by Beth Haddock
I. Important SEC Signal on Conflicts of Interests
On June 5, the SEC announced two major changes with the release of new Regulation Best Interest (“Reg BI”) for broker-dealers (“BDs”) and Commission Interpretation/Standard of Conduct for Investment Advisers (“RIAs”).
A close read of both initiatives reveals that disclosure alone may not adequately address conflicts of interest (“COIs”) under either Reg BI or the fiduciary standard for RIAs. The new efforts to protect retail investors under Reg BI and advisory clients more generally under the Commission Interpretation will compel regulatory compliance programs at both BDs and RIAs to consider adopting a new sustainable governance approach for compliance controls in order to effectively detect, mitigate and/or eliminate COIs. Such reforms can also ensure more fulsome and accurate disclosures and help in discerning when using “may” or “will” appropriately communicates informed notice and securing consent.
Under Reg BI, BDs must act in the best interest of retail customers when recommending any securities transaction or investment strategy involving securities to a retail customer. Under Reg BI, product and client development initiatives must be reviewed to ensure a BD does not put its financial interests ahead of the interests of a retail customer when making securities recommendations.
The SEC concurrently released its Commission Interpretation to reaffirm and clarify the SEC’s views of the fiduciary duty that RIAs must perform for their clients under the Investment Advisers Act of 1940 as amended. Within the interpretation, the SEC explains how the Commission and its staff have applied, enforced and inspected for compliance when examining advisers’ execution of their duty of loyalty and care to their clients over time.
Arguably, it is clear neither a BD or an RIA may put their interests ahead of a client. Yet compliance officers still struggle with augmenting or designing a compliance program to practically align interests and ensure their programs can effectively incentivize identification and reporting of any misalignment or conflicts before clients are impacted. For instance, the new Interpretation exhorts advisers (PDF: 411 KB) to “eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.” Compliance programs might not meet such a comprehensive obligation unless they effectively maintain a COI ledger that also dynamically adjusts to evolving business practices.
COI compliance should not merely chronicle a firm’s conflicts and disclosures, however. If a conflict clearly violates a duty to a client, the firm’s interests are clearly prioritized over the client’s and if disclosure is not fulsome or accurate, a client may not easily provide informed consent to cure COIs.
So how should compliance programs handle different types of COIs and satisfy these new requirements? Compliance officers have been granted an opportunity to adopt an innovative approach to compliance – one that will ease the burden of the new requirements, help streamline compliance efforts and enable more engagement in a firm’s governance.
II. Sustainable Governance and a Compliance ROI
Sustainable governance refers to a compliance program that is more systemically effective than a traditional compliance program which tends to focus primarily on the understanding a law or regulation’s requirements. With sustainable governance, compliance controls not only address protection from legal and regulatory risks but also achieve objectives for productivity and impact. In other words, sustainable governance program architects must consider operational efficiency, alignment with business processes and incentives to encourage buy-in and engagement.
Compliance controls under a sustainable governance framework can more effectively address complex organizational needs – such as identifying COIs across business, products and stakeholders because such controls are designed to deliver a Compliance return on investment (ROI). A Compliance ROI entails leveraging behavioral incentives and a focus on business objectives in order to build sustainable controls aligned with broader business objectives. Properly developed, sustainable compliance controls incentivize employees and business leaders to more fully engage and support compliance. With the sustainable governance framework, the controls govern behavior throughout the organization, even when a compliance officer is not enforcing the firm’s protocols.[1]
For a BD or RIA to maintain an “adequate compliance program” as required under FINRA Rules and the Investment Advisers Act of 1940 as amended, a program should avoid repeat deficiencies and incentivize good business judgment, ethical conduct and collective ownership with employees. In light of the new SEC guidance, the shared responsibilities inherent in sustainable governance fulfill these mandates more effectively than the now-familiar tone-at-top approach commonly used in light of the Chief Compliance Officers in gatekeeper roles. A collective action approach will minimize the friction and burden on current processes once compliance adopts new controls that more positively align with the goals of the underlying business. This process begins by creating:
1) an inventory of actual COIs
2) an inventory of potential conflicts that do not currently exist but might reasonably present itself in the future
3) an inventory and schedule review of regulatory filings, client disclosures and agreement
4) a process for reviewing incentive compensation programs
5) a process for reviewing new business and products including revenue sharing arrangements for conflicts, and
6) a process for reviewing personal conflicts regarding non-cash compensation, gifts and personal investments.
III. Bottom-up and Real-Time Horizontal Engagement
A COI compliance program with a solid engagement foundation delivers a higher Compliance ROI than a program which relies on reactive audits to detect compliance gaps.
In order to meet the new SEC requirements/interpretations, BDs and RIAs will create or refresh and inventory COIs in order to effectively revise and maintain standard disclosure documents; assess and enhance compliance controls as needed; and prepare to draft, file and deliver the SEC’s new Customer/Client Relationship Summary (“CRS”) form. Rather than compel a compliance officer to review financial statements to detect inappropriate expenses, fees or revenue sharing arrangements, sustainable governance compels the financial, product and sales experts within the firm to self-report conflicts to compliance. From there, the stakeholders work together to remediate by adjusting work flows, disclosures and sales practices. Some firms use a COI Committee; others use performance incentives to encourage leaders to tackle compliance issues before they grow and become material and/or systemic. Either method offers a real improvement upon merely changing policies and revising disclosures because both stress business engagement, productivity and impact as much as they do protection.
With a sustainable governance approach, compliance programs can also report on operational adequacy by measuring the effectiveness of the controls with a Compliance ROI calculation. Firms can measure the effectiveness of each component of the compliance program, such as annual training and testing and annual reviews, by calculating a Compliance ROI on the adequacy of those efforts to effectively uncover and address conflicts; for example, by increased self-reporting of issues, the calculation can detect savings on decreased customer compliance, insurance claims and litigation matters as well as increased response times for requests for proposal (RFPs) and disclosure document reviews. A Compliance ROI calculation measures the investment of time and resources spent on detecting and mitigating COIs as well as the risks mitigated. But they also reveal productivity gains and business development in other compliance realms as well by tracking metrics on client and prospective client inquiries, business engagement, behavioral incentives, efficiencies within operational processes, errors mitigated and IT and staffing budgets.
Tipping Point and Opportunity
Regulators continue to bring enforcement cases when they find professionals and firms act in their self-interest at the expense of duties to clients.[2] According to Transparency International’s Corruption Perception Index (CPI) statistic, two-thirds of the 180 countries and territories ranked still receive a failing score at fighting fraud and corruption, with an average score of 43 out of 100. Sustainable governance can help break what appears to be a lopsided fight against fraud and corruption. Armed with a new approach that enlists employee engagement and self-interest as its first line of defense, compliance efforts can be proactive.
Particularly, when discerning actual, potential and at times hidden COIs, a proactive sustainable governance approach can more effectively manage and eliminate COIs. Bottom-up and real-time horizontal engagement can utilize effective compliance controls that deliver a ROI instead of controls that are either misaligned with the core business or incapable of adjusting to its complex processes. As firms ponder how to invest their resources in building Reg BI compliance controls, sustainable governance tools can help them mitigate these now-heightened risks.
Footnotes
[1] This concept has been in part developed to align with Professor Cynthia Williams’s Harvard Law Review Article on Social Transparency and later comments about developing a compliance atmosphere.
[2] SEC Shows Zero Tolerance for Undisclosed Conflicts of Interest; SEC’s War on “May” Continues; and How a Failure to Supervise Leads to Personal Liability: Lessons Learned from Recent SEC and FINRA Cases – June 2019
Beth Haddock is Managing Partner at Warburton Advisers and author of Triple Bottom-line Compliance – How to Deliver Protection, Productivity and Impact.
Disclaimer
The views, opinions and positions expressed within all posts are those of the author alone and do not represent those of the Program on Corporate Compliance and Enforcement (PCCE) or of New York University School of Law. PCCE makes no representations as to the accuracy, completeness and validity of any statements made on this site and will not be liable for any errors, omissions or representations. The copyright of this content belongs to the author and any liability with regards to infringement of intellectual property rights remains with the author.