Disclosing Financial Conflicts in Your Form ADV

March 2, 2020

As the Form ADV annual update deadline is fast approaching and advisers with retail clients begin to draft their Form CRS, it’s the perfect time for advisers to re-examine their financial conflict of interest disclosures to ensure they are accurate and complete.

The SEC has been focused on financial conflicts of interest for several years, beginning most prominently with the Share Class Selection Disclosure Initiative (“SCSDI”) which launched in February 2018.  The SCSDI has resulted in nearly 100 settlements (returning over $135M to investors) with advisers that failed to properly disclose their practices related to selection of mutual fund share classes that paid the adviser or an affiliate a 12b-1 fee when lower cost share classes were available. The SEC has also brought actions outside of the SCSDI against several other advisers for similar disclosure deficiencies related to conflicted receipt of 12b-1 fees, revenue sharing or receipt of other forms of compensation.

Not that we needed any more evidence of the SEC’s focus in this area, but the SEC’s Office of Compliance Inspections and Examinations included in its 2020 Examination Priorities its focus on advisers’ undisclosed or under disclosed compensation arrangements, including financial conflicts of interest.

As you prepare for your ADV filing, we wanted to remind you of a publication issued by the SEC’s Division of Investment Management in October 2019 titled: Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation (the “FAQ”).  While the FAQ focuses on disclosure obligations related to receipt of 12b-1 fees and revenue sharing, we encourage you to apply these concepts more broadly to any financial conflict of interest that may be relevant to your firm.  For example, you may receive a discount on a third-party service or subscription as a result of maintaining a certain amount of your clients’ assets at a custodian.  Although you are not receiving additional compensation or revenue through this arrangement, the arrangement still creates an incentive to recommend your clients utilize the custodian providing the discount.

As you prepare your Form ADV annual amendment and begin preparing for your initial Form CRS filing this spring, we recommend you consider the following steps related to financial conflicts of interest:

Meet with your Accounting team and Operations teams and ask questions regarding the types of compensation received by your firm, its affiliates and your employees or any discounts received by your firm or its affiliates resulting from the investment decisions or recommendations your firm makes for its clients related to the types of investments recommended, the particular fund families or funds utilized, the share classes of particular funds utilized, the custodians or other service providers you recommend your clients use, etc.  If practical, you could also request a P&L ledger to ensure you understand the sources of revenue for the firm with the goal of determining whether any of those sources create conflicts of interest.

Ensure any financial conflicts of interest you have identified are thoroughly disclosed.  Review the FAQ for guidance from the Division of Investment Management regarding adequate disclosure, which generally includes (1) the existence and effect of financial incentives; (2) the nature of the resulting conflict of interest; and (3) how the conflict of interest is addressed.  In our experience, advisers often disclose the existence of a conflict of interest without explaining steps taken to mitigate it. 

Consider whether disclosure alone is enough to address a conflict of interest or if additional steps should be taken to mitigate or eliminate the conflict.  For example, an adviser could choose to begin offsetting client management fees by any compensation it receives as a result of recommendations made for that client’s account.

Ensure the disclosure you include in Form ADV Part 2A is consistent with the disclosure you eventually include in your Form CRS.