SEC Warns Broker Dealers and Investment Advisers About Conflicts of Interest Related to Compensation Incentives

On August 3, 2022, the U.S. Securities and Exchange Commission (“SEC”) published a Staff Bulletin related to compensation incentives that may cause a conflict of interest in violation of Regulation Best Interest (“Reg BI”) rules and the SEC’s fiduciary standards for investment advisers (“IA fiduciary standard”). Reg BI and the IA fiduciary standard provide that a conflict of interest is an interest that may consciously or unconsciously incline a broker dealer or investment adviser to make recommendations or render advise that is not disinterested. According to Reg BI and the IA fiduciary standard, broker dealers and investment advisers must identify and either disclose or eliminate all conflicts of interest.

The IA fiduciary standard encompasses both the duty of loyalty and the duty of care. According to the Commission Interpretation Regarding Standard of Conduct for Investment Advisers published in 2019, the duty of loyalty requires investments advisers to at a minimum disclose a conflict of interest so that a client may provide informed consent to said conflict or eliminate the conflict entirely. The 2019 Commission Interpretation also explains that the duty of care requires investment advisers to provide advice based on a reasonable understanding of the client’s goals and objectives that is in the client’s best interest.

In conjunction with the IA fiduciary standard, investment advisers must also adopt policies and procedures that are created to prevent violations of the Investment Advisers Act and corresponding rules. These policies and procedures should include terms designed to prevent breaches of the IA fiduciary standard and also requirements related to recordkeeping.

In the staff bulletin, the SEC encouraged broker dealers and investment advisers to discontinue both cash and non-cash compensation structures, including compensation, revenues, commissions, gifts, and other benefits related to products sold, accounts recommended, quotas, sales contests, special awards, personal relationships with third parties.

The SEC emphasized that these types of compensation structures can lead to conflicts of interest, and that identifying and addressing these conflicts should be a robust process that is unique to each situation and not merely a “check-the-box” approach. The SEC also noted that it would be difficult for advisers to show how they comply with IA fiduciary standards if they do not keep adequate records related to addressing these conflicts.

The SEC also provided guidance on how to identify, disclose, and eliminate conflicts related to compensation structures and emphasized that these steps will depend on each firm’s business model. First, advisers should include the following items in their policies and procedures to help identify conflicts of interest: define conflicts in a way relevant to the firm’s business and across the scope of advice or recommendations made to retail investors, establish processes to identify the types of conflicts advisers may face, provide for an ongoing periodic process to identify conflicts, and create training programs. The SEC emphasized that there should be a general culture of compliance so that conflicts are taken seriously. Second, the SEC emphasized that disclosure may not satisfy an adviser’s obligation to act in their client’s best interests and that some conflicts may require mitigation. Third, if mitigation is not sufficient, then elimination may be required.

Investment advisers that utilize compensations structures such as these should take note of this bulletin and ensure that all conflicts are disclosed, mitigated, or eliminated consistent with SEC rules and guidance.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.

Contact Information