General disclosures

General disclosures

These are four general disclosures that both broker-dealers and investment advisers must make (and that also apply to agents and IARs by extension):

• Conflicts of interest
• Internet-related disclosures
• Disclosure of capacity
• Third-party research

Conflicts of interest

A good starting point is this definition from the Merriam-Webster dictionary:

Definitions

Conflict of interest

A conflict between the private interests and the official responsibilities of a person in a position of trust

A conflict of interest exists when a financial professional could personally benefit from something connected to a client interaction. For example, an investment adviser might be compensated by an issuer for recommending that issuer’s security to clients. If your adviser has a financial interest in recommending a particular security, product, or service, that’s something you’d want disclosed.

Conflicts of interest aren’t automatically illegal or unethical. The problem is failing to disclose them. Conflicts can take many forms, but these are common examples:

• Recommending a security that financially benefits a registered person (beyond normal transaction or advisory fees)
• Recommending a security directly tied to an officer, director, or partner of the firm
• Recommending securities issued by their own firm or an affiliated firm
• Recommending a more expensive product or service resulting in higher compensation for the financial professional
• Recommending a security that will be sold out of the firm’s inventory
• Offering a product or service at a discounted rate only to a specific type of client
• Recommending a proprietary investment or service*

Definitions

Proprietary investment or service*

A security, product, or service developed by a company that is generally only available through that company

For example: Fidelity’s Portfolio Advisory Service, which is a model portfolio offered by Fidelity and created for investors based on their needs, risk tolerance, and time horizon. This proprietary service is only offered to Fidelity clients.

Notice that most of the conflicts listed above involve recommendations.

• Broker-dealers can recommend securities, but their core business is executing transactions.
• Many broker-dealer trades are unsolicited, meaning the customer initiated the trade without influence from a financial professional.

In unsolicited situations, broker-dealers aren’t subject to a fiduciary duty, so conflicts of interest are less likely to arise.

Definitions

Fiduciary duty

The requirement for a person (typically a professional) to hold another person’s interest above its own in all matters

Investment advisers, however, must always act in a fiduciary capacity with their clients. That means advisers must remove and/or mitigate conflicts of interest as much as possible. If a conflict still exists, it must be disclosed.

• Ongoing (permanent) conflicts are typically disclosed in the brochure.
• If a conflict arises in connection with a specific recommendation, it must be disclosed during the recommendation or before trade execution.

Internet-related disclosures

When financial professionals communicate with investors online, they must follow certain protocols to stay compliant with regulatory requirements. In 1997, NASAA released an order relating to internet communications. As the internet became a common way to communicate in the late 1990s, regulators needed a clear approach - especially around state registration.

A key question is whether online activity triggers registration in every state where an investor might be located. For example, suppose an IAR is registered and operating in only one state but discusses securities in an online comment thread (Facebook, Reddit, etc.). Users from all 50 states join the conversation. Does the IAR need to be registered in all 50 states?

It depends on what the communication looks like. Under the 1997 NASAA order, registered persons are not considered to be “transacting business” if the following requirements are met:

• The registered person discloses they may only perform securities-related services if properly registered in a client’s state
• Any individualized responses must comply with relevant rules and regulations
• The firm maintains a system that ensures these communications comply with applicable rules and regulations
• Communications are general and non-specific if engaging investors in states the person isn’t registered in

Additionally, the same NASAA order requires agents and IARs to:

• Prominently disclose the firm they’re affiliated with
• Ensure their communications are properly supervised
• Ensure their firm authorizes these communications
• Ensure their communications remain within the scope of their abilities

Keep in mind these rules apply only to online communications made while acting in a professional capacity. They generally don’t apply when you’re not discussing securities or when you’re communicating purely in a personal capacity. For example, an agent posting a general comment about the stock market on Facebook in their free time would generally not be subject to the rules above. If the comment is clearly personal and doesn’t reference professional affiliations, it typically falls outside the administrator’s jurisdiction.

Disclosure of capacity

To understand this section, you’ll need to be familiar with agency and principal capacities. Use the link for a quick refresher.

The capacity in which a securities transaction occurs must be disclosed to investors.

In most cases, broker-dealers disclose capacity on the trade confirmation after the transaction is executed. Trade confirmations must be sent to investors by settlement, which is typically the first business day after a trade occurs (depending on the security; the details are not important for the Series 66).

Most capacity disclosures happen after the trade, but some situations require disclosure before the trade. In particular, under Section 102(a)(3) of the Uniform Securities Act, an investment adviser who acts as principal for its own account in a trade with an advisory client must, before the transaction is completed, (1) disclose to the client in writing the capacity in which it’s acting, and (2) obtain the client’s consent to that transaction. In this context, “pre-disclosure” means that written disclosure and consent - not just a verbal heads-up during the recommendation.

This requirement doesn’t apply to a broker-dealer that isn’t acting as an investment adviser on the trade - for example, when the firm simply executes an unsolicited order the client placed without any recommendation. In that case, capacity is disclosed the ordinary way: on the trade confirmation after execution.

For example, an adviser recommends ABC Company common stock, and if the client agrees, the security will be sold out of the adviser’s inventory. Because the adviser is acting as principal, the adviser must give the client written disclosure of this capacity and obtain the client’s consent before the trade is completed.

The same written-disclosure-and-consent-before-completion requirement applies when the adviser acts as broker for the other side of the client’s trade - that is, to agency cross transactions, covered in detail just below.

Agency cross transactions also require certain pre-disclosures. An agency cross transaction occurs when an investment adviser “crosses” two of their own clients on the same trade.

For example, suppose an adviser has two clients - Leon and Ebony. On a quick phone call with their assigned IAR, Leon expresses interest in buying Tesla stock. Later that day, the IAR reviews Ebony’s account and determines her Tesla position is unsuitable. The IAR recommends that Ebony liquidate the position, and she agrees. The IAR then contacts Leon, matches the two clients on the trade, and earns an advisory fee from Ebony.

This would not be considered unethical if the following conditions are met (according to NASAA rules):

• Written disclosure provided to clients documenting the details of an agency cross transaction
• Written approval from each client to perform this type of transaction
• A confirmation with trade details is provided by the settlement of the trade
• An annual disclosure is provided to all clients detailing:
  • Total number of agency cross transactions performed
  • Total compensation received in connection to these transactions
• The client’s written approval may be rescinded at any time
• A recommendation was made only to one of the two clients

In the example above, the transaction was recommended only to Ebony, which satisfies the last condition. Beyond that, the written disclosures and written approvals must be obtained and retained before executing the agency cross transaction. The adviser must also provide the required annual disclosures to all clients.

Third-party research

Financial firms and their representatives may provide access to third-party research reports as an ongoing service. These reports often include investment insights on specific securities from professional analysts. With this added information, clients can better understand the markets and make more informed decisions.

NASAA rules emphasize one key requirement: disclose the source. The registered person must not imply the research is their own.