20.01  The retail markets in the United States and the United Kingdom have been troubled by incidents of misconduct over the past ten years. Consider a few prominent examples. Prior to the financial crisis of 2008, in the United States and elsewere, numerous retail banks sold customers mortgage products that were not in their best interests.¹ Nearly a decade later, in 2016, it was uncovered that employees at Wells Fargo—striving to meet sales quotas—opened about three and a half million false and unauthorized deposit and credit card accounts on behalf of existing clients.² (p. 490) Meanwhile, in the United Kingdom, concerns of misconduct in the British pension market have been stirring since 2017. Recent changes in UK law gave pensioners the ability to cash out their employer pension plans, which cash they can then move into personal pension plans.³ The Financial Conduct Authority (FCA) has expressed concern that financial advisers may be pressuring and scare-mongering plan-holders to roll their accounts in this way.⁴

20.02  Because of the structure of incentives, conflicts of interest situations regularly arise in the context of retail investment advice. In parallel, empirical studies show that advisers from the financial industry, as from other professions, often give biased advice in the presence of a conflict of interest.⁵ So it should come as no surprise that conflicts of interest have been the focal point of regulators’ efforts to improve conduct in the retail investment space. In law, formal fiduciary duties attempt to align professional norms with professional responsibilities in order to alleviate some of the negative effects that arise from conflict of interests.⁶

20.03  In the United States, both the Securities and Exchange Commission (SEC) and the Department of Labor (DOL) have embarked on rule-making projects to heighten and refine the fiduciary duties that investment advisers owe to retail clients—and, in particular, the duty of loyalty that dictates the identification and management of conflicts of interest. Similarly, as a result of the FCA’s ‘Retail Distribution Review’, UK regulators issued new guidance on how the investment adviser can best comply with his or her fiduciary duties. However, with the bulk of regulatory attention so focused on revamping the legal and regulatory frameworks surrounding fiduciary duties, one wonders whether an important element will go missing. Specifically, will firms be sufficiently compelled to focus on building the cultural infrastructure which, while perhaps not mandated by regulators, is nonetheless necessary to support—and fill gaps in—fiduciary duty rules?

(p. 491) 20.04  The core claim of this chapter is that the prudent and forward-looking investment firms will see the incentives for doing so. These firms, anticipating novel conflicts-of-interest challenges on the horizon, and reading the tea leaves of supervisory expectations, will begin to think more expansively and creatively about how their internal compliance functions might include a culture dimension. Indeed, it is predicted in this chapter that both supervisors and the market will soon come to demand proof that a cultural shift in retail investment firms is happening, in the form of evidence that a firm espouses and abides by certain norms of business conduct that govern its employees’ interactions with retail clients. Accordingly, those investment firms that start expanding their view of compliance now, to address ‘culture’—that is, firm values and attitudes towards the proper treatment of retail investment clients⁷ —alongside their formal processes for dealing with conflicts of interest, will no doubt have a head start in confronting the next generation of retail investment regulations.

20.05  In that vein, this chapter will first examine the traditional legal frameworks that address conflicts of interest in the retail investment space, outlining how they are narrowly anchored in fiduciary duty law, as well as recent developments in these regimes. Then, the chapter will offer some predictive analysis concerning where conflicts-of-interest challenges are likely to lie on the horizon in retail investing, and how existing and proposed fiduciary duty rules are likely to fall short in addressing them. Finally, and prescriptively, the chapter will explore the implications of that prediction for integrating compliance (a legal construct) with culture (an ethical, professional, and behavioural one). Specifically, the chapter will conclude by suggesting how the compliance function of retail investment advisory firms can evolve—indeed, expand—to incorporate legal risk considerations together with cultural risk considerations. Concretely, the chapter will set out some tentative ideas for constructing this new legal-cultural apparatus in the retail investment firm.

20.06  Investor protection is a fundamental goal of the securities law in both the United States and Europe.⁸ The US Securities Act of 1933 and the Securities Exchange Act of 1934 were introduced with the express goal of protecting investors from (p. 492) misconduct-related abuse, like fraud.⁹ And investor protection is one of the SEC’s three direct mandates (alongside the support of efficient markets and capital formation).¹⁰

20.07  Indeed, investor protection may well be the backbone of the SEC’s work. Precisely as former SEC Chair Mary Jo White remarked, ‘Each part of our mission circles back to the first—to protect investors—because if our markets are not fair and safe, they will not attract investors to provide the capital companies are seeking.’¹¹ In similar ilk, investor protection goals feature prominently in each of the major EU Directives regulating investments.¹²

20.08  Retail investors comprise a significant segment of investors. As the SEC has described:

Over half of Americans, either personally or jointly with a spouse, report that they own a stock directly or through investment vehicles, like a self-directed 401(k) or IRA. And over 44 percent of Americans— including most retail investors—invest in a mutual fund, which … pools money from many investors and invests it in stocks, bonds, money-market instruments, other securities, or even cash.¹³

And as a public policy matter, the law views the retail investor—as compared to institutions and high net-worth individuals—as requiring special protection from fraud and abuse.¹⁴ Thus, as the SEC notes, the retail investor ‘must be a constant focus’ of financial law and regulation.¹⁵

