Conflicts of Interest - Disclosure and Management

Understanding prohibited activities is essential, but not every conflict of interest results in a prohibition. Many conflicts are manageable through proper disclosure. This final section covers the conflict-disclosure framework that applies to broker-dealers, agents, and investment advisers.

How Do Broker-Dealers Disclose Conflicts (Regulation Best Interest)?

Under SEC Regulation Best Interest, a broker-dealer that recommends a securities transaction to a retail customer must disclose the material facts relating to conflicts of interest associated with the recommendation, must establish and enforce policies to address those conflicts, and must not place its own interest ahead of the customer's. (Reg BI is covered in the Compensation unit.)

Exam Tip: Gotchas

• Reg BI is a best-interest standard, not a suitability standard. Suitability only asked "is this appropriate?" Reg BI asks "is this in the client's best interest?" Reg BI requires the broker-dealer to consider reasonably available alternatives that the firm offers, but it does not require recommending the single "best" or lowest-cost product. Compliance is judged on the reasonableness of the process at the time of the recommendation, not in hindsight.

How Must Investment Advisers Disclose Conflicts?

An investment adviser's conflict-disclosure duty is stricter than a broker-dealer's, consistent with the fiduciary standard IAs are held to:

• Must disclose in writing before rendering any advice every material conflict of interest that could reasonably be expected to impair unbiased, objective advice
• Includes, but is not limited to:
  • Additional compensation arrangements beyond what the client directly pays the adviser
  • Receiving commissions for executing trades made pursuant to the adviser's own advice (dual compensation)

Exam Tip: Gotchas

• Timing differs by professional. An IA must disclose a material conflict before giving the advice it relates to. A BD's Regulation Best Interest disclosure attaches to the recommendation itself; neither professional gets to disclose the conflict only after the transaction closes.
• Dual compensation is the classic tested conflict. An adviser who is paid a fee for the advice and then also collects a commission for executing the resulting trade has a conflict that must be disclosed in writing before the advice is given, even if the total compensation is reasonable.

When Must a BD Disclose a Control Relationship?

Under the NASAA Statement of Policy on Dishonest or Unethical Business Practices:

• Must disclose control relationships with issuers before entering into any transaction with the customer
• If oral disclosure is given first, it must be supplemented by written disclosure at or before completion of the transaction
• Control relationships include: controlled by, controlling, affiliated with, or under common control with the issuer

What Standard of Care Applies: BD vs. IA?

Know the high-level distinction in standards:

• A broker-dealer making a recommendation to a retail customer is held to Regulation Best Interest (a best-interest standard).
• An investment adviser, IAR, or federal covered adviser is a fiduciary with a duty to act primarily for the benefit of its clients, a higher standard than Reg BI's.
• The extent and nature of the fiduciary duty varies with the specific relationship and circumstances; it is not a single fixed checklist applied identically to every client.
• For a federal covered adviser, the state-law conduct standard reaches the adviser's conduct only to the extent that conduct is fraudulent or deceptive, since federal law otherwise occupies the field for federal covered advisers.

What Other Conduct Standards Apply to Investment Advisers?

Beyond conflict disclosure, several other NASAA prohibitions apply specifically to advisers:

• Misrepresentation: An adviser cannot misrepresent its qualifications, the nature of the services it provides, or its fees, and cannot omit a material fact necessary to keep a statement from being misleading
• Undisclosed third-party reports: An adviser cannot give a client a report prepared by someone else without disclosing that fact, unless the report is published research or a statistical analysis the adviser uses in its normal course of business
• Indirect conduct: An adviser cannot accomplish indirectly what these rules prohibit it from doing directly
• Waiver of compliance: An advisory contract cannot include a provision binding the client to waive compliance with state securities law or the Investment Advisers Act
• Client credentials: An adviser cannot use a client's own username and password to access the client's account. Read-only account aggregation falls outside this prohibition when the adviser cannot itself access the credential and the aggregator has the required platform agreement in place

Exam Tip: Gotchas

• Passing off someone else's research as the adviser's own work is a separate violation from any underlying suitability problem, even if the recommendation built on that research turns out to be appropriate for the client.

What Are Some Practical Examples of Conflicts Requiring Disclosure?

• A BD that earns revenue-sharing payments from mutual fund companies whose products it recommends
• An agent who receives higher commissions for selling proprietary products versus third-party products
• A BD that has a control relationship with the issuer of a security it recommends to customers
• An IA whose IAR earns extra compensation for steering clients into an affiliated fund

What Should You Check on Exam Day?

• Not every conflict is a prohibited practice; the rule is disclosure and management, not automatic disqualification.
• BD conflict disclosure (Reg BI) is tied to the recommendation; IA conflict disclosure must happen in writing before the advice is rendered at all. Do not swap the timing between the two.
• Fiduciary duty (IAs) is a higher standard than best interest (BDs); a question asking which professional owes the stricter duty is testing this distinction.