Articles Posted in Compliance

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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.
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For the past several years, regulators at both the federal and state levels have placed a greater emphasis on the advisory fees charged to retail clients and how those fees are calculated and disclosed. We have previously written about these efforts publicized through Risk Alerts, Exam Priorities and Observations, and Staff Bulletins. Recently, the Colorado Division of Securities published an Ongoing Financial Planning Guide that articulated its concerns regarding investment adviser firms that provide continuous financial planning services.

The Colorado Division of Securities stated that it has encountered a growing trend in which investment advisers provide on-going financial planning rather than the traditional hourly or one-time fixed fee models. Under the on-going financial planning arrangement, investment advisers theoretically take a greater role in implementing financial plans, assisting clients with day-to-day financial decisions, updating financial plans, and making themselves available to the client as needed.

Compliance concerns regarding financial planning have traditionally focused on the disclosure of services and fees, including how and when the fees are charged, whether collecting fees in advance triggers custody concerns, and whether collecting fees in advance create a refund obligation. Colorado’s Guidance continues highlighting these areas of focus and expands what it considers to be best practices.
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On June 13, 2022, the Securities and Exchange Commission (“SEC”) issued an order instituting administrative and cease-and-desist proceedings against Charles Schwab & Co., Inc. (“CS & Co.”), Charles Schwab Investment Advisory, Inc. (“CSIA”), and Schwab Wealth Investment Advisory, Inc. (“SWIA”), (collectively, “Schwab subsidiaries”) who submitted an offer of settlement without admitting or denying the findings of the order, except as to jurisdiction and subject matter. The order alleges that these investment adviser subsidiaries of The Charles Schwab Corporation (“Schwab”) listed before made false and misleading disclosures on Forms ADV Part 2A and published false and misleading advertising regarding Schwab Intelligent Portfolios (“SIP”), a robo-adviser service.

The Schwab subsidiaries did not charge an advisory fee for the SIP service and instead made money by allocating a fixed percentage of a client’s portfolio to cash and depositing that cash with Schwab Bank. Schwab Bank then loaned the cash out at a higher interest rate than the interest rate paid to clients in order to make a profit.

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The Securities and Exchange Commission (SEC) recently released a Staff Bulletin regarding the Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors. Since the adoption of Regulation Best Interest, or Reg BI, in 2019, the SEC has issued guidance and best practices for adoption of the policies and procedures expected for compliance with the regulation. We have previously written about the best interest standard applied to retirement rollover recommendations and the SEC’s announcement of the first enforcement case being filed under Reg BI.

The Staff Bulletin, presented in a Q&A format, provides the SEC’s views on how financial professionals can fulfill their obligations to retail investors when making account recommendations. The obligations discussed include the applicable standard for making account recommendations, factors to consider when making account recommendations, how and when cost is a factor, retirement rollover considerations, client account preferences, and developing and implementing a compliance plan reasonably designed to address Reg BI.

While Reg BI and the investment adviser fiduciary standard differ, the SEC points out that both standards require an account recommendation to be in the client’s best interest and prohibits an investment adviser from placing its interest ahead of a client’s interest. Additionally, the SEC states that a firm that does not evaluate sufficient information about a retail investor, it will not have the ability to form a reasonable basis to believe its account recommendations are in the retail investor’s best interest.

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While the majority of the Department of Labor’s new fiduciary rule, Prohibited Transaction Exemption 2020-02 (“PTE 2020-02), became enforceable on January 31st, some of the requirements pertaining to rollover recommendations are set to be enforced on July 1, 2022.

As detailed in this blog post, the DOL provided transition relief in its Field Assistance Bulletin, FAB 2021-02 by extending the enforcement date of PTE 2020-02 through January 31, 2022 for investment advice fiduciaries who are working diligently and in good faith to comply with the “Impartial Conduct Standards” for any transactions that are exempted under PTE 2020-02. These standards include a best interest standard, a reasonable compensation standard, and a requirement to avoid any materially misleading statements about the recommended transaction and other relevant matters.

PTE 2020-02 also requires investment advice fiduciaries to document the specific reasons any rollover recommendations from an employee benefit plan to another plan or an IRA, from an IRA to a plan, from an IRA to another IRA, or from one type of account to another is in the best interest of the retirement investor. PTE 2020-02 further requires this documentation to be provided to the retirement investor prior to engaging in the rollover. In FAB 2021-02, the DOL announced that it would not enforce the documentation and disclosure requirements for rollover recommendations under PTE 2020-02 through June 30, 2022.
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The Securities and Exchange Commission (SEC) recently released the 2022 Examination Priorities from the Division of Examinations, formerly known as the Office of Compliance Inspections and Examinations. This annual release provides insight into the areas that the SEC plans to highlight when examining investment advisers during the coming year.

While the SEC notes the continued impact of COVID-19 on investment advisers and the investment industry, the SEC reported an increase in examinations conducted during FY21, with the total number of completed examinations close to the pre-pandemic levels of FY19.

