On December 17, 2021, the U.S. Securities and Exchange Commission ("SEC") staff ("Staff") issued a statement (the "Statement"),1 which summarizes certain observations made by the SEC's Standards of Conduct Implementation Committee (the "Committee") in connection with its review of Form CRS relationship summaries ("relationship summaries") filed by a cross-section of firms and their compliance with Form CRS requirements. The Committee observed various areas where improvements are needed with respect to both the content of the disclosures and the format of the form itself.2 Among the Committee's observations included:
- firms are not permitted to include disclosures in the relationship summary beyond those that are required or permitted by the Form CRS instructions;
- if an investment adviser provides both discretionary and non-discretionary services, it must describe in their relationship summaries which investment authority applies to which services or accounts that they offer;
- firms must summarize the principal fees and costs that retail investors will incur;
- investment adviser firms that offer wrap fee programs must adequately describe these programs, the services included within such programs, and their corresponding fees and costs in the relationship summary; and
- firms must disclose how their professionals are paid and describe potential conflicts related to such compensation in a way that helps investors understand how conflicts may impact a financial advisor's motivation.
Background
Since June 30, 2020, the SEC has required broker-dealer and investment adviser firms to deliver a relationship summary to existing and prospective retail investors.3 Firms are required to file the relationship summary with the SEC and post the same on the firm's public website. Intended to be a short and accessible disclosure form, a relationship summary allows firms to summarize information about services, fees and costs, conflicts of interest, legal standard of conduct and whether or not the firm and its financial professionals have disciplinary history. The SEC hopes that retail investors will use the relationship summary to compare information about firms' brokerage or investment advisory offerings.4
The Committee's Observations
- Use of Technical Language and Disclaimers
– The relationship summary must be concise and direct, using
plain English and taking into consideration retail investor's
level of financial experience. In this regard, firms must avoid
legal jargon and highly technical business terms or citing SEC
rules unless they are clearly explained. Firms are not
permitted to include disclosures in the relationship summary beyond
those that are required or permitted by the Form CRS
instructions. For example, the Committee observed firms using
impermissible hedging language, stating that the relationship
summary "does not create or modify any agreement,
relationship, or obligation" between the investor and the firm
or its financial professionals.
- Omission of Required Information – As a
general matter, firms must include all required headings,
conversation starters and prescribed language and may only omit a
required disclosure in very limited circumstances, such as where
the disclosure is inapplicable to the firm's business or the
specific wording required by the form would be inaccurate with
respect to the firm.
- Reliance on Proposed, Rather than Final
Instructions – The Committee also observed firms
relying on the proposed instructions5 to Form CRS rather
than the adopted final instructions6 and, as a result,
such firms failed to comply with the form's requirements.
Relationship summaries are intended to be standardized to enable
retail investors to easily compare information between firms in
order to decide among firms, financial professionals, services and
accounts. Firms must review their relationship summaries against
the final instructions to ensure their disclosures align with the
final rule.
- Lack of Specific References to More Detailed
Information – While the relationship summary is
limited in length,7 firms must include specific
references to more detailed information referenced in the form,
describing the firm's services, fees and costs, and conflicts
of interests. A relationship summary that is posted on a firm's
website or otherwise provided electronically must facilitate access
to any information that is referenced in the relationship summary
if the information is available online. It is not enough to simply
state that more information is available elsewhere; firms must
facilitate access to that information by including hyperlinks to
such information. The Committee noted that many firms complied with
the form's instructions by providing direct hyperlinks to their
Form ADV Part 2A or to fee information or tables related to the
specific service or account being described.
- Descriptions of Relationships and Services, Fees,
Costs, Conflicts and Standards of Conduct – The
Committee observed the below shortcomings in their review of
relationship summaries, some of which did not include required
information or included impermissible, extraneous or unresponsive
disclosures. SEC Staff is of the view that when firms do not meet
the standards imposed by Form CRS, it is harder for retail
investors to focus on key information.