20.09  Although US and EU securities laws protect the retail investor in myriad ways, one of the primary vehicles for doing so is a robust framework of fiduciary duty laws and rules. As was well summarized by SEC Commissioner Kara Stein, ‘[t]he lynchpin of investment adviser regulation is the fiduciary duty’, and the essence of the duty is ‘that the adviser must avoid conflicts of interest and cannot take unfair (p. 493) advantage of a client’s trust’.¹⁶ Bank regulators have spoken on the matter as well. Citing the common law (Restatement of Trusts),¹⁷ the Office of the Comptroller of the Currency (‘OCC’) has explained that ‘bank fiduciaries have a heightened responsibility to avoid impermissible conflicts of interest and to ensure that they are acting in the best interests of fiduciary accounts’.¹⁸

20.10  The most ‘fundamental’ of fiduciary duties is generally taken to be the duty of loyalty, that is, the duty not to engage in ‘self-dealing’ transactions or transactions ‘that otherwise involve or create a conflict between the … fiduciary duties and personal interest’.¹⁹ As explained in a statement by the SEC Director of Compliance and Investigations:

[A] conflict of interest [is] a scenario where a person or firm has an incentive to serve one interest at the expense of another interest or obligation. This might mean serving the interest of the firm over that of a client, or serving the interest of one client over other clients, or an employee or group of employees serving their own interests over those of the firm or its clients.²⁰

20.11  In the United States, the fiduciary standards that apply to investment advisers have been hardwired into federal securities law.²¹ In particular, any investment adviser registered with the SEC is considered to be a fiduciary, and therefore ‘has a duty to make full and fair disclosure of all material facts to, and to employ reasonable care (p. 494) to avoid misleading, clients’.²² Retail clients should be able to ‘understand the investment adviser’s business practices and [any] conflicts of interest’.²³ More specifically, SEC (and related Financial Industry Regulatory Authority (FINRA)) rules²⁴ promulgated pursuant to the Investment Advisers Act of 1940 generally require that registered investment advisers act

in the best interests of [their] clients and to provide investment advice in [their] clients’ best interests. [Investment advisers] owe [their] clients a duty of undivided loyalty and utmost good faith. [They] should not engage in any activity in conflict with the interest of any client, and [they] should take steps reasonably necessary to fulfill [their] obligations. [Advisers] must employ reasonable care to avoid misleading clients and [they] must provide full and fair disclosure of all material facts to [their] clients and prospective clients.²⁵

This is commonly referred to as the ‘best interests’ standard, which, again, applies to registered investment advisers. Meanwhile, broker-dealers are subject to FINRA rules that require investment advice to be ‘suitable’ for their clients.²⁶ As applied, the suitability standard is viewed as somewhat less rigorous than the best interest standard that is imposed on advisers under the Investment Advisers Act. However, the SEC has recently proposed a new rule under the Exchange Act which would require broker-dealers also to act in the ‘best interests’ of their retail clients when making recommendations about securities transactions or investment strategies involving securities.²⁷

20.12  As for banks, although normally exempt from securities law regulation, those institutions are required to invest funds of any fiduciary account ‘in a manner consistent with applicable law’, which is defined to mean, among other things, ‘any applicable Federal law governing [a bank’s fiduciary relationships], the terms of the instrument governing a fiduciary relationship, or any court order pertaining to the relationship’.²⁸

(p. 495) 20.13  Rules in the United Kingdom governing the provision of investment advice are similarly grounded in fiduciary law. Notably, the UK Securities and Investments Boards (SIB) adopted the Core Conduct of Business Rules pursuant to the Financial Services Act 1986. Under these Rules, independent financial advisers were subject to a ‘best advice rule’²⁹ when making personal recommendations for investments in ‘packaged investment products’, such as units in regulated collective investment schemes.

20.14  According to a number of scholars, the best advice rule was, in effect, an application of the best execution principle, which applies to independent financial advisers acting as investors’ agents. Of fiduciary origin, the best execution principle imposes a duty on investment advisers to act in the best interests of the client. In 2004, the Financial Service Authority revamped the 1986 system,³⁰ adopting the Principles for Businesses that, among other things, require financial advisers to pay ‘due regard’³¹ to the interests of customers and to treat them fairly. Although formulated somewhat mildly, this duty to consider customers’ interests and to ensure their fair treatment is in effect a fiduciary duty of loyalty; it certainly precludes the provision of investment advice driven by a conflict of interest.

20.15  While this basic fiduciary framework has been a mainstay of the securities law for decades (in the United States), and since the early days of EU financial services law (in Europe), regulators have doubled-down on fiduciary duty rules in their recent effort to improve the conduct of the retail investment sector. In the United States, both the DOL and the SEC have either promulgated or have considered reinforcing fiduciary duty rules pursuant to their statutory authority. In the United Kingdom, the FCA undertook a comprehensive Retail Distribution Review with much the same goal in mind, while the EU has introduced even more stringent rules.

20.16  The DOL ‘fiduciary rule’ also known (informally) as the ‘conflict of interest rule’ was adopted in 2016 and expands the scope of fiduciary duties in the retirement investment space. Presently, the future of the rule remains uncertain: key provisions were delayed until July 2019,³² and a recent decision by the Fifth Circuit Court of Appeals vacated (i.e. invalidated) the rule.³³ Despite this uncertainty about the (p. 496) rule’s future impact, it is nonetheless useful to explore the rule’s parameters—if for no other reason than an academic study of how forward-leaning fiduciary duty regulations could be structured, and as a case study of regulatory appetite for strengthened fiduciary duty law.

