As you prepare your update to Form ADV, pay particular attention to disclosure of conflicts of interest. Everyone should have gotten the memo by now about disclosure of 12b-1 fees and share class selection, given the SEC’s pursuit of 96 investment advisers (and still counting) as a result of its Share Class Selection Disclosure Initiative (the “SCSD Initiative”). But the SEC is expecting even more granular disclosure about other types of conflicts, including specifics about how much compensation a firm receives from other sources and what effect this has on recommendations to its clients. Based on recent cases, the SEC’s FAQs on Conflicts of Interest, the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, and questions received from SEC staff during examinations, the SEC is expecting “full and fair” disclosure, meaning that advisers need to explain to clients in detail whether and when a conflict does exist and the effect these conflicts have on their relationship. (See our related blog post What Your Next Deficiency Letter is Going to Say: SEC Tells Advisers What Fiduciary Duty Means.)
To understand what this means, let’s take a deep dive into the SEC’s settlement with Hefren-Tillotson, Inc., (“Hefren”) a dually-registered investment adviser and broker-dealer. Hefren paid an unaffiliated clearing firm $7.95 per trade for clearing and execution charges and passed this charge on to its clients. Over time, Hefren negotiated a reduced fee of $6.00 per trade with the clearing firm, although it continued to charge clients $7.95 and kept the $1.95 difference. Hefren disclosed that its registered representatives earned commissions for executing trades and that the commissions may be retained by the firm. Hefren’s Form ADV informed clients that the receipt of commissions is a conflict of interest. From Hefren’s point of view, clients understood that they were paying a service charge or commission for trades and that Hefren, in its capacity as a broker-dealer, could keep a portion of that commission. From the SEC’s point of view, however, Hefren was misleading its clients by not disclosing the fact that it was retaining a portion of the commission and that this extra compensation was an incentive for Hefren to trade with the unaffiliated clearing firm to increase its revenue. Moreover, the deal incentivized Hefren to trade client accounts more frequently. Ultimately, the SEC ordered Hefren to return the extra funds it earned on the trades to clients ($254,060) and pay a civil penalty of $80,000. Hefren also stopped charging the additional $1.95 per trade.
SEC examiners have also started questioning whether advisers are giving their clients enough information to make an informed decision about services. In a recent SEC exam, examiners asked a registered investment adviser that used its affiliated broker-dealer for trading and custody whether the firm had ever provided clients (existing or prospective) with any documentation or disclosure that compared the services and costs associated with maintaining a brokerage/custodial relationship with its affiliate or its preferred custodian versus other brokers/custodians used by the firm. Although there is no regulatory requirement mandating this type of comparison, the SEC appears to be looking for more specific disclosure about costs clients pay as a result of the adviser recommending or requiring the use of a particular custodian when lower-cost alternatives are available.
Some firms have already begun to incorporate more details regarding their conflicts of interest. I have taken samples from some more recent Form ADV Part 2A disclosures dealing with some common conflicts of interest, modified them slightly, and included them below.
- Fee-based Accounts versus Commission-based Accounts (dual registrants or advisers that use an affiliated broker-dealer): The firm’s financial advisers receive more compensation over time through a fee-based (advisory) account as compared to a commission-based (brokerage) account. Thus your adviser has a greater incentive to recommend a fee-based advisory account. Fee-based accounts provide clients with additional services, including periodic account review and ongoing advisory services, as compared to commission-based accounts. Feel free to ask your financial adviser why he or she recommends a specific account type for you. To overcome this conflict, our firm has instituted guidelines for the account selection process. [Describe the firm’s account selection procedures, such as guidelines for account recommendations based on analysis of client investment objectives and risk tolerance, and periodic review of accounts to ensure that account types remain appropriate.]
- Shareholder Servicing and Sub-transfer Agency Fees from Mutual Funds. The firm participates in a mutual fund platform program offered by its clearing broker. Some of the mutual funds in this program pay the firm mutual fund service fees (shareholder servicing fees and sub-transfer agency fees), which create an incentive for the firm to use its clearing broker as a custodian over other custodians that do not offer to share these same types of fees. The firm also has an incentive to recommend mutual funds on its clearing broker’s platform as a result of the fee-sharing arrangements. These are conflicts of interest between the firm and you, the client. [Describe the firm’s procedures for mitigating the effect of this conflict, which might include that the firm’s financial advisers are not compensated based on service fee revenue, the firm’s mutual fund selection process includes reviewing whether fees and expenses charged by such funds are reasonable as compared to the industry, and the firm’s periodic review of the suitability of investment recommendations.]
