Regulators set to ‘turn the heat up’ on enforcing conflicts of interest

Register now

Reg BI may have relaxed conflict of interest obligations to clients, but financial advisors shouldn’t let their guard down.

The new regulations have nominally eased burdens for advisors, Dan Bernstein, chief regulatory officer for MarketCounsel, told advisors at Schwab’s Impact conference in San Diego.

But MarketCounsel CEO Brian Hamburger warned in a subsequent interview that in the wake of Reg BI, regulators will likely to “turn the heat up on enforcement efforts addressing undisclosed conflicts of interest.”

As a result, advisors can expect to be scrutinized by the SEC on potential conflicts including revenue sharing, wrap fee programs — especially in the wake of zero commission trading — and the influence of outside investors.

The inability of advisors to identify conflicts in the first place is “far and away” the biggest problem MarketCounsel encounters, Hamburger said.
“It’s very challenging for advisors to be objective,” he explained. “And even if advisors do identify a conflict, they often convince themselves they don’t need to mitigate and disclose it. They fool themselves.”

Reg BI’s language regarding conflicts is “significantly more permissive” than the wording in the Advisers Act of 1940, which it replaced, according to Hamburger.

The Advisers Act said advisors “must seek to avoid conflicts with its clients.” But in Reg BI, the SEC instructs advisors to “eliminate or at least expose through full and fair disclosure all conflicts of interest.”

The “at least” clause is critical, Hamburger said. “All you need to do [now] is disclose.”

Reg BI’s language regarding conflicts is significantly more permissive than the Advisers Act of 1940.
Brian Hamburger, MarketCounsel CEO

Nonetheless, Bernstein stressed to advisors that they are still obligated to provide advice that is in the best interest of the client. What’s more, they still have “a duty of care” and “a duty of loyalty” to the client.

Advisors “can’t subordinate a clients’ interests to their own,” he emphasized, adding that rendering advice “which is not disinterested” is a red flag, and any conflicts leading to that advice should be eliminated or disclosed “fully and fairly,” Bernstein said.

Here’s how advisors can identify and manage some of the most common conflicts, as gleaned from Hamburger and Bernstein at their Impact panel and subsequent interview.

Revenue Sharing: 12b-1 fees are the classic example of advisors receiving an economic benefit as a result of a recommendation to a client.

And according to a new report from Morningstar, 12b-1 fees remain shrouded in mystery and “a variety of opaque arrangements” that impacts an advisors’ mutual fund recommendations.

A custodian may give an RIA a portion of 12b-1 fees from investments by clients in certain mutual funds.

As a result, the firm “has an incentive to recommend share classes that result in revenue to the firm, but may be more expensive to the clients, or otherwise inferior to other mutual funds,” Bernstein said.

Advisors who recommended an investment after going on a due diligence trip that involved entertainment can expect to get the SEC's attention.
Dan Bernstein, Market Counsel chief regulatory officer

The SEC is particularly interested in how that compensation would or could impact advice to clients, Hamburger said. The agency was not likely to look kindly, for instance, on an advisor who was compensated for a recommendation that cost the client more money than one with a similar benefit that cost less, he explained.

Likewise, advisors who recommended an investment from a company after going on a “due diligence” trip that involved entertainment in addition to education may also expect to catch the SEC’s attention.

To mitigate the conflict, advisory firms can offset the revenue received from the 12b-1 fee from the client’s advisory fee. They can also review all their clients’ mutual funds to make sure the funds are in the best interest of the client, regardless of revenue sharing, Bernstein added.

Advisors also face a regulatory and business issue when it comes to revenue sharing, Hamburger said.The regulatory answer is clear, he said: full and fair disclosure on Form ADV parts 1 and 2 and on Form CRS.

While RIAs are no longer required to eliminate a revenue-sharing conflict, they may decide doing so better aligns their interest with their clients — and helps them make a fiduciary distinction from broker-dealer competitors.

But the RIA must also make a business decision, using a cost/benefit analysis, Hamburger pointed out. If the firm decides to stop participating in 12b-1 programs, it may also have to charge higher fees.

If the SEC decides to take regulatory action, remedies may include a disgorgement payment that gives the money received from 12b-1 fees back to the client as well as penalties and a fine.

Wrap fee programs: Advisors, especially those that have left a broker-dealer to go independent, sometimes charge clients a consolidated fee that includes both advisory and brokerage expenses.

However, the amount previously budgeted for brokerage transactions may be “reduced significantly,” Hamburger said, resulting in a fee arrangement that may be unsuitable for the client and a conflict of interest.

Zero commission trading is a significant new development that can impact wrap fee programs.
Brian Hamburger, MarketCounsel CEO

What’s more, the recent move by Charles Schwab and other custodians to drop commission fees for U.S. stocks, ETFs and options is a “significant new development,” that can impact wrap fee programs and cause the SEC to scrutinize them more carefully, he pointed out.

