Recent “Guidance” on Form CRS Disciplinary History Is Bad “Law”

Recently, I wrote a post that investment advisers and broker-dealers should review their Form CRS in light of new guidance on the disciplinary history section (Review your Form CRS Disciplinary History Disclosure in Light of New Guidance). As that post addressed, earlier in the month, Commissioner Clayton and Directors Blass and Redfearn put forth a Joint Statement Regarding New FAQs for Form CRS. On the same day as the Joint Statement was issued, the staff of the Division of Investment Management and the Division of Trading and Markets amended its Frequently Asked Questions on Form CRS by adding four new questions and answers.

As a follow up to my earlier post, I wanted to examine this guidance, ponder its intent, poke holes in its legality, and question whether it is even good public policy.

The Relevant Guidance

The guidance from the Joint Statement boils down to two major concepts:

  1. “Firms do not have discretion to leave the answer blank or to omit reportable disciplinary history from the relationship summary. ”
  2. “When responding to the disciplinary history heading in their relationship summaries, firms may not add descriptive or other qualitative or quantitative language.  Adding such language might, intentionally or unintentionally, obfuscate or otherwise minimize the disciplinary history.  However, as we describe below, firms or their financial professionals may provide the relevant disciplinary history directly to retail investors.”

Intent of the Guidance

I think Commissioner Clayton and Directors Blass and Redfearn were feeling pressure from the recent reporting by the Wall Street Journal – Financial Firms Fail to Own Up to Advisers’ Past Misdeeds – on the lack of accurate disclosure on Form CRS. Based on that pressure, they reacted by putting forth the Joint Statement and tried to clear up confusion in the industry regarding disciplinary history reporting on Form CRS. I think their Joint Statement went too far in trying to clear up that confusion, and caused them to provide guidance that is contrary to the Instructions to Form CRS.

Legality of the Guidance

The first bit of guidance referenced above is legally enforceable, was well-intentioned, and was a matter of good public policy. It is based on the Instructions to Form CRS and complies with the intent outlined in the proposing and adopting rule releases.

However, I believe the second bit of guidance is less likely to be legally enforceable, was an overreach in reaction to the Wall Street Journal’s reporting, and is also bad public policy.

The Instructions to Form CRS make it clear that investment advisers and broker-dealers must respond to each question and only include disclosure that is required or permitted by the instructions. Instruction 1.B. states, “You must respond to each item and must provide responses in the same order as the items appear in these instructions. You may not include disclosure in the relationship summary other than disclosure that is required or permitted by these Instructions and the applicable item.” However, instruction 2.B. states, “All information in your relationship summary must be true and may not omit any material facts necessary in order to make the disclosures required by these Instructions and the applicable Item, in light of the circumstances under which they were made, not misleading. If a required disclosure or conversation starter is inapplicable to your business or specific wording required by these Instructions is
inaccurate, you may omit or modify that disclosure or conversation starter.” (emphasis added). Footnote 92 of the adopting release identifies the tension between these two instructions by using the legal signal “Cf.” when comparing the two instructions.

Footnote 91 of the adopting release provides somewhat relevant guidance on instruction 2.B. It states, “We are adopting this provision to ensure that firms are not compelled to include wording in their relationship summaries that is misleading or inaccurate in the context of their business models. This provision may apply in limited circumstances. For example, the headings and conversation starters prescribed by the final instructions are worded at a highly generalized level and cover selected key topics that are broadly applicable to broker-dealers and investment advisers and their relationships with retail investors, irrespective of business model (i.e., relationships and services the firm offers to retail investors, fees and costs that retail investors will pay, specified conflicts of interest and standards of conduct, and disciplinary history).” (emphasis added). This signifies that a firm could add additional content to their discussion on their disciplinary history if they did so to make their disclosure more accurate or less misleading.

In addition, the adopting release goes on to state:

Firms or financial professionals would have the opportunity to provide more information about and encourage retail investors to ask follow-up questions regarding the nature, scope, or severity of any disciplinary history, so that retail investors have the information they need to decide on a relationship. In particular, financial professionals who themselves have no disciplinary history can make clear that a “Yes” disclosure in response to the heading question relates to the firm and other personnel (if applicable) and not to them.

Adopting release at p. 176

The adopting release isn’t clear on whether firms or financial professionals could provide more information in the Form CRS itself, but the ambiguity should be interpreted against the SEC in this case.

Guidance from a single Commissioner or the SEC staff do not have the impact of law. In fact, the Joint Statement acknowledges this in footnote 1. “This statement represents the views of Chairman Clayton and Directors Blass and Redfearn. It is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”). The Commission has neither approved nor disapproved its content. This statement has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.” The introduction to the FAQs have a very similar disclaimer.

This is important because the law in effect is the Form CRS and its instructions. Whereas, guidance is issued to help interpret or clarify an existing law. Whether the Joint Statement and FAQs are even to be considered guidance is up for debate because of the disclaimers they contain. Even if they were to be treated as guidance, I think that a federal court would agree that they are inconsistent with the regulation, which is historically the standard used in determining whether the guidance should be afforded deference. 

Bad Public Policy

I personally don’t understand why an investment adviser or broker-dealer could not provide additional clarification in response to a disciplinary question on Form CRS so long as they do so in a non-misleading way. I believe that the investing public would benefit from having additional, relevant information about the disciplinary history of a firm or a financial professional at a firm. While Chairman Clayton and Directors Blass and Redfearn believe that it could obfuscate or minimize a firm’s reportable disciplinary history, I believe that additional information is fair, and even warranted, in certain instances.

For example, I am aware of a small firm where one of its financial professionals had a single incident that caused the firm to make an affirmative response to the disciplinary history question. The event at issue involved a nearly 30-year old administrative error that resulted in a financial professional temporary having his license to render advice suspended by a state securities regulator in a state that he didn’t even have any clients or prospective clients. I hold this firm and the individual in question in high regard and I think it is unfair that they cannot provide a little bit of context around their affirmative response to make it not misleading.

Chairman Clayton and Directors Blass and Redfearn opted to try and make “black and white” that which is always a balancing act–the federal securities laws.

Should Your Firm Add or Remove Context?

I can’t tell you whether your firm should or should not provide context if it responds affirmatively to the disciplinary history question. That is a business decision. However, you should understand the law, the impact of guidance (and non-guidance), understand that this issue will likely arise during an examination, may be referred to enforcement, and determine whether you are prepared to litigate over this issue. For most investment advisers and broker-dealers with disciplinary histories, the answer will be easy–remove the additional context.

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