- Service Fees and Trade Processing Charges (dual registrants or advisers that use an affiliated broker-dealer). The firm [or its affiliated broker-dealer] receives compensation through the markup of account service and trade processing charges above the costs charged by the clearing broker. These charges include [specific dollar amounts for confirmation fees, account transfer fees, inactive accounts fees]. The compensation we [or our affiliate] receive in connection with certain transactions and services is an additional source of revenue to the firm and defrays the costs associated with maintaining and servicing client accounts. This compensation presents a conflict of interest because the firm has a greater incentive to make available, recommend, or make investment decisions regarding investments and services that provide additional compensation to the firm over those investments and services that do not. Financial advisers are not compensated on the markup of account services or trade processing charges, so they do not have an incentive to recommend transactions that would generate these charges.
- Money Market Sweep Revenue Sharing. The firm uses Broker-Dealer as its clearing and custody firm. The Broker-Dealer receives revenue from [sweep programs/money market funds] that the firm makes available as a cash sweep option, and the Broker-Dealer shares some of that revenue with the firm (as further discussed in Item 14). This compensation defrays the firm’s costs of providing and administering these sweep programs and provides a source of revenue. Any payment the firm receives reduces the interest you receive. This additional compensation received by the firm creates a conflict of interest with our clients. This compensation is retained by the firm and is not shared with your financial adviser, so your financial adviser does not have an additional financial incentive tied to the payment from the cash sweep program. Your advisory fee is not reduced or offset as a result of any revenue sharing the firm receives.
- Compensation Received from Product Sponsors. The mutual fund companies whose products we offer participate in activities that are designed to help our financial advisers be more knowledgeable about those company’s products, operations, and management. They provide other forms of compensation to the firm’s financial advisers relating to the sale and distribution of their products, including merchandise, gifts, prizes, and entertainment such as tickets to sporting events and leisure activities, as well as payment or reimbursement for the costs of business development expenses, client seminars, client appreciation events, software, and marketing materials designed to help promote the adviser’s business. The educational activities and gifts and entertainment received by financial advisers from mutual fund companies do, however, create a conflict of interest for financial advisers. They incentivize our financial advisers to focus more on or otherwise recommend or promote the products of those mutual fund companies that provide this compensation over those that do not. The firm has policies and procedures in place intended to help ensure our financial advisers offer recommendations that are in the best interest of our clients. [Describe those policies and procedures, which might include reviewing the suitability of investment recommendations, monitoring by the compliance department of the amount and frequency of such compensation, merchandise, etc., and pre-approval of content to be used with clients to ensure it is fair and balanced.]
- Proprietary Products Conflicts. Clients should be aware that the compensation to the firm and your financial adviser will differ according to the specific advisory programs or services provided. This compensation to the firm and your financial adviser may be more than the amounts we would otherwise receive if you participated in another program or paid for investment advice, brokerage, or other relevant services separately. Lower fees for comparable services may be available through the firm or from other sources. Therefore, the firm and its financial advisers have a financial incentive to recommend advisory programs or services that provide us higher compensation over other comparable programs or services available through the firm or elsewhere that may cost you less. [Describe how this conflict is mitigated, such as the adoption of firm guidelines for recommending certain account types and periodic evaluation of firm products and services to ensure pricing is in line with similarly-situated firms.]
- Markups on Fixed Income Transactions (dual registrants or firms that use an affiliated broker-dealer). The firm [or its affiliated broker-dealer] receives compensation from markups on fixed income transactions. Because the markup is higher for longer-dated securities, the firm and its financial advisers have a conflict of interest since revenue will increase as the firm invests in securities with maturities over five years. The firm has policies and procedures in place to help ensure that the recommendations are in the best interest of our clients. This includes oversight by the firm’s [investment committee/management/compliance] to review the suitability of portfolio holdings and asset allocation.