20.17  In broad strokes, the rule aims to ensure that all retirement advice is given pursuant to the retiree’s best interests.³⁴ It requires that any financial professional giving advice or recommendations in connection with retirement plans (e.g., 401K plans or IRAs)—which includes investment advisers as well as broker-dealers—will be considered a fiduciary giving ‘fiduciary investment advice’ under the Employee Retirement Income Security Act of 1974 (ERISA).³⁵

20.18  There are two key components to note. First, the rule expands the category of investment professionals which come within the scope of the ERISA definition of ‘investment advice fiduciary’.³⁶ Specifically, the new fiduciary rule applies to any financial professional that makes a recommendation in connection with a retirement account. This would include, for example, ‘advice’ given on securities or other property transactions; decisions regarding distributions or plan rollovers; and general investment management decisions, among other things.³⁷ It bears emphasis that broker-dealers used not to be considered ERISA fiduciaries, and so this new rule significantly expands the conduct standards that apply to this category of investment professional.

20.19  The rule also contains a substantial exemption. As a baseline, the rule seeks to discourage commission fee structures, on the view that these can be more conflict-prone than flat fee based structures. However, the rule’s ‘Best Interest Contract Exemption’ or ‘BIC Exemption’ permits fiduciaries to receive commissions—and other similar types of compensation that might otherwise give rise to conflicts of interest—in certain cases. The BIC exemption can apply where the fiduciary:

• •  agrees to provide advice that is in the ‘best interests’ of the retirement investor;

• •  does not charge more than reasonable compensation;

• •  does not make any misleading statements.³⁸

(p. 497) 20.20  As a possible downside, the DOL rule would make fiduciary standards uneven across retail investment advisers. Under the rule, retirement advice (whether given by broker-dealers or investment advisers) would be held to a different, some argue higher, fiduciary standard than other forms of retail investment advice.³⁹ Already, as SEC Commissioner Hester Peirce points out, ‘fiduciary’ has different legal meanings in ERISA and under the Investment Advisers Act of 1940.⁴⁰ Moreover, as discussed, broker-dealers and registered investment advisers are held to different conduct standards generally—a ‘suitability’ standard for the broker-dealers and the ‘best interests’ standard for advisers—a disparity which preexisted the new DOL rule. Indeed, the Dodd-Frank Act required the SEC to consider this unevenness between registered investment advisers and broker-dealers, and gave the SEC authority to create a uniform ‘best interest’ standard of conduct for investment advisers and broker-dealers if needed.⁴¹ On that mandate, the SEC has, as discussed, proposed a new rule which would require broker-dealers to act in the ‘best interests’ of their retail clients—thus bringing their duties in line with those imposed on registered investment advisers.⁴² This SEC rule may yet come to render moot and/or supplant the DOL rule.

20.21  In the European Union, the Markets in Financial Instruments Directive (MiFID II), adopted in 2014 and applied from the beginning of 2018, governs the relationship between financial advisers and their clients.⁴³ Article 24(1) of MiFID II requires investment firms to act honestly, fairly, and professionally, in accordance with the best interest of their clients.⁴⁴ In practice, a network of rules covers the various stages of the relationship between the client and the adviser, including the marketing phase.⁴⁵ The rules require in particular that investment advice be suitable for the client and not be tainted by conflicts of interests. Firms must also implement policies and procedures to manage conflicts of interest as well as systems to monitor and maintain those conflicts systems.

20.22  The broad, fiduciary-like ‘fair treatment’ obligation provides national regulatory authorities with a convenient, flexible mechanism to assess firms’ behaviour, and (p. 498) even proactively address the asymmetry in bargaining power between firms and their clients.⁴⁶ In addition, Member States can supplement the compulsory core ‘fair treatment’ obligation and adopt legislation that goes above and beyond the EU provisions. For example, the United Kingdom introduced, as from 1 January 2013, a prohibition on the taking of commissions by independent advisers that gold-plated the requirements that were then in place.

20.23  Moreover, pursuant to its Retail Distribution Review (RDR), the FCA concluded that notwithstanding the existing ‘best interests standards’ (similar to what existed in the United States), the market for financial advice was still too conflicted.⁴⁷ The main changes that emerged from the RDR, in addition to the banning of commissions,⁴⁸ include:

• •  a requirement that independent advisers document that their advice considered/addressed all of the of retail products available;⁴⁹

• •  the addition of more stringent qualifications to obtain a licence as a financial adviser, including subscribing to a code of ethics and fulfilling continuing professional education requirements.⁵⁰

This regulatory project is ongoing and in some respects historic.⁵¹ In May 2018, the FCA retired two pieces of guidance on the RDR, on the ground that the guidance had been superseded by new rules implementing MiFID II.⁵²

(p. 499) 20.24  Developments in UK banking regulation have also had some cross-over into the retail investment space. In particular, the Parliamentary Commission on Banking Standards (PCBS) was established in 2012 to conduct an inquiry into professional standards and culture in the UK banking sector and to make recommendations for legislative and other action. PCBS published its final report in June 2013 entitled ‘Changing Banking for Good’, including recommendations to make senior bankers more responsible, as well as encouraging behavioural change through increased individual accountability.

20.25  The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) responded to these recommendations with proposals introducing a new regime included in various consultation papers between July 2014 and July 2015. This new regime is made up of three components:

• •  The senior managers regime creates direct accountability to the regulators for individuals taking (or participating in) important decisions about a firm’s affairs. It also ensures that firms allocate the most important senior management functions to individuals in a clearly defined manner;

• •  The Certification Regime requires firms to certify that certain employees are ‘fit and proper’ to perform their functions, having regard to their qualifications, training, competence, and personal characteristics; and

• •  The Conduct Rules are the Regulator-prescribed code of conduct applying to all non-ancillary staff within firms. Firms are required to report breaches of the Conduct Rules to the appropriate Regulator.

