On October 18, 2019, the SEC’s Division of Investment Management (Division) released a frequently asked questions document (FAQ) regarding an SEC-registered investment adviser’s (adviser) disclosure obligations with respect to certain compensation arrangements that create conflicts of interest between the adviser and its clients.1 While the FAQ is a staff statement, and not a rule or an interpretation approved by the Commission, it follows recent SEC complaints filed in litigation against two advisers and enforcement actions against other advisory firms that concerned similar factual situations. In the FAQ, the Division staff (Staff) discusses its views on the disclosure obligations arising from certain compensation arrangements (such as Rule 12b-1 fees and revenue sharing received in connection with investments in mutual funds) that are based on the adviser’s fiduciary duty to clients and requirements specified in Form ADV.2 The FAQ provides examples of the types of disclosures that the Staff expects when these conflicts exist. The Staff stresses that the principles covered in the FAQ may apply to other types of compensation arrangements that create similar conflicts. The FAQ also notes that an adviser is required to highlight any changes to its Form ADV disclosures concerning conflicts as part of its annual update of its Form ADV.
Requirements Relevant to Conflicts Disclosures
The FAQ reminds advisers that an adviser’s duty of loyalty, as interpreted by courts and the Commission, requires disclosure of material facts relating to the adviser’s conflicts, which disclosure is designed to enable informed consent of the client to the conflict.3 An adviser’s receipt of compensation from a third party in connection with investments it recommends (such as 12b-1 fees or revenue sharing for investments in mutual funds) creates a conflict of interest for the adviser.4 In such a circumstance, the adviser has a financial incentive to recommend investments that provide the adviser with benefits, which contravenes the adviser’s duty to place client interests ahead of its own. The adviser receiving this compensation must therefore disclose or mitigate this conflict.
The FAQ identifies specific instructions and requirements in Form ADV that require particular conflict disclosures. These are: (i) General Instruction 2 for Part 2 (which requires disclosure of actual conflicts, rather than using the term “may”); (ii) General Instruction 3 for Part 2 (which requires disclosure of specific facts about conflicts); (iii) Item 5E of Part 2A (which requires disclosure of receipt of sales compensation, including asset-based charges or service fees); (iv) Item 4 of Part 2B (which requires disclosure of other business activities of supervised persons, including in their capacities as a registered representative of a broker-dealer, including the receipt of distribution or service fees directly or indirectly as part of bonuses or sales commissions); and (v) Item 14A of Part 2A (which requires disclosure of compensation received by an adviser from non-clients as a result of advisory services to clients).
The FAQ emphasizes that these conflict disclosure requirements not only mandate disclosure of the conflict, but also the nature of the conflict and how the conflict is addressed, both at the time of the initial recommendation and any recommendation to continue holding the investment. The FAQ reiterates that the use of the term “may” is not sufficient to describe a conflict if, in fact, the adviser has the conflict.
Material Facts that Should be Disclosed for Certain Types of Conflicts
The FAQ provides an illustrative list of material information that should be addressed in disclosures when an adviser has share class and revenue sharing conflicts that includes:
- for share class selection conflicts;
- how differences in sales charges, transaction and ongoing fees would affect a client’s investment returns over time;
- that the adviser has financial interests in the choice of share classes that conflict with the interests of its clients because compensation that varies by class is received:
- from the mutual fund’s adviser; or
- from an intermediary;
- whether there are any limitations on share class availability5 that are imposed by the fund, the adviser, or its service providers (and what these limitations are);
- what factors the adviser considers in making share class recommendations; and
- whether an adviser bears the costs of certain class specific differences; and
- for revenue sharing conflicts;
- any agreement pursuant to which the adviser or its affiliates receives payments from a clearing broker for recommending no-transaction-fee mutual fund share classes offered on the clearing broker’s platform and 12b-1 fee-paying share classes on the broker’s platform; and
- any agreements pursuant to which the adviser or its affiliates receive payments and/or expense offsets from a custodian for referring clients to the custodian.
The FAQ continues the Staff’s focus on reminding advisers of their fiduciary duties to clients, particularly in the area of arrangements benefiting advisers to the potential detriment of clients. It serves as a reminder that the Staff will “follow the money” in identifying arrangements compensating an adviser or its affiliates and that full and fair disclosure of those arrangements may be the only safe way for an adviser to make a conflicted recommendation (absent avoiding such arrangements altogether). Advisers should again take this opportunity to: (i) identify all arrangements with third parties pursuant to which the adviser or an affiliate receives compensation or other benefit (not just those involving 12b-1 fees and revenue sharing payments); and (ii) review and, if necessary, update Form ADV disclosures of those arrangements (e.g., whether the disclosures are adequate, sufficiently specific and follow the form’s instructions, such as on the use of the term “may”). The FAQ may change over time as some of the share class selection actions have yet to be litigated, and the FAQ itself invites comments on what is suggested. The guidance in the FAQ is also relevant for conflicts of interest disclosures in registration statements for registered funds, which are often derived from relevant Form ADV disclosures of their advisers.
1 “Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation” (Oct. 18, 2019), available at https://www.sec.gov/investment/faq-disclosure-conflicts-investment-adviser-compensation.
2 These actions were summarized here: https://40actblog.sewkis.com/sec-continues-to-pursue-share-class-selection-cases/ and here: https://40actblog.sewkis.com/sec-orders-an-additional-16-self-reporting-advisory-firms-to-pay-nearly-10-million-to-investors/.
3 See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, SEC Rel. No. IA-5248 (June 5, 2019) and SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963).
4 The FAQ lists the following as examples of compensation received by advisers from third parties in connection with client investments that could create conflicts: service fees, offsets or credits from a broker-dealer or 12b-1 fees, revenue sharing, marketing-support payments or payments to offset education and training costs for certain investment products from a mutual fund or its adviser.
5 The Staff considers a share class to be “available” for purchase if a client is eligible to purchase the share class, unless the share class is not eligible for purchase by the client due to limitations imposed by an adviser or its service provider and the adviser has received informed consent from the client to those limitations.