Compliance Newsflash for October 24th, 2019 – Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation

The following represents the views of the staff of the Division of Investment Management. The following does not alter or amend applicable law and has no legal force or effect, and it creates no new or additional obligations for any person. This is not a rule, regulation, guidance, or statement of the Commission and the Commission has neither approved nor disapproved this information.

Compensation that an investment adviser, its affiliates or its associated persons receives in connection with the investments it recommends and related services it provides can result in the investment adviser having interests that conflict with those of its clients.[1] Many investment advisers appear to have recognized these conflicts and responded through practices designed to address them, including through elimination, disclosure or a combination of disclosure and mitigation. However, SEC examinations staff have observed and enforcement cases have illustrated that, in some instances, investment advisers have not appropriately addressed these conflicts of interest.

In the FAQs below, we discuss certain compensation arrangements and related disclosure obligations arising from both the investment adviser’s fiduciary duty and Form ADV.

While the FAQs illustrate the application of these disclosure obligations in the context of certain types of compensation that investment advisers receive, such as 12b-1 fees and revenue sharing,[2] many of the same principles and disclosure obligations apply to other forms of compensation. These may include, among other forms of compensation, an investment adviser’s direct or indirect receipt of service fees from its clearing broker-dealer, marketing-support payments from a mutual fund’s investment adviser, transaction fees, or receipt of payments from a mutual fund’s investment adviser to help defray the costs of educating and training its personnel regarding certain investment products. Depending on the nature of the compensation, the resulting financial incentives would give rise to conflicts relating to, for example, the types of investments, the fund families, the particular funds and the share classes of individual funds that the adviser recommends, as well as the extent of trading it recommends. The staff does not intend the examples below to be comprehensive or to provide model or preferred disclosure language for the compensation arrangements discussed. Market practices evolve regularly, including with respect to compensation arrangements and fund sales practices more generally. Accordingly, the staff encourages investment advisers to be proactive in reviewing their practices concerning the compensation that they, their affiliates or their associated persons receive in connection with the investments they recommend and related services they provide to identify conflicts of interest regardless of whether we specifically identify those practices below.

These FAQs focus on the identification and disclosure of certain conflicts of interest and are not a comprehensive discussion of an investment adviser’s fiduciary duty with respect to these or other conflicts. For example, an investment adviser owes its clients a duty of care that requires it to provide investment advice that is in the best interest of the client based on the client’s objectives.[3] In addition, investment advisers are required to adopt and implement policies and procedures reasonably designed to prevent violations of the Investment Advisers Act and the rules thereunder.[4] While we do not discuss these obligations here, additional information can be found in the relevant Commission releases on these topics.[5]

If you have questions or would like to provide feedback on these FAQs, or if you have questions the staff should consider for future FAQs, please contact the Division’s Chief Counsel’s Office at (202) 551-6825 or [email protected].

What requirements must an investment adviser consider with respect to disclosure of conflicts of interest related to compensation that it, its affiliates or its associated persons receive in connection with the investments it recommends?[6]

An adviser must look to both its general disclosure obligations as a fiduciary and to the specific disclosure requirements in Form ADV. In particular, in seeking to meet its duty of loyalty as a fiduciary, an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.[7] An adviser must eliminate or at least expose through full and fair disclosure all conflicts of interest that might incline it – consciously or unconsciously – to render advice that is not disinterested.[8]

An adviser that receives, directly or indirectly, compensation in connection with the investments it recommends has a financial incentive to make recommendations that result in the receipt of that compensation.[9] Depending on the nature of the compensation, this financial incentive would give rise to conflicts relating to, for example, the types of investments, the fund families, the particular funds and the share classes of individual funds that the adviser recommends, as well as the extent of trading it recommends. For instance, when an adviser receives, directly or indirectly, 12b-1 fees in connection with mutual fund recommendations, it has a financial incentive to recommend that a client invest in a share class that pays 12b-1 fees. The resulting conflict of interest is especially pronounced when share classes of the same funds that do not bear these fees are available to the client.[10]