- Monitoring – Firms must disclose whether they
monitor client investments. The Committee observed that certain
firms did not explain the frequency with which they monitor
investments or disclose whether there are material limitations on
such monitoring services, as required in the relationship
summaries.
- Investment Authority – If an investment adviser
accepts discretionary authority, it must describe those services in
the relationship summary and whether there are any material
limitations on such authority (e.g., length of time). If an
investment adviser offers non-discretionary services, it must
explain in the relationship summary that the retail investor holds
the ultimate decision-making authority with respect to the purchase
or sale of investments. The Committee advised that if an investment
adviser provides both discretionary and non-discretionary services,
it must describe in their relationship summaries which investment
authority applies to which services or accounts that they
offer.
- Limited Investment Offerings – If a firm offers
or makes available only proprietary products or a limited group of
products or types of investments, it must state this in its
relationship summary. It is not enough for a firm to simply
acknowledge that it offers a limited product set, it must describe
such limitations.
- Principal Fees and Costs – Firms must summarize
the principal fees and costs that retail investors will incur. For
example, the Committee notes that some firms provided vague fee
descriptions, stating that that they charged an "advisory
fee" but did not describe how the fee is assessed or how often
the fees are billed to the retail investor.
- Wrap Fee Program Offerings and Fees – Investment
adviser firms that offer wrap fee programs must adequately describe
these programs, the services included within such programs, and
their corresponding fees and costs in the relationship summary.
Firms should also explain that asset-based fees associated with a
wrap fee program will include most transaction costs and fees,
resulting in the fees being higher than those of a typical
asset-based advisory fee alone.
- Extraneous Disclosures – While relationship
summaries are required to include certain standardized disclosure,
firms should also avoid including language beyond the scope of Form
CRS and Regulation Best Interest. The Committee noted that certain
firms referred to themselves as "fiduciaries" or subject
to a "fiduciary duty" as the appropriate standard rather
than the standard "best interest" which is the standard
of conduct specified in Item 3 of the Instructions to Form
CRS.
- Compensation Arrangements and Conflicts of Interest
– Firms must disclose how their professionals are paid and
describe potential conflicts related to such compensation in a way
that helps investors understand how conflicts may impact a
financial advisor's motivation. According to the Statement,
conflicts disclosures which included concrete explanations of
incentives associated with cash sweep programs or payment for order
flow were helpful. Firms should avoid simply stating that it
"may" have conflicts of interest or explaining how it
mitigates conflicts without explaining the actual conflict
itself.
- Monitoring – Firms must disclose whether they
monitor client investments. The Committee observed that certain
firms did not explain the frequency with which they monitor
investments or disclose whether there are material limitations on
such monitoring services, as required in the relationship
summaries.
- Modification of Disciplinary History – Relationship summaries include a section on disciplinary history. Firms must affirmatively state whether it or its financial professionals have legal or disciplinary history. Firms may not otherwise explain this response by adding descriptive or other qualitative or quantitative language. The use of extraneous information may minimize the disciplinary history. SEC Staff further notes that firms may not omit or modify this heading, even if there is no disciplinary history to disclose.
- Prominent Display on Firm Website – The Committee also observed that certain firms made the relationship summary difficult to locate. The relationship summary must be posted on a firm's website in a location and format that is easily accessible to retail investors, such as the firm's homepage. It should be noted that placing a hyperlink to the relationship summary several clicks away from the firm's homepage and placing the relationship summary among numerous other disclosures or documents were among the issues the Committee and Staff observed and disfavored.
- Description of Affiliate Relationships – Firms registered as both a broker-dealer and investment adviser may submit one joint relationship summary. However, the brokerage and investment advisory information must be presented with equal prominence. The Committee observed various instances where it was not clear whether a disclosure applied to the brokerage business, investment advisory business or both. Dually-registered firms should review their relationship summaries to ensure that their affiliate structures are clearly presented for a retail audience.8
- Poor Design – The Committee encourages the use of charts, graphs, tables and other graphics to explain or compare different aspects of the firm's products and services. Firms should endeavor to make use of white space and other design features to increase readability.