20.26  The new regime came into force for all ‘relevant authorized persons’ on 7 March 2016 and will be extended to all ‘authorized persons’ during 2018. ‘Relevant authorized persons’ include banks, building societies, credit unions, PRA-designated investment firms, and branches of foreign banks operating in the United Kingdom. The government has estimated that the proposed extension to ‘authorized persons’ will apply to 60,000 additional firms, including 17,200 investment firms.

20.27  Pursuant to this regime, individuals (senior managers) who hold one or more key functions within a firm (senior management functions) must be approved by the appropriate regulator before they can be formally appointed. Senior managers typically include a firm’s board members; executive team members and heads of key business areas such as risk, internal audit, and finance; compliance officers; and money laundering reporting officers. Under the duty of responsibility, the FCA and the PRA can take action against senior managers if they are responsible for the management of any activities in their firm in relation to which their firm contravenes a regulatory requirement, and they do not take such steps as a person in their (p. 500) position could reasonably be expected to take to avoid the contravention occurring (or continuing).⁵³

20.28  The duty of responsibility requires the regulators to prove a contravention of a regulatory requirement by the firm, and that the senior manager was responsible for the management of any activities in their firm in relation to which the firm’s contravention occurred. The burden of proof lies with the regulators to show that the senior manager did not take such steps as a person in their position could reasonably be expected to have taken to avoid the firm’s contravention occurring. In substance, then, the Senior Manager and Certification Regime builds on (but goes further than) certain fiduciary duty principles.

20.29  In the US especially, given the possibility of the DOL phase-in and/or a new SEC rule, retail investment firms face the prospect of increased costs of compliance.⁵⁴ The sources of these additional compliance costs are likely to run the gamut from installing new procedures for ensuring that all relevant professionals are appropriately categorized as fiduciaries, and properly training these fiduciaries regarding their legal obligations, particularly as they relate to actual or potential conflicts. Additionally, as other experts have pointed out, firm compliance departments will be tasked with reviewing the roles played by their various vendors and service providers, and evaluating whether these third parties provide information in ways that will qualify as investment advice or recommendations under the new rules.⁵⁵ In tandem with that review, firms will have to ensure that all service agreements, contracts, and fiduciary liability insurance policies cover relevant employees and third parties.⁵⁶

20.30  But with compliance professionals hyper-focused on digesting new rules and guidance in the first instance, and then installing the necessary procedures to ensure that these new requirements are met, there may be few resources left to think more expansively about ways to fundamentally change institutional behaviour—culture—to align with the broader spirit of the invigorated fiduciary duty rules.

20.31  The next section of this chapter urges that embracing a broader vision of compliance—which addresses the cultural underpinnings of the fiduciary duty rules—is not just (p. 501) academic idealizing or aspirational. To the contrary, it is suggested that incorporating cultural elements into retail investment firms’ compliance functions will be essential to their task of managing the kinds of non-traditional conflicts of interest that are likely to arise in the near and medium term. In particular, the authors seek to show that there is good reason for investment firms to embrace a proactive approach to conflicts-of-interest compliance, and to begin thinking innovatively about the sorts of cultural infrastructure that can be implemented internally to support (and advance) the goals that animate this new fiduciary duty regime.

20.32  While heightening fiduciary standards is certainly an important—and tangible—step towards improving conduct in the retail investment space, there is some danger that too steady a focus on rules will unduly narrow the conduct reform project. Fiduciary rules are likely to focus firms and their advisers on process—incentivizing these firms to add layers of internal disclosure (regarding fees and all manners of conflicts) and documentation (regarding what range of investment options were considered and which reasons advanced for the advice/recommendation given).

20.33  But this manner of layered process may fail to adequately address the next generation of conflicts of interest likely to arise in an evolving retail investment market. In particular, the typical ‘look and feel’ of a conflict of interest may change as financial institutions become larger and more diversified, robo-advising proliferates, competition among retail advisers intensifies, and retail investors continue to flock into passive funds. In this environment, a solely process-oriented approach to complying with fiduciary duty rules will have limited agility to head off reputation-damaging (even if not legally prohibited) conflicts.

20.34  With this imperative in mind, this section intends to press retail investment firms to think ahead of the regulatory curve, and to consider whether the current regulatory initiatives in the fiduciary duty space may be soon bypassed by certain market developments.

20.35  Some of the most significant innovations in the financial markets are happening in the retail space. And inevitably, innovation gives rise to new potential conduct problems, including novel conflicts of interest.⁵⁷

20.36  Despite some efforts to reduce the size (or systemic footprint) of the largest financial institutions, in actuality, the largest financial institutions have become larger.⁵⁸ Some banks grew larger in the last decade because they rescued—thereby absorbing—other failing institutions; others, like Goldman Sachs, converted to Bank Holding Companies, which meant eventual expansion of a retail deposit and investor base that did not exist before. With the growth of these financial institutions came increased diversification along a number of business lines.

20.37  On a corporate level, the largest financial institutions now have a broader range of competing interests, all vying for the most attractive investment opportunities available to the firm. One conflicts-related question, then, is who decides which investor base gets the opportunity? And by what criteria?