Form ADV provides further direction concerning the information that an adviser must disclose about these types of conflicts.[11] For example:

• General Instruction 3 for Part 2 reminds an adviser of its fiduciary duty and the related disclosure obligations described above.
• General Instruction 3 for Part 2 also reminds an adviser that disclosure must include “sufficiently specific facts” to allow clients to understand the adviser’s conflicts and business practices and give informed consent or reject them.[12] This may require an adviser to disclose “information not specifically required by” the Form or more detail than the Form otherwise requires. For example, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists.[13]
• General Instruction 2 for Part 2 instructs advisers that, if a conflict or practice exists with respect to only certain classes of clients, advice or transactions, an adviser must “indicate as such rather than disclosing that [the adviser] ‘may’ have the conflict or engage in the practice.”[14] For example, if an adviser engages in a practice of recommending share classes with 12b-1 fees for clients in one advisory program, the adviser must fully disclose the practice with respect to that program even if it represents a minority of the adviser’s assets under management.

Several items on Form ADV provide additional, relevant instruction. For example:

• Under Item 5.E of the firm brochure (Part 2A of Form ADV), an adviser must disclose if it or its supervised persons accepts sales compensation, including asset-based sales charges or service fees. This item includes several specific disclosures, including information about the conflict, how the adviser addresses the conflict and whether the adviser offsets the compensation against its advisory fees.
• Item 4 of the brochure supplement (Part 2B of Form ADV) requires an adviser to disclose other business activities of its supervised persons. Under Item 4.A(2), if an adviser’s supervised person “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 (‘trail’) fees from the sale of mutual funds, [the adviser must] disclose this fact” in its brochure supplement.

An adviser’s fiduciary duty and these instructions require the adviser to disclose in Form ADV the conflict of interest that results when it receives compensation, directly or indirectly, in connection with the investments it recommends.[15] Where this conflict exists, an adviser must also disclose how it addresses the conflict.[16] An adviser’s fiduciary duty may also require it to make disclosures to clients that are in addition to those required in Form ADV.[17] An adviser should consider these disclosure obligations with respect to both recommendations to purchase and recommendations to continue holding an investment.[18]

Advisers should bear in mind that the brochure is, first and foremost, a document “designed to promote effective communication between [an adviser] and [its] clients.”[19] The SEC intended brochures to be concise, direct, appropriate to the level of financial sophistication of the adviser’s clients and written in plain English. As a result, longer disclosures may not be better disclosures.

What are some examples of material facts that, in the staff’s view, an adviser should disclose about its practices related to recommending investments or services with different adviser compensation characteristics, such as mutual fund share classes, and the related conflicts, if applicable, in light of the principles and disclosure requirements discussed above?

The general disclosure obligations arising from the availability of multiple mutual fund share classes are well-established and are illustrative of the principles that apply to compensation-related conflicts more generally. An adviser has a conflict of interest that it must disclose when more than one mutual fund share class is available to a client and the adviser receives, directly or indirectly, compensation based on the share class it recommends.[20] An adviser that has this conflict of interest should carefully consider the material facts that it needs to disclose in light of the requirements and principles discussed above.[21]

In the course of administering Form ADV, as well as conducting compliance examinations and enforcement investigations, the staff has observed a range of practices with respect to this type of disclosure. Following are some examples of material facts that, in the staff’s view, an adviser should disclose about its practices and conflicts, if applicable. These disclosures should be concise and in plain English. This is not a comprehensive list, and an adviser may need to disclose different or additional facts depending on its circumstances.

