FYI: FAQs Address Adviser Compensation and Conflicts Disclosure

FYI: Perhaps under the banner of better late than never, the Division of Investment Management yesterday posted FAQs that are a MUST READ for all advisers, addressing expectations and practices surrounding adviser compensation and the related conflicts that, according to the FAQs, are not being disclosed appropriately by some advisers.

The FAQs help to pull together various seemingly disparate threads that have arisen recently but are rarely (or never) addressed in an integrated way, such as:

  • the Share Class Selection Disclosure Initiative, which focuses on 12b-1 compensation, conflicts and disclosures in the selection of mutual fund share classes,
  • other recent enforcement cases based on failures to disclose compensation conflicts outside the Initiative, including cases focused on revenue sharing or other types of non-12b-1 compensation (see my ‘FYI’ blog post dated September 30, 2019, for more details),
  • the SEC’s Fiduciary Interpretation issued in June 2019, addressing the standard of conduct applicable to advisers under Section 206 of the Advisers Act, which staccatos the point that disclosing an adviser “may” have a particular conflict, without more, is not adequate when the conflict actually exists,
  • OCIE Risk Alerts addressing adviser fee issues, and
  • various Form ADV instructions and guidance that address compensation disclosure.

Among the significant points highlighted in the FAQs were the following:

  • Requirements/guidance relating to advisers receiving compensation also apply to advisers receiving compensation in other capacities, such as in their capacity as broker-dealers (if dual registered), and to adviser affiliates receiving compensation, such as the adviser’s affiliated BDs and its IA reps.
  • While focus is often placed on compensation in the form of 12b-1 fees or revenue sharing, many of the same principles and disclosure obligations apply to other forms of adviser compensation. Specifically mentioned in the FAQs (but not intended to be all-inclusive) were:
    • direct or indirect receipt of service fees from the adviser’s clearing broker-dealer,
    • marketing-support payments from a mutual fund’s investment adviser,
    • transaction fees,
    • 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, and
    • payments and/or expense offsets from a custodian based on the value of client assets maintained at that custodian.
  • Since market practices evolve regularly, including compensation arrangements and fund sales practices more generally, advisers should be proactive in reviewing their compensation practices in order to identify conflicts regardless of whether they are specifically identified in SEC rules or guidance.
  • An adviser’s fiduciary duty may also require it to make disclosures in addition to those required in Form ADV.
  • Advisers should consider disclosure obligations with respect to both recommendations to purchase and recommendations to continue holding an investment. In an on-going advisory relationship, this might include, for example, the recommendation to continue holding a particular class of mutual fund shares.
  • Examples of material facts that should be disclosed regarding a conflict include the existence of the conflict, the nature of the conflict and how the adviser addresses the conflict.

Many other significant points are contained in the FAQs. Although it would have been helpful for these FAQs to have been issued before the Share Class Selection Disclosure Initiative was pursued and before the other recent compensation conflicts cases were brought, at least these various threads have been brought together before the next Form ADV updating season has come and gone, so advisers can take the breadth and depth of this guidance into account when drafting their amendments.

In that regard, particular attention should be paid to the last FAQ, which asks in substance whether an adviser that materially amends or supplements its compensation disclosures as discussed is required to highlight the new disclosure in its Form ADV’s summary of material changes. The answer given is YES.


* * *