20.38  Consider a hypothetical: the CEO of Goldman Sachs becomes aware of a unique investment opportunity, one that is 90 per cent likely to generate a handsome (and safe) return. The opportunity could go to Goldman’s asset management subsidiary, its retail group, or to its wholesale trading arm. How is that decision made, and who considers the conflicting interests between the retail investment arm and the others? The answer is not likely to be dictated by fiduciary duty rules,⁵⁹ but the way in which the allocation is made does arguably implicate the best interests of the retail investor and whether that group is being treated fairly in the mix of the holding company’s subsidiaries.

20.39  A second likely source of future conflicts stems from the rise of robo-advisers. These are automated, internet-based investment services that make investment recommendations and offer investment advice to retail customers using computer algorithms (drawing from responses given to answers to online questions).⁶⁰ Robo-advisers have become attractive to the retail investor because they are easy to use (often available on smart phone applications), less expensive than traditional investment advisers (with lower fees and lower minimum investment amounts), and—attractive to some—the ability to avoid interaction with a human adviser.

(p. 503) 20.40  Robo-advice is on a tremendous growth trajectory. One study refers to estimates that predict over 2 trillion US dollars of assets will be managed with the help of robo-advisers; and by 2015, over 16 trillion US dollars (which, as that study puts into context, would be three times the assets managed by the world’s largest asset manager, BlackRock).⁶¹ The United States leads the market in robo-advice, but Asia and Europe are also growth areas.⁶²

20.41  Facially, the fiduciary standards that apply to robo-advisers are straightforward. Robo-advisers are ‘investment advisers’ under the Investment Advisers Act of 1940 (thus have to register under the Act).⁶³ As such, the SEC treats them like fiduciaries—and they therefore must provide their advice consistent with that role.⁶⁴ (Obligations under the Investment Company Act may also apply, depending, in particular, whether Rule 3a-4 is applicable.⁶⁵) As will be recalled, this means that a robo-adviser, as a fiduciary, has an obligation ‘to act in the best interests of its clients and to provide only suitable investment advice’ based on its assessment of the client’s ‘financial situation and investment objectives’.⁶⁶

20.42  But practically, how can a robo-adviser meaningfully be held to a fiduciary duty of loyalty standard? Robo-advisers are not capable of varying their electronic questionnaire/script based on in-the-moment judgements about their client’s needs, hesitations, or subconscious biases.⁶⁷ As relating to conflicts, then, the robo-adviser may not have sufficient data to know that the advice being given is actually, in a broad sense, conflicted—the robo-advice may inadvertently serve the interests of the investment company affiliated with the robo-adviser (by channeling capital into one of its funds) more so than the retail investor-client’s interests.⁶⁸

20.43  There is also a question of whether a robo-adviser can explain its business model consistent with a best-interest type standard.⁶⁹ Do the investors get adequate and comprehensible information about the algorithms that drive the advice? That kind of information would likely not be considered investment ‘advice’ under the DOL (p. 504) rule, but arguably could give rise to conflicts of interest. Consider, for example, the possibility that a third party could offer the robo-adviser an algorithm at a discount, which could then ultimately affect the direction of investment advice given.⁷⁰ More generally, one may also wonder whether robo-advisers will make disclosures—about fees or other possible sources of conflicts—in a way that is comprehensible to the retail investor.⁷¹ A robo-adviser may not be as effective as a human adviser in explaining potential conflicts of interest.

20.44  Conflicts can also arise from the algorithmic coding itself. The technology behind robo-adviser algorithms can allow the program to draw relationships directly. But there could be some risk that when the program confronts relationships it has not seen before, it will react incorrectly. For example, with the use of big data processing, an algorithm could intake information that retail investors wake up and eat breakfast each day and, from those data points, ‘conclude’ that these investors wake up because they are hungry. More likely, however, any one given investor wakes up because her alarm is set to that time, and then later eats breakfast as part of a morning routine.

20.45  This stylized example simply underscores that correlation is not causation. But one could readily see the potential for misconstruing two seemingly linked data points into a causal chain and, accordingly, the risk that robo-advisers would give investment advice on that flawed basis. Perhaps this kind of data-interpretive error may come to be seen as another form of conflicted advice, insofar as such advice would place an investor into financial products that grow an investment firm’s assets under management, but which advice is not in that client’s best interests.

20.46  Competition among financial advisers could become another possible source of conflicts of interest. Not only have financial services become more globalized in general, but the options available to retail investors have expanded along with the rise of exchange-traded funds (‘ETFs’) and new alternative mutual funds, called ‘hedge funds for the masses’.⁷² The retail investor, in short, has access to a wider range of funds, platforms, and services than ever before. In this environment, the traditional financial adviser will quite likely be pressed to show prospective clients why his or her services are needed, in a world where the retail investor is increasingly able to access funds more simply and directly—without the help of an adviser.

(p. 505) 20.47  The question then becomes how financial advisers will distinguish their services. How might financial advisers seek to demonstrate themselves as the ‘best’ fiduciary on the market? Ideally, this kind of competition would drive a race to the top, as fiduciaries strive to find ways of proving to the retail client that their approach to considering and recommending investment products surpasses their peers in fulfilling a client’s bona fide best interests. But it is also possible that the competitive race among fiduciaries will create new incentives and opportunities for advisers to mislead investors—that is, to point to metrics or heuristics that are not in fact reliable indicators of the adviser’s future performance, let alone indicative of his or her methodology for satisfying the client’s best interests.

