Conflicts of Interest and Dual Registrants

The Securities and Exchange Commission (the “SEC”) continues to pay close attention to the conflicts of interest that can exist in broker/dealers and investment advisory firms that share financial professionals and dually registered firms.  In the Staff Report issued by the SEC on January 21, 2011, the SEC principally based its advocacy for a uniform regulatory standard on the management of conflicts of interest, noting that “[c]larification will be particularly important in applying the [broker] obligation to eliminate or at least disclose all material conflicts of interest, as contemplated by the Dodd-Frank Act,” and emphasizing that such disclosures must be clear and specific enough to provide sufficient facts for the retail investor to understand the nature of the applicable conflicts.  Thus, particular attention should be paid to the management of conflicts of interest, even in the absence of a harmonized regulatory regime.

That emphasis has been integrated into the SEC examination program.  This is evidenced in two ways. First upon announcing its examination priorities, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has indicated that the SEC staff would review:

  • how financial professionals and firms satisfy their suitability requirements when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed;
  • dually registered firms’ policies and procedures related to such recommendations;
  • the significant risks to investors of migration and other conflicts this business model presents;
  • the impact to investors of the different supervisory structures and legal standards of conduct that govern the provision of brokerage and investment advisory services; and
  • when a variety of fee arrangements is offered for advisory accounts, whether the recommendation of an advisory account is in the best interest of the client at the inception of the arrangement and thereafter, including fees charged, services provided and disclosures made about such relationships.

Second, the actual exams of dual registrants by OCIE including substantial attention being given to locating and flushing out undisclosed conflicts of interest.  In any event, it is necessary be aware of the potential conflicts of interest, as they may arise in number of scenarios.  To that end, compensation arrangements may generate conflicts to the extent that incentives exist for an advisor or broker to place investors in accounts with high fee structures relative to the services provided, or where the advisor or broker may be financially rewarded for recommending inappropriately risky instruments given an investor’s level of sophistication.  Other conflicts may be subtler, such as where an investor holds a position that is illiquid or difficult to value, and an advisor or broker stands to earn higher fees by valuing the position at the high end of a given range.  Other examples of typical conflicts also include: (i) advisors’ favoritism between accounts managed side-by-side; (ii) affiliations between advisors and brokers; (iii) preferential execution of trades of certain customers; and (iv) research coverage conflicts where an advisor or broker firm’s research analysts are incentivized to advise customers to buy into companies in which such firm holds a proprietary or creditor interest.