“If the broker utilized goes to zero commissions, than the advisor is making more money than they were previously,” Bernstein explained in an interview.

Accordingly, there is a case to be made that the client should get the benefit of the zero commissions and the wrap fee should be reduced. But if the advisor decides to keep the benefit of zero commissions, they should disclose that decision to clients.

“As a fiduciary, an advisor’s fee must be fair, and there must be proper disclosures of any material conflicts of interest,” Bernstein said.

Regulators may also look more closely at “reverse churning,” where advisors make little or no trades in the client’s account, but the client continues to pay for transactions as part of an ongoing wrap fee.

There is an incentive for an advisor using wrap fees to trade less because they pay for the brokerage charges. Advisors may argue that while zero commissions help with reverse churning, wrap fee programs may still incentivize advisors to invest in certain products over others, such as ETFs over mutual funds, Bernstein said,

Another conflict is posed by “trading away,” where an advisor uses another broker but doesn’t disclose additional costs, incentives or benefits — such as soft dollars — to the client, that benefit the advisor.

Wrap fee programs are on the SEC's hit list.
Dan Bernstein, MarketCounsel chief regulatory officer

Advisors also need to be careful if they choose a more expensive share class for a client’s account.

“The share-class issue is a very important wrap fee issue,” Bernstein said. “In essence, the advisor has to pay for brokerage expenses in a wrap, which they will continue to do for most mutual funds. So they have an incentive to choose an NTF fund, which has a higher expenses to the client, because it avoids a transaction fee that the adviser would have to pay.”

If there are changes in brokerage expenses or trading frequency or expenses, advisors must make sure the client’s account or program type continues to be in the clients’ best interest, he continued.

While the SEC is unlikely to take regulatory action anytime soon, Hamburger said the agency may well look back at this time period and ask why advisors didn’t take the opportunity to make changes to their wrap fee programs to reflect the elimination of commissions on trades.

Advisors can either reduce their fees to reflect the new reality, he suggested, or increase service to create added value.

Wrap fee programs are indeed on the SEC’s “hit list” and enforcement actions have increased, Bernstein told advisors.

“Now would be a good time for advisors to determine if they should discontinue their [wrap fee] program,” he said, “and just have clients pay the brokerage charges, which may be nothing or negligible.”

Outside investors: A client purchasing shares in an advisory firm is the “most rapidly increasing” form of conflict MarketCounsel is seeing, Hamburger said, adding that private equity firms with stakes in other financial services companies is another fast-growing example of an outside investor posing a conflict of interest.

If a client buys shares in an RIA, they need to confirm that they made the investment separate from the advice the RIA gives them as a client, Hamburger said. That’s because a client of an advisor making an investment in the advisory firm is a clear conflict of interest “with a number of regulatory implications.”

Although advisory firms usually don’t make such recommendations, “that should be confirmed in writing and conflict disclosures must be made.” Bernstein stressed.

One can have a conflict of interest without being in the wrong.
Michael Davis and Andrew Stark, authors of 'Conflict of Interest in the Professions'

And if a company such as a private equity firm controls part of an RIA, underlying corporate documents should be examined to assess conflicts, Bernstein told advisors.

“Where the financial interests of the outside investor lies is the key question,” Hamburger noted.

Conflicts arise when the investment is not passive, but involves affiliates of the investor providing financial products, services or research to the RIA that will benefit the investor, he said. In addition, a short time horizon for the outside investor could lead to the RIA making riskier investments or operating decisions.

SEC penalties for these conflicts can be severe, he warned.

The upshot is that RIAs should exercise independent objective judgement when selecting products or services for clients, Hamburger said.

Firms that instead use products or services from an affiliate of an outsider investor that may not be in their client’s best interest can face steep penalties, he noted — and may even be barred from the industry.

In July, for example, the SEC charged Fieldstone Financial Management Group and its owner with defrauding clients by failing to disclose conflicts of interest related to their recommendations to invest in securities issued by affiliates of Aequitas Management, which provided the firm with a $1.5 million loan and access to a $2 million line of credit.

“The loan and line of credit both had terms that created a significant financial incentive for the firm to recommend Aequitas securities to clients,” Bernstein noted in an interview.

In San Diego, he told advisors that it was important to view conflicts as problems that require solutions, not judged from an absolute right or wrong perspective.

To illustrate the point, Bernstein quoted from Conflict of Interest in the Professions by Michael Davis and Andrew Stark:

“Having a conflict of interest in not like being a thief or holding a grudge. One can have a conflict of interest without being in the wrong. To have a conflict of interest is merely to have a moral problem.”

For reprint and licensing requests for this article, click here.
RIAs SEC regulations MarketCounsel Brian Hamburger