20.48  An increase of conflicts among passive fund managers could be a knock-on effect of heightened fiduciary duty rules for retail investment advice. ETFs and other passive funds have become hugely popular with retail investors over the past several years.⁷³ But passive fund managers may be susceptible to a very particular form of conflict of interest which has not yet been legally diagnosed as such.

20.49  In the passive fund model, managers’ performance is ordinarily measured on a quarterly basis relative to their peers. Some academic literature now suggests that due to the reputational risk of underperforming peers in the short term, this structure creates incentives for passive fund managers to follow market momentum and ride systemically dangerous bubbles.⁷⁴ According to these theories and research, rather than acting in what may be the individual investor’s (or the market’s) best interest—that is to ‘prick’ the bubble—some passive fund managers will be incentivized to forgo acting on information that points to the long-term benefit of investing in directions contrary to the market’s movement. Stated differently, these managers may choose to ride bubbles in order to demonstrate short-term (but possibly spurious) good performance—all the (p. 506) while growing their assets under management—rather than act as ‘rational arbitrageurs’.⁷⁵

20.50  While not exhaustive, this brief predictive survey of the conflicts of interest that may develop in retail investment markets is meant to illustrate the very general point that conflicts are dynamic.⁷⁶ No fiduciary duty (legal) rule, regardless how comprehensively crafted, will be capable of anticipating the wide range of possible conflicts likely to face investment advisers in the years to come. Accordingly, for the retail investment firm, managing conflicts of interest among its employees will require more than straightforward ‘compliance’. Instead, it will require the development of a holistic compliance function that is designed to instill a firm-wide culture that is committed to the ethical treatment of customers, which may go beyond what law and regulation strictly require.⁷⁷

20.51  Reflecting again on the Wells Fargo case, one may well wonder to whom fiduciary duties were owed. Wells Fargo shareholders filed a derivative lawsuit alleging, among other things, that the bank’s officers, directors, and senior management breached the fiduciary duties which are owed by directors of federal banking institutions—citing explications of those duties by the FDIC and the OCC.⁷⁸ However, it is not legally certain that the bank owed a fiduciary duty to its retail depositor-customers.⁷⁹ But the sales force’s failure to account for the broader interests of the bank’s retail customers surely reflects, the authors think, a cultural lapse. There were arguably ethical commitments at stake in safeguarding the Wells customers’ interests in the security of their personal information, the integrity of their credit scores, and the peace of mind that their banking institution would not act in an unauthorized way.

20.52  According to the conclusion of recent behavioural studies, fiduciary duties are likely to have a different effect on how advisers manage their conflicts of interest, (p. 507) depending on how such advisers perceive their professional norms. Conflicts of interest situations directly test the content of the firm’s culture and, more precisely, what the advisers’ perceived professional norms are. There might be a difference between the norms that are expressed and the ones that are perceived. Typically, advisers can perceive the norms of their environment, or institution, as either prioritizing self-interests or placing clients first in the context of a conflict of interests.⁸⁰ These professional norms are developed from employees’ perceptions of both injunctive norms (what we believe we should do) and descriptive norms (what we believe others actually do). They may align with professional responsibilities to place clients first if the perceived norms dictate ‘clients first’, or differ from professional responsibilities if the norms dictate ‘self-interest first’.

20.53  Empirical studies show that norms direct behaviour only when they are made salient.⁸¹ For example, the requirement to disclose conflicts of interests—which is a common method for managing conflicts of interests—will prompt advisers to consider the dilemma they face more deeply, which in turn makes the perceived professional norm more salient. Depending on the content of this perceived norm (‘clients first’ or ‘self-interest first’), advisers will give less or more biased advice than they would if they were not asked to disclose their conflict of interest.⁸²

20.54  These findings demonstrate more generally the impact of culture, or as psychologists call it ‘context’, defined as ‘the surroundings associated with phenomena which help to illuminate that phenomena’,⁸³ in the context of conflicts of interests. The growing importance granted to compliance may nudge firms’ culture towards a more ethical content.

20.55  Federal securities law mandates that investment advisers have compliance programs; but the law does not specify how, precisely, those programs should be designed.⁸⁴ The United States Federal Sentencing Guidelines (§ 8B2.1) also addresses (p. 508) compliance: they promise reduced corporate criminal sentences for companies that have adopted ‘effective’ compliance programs. In essence, what makes a compliance program ‘effective’ is the extent to which it figures centrally in corporate culture (e.g., that it be well-designed, regularly evaluated, sufficiently funded and staffed, embraced by top management, the object of training). Compliance policies that are mere ‘window dressing’,⁸⁵ are insufficient when it comes to seeking sentence reductions under the organizational sentencing guidelines.

20.56  Similar principles seem to be on the rise in European countries. In the corruption context, for example, France’s 2016 law on transparency, anti-bribery, and modernization of the economy (known as Sapin II law)⁸⁶ requires that companies implement compliance policies to prevent and detect acts of bribery and corruption⁸⁷ The law requires that compliance policies be regularly updated, evaluated for effectiveness, and that key management and employees be trained on anti-corruption compliance policies and procedures. These types of compliance obligations become much simpler to implement company-wide (particularly in sprawling companies) when a commitment to effective compliance figures centrally in corporate culture.

