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SEC Division of Investment Management Releases FAQs Regarding Disclosure of Financial Conflicts Related to Investment Adviser Compensation

The staff of the Securities and Exchange Commission’s (SEC) Division of Investment Management released frequently asked questions (FAQs) on October 18, 2019, which discuss certain compensation arrangements and related disclosure obligations arising from an investment adviser’s fiduciary duties and from Form ADV requirements. The FAQs provide guidance on disclosure requirements related to (i) conflicts of interest regarding compensation that an adviser receives in connection with recommended investments; (ii) adviser conflicts related to mutual fund share class recommendations; (iii) advisers’ receipt of revenue sharing payments; and (iv) material amendments to Form ADV. The guidance specifically notes that it does not alter or amend applicable law and has no legal force or effect, nor does it create any new or additional obligations for advisers. Interestingly, the Division of Investment Management issued this guidance almost twenty months after the Division of Enforcement announced its Share Class Selection Disclosure Initiative to self-report and almost eleven months after the Division of Enforcement initiated a “sweep” regarding revenue sharing.

Key takeaways from the FAQs are outlined below.

Recommended Investments

The FAQs emphasize that an investment adviser is subject to general disclosure obligations as a fiduciary in addition to the specific disclosure requirements of Form ADV. As part of an adviser’s duty of loyalty as a fiduciary, an adviser must make full and fair disclosure to its clients of material facts relating to the advisory relationship. Thus, an adviser must eliminate or disclose all conflicts that might incentivize the adviser to render advice that is not disinterested or not in the best interest of its client.

In addition to discussing an adviser’s fiduciary obligations, the FAQs highlight key parts of Form ADV and related instructions that relate to disclosure requirements of adviser conflicts with respect to recommended investments, including the following:

  • Disclosure must include sufficiently specific facts to allow clients to understand an adviser’s conflicts and give informed consent to accept or reject them, which may require an adviser to disclose “information not specifically required by the Form.”

  • An adviser disclosing that it “may” have a conflict is not adequate disclosure where a conflict actually exists.

  • An adviser must disclose if it or its supervised persons accept sales compensation, including asset-based sales charges or service fees, including how the adviser addresses the conflict and whether the compensation is offset against the adviser’s advisory fees.

  • An adviser must disclose in its brochure supplement whether a supervised person of the adviser receives commissions, bonuses or other compensation based on the sale of securities or other investment products, including as a broker-dealer or registered representative, and including distribution or service fees from the sale of mutual funds.

Where a conflict exists, an adviser must also disclose how it addresses the conflict, and, as noted previously, an adviser’s fiduciary duties may require it to provide disclosure beyond what is specifically required by Form ADV. These disclosure obligations should be considered by advisers when making a recommendation to purchase an investment or to continue holding an investment. The FAQs also emphasize the importance of utilizing concise and direct language that is written in plain English.

Mutual Fund Share Class Recommendations

The FAQs state that an adviser has a conflict of interest that must be disclosed when multiple mutual fund share classes are available to a client and the adviser receives, directly or indirectly, compensation based on the recommended share class. Advisers must disclose material facts related to (i) the existence and effect of different incentives and resulting conflicts, (ii) the nature of the conflict; and (iii) how the adviser addresses the conflict. The FAQs highlight the following material facts that should be disclosed to investors, if applicable:

  • The fact that different share classes are available that represent the same underlying investments; (ii) how differences in sales charges, transaction fees and other fees may affect a client’s returns over time; and (iii) the fact that an adviser has a conflict of interest with respect to the selection of share classes.
  • The nature of the conflict, including (i) whether the conflict arises as a result of differences in compensation that the adviser or its affiliates would receive or from the existence of incentives shared between the adviser and a clearing broker or custodian; and (ii) whether there are any limitations on the availability of share classes resulting from the nature of the business of the adviser or of other service providers.
  • Whether an adviser’s practices with regard to share class recommendations differ when it makes an initial recommendation to invest in a fund compared to (i) recommendations regarding share class conversions and (ii) recommendations to buy additional fund shares.
  • The circumstances under which the adviser recommends share classes with different fees and the factors considered by the adviser in making such recommendations.
  • Whether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees or sales charges), the impact of such offsets or rebates, and whether the practice varies depending on the class of client, advice or transaction.

Revenue Sharing

According to the FAQs, if a nonclient provides an economic benefit to an adviser for providing investment advice or other advisory services to its clients, the adviser must disclose the arrangement, explain the associated conflicts and describe how the adviser addresses the conflicts. The FAQs note that advisers must disclose the existence of any incentives provided to advisers or shared between the adviser and others, including clearing brokers, custodians, fund advisers or service providers. As with receipt of 12b-1 fees, an adviser disclosing that it “may” have a conflict of interest is not sufficient disclosure where a conflict actually exists.

Material Amendments to Form ADV

The FAQs remind advisers that if an adviser materially amends its brochure for its annual update, the adviser must identify and discuss those changes on the cover page of the brochure, the page immediately following the cover page or as a separate document accompanying the brochure, including with respect to disclosures regarding share class recommendations and revenue sharing.

Practice Points and Tips

A key takeaway from the FAQs is that the SEC is focused on transparency with respect to conflicts related to share class recommendations and revenue sharing. The FAQs are in line with the SEC’s Commission Interpretation Regarding Standard of Conduct for Investment Advisers (the “RIA Interpretive Guidance”) that it issued in June, and advisers should analyze the FAQs in conjunction with the RIA Interpretive Guidance. Further and more generally, this guidance is consistent with the SEC’s heightened focus on all financial conflicts related to compensation, such as other types of fees and undisclosed mark-ups. Based on the Division of Enforcement’s efforts as discussed at the start regarding these issues, many in the industry have been aware of the heightened focus on these particular conflicts and disclosures. Nevertheless, this guidance provides helpful specificity that advisers should strongly consider to evaluate their practices and disclosures accordingly.

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About this Author

David Williams, Drinker Biddle Law Firm, Chicago, Investment Law Attorney
Partner

David L. Williams represents and counsels a variety of clients in the investment management industry. He prepares registration and proxy statements and handles various securities filings for both open-end and closed-end funds. He counsels multi-series and multi-class funds and their boards, money market funds, exchange-traded funds, multi-manager funds and investment advisers.

David also represents and advises sponsors of unregistered investment funds organized both in the United States and offshore. David provides advice...

312-569-1107
James G. Lundy, Drinker Biddle, regulatory investigations lawyer, financial services compliance attorney
Partner

James G. Lundy represents clients in Securities and Exchange Commission (SEC), Commodities Futures Trading Commission (CFTC), self-regulatory organization, and other financial regulatory agency investigations and examinations, and compliance and governance counseling, white collar criminal investigations, and complex business litigation.

With 12 years of senior SEC experience and more than two years of in-house experience at a futures and securities brokerage firm, Jim has developed an in-depth working knowledge of the various regulatory bodies with enforcement, examination, and policy oversight of the securities and futures industries.

312-569-1120
Kellilyn Greco, Drinker Biddle Law Firm, Investment Management Attorney
Associate

Kellilyn Greco counsels clients in the investment management industry, including investment companies and investment advisers. She has prepared registration statements and has handled other securities filings and compliance matters.

During law school, Kelli served as the Executive Vice President of the Notre Dame Business Law Forum. Kelli worked as a legal intern for both the Philadelphia District Attorney’s Office and the Athletics Compliance Office at the University of Notre Dame.

215-988-2579