- Conflicts Associated with Using a Specific Custodian. The firm uses Custodian as its executing broker and clearing agent. [Clients may choose a different brokerage firm or custodian provider.] The custody and brokerage fees charged by other broker-dealers or custodians may be higher or lower than the fees charged by the Custodian. The firm decided to use the Custodian based on a comparison of the Custodian’s services and fees against other broker-dealers (including past experiences we have had with other broker-dealers) and is aimed at minimizing brokerage expenses and other costs while taking into account the offerings or services the Custodian provides that the firm or clients may require or find valuable. By selecting one brokerage platform, the firm can avoid additional compliance, recordkeeping, staffing, and technological costs that may be associated with implementing procedures designed to work with multiple brokerage platforms. Based on the firm’s structure and capacities, the firm concluded that requiring one brokerage platform is a better policy than permitting multiple brokerage arrangements. However, this arrangement creates a conflict of interest between the firm and its clients, since the firm receives compensation, including mutual fund shareholder servicing and sub-transfer agency fees and revenue sharing payments from money market sweep programs offered by the Custodian. We believe this conflict is mitigated by the fact that the fees and expenses charged by the Custodian to the firm’s clients are competitive in the marketplace. Additionally, the firm’s [investment committee] periodically performs a best execution review to evaluate the Custodian’s execution services.
- Firms Providing Bonuses to IARs. The firm offers its financial advisers (Investment Adviser Representatives, “IARs”) financial benefits based on his or her assets under management. This provides an incentive for the financial advisers to seek to retain additional assets from you. This conflict is mitigated by the financial adviser’s adherence to the firm’s guidelines for account recommendations based on analysis of client investment objectives and risk tolerance, and periodic review of accounts to ensure that account types remain appropriate. [Management/investment committee/compliance] also review accounts to ensure the appropriateness of investment recommendations.
Keep in mind that Form ADV Part 2A disclosure should be customized to describe the conflicts of each registered investment adviser. The samples provided are only a starting point. The SEC expects disclosures to be specific and forthright when it comes to conflicts. Statements like “the firm may receive compensation” or “the receipt of this revenue creates a potential conflict of interest” are not going to fly. According to the SEC’s Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation, disclosure about conflicts of interest should include:
- The existence of the conflict (e.g., an agreement to receive payments from a clearing broker for recommending that clients invest in no-transaction-fee (NTF) mutual fund share classes offered on its platform);
- The nature of the conflict (e.g., The firm benefits from selecting NTF funds on the clearing broker’s platform since those transactions incur less expense for the firm than if the firm chose a mutual fund with transaction fees. Many NTF funds have higher internal costs as compared to non-NTF funds. A conflict of interest exists because the firm and its financial advisers have a financial incentive to recommend or select NTF funds (where clients pay more in internal expenses) than funds with transaction charges (which cost clients less in internal expenses). In addition, the higher internal costs charged to clients who hold NTF funds will adversely affect the long-term performance of their account when compared to share classes of the same fund that assess lower internal expenses.); and
- How the adviser addresses the conflict (e.g., Financial advisers are not provided with the list of NTF funds; or the firm has guidelines regarding selection of mutual fund share classes that take into consideration whether lower-cost share classes are available and appropriate for client accounts in consideration of their expected investment holding periods, amounts invested, and anticipated trading frequency).
As you prepare to bare your soul, check out these other Hardin articles on maintaining your sanity during your annual ADV amendment, How I Learned to Stop Worrying and Learned to Love Form ADV and Feeling Your Pain: Advice on Answering Form ADV’s Trickier Questions. And, if you need help, give us call!
Partner with Hardin Compliance
Need help drafting your Form ADV? Call us today at 1.724.935.6770, or shoot us an email at email@example.com so we can set up a time for one of our consultants to discuss your needs and how we can help. Hardin is always in your corner.
Hardin Compliance Consulting provides links to other publicly-available legal and compliance websites for your convenience. These links have been selected because we believe they provide valuable information and guidance. The information in this e-newsletter is for general guidance only. It does not constitute the provision of legal advice, tax advice, accounting services, or professional consulting of any kind.