20.57  While the US Federal Sentencing Guidelines apply to all corporate entities, including those in the financial services sector, the new French obligations do not relate to compliance with fiduciary duties in the provision of investment advice. But, French judges—like American judges—enjoy substantial discretion in imposing sentences in criminal cases, and it would not be surprising if a French judge were to be persuaded, in a case involving a corporate defendant in the financial services industry, to take into account the existence of an effective compliance program as a mitigating factor in sentencing. (Of note here is that under the American rules, the mere existence of a legal violation in a particular case is not conclusive evidence of the overall ineffectiveness of the compliance program).⁸⁸

20.58  It is suggested by the authors that these are related phenomena, both deriving from inadequacies in the company’s cultural commitment to compliance. Conversely, embracing a robust compliance culture—as now mandated by French law in the corruption context—could have spillover effects and minimize not only the specific illegalities for which compliance systems are legally mandated (e.g. bribery), but also other legal violations including breaches of fiduciary duties.

20.59  The previous sections suggested that the compliance function of retail investment firms should address culture by establishing ethical norms for interacting with (i.e. serving) the retail client. But before discussing concrete options for operationalizing this cultural program, some fundamental questions of compliance governance and design are addressed first.

20.60  A firm’s ‘compliance function’ is generally responsible for ensuring that employees (and the corporate entity) comply with binding legal frameworks as well as the firm’s internal codes of conduct.⁸⁹ The compliance function thus functions as the firm’s internal system for enforcement. Compliance personnel focus and draw on various sources of hard and soft law—primary legislation, regulatory rules, and supervisory standards or guidance.⁹⁰ Accordingly, dealing with conflicts issues usually falls within the compliance function of an organization. And for a financial institution specifically, supervisors may examine its compliance system to evaluate how well it is equipped to manage legal risk, including, for relevant investment firms, conflicts of interest.⁹¹

20.61  How and where culture fits in is still, for many firms, an open and evolving question. Culture, as ‘the set of explicit and implicit norms, practices, and expected behaviors that influence how firm executives, supervisors and employees make and implement decisions in the course of conducting a firm’s business’,⁹² refers to the intangible ethos (or values) of an institution that should, for example, guide employee behaviour in situations where a fiduciary duty law, or a provision in a corporate code of conduct, might seem silent or unclear. And, despite the fact that all of the action on the rule-making front has focused on fiduciary duty rules, conduct authorities have given signs (through speeches, announcements, and letters setting out enforcement priorities) that they expect retail investment firms to integrate culture into their overarching compliance systems. For example,

(p. 510) 20.62  One senior FCA official has remarked:

[c]ulture drives individual behaviours, which in turn affect day-to-day practices in firms and their interaction with customers and other market participants. Culture is therefore both a key driver, and potential mitigate, of conduct risk. The experience of the past demonstrates that a poor culture can lead to poor outcomes for consumers and markets.⁹³

20.63  In a similar vein, a letter setting out FINRA’s 2016 enforcement priorities noted:

A firm’s culture is both an input to and product of its supervisory system, including its approaches to identifying and managing conflicts of interest and ensuring the ethical treatment of customers.⁹⁴

20.64  And, as one SEC official stated publicly,

At the end of the day, managing conflicts is much more than just having a strong compliance program, although that is obviously critical. It also requires establishing a culture that, regardless of regulatory requirements, does not tolerate conduct that casts doubt on the organization’s commitment to high ethical standards, and that values the firm’s long-term reputation over any possible short-term benefit from exploiting its clients or customers.⁹⁵

20.65  In short, as a matter of supervision, the regulators certainly seem eager for retail investment firms to integrate culture as part and parcel of their compliance functions—regardless of whether such efforts can or should be legally mandated or measured.⁹⁶

20.66  Symmetrically, investment firms have indicated their willingness to change their culture and move from an industry closer to a profession.⁹⁷ Some may ask whether a tiger (p. 511) can change its stripes. If changes in banking culture are any indication, then, indeed, change to retail advisers’ habits and priorities may also be possible.⁹⁸ When traditional banks added trading-related activities, the traditional long-term relationship in which bankers acted as agents for their clients—owing them fiduciary duties—changed to a transaction-oriented business, with bankers acting as principals and customers as counterparties subject to the caveat emptor rule.⁹⁹

20.67  Thus, the question for the retail investment firm is not whether culture has a necessary or proper place within compliance, but rather, how a compliance system designed to process legal and regulatory inputs can expand to integrate behavioural ones.

20.68  To be sure, conduct regulators remain in the relatively early days of their efforts to supervise culture as a component (and not only a by-product) of firm compliance. As such, investment firms have both a challenge and an opportunity to be innovative in the compliance-culture space. Retail investment firms have room not only to demonstrate industry leadership to their supervisors, but also to distinguish themselves to customers as conduct leaders. Considered carefully, then, there is a strong regulatory as well as business case for dedicating compliance resources to developing cultural infrastructure.

20.69  Concretely, what steps might firms take (other than disclosures)? The following offers three possibilities for operationalizing culture into the retail investment firm’s compliance function.

20.70  As one possible strategy, firms could employ scenario-based exercises in connection with their efforts to improve their conduct towards retail investors. After all, financial firms routinely engage in stress-testing in order to assess quantitative risk, that is, their vulnerability to market and credit risk. As one of the authors has previously argued, there is opportunity also to develop similar strategies for stressing qualitative risks, like conduct risk, as well.¹⁰⁰ Such qualitative, conduct-focused (p. 512) stress-testing could involve, for example, a hypothetical scenario of misconduct, with which compliance prompts employees, and then collects employee responses akin to modelling results. These scenarios could be tailored to conflict-type situations, with the idea being to anticipate, in a forward-looking fashion, what types of conflicts might be coming down the pike. One could readily imagine scenarios crafted around the kinds of conflicts that could emerge in the context of investment allocation decisions, fintech platforms, and the marketing of advisory services, as discussed earlier.