- Use of Marketing Language – The relationship summary must be factual and may not include exaggerated or unsubstantiated claims and should not be thought of or drafted as a marketing tool. Firms must avoid using "marketing language" that touts firms' abilities or uses superlatives. For example, some firms included language that they were "held to the highest possible legal standard."
- Boilerplate – Firms should avoid using vague and imprecise "boilerplate" explanations in their relationship summaries. The Committee observed that some firms used boilerplate phrasing to suggest that firms "may" have a conflict of interest, without further explaining what that conflict of interest may be. In reviewing relationship summaries, firms should look to highlight the presence of conflicts of interest and help retail investors understand the incentives they create.
Looking Ahead
In its 2021 Examination Priorities statement, the SEC Division of Examinations noted that it would focus on compliance with Form CRS and Regulation Best Interest and would examine whether firms are properly disclosing conflicts of interest to retail investors.9 Given that the Committee reviewed a cross-section of firms' relationship summaries and that the Division of Examinations and FINRA have been examining firms to assess compliance with Form CRS, we can expect both the SEC and FINRA to continue its focus on Form CRS and Regulation Best Interest compliance. Indeed, in July 2021, the SEC charged 27 firms for failing to properly deliver and file Form CRS.10 As previously noted, lessons learned by examiners during initial post-effective-date examinations are sometimes later cited as best practices by the SEC and FINRA.11 The Shearman & Sterling team continues to pay close attention to these developments, and we welcome any questions you may have.
Footnotes
1. SEC Standards of Conduct Implementation Committee, Staff Statement Regarding Form CRS Disclosures, December 17, 2021, available at: https://www.sec.gov/news/statement/staff-statement-form???????-crs-disclosu??res-121721?utm_medium=email&utm_source=govdelivery (the "SEC Statement"). Firms prepare relationship summaries in accordance with the Instructions to Form CRS to provide retail investors with easy-to-understand information about the nature of their relationship with the firm, and to aide retail investors in comparing firms and financial professionals.
2. On April 7, 2020, the SEC's Office of Compliance Inspections and Examinations also issued a risk alert regarding Form CRS examinations. Please see our publication regarding the same: "OCIE and FINRA Provide Guidance Regarding Regulation Best Interest and Form CRS Examinations."
3. SEC Release No. 34-86032, available at: https://www.sec.gov/rules/final/2019/34-86032.pdf. For a comprehensive summary of Form CRS and Regulation Best Interest, you may wish to refer to our client publications: "Raising the Bar? SEC Proposes Broker-Dealer Standard of Care and Guidance on Investment Advisers' Fiduciary Standard" and "Raising the Bar: SEC Adopts Broker-Dealer Standard of Care and Guidance on Investment Advisers' Fiduciary Duty." Form CRS defines a "retail investor" to mean "a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes." SEC Release No. 34-86032, available at: https://www.sec.gov/rules/final/2019/34-86032.pdf.
4. Id.
5. See Proposed Instructions to Form CRS, available at https://www.sec.gov/rules/proposed/2018/34-83063-appendix-b.pdf.
6. See Adopted Instructions to Form CRS, available at https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf.
7. The relationship summary for broker-dealers and investment advisers must not exceed two pages. For dual registrants that include their brokerage services and investment advisory services in one relationship summary, it must not exceed four pages. See Instructions to Form CRS, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf.
8. Please also see our publication "SEC Publishes Frequently Asked Questions on Regulation Best Interest," noting that dually-registered associated persons must make clear whether they are acting for the broker or the investment adviser.
9. SEC Division of Examinations, SEC Division of Examinations Announces 2021 Examination Priorities, available at: https://www.sec.gov/news/press-release/2021-39.
10. SEC, SEC Charges 27 Financial Firms for Form CRS Filing and Delivery Failures (Jul. 26, 2021), available at: https://www.sec.gov/news/press-release/2021-139. The SEC charged 21 investment advisers and 6 broker-dealers for failing to timely file and deliver their Forms CRS to retail investors.
11. Please see our publication "OCIE and FINRA Provide Guidance Regarding Regulation Best Interest and Form CRS Examinations."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.