SEC staff publish statement regarding form CRS disclosures

Introduction
Background
Committee's observations
Comment

Introduction

On 17 December 2021, the US Securities and Exchange Commission (SEC) staff (Staff) issued a statement (the statement),(1) which summarises certain observations made by the SEC's Standards of Conduct Implementation Committee (the Committee) in connection with its review of customer relationship summary forms (forms CRS) 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 were the following:

• 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 its relationship summaries which investment authority applies to which services or accounts that it offers.

• Firms must summarise the principal fees and costs that retail investors will incur.

• Investment adviser firms that offer wrap fee programmes must adequately describe these programmes, the services included within such programmes, and their corresponding fees and costs in the relationship summary.

• Firms must disclose how their professionals are paid and describe potential conflicts relating to such compensation in a way that helps investors understand how conflicts may impact a financial advisor's motivation.

Background

Since 30 June 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 it on the firm's public website. Intended to be a short and accessible disclosure form, a relationship summary allows firms to summarise information about services, fees and costs, conflicts of interest, legal standard of conduct and whether 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)

Committee's observations

The Committee's main observations were as follows:

• use of technical language and disclaimers – the relationship summary must be concise and direct, using plain English and taking into consideration the 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 instructions(5) to form CRS rather than the adopted final instructions(6) and, as a result, such firms failed to comply with the form's requirements. Relationship summaries are intended to be standardised 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 relating to the specific service or account being described;

• descriptions of relationships and services, fees, costs, conflicts and standards of conduct – the Committee observed the following shortcomings in its review of relationship summaries, some of which did not include required information or included impermissible, extraneous or unresponsive disclosures. SEC staff are 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 (eg, 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 its relationship summaries which investment authority applies to which services or accounts that it offers;

• 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 summarise 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 programme offerings and fees – investment adviser firms that offer wrap fee programmes must adequately describe these programmes, the services included within such programmes and their corresponding fees and costs in the relationship summary. Firms should also explain that asset-based fees associated with a wrap fee programme 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 standardised 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; and

• compensation arrangements and conflicts of interest – firms must disclose how their professionals are paid and describe potential conflicts relating 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 that included concrete explanations of incentives associated with cash sweep programs or payment for order flow were helpful. A firm should avoid simply stating that it "may" have conflicts of interest or explaining how it mitigates conflicts without explaining the actual conflict itself;

• modification of disciplinary history – relationship summaries include a section on disciplinary history. A firm 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 minimise the disciplinary history. SEC Staff further note 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 disfavoured;

• 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 endeavour to make use of white space and other design features to increase readability;

• use of marketing language – the relationship summary must be factual, 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"; and

• 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 they "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.

Comment

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 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 Financial Industry Regulatory Authority (FINRA) have been examining firms to assess compliance with form CRS, it is expected that both the SEC and FINRA will continue their 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) Lessons learnt by examiners during initial post-effective-date examinations are sometimes later cited as best practices by the SEC and FINRA.(11)

For further information on this topic please contact Jennifer D Morton, Taylor Pugliese, Caitlin Hutchinson Maddox or Andrew Lewis at Shearman & Sterling LLP by telephone (+1 212 848 4000) or email ([email protected], [email protected], [email protected] or [email protected]). The Shearman & Sterling LLP website can be accessed at www.shearman.com.

Endnotes

(1) SEC Standards of Conduct Implementation Committee, Staff Statement Regarding Form CRS Disclosures, 17 December 2021, available here. 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 aid retail investors in comparing firms and financial professionals.

(2) On 7 April 2020, the SEC's Office of Compliance Inspections and Examinations also issued a risk alert regarding form CRS examinations. For further information, please see "OCIE and FINRA Provide Guidance Regarding Regulation Best Interest and Form CRS Examinations".

(3) SEC Release No. 34-86032, available here. For a comprehensive summary of form CRS and Regulation Best Interest, see "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 here.

(4) Id.

(5) See proposed instructions to form CRS, available here.

(6) See adopted instructions to form CRS, available here.

(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 here.

(8) Please also see "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 press release, available here.

(10) SEC press release, available here. The SEC charged 21 investment advisers and six broker-dealers for failing to file and deliver their forms CRS to retail investors in a timely manner.

(11) See "OCIE and FINRA Provide Guidance Regarding Regulation Best Interest and Form CRS Examinations".