Examples of material facts related to share class conflicts:

• The existence and effect of different incentives and resulting conflicts.
  • The fact that different share classes are available and that different share classes of the same fund represent the same underlying investments.
  • How differences in sales charges, transaction fees and ongoing fees would affect a client’s investment returns over time.
  • The fact that the adviser has financial interests in the choice of share classes that conflict with the interests of its clients.
• The nature of the conflict.
  • For example, whether the conflict arises: (a) as a result of differences in the compensation the adviser and its affiliates receive; or (b) from the existence of any incentives shared between the adviser and the clearing broker or custodian (such as offsets, credits, or waivers of fees and expenses).
  • Whether there are any limitations on the availability of share classes to clients that result from the business of the adviser or the service providers that the adviser uses. These may include, for example:
    • Limitations that a fund or the adviser’s clearing broker or custodian imposes (for instance, where a custodian’s platform only makes certain share classes available or a fund or platform has minimum investment requirements);[22] and
    • Limitations that the adviser imposes (for instance, by type or class of clients, advice, or transactions).
  • Whether an adviser’s practices with regard to recommending share classes differs when it makes an initial recommendation to invest in a fund as compared to: (a) when it makes recommendations regarding whether to convert to another share class; or (b) when it makes recommendations to buy additional shares of the fund. For example, the adviser could consider disclosing its practices for reviewing, in conjunction with its periodic account monitoring, whether to convert mutual fund investments in existing or acquired accounts to another share class.

• How the adviser addresses the conflict.
  • The circumstances under which the adviser recommends share classes with different fee structures and the factors that the adviser considers in making recommendations to clients.
    • For example, where the adviser would bear the cost of a transaction fee, how the adviser evaluates the differences between, on the one hand, a share class with a 12b-1 fee but no transaction fee and, on the other, a share class of the same fund with a transaction fee but no 12b-1 fee.
  • 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 and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction (e.g., with regard to clients whose accounts are subject to the Employee Retirement Income Security Act of 1974 or clients with individual retirement accounts).

Similar to an investment adviser’s receipt of 12b-1 fees, the receipt of revenue-sharing payments creates incentives for investment advisers that, in turn, give rise to conflicts of interest. In addition to the principles and disclosure requirements discussed above, as relevant, what particular Form ADV disclosure requirements relate to an adviser’s receipt of revenue-sharing payments?

Under Item 14.A of Part 2A of Form ADV, if someone who is not a client provides an economic benefit to an adviser for providing investment advice or other advisory services to its clients, the adviser must generally describe the arrangement, explain the conflicts of interest, and describe how it addresses the conflicts of interest.[23] For example, an adviser that receives payments from a custodian based on the value of client assets maintained at that custodian would have to provide disclosure in response to this item.[24]

What are some examples of material facts that an investment adviser should disclose about its practices related to revenue-sharing arrangements, if applicable?

Following are some examples of material facts that, in the staff’s view, an adviser should disclose about its practices and conflicts, if applicable. These disclosures should be concise and in plain English. This is not a comprehensive list, and an adviser may need to disclose different or additional facts depending on its circumstances and how its practices change over time. These examples are in addition to the examples provided above with respect to disclosure, generally, about practices related to recommending share classes and the related conflicts, as applicable.

• The existence of any incentives provided to the adviser or shared between the adviser and others (e.g., clearing brokers, custodians, funds’ investment advisers or service providers). For example:
  • Any agreements to receive payments from a clearing broker for recommending that clients invest in no-transaction-fee mutual fund share classes offered on the clearing broker’s platform, as well as any agreements to receive payments from the clearing broker for recommending that the adviser’s clients invest in 12b-1-fee-paying share classes; and
  • Any agreements to receive payments and/or expense offsets from a custodian for recommending that the adviser’s clients maintain assets at the custodian.
• As with the receipt of 12b-1 fees, an adviser disclosing that it “may” have a conflict as the result of receiving revenue-sharing payments is not adequate when the conflict actually exists.

If an investment adviser materially amends or supplements its disclosures concerning share class recommendations or revenue sharing arrangements in an annual update, is it required to highlight the new disclosure in its Form ADV’s summary of material changes?

Yes. Form ADV requires, in Item 2 of Part 2A, that, if an adviser is amending its brochure for its annual update and the brochure contains material changes from its last annual update, the adviser must identify and discuss those changes. The adviser may include this disclosure on the cover page of the brochure, on the page immediately following the cover page, or as a separate document accompanying the brochure.