20.71  Internally, with this this kind of qualitative stress-testing, firms could encourage thinking outside the box, endorse employee challenging of ideas (both up and down firm hierarchy), and generally send a firm-wide message that addressing the risks posed by conflicts is a priority on a par with the management of quantitative risks like market and credit risk. Moreover, to the extent results of the simulation were voluntarily shared with regulators, that collaboration might in fact speed regulators’ understanding of the most appropriate (and helpful) role of supervisory authorities intervening in firm culture.

20.72  Externally, there are several opportunities for retail investment firms in the conduct and culture space. First, those firms that move fastest (creatively and effectively) in the conduct and culture space will be able to lead the development of the next generation of industry standards. This would require firm management to expand the institution’s compliance function to include a mandate to innovate new ways of socializing, among the employees, the ethical treatment of retail clients. The firm’s compliance professionals could then go a step further in pioneering methodologies of propagating those firm innovations at the industry level. Firms could also lead their peers by convening forums, working groups, knowledge sharing programs, and other initiatives for spreading culture-related ideas.

20.73  Second, and related, investment professionals might begin to self-regulate. Were several firms to decide to pursue certain (higher) norms, the industry as a whole might agree to a unified and higher set of fiduciary standards—which would apply across all forms of investment advice and to investment advisers and broker-dealers alike.¹⁰¹ An industry-agreed standard might pre-empt supervisory authorities from establishing more specific (and perhaps less fitting) requirements.

20.74  This kind of firm-leading-the-supervisor strategy resonates with various theories of administrative governance, like experimentalism and management-based (p. 513) regulation.¹⁰² As one of the authors has argued elsewhere, these kinds of experimental regimes allow firms to:

take the lead in designing internal compliance policies and procedures to meet general regulatory objectives that are aimed at the drivers of misconduct risk. It thus gives institutional stakeholders the opportunity to advise regulators about what types of compliance systems work best—and then to prove their success—before top-down regulation is imposed, if at all.¹⁰³

20.75  Third, firms could gain a competitive advantage by leading the industry in conduct standard-setting. For one, by experimenting and innovating, interesting ideas for complying with certain duties might emerge. Typically, to go back to the example above, it might be more efficient for investment advisers to adhere to heightened standards for all clients. This would potentially help to ensure that no specially regulated account falls through the cracks, leading to lawsuits or enforcement actions. It could also create efficiency gains from an operations standpoint because investment advisers would not need to track and apply different sets of rules and standards to different accounts, depending on the purpose of the investment. Broadly, the ability to ‘market’ high quality and innovative conduct standards could increase their customer base and loyalty.

20.76  Firms could also demonstrate leadership by innovating responsibility structures. In particular, firms might focus compliance efforts on filling gaps in the law where individual accountability is concerned.

20.77  In the United States, at least, individual accountability in the compliance arena has been difficult to accomplish via law or regulation.¹⁰⁴ A proposal by the former superintendent of New York State’s Department of Financial Services for executive liability for anti-money laundering controls largely fell flat.¹⁰⁵ As a matter of state corporate law, meanwhile, Delaware law has taken a reserved approach to holding board members accountable for compliance systems—all but the most egregious failures to establish and monitor a compliance function are shielded by the business judgement rule.¹⁰⁶ (That being said, director liability may yet be found in the (p. 514) particular case of the Wells Fargo mis-selling scandal for, among other possible things, the directors’ failure to monitor the bank’s compliance system.¹⁰⁷)

20.78  As private actors, firms therefore have considerable latitude to innovate responsibility mechanisms that could become the industry (and even supervisory) gold standard. Responsibility mechanisms might, for instance, be fortified through compensation schemes. Positively, firms might choose to tie bonus compensation to an employee’s contribution to the firm’s retail culture or values (in addition to traditional performance or sales targets). Culture-based compensation awards could also be negative, that is, whereby firms reduce discretionary compensation awards in cases where the employee is unable to carry forth a burden of showing his or her contribution to firm culture/values surrounding the ethical treatment of the retail customer. (An even more aggressive approach would be to impute responsibility to managing directors for associates’ and analysts’ serious conduct shortcomings.¹⁰⁸)

20.79  With little doubt, there is a wide range of ways that firms could design compensation systems to better hold employees responsible for the failure to behave consistently with the fiduciary duty of loyalty. The key, here, is persuading firms to do so in ways that go beyond what the formal rules require.

20.80  Conduct regulators are increasingly focused on conflicts of interest in the retail investment space and, in particular, heightening the legal standards surrounding the fiduciary duty of loyalty. However, with so much rule making and guidance-giving centred on fiduciary duty rules, there is some risk that firms, hewing close to the regulatory agenda, will fail to anticipate the next generation of conflicts on the horizon. Forward-looking retail investment firms thus have an opportunity to demonstrate industry leadership, both to the supervisor and to the client, along a conduct dimension. They might do so by pioneering innovative methods for establishing an organizational culture that values conflict-free interactions with the retail client. Such efforts, though not demanded by law or regulation, could nonetheless be incentivized by the opportunity to set industry standards and garner some (conduct-based) competitive advantage in a rapidly evolving marketplace of retail investment services and products.