Bates Research  |  11-21-19

SEC Zeroes in on Investment Adviser Compensation Conflicts

SEC Zeroes in on Investment Adviser Compensation Conflicts
photo from SEC under CC 2.0 license

On October 18th, 2019, more than a year after the launch of the SEC Share Class Disclosure Initiative and targeted enforcement activity, the SEC Division of Investment Management issued information clarifying conflicts of interest raised by different types of investment adviser compensation. In a new set of FAQs, SEC staff reviewed general conflicts of interest disclosure requirements and offered insight on the “material facts” that need to be disclosed concerning mutual fund share classes and an adviser’s receipt of revenue-sharing payments. Here’s a closer look.

Why It’s Important

In a recent regulatory alert, we highlighted recent actions targeting investment advisers by the SEC Enforcement Division. The noted actions were aimed at potential conflicts of interest that arose from revenue-sharing payments and other forms of representative compensation or cost offsets. In general, the actions test whether investment advisers are adequately disclosing potential conflicts of interest consistent with the fiduciary obligations owed to their clients.

These enforcement efforts follow on the heels of the Share Class Disclosure Initiative, an undertaking intended to encourage firms to self-report past violations relating to certain mutual fund share class selection conflicts, and to promptly return money to harmed clients. As Bates has cautioned, the enforcement activity sends firms a strong message to make sure that disclosure concerning revenue-sharing arrangements and other forms of compensation are consistent with SEC interpretations.

New FAQs

The new FAQs cover (i) general compensation disclosure obligations for investment advisers related to recommended investments, (ii) “material facts” that advisers should disclose concerning mutual fund share classes,” and (iii) disclosure requirements related to an adