SEC Crack-Down on Firms Who Fail to Spot Conflicts of Interest

Published On November 11, 2019

19 November 2019: The Securities and Exchange Commission is cracking down on firms and their affiliates who fail to identify and take action in instances where conflicts of interest arise. Speaking at the SEC’s Regulation Outside the United States Conference, Co-Director of the Division of Enforcement, Stephanie Avakian, set out how the Division is moving to “identify and address misconduct and illicit practices,” specifically “conflicts of interest that are harmful to investors.”

In particular, Avakian highlights that the SEC is looking at circumstances where advisers are financially conflicted by incentives that have a subsequent effect on the investments they recommend to clients. Where it uncovers such instances, the SEC is asking the following: “Has the adviser explained the conflict to the client? Does that explanation cover how the conflict may affect the recommendation? Does the client have sufficient information to make an informed decision?”

The SEC plainly identifies a conflict of interest as a situation in which an investment adviser receives some or greater compensation for selecting certain share classes over others. As is well established, under federal securities law, such a conflict must be fully and fairly disclosed to clients and prospective clients, with a provision of all the material facts. 

The SEC has so far been carrying out investigations through its Share Class Initiative. It has seen a number of cases where firms will routinely opt to invest client money in a more expensive option – which will pay the firm additional compensation but at a higher cost to their client. Firms are seldom informing their clients that this is the case. While the findings offer insights for the SEC, Avakian noted that the SEC will not rest on the success of the Initiative so far: “let me assure you, we are looking for other undisclosed material conflicts – and we are finding them.” As an example, she noted that while instances of undisclosed material conflict arises across the board, the SEC has found it to be prevalent in instances of revenue sharing, cash sweep arrangements, investments in unit investment trusts and in the administration of teacher retirement plans.

Looking ahead, the SEC wants to see that investment advisory firms are no longer turning a blind-eye to potential conflicts of interests and are instead being proactive in evaluating scenarios where a conflict could arise, including the assessment of disclosures. Firms should be taking steps to assess the compensation that their employees or affiliates receive and explore whether there are associated decisions of recommendations that have been made to warrant such compensation. The same approach should also be applied to expenses. Firms should be switched on to the potential for conflict and actively rooting it out.

As well as taking steps to identify where conflicts arise, Avakian highlights that firms must also take action where it is uncovered. The SEC has seen a number of instances where an undisclosed conflict of interest has been identified, but businesses have failed to take remedial action – or such action has taken too long.