For FY22 examinations, the SEC will place a significant focus on (1) private funds; (2) environmental, social, and governance (ESG) investing; (3) standards of conduct: Regulation Best Interest (Regulation BI), fiduciary duty, and Form CRS; (4) information security and operational resiliency; and (5) emerging technologies and crypto-assets. Many of these focus areas, such as ESG and Regulation BI, are carried over from previous years and mark a multi-year emphasis for the SEC.

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With the date for compliance with the new Investment Adviser Marketing Rule approaching, now is the time for registered investment advisers to consider how the new rule impacts many facets of their regular practices. One area that should be carefully evaluated is the use of “hypothetical performance.” The new rule expands the definition of an “advertisement” to include many one-on-one presentations that were not covered by the former advertising rule. Now, any one-on-one presentation that contains “hypothetical performance” is subject to the general anti-fraud provisions of the new rule, as well as to several specific conditions and limitations on the use of hypothetical performance.

The definition of “hypothetical performance” is “performance results that were not actually achieved by any portfolio of the investment adviser.” That definition expressly encompasses “targeted or projected performance returns.” The illustration of “targets” or “projections” in one-on-one presentations was previously covered by the general anti-fraud rules, but the new regime imposes more onerous requirements and may indeed prevent RIAs from using the types of illustrations they are currently routinely using with new clients and prospects.

A common approach to acquiring new clients involves presenting an illustration of how a proposed portfolio will perform. This is frequently done through the use of reporting software or publishing services such as Morningstar, Riskalyze, and others, although the adviser may have the ability to customize the inputs and the contents of the final report. Sometimes specific returns are projected, while at other times the projections will show a range or band of returns coupled by a specific probability range.

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Earlier this month the National Society of Compliance Professionals, a nonprofit membership organization that supports compliance personnel and programs in the financial services industry, published a report entitled “Firm and CCO Liability Framework.” The report is designed as an aid to compliance professionals and as a proposal to regulators, including the Securities and Exchange Commission, to determine situations in which liability of Chief Compliance Officers should be mitigated.

The SEC has provided its own guidance regarding when CCOs may be held liable, some of which we have highlighted in a previous post. Additionally, the New York City Bar Association’s Compliance Committee released a comprehensive report last year that contains a description of the history of regulatory comments and guidance provided on the issue of CCO liability and proposes its own framework of liability.

The NSCP report was motivated in part by a widespread belief among compliance professionals that financial services regulators have expanded the situations in which CCOs will face liability for firm compliance failures. According to a survey contained in the report, 72% of compliance professionals share that belief. Additional survey results contained in the report include: that 35% of compliance professionals claim to have insufficient resources to adequately carry out the obligation to provide firm training on compliance issues; that 20% claim to have insufficient authority either to enforce or to develop compliance policies and procedures; and that 25% claim to be unable to meaningfully raise compliance concerns to the firm’s senior management.

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On July 13, 2021, the Securities and Exchange Commission (“SEC”) published an order instituting administrative cease-and-desist proceedings against TIAA-CREF Individual & Institutional Services, LLC (“TIAA”). TIAA consented to this order without admitting or denying the findings except as to jurisdiction and subjection matter. The SEC’s order alleges TIAA failed to properly disclose conflicts of interest and made materially misleading statements concerning rollover recommendations they made to clients over a five-year period from 2013 to 2018.

TIAA’s policies and procedures required their investment adviser representatives, who were also dually registered as registered representatives, to present clients with four options regarding rollover recommendations when providing financial planning services. The options were:

  1. Leave client assets in their employer-sponsored retirement plans;
  2. Rolling the assets into a self-directed individual retirement account;
  3. Rolling over the assets to a new employer’s plan; or
  4. Cashing out the account value/taking a lump-sum distribution.

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Rule 206(4)-1 under the Investment Advisers Act, known as the “Marketing Rule,” becomes effective on May 4, 2021. Full details of the new rule and the related amendments to the Books and Records Rule and for ADV can be reviewed in the SEC’s adopting release. The new rule changes many aspects of the current guidance applicable to advertising by SEC-registered investment advisers, some of which is drawn from no-action letters and other informal releases. Advisers must come into compliance with the new rule within eighteen months of the effective date or by November 4, 2022. Firms may choose to come into compliance at any time between the effective date and the compliance date, but the SEC has warned that RIAs may not choose to implement parts of the new rules at different times. Rather, a firm must implement and be prepared to comply with the entirety of the new rule on a single date within the eighteen-month compliance period. The rule does not, on its face, apply to state-registered RIAs, who should continue to follow the rules applicable to the states in which they conduct business. Some state rules mirror or adopt the SEC advertising rules in some respects.

One of the most important changes relates to using what has historically been referred to as “testimonials,” or statements by clients regarding their experience with an adviser. The current rule 206(4)-1, titled “Advertisements by Investment Advisers,” states that any advertisement by an adviser that uses a “testimonial of any kind” is deemed fraudulent, deceptive or manipulative. Although “testimonial” is not defined in the current rule, the SEC consistently interpreted the term as a statement of a client’s experience with, or endorsement of, an investment adviser. Under the new rule, however, testimonials as traditionally understood are permitted as long as firms comply with a number of requirements. Continue reading ›

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