then streamlining to a smaller number of options that are more focused on meeting the best interest of the investor. Financial professionals are not required to evaluate all alternatives; however, they will need to review an amount that is sufficient to form a “reasonable basis to believe the recommendation or advice is in the best interest of the retail investor.”
Factors to consider when evaluating alternatives include, but are not limited to associated risks, rewards, and costs. It is also important for a firm to maintain documentation of the evaluation of alternatives in order to demonstrate compliance with its fiduciary obligations.
Firms should perform heightened scrutiny on complex or risky investment products, such as inverse, leveraged, and volatility-linked exchange-traded products, investments traded on margin, derivatives, crypto asset securities, penny stocks, private placements, asset-backed securities, and reverse-convertible notes. In addition, firms should have processes and procedures in place for, among other things, the ongoing evaluation of the complex and/or risky products held by clients.
Dually registered firms and financial professionals must consider whether the recommendation of an investment or strategy is more appropriate for a brokerage or advisory account. When an investor has both types of accounts, the SEC staff said they will examine factors that include but are not limited to the type of account, how the account is described, the type of compensation, and the extent to which the dually registered firm and financial professional disclosed the capacity in which they were acting to the investor.
Key Compliance Takeaways and Action Items
Through the written guidance and Staff Bulletins, the SEC has made it clear that investment advisory firms and their representatives have an ongoing responsibility to ensure that the recommendations and advice provided to clients always remains in their best interest. This includes having an in-depth knowledge of each client’s investment objectives and experience, along with a deep understanding of the investments and strategies being used.
From a compliance perspective, a firm needs to have processes and controls in place that are appropriate and reasonably designed to address such responsibility. To accomplish this, an investment advisory firm should, at a minimum, take the following steps:
- Confirm that your written policies and procedures not only cover all the areas that are applicable to relevant regulations and the firm’s business model, but also include enough detail for supervised persons to understand the regulations, the firm’s policies and processes, and their specific duties pertaining to each area.
- Perform a conflicts of interest inventory at least annually that outlines: (i) all identified conflicts; (ii) how the firm is addressing each conflict (i.e., through elimination or mitigation); and (iii) the specific policies, procedures, and controls that are in place to address each conflict.
- Provide training on the firm’s compliance policies and procedures to all supervised persons.
- Provide comprehensive training to investment adviser representatives regarding their duty of care and loyalty responsibilities.
- Ensure the firm’s supervisory oversight structure is robust and reasonably designed to monitor, among other things, applicable duty of care obligations.
- Analyze surveillance and testing controls to determine whether they are appropriately structured to help prevent violations.
- Review disclosures that are provided to prospective and existing clients through regulatory filings, marketing materials, electronic communications, and any stand-alone documents to confirm they include enough information about the advisory services and associated conflicts to allow recipients to make an informed decision.
- Verify that adequate documentation is being created and maintained that substantiates that the recommendations and investments made are (and continue to be) in each client’s best interest.
This Risk Management Update is only a summary of the information provided by the SEC regarding a firm’s duty of care and loyalty. Therefore, it is extremely important that compliance personnel and senior management review the guidance and bulletins in detail prior to taking the recommended action steps. This will allow you to determine whether additional considerations and compliance controls are necessary to ensure your firm and its representatives are adhering to applicable fiduciary obligations.
The Core Compliance consulting team has extensive knowledge of regulatory requirements for investment advisers and broker-dealers and can assist firms with implementing and enhancing their compliance programs. We also offer compliance technology solutions, which are crucial for ensuring adherence to applicable regulations. For more information, please contact us at firstname.lastname@example.org, at (619) 278- 0020 or visit us at www.corecls.com.
Author: Tina Mitchell, Managing Director, Consultation Services, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, and private fund managers on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
 Individual registered with both a broker-dealer and an investment adviser.
 These include, but are not limited to, level of services available and features of existing account, costs, investment options available, ability to take penalty-free withdrawals, application of required minimum distributions, protections from creditors and legal judgments, and holdings of employer stock.
 In the bulletin, the SEC staff provides examples of facts to disclose when dealing with conflicts surrounding compensation arrangements.
 In the bulletin, the SEC staff provides a “non-exhaustive” list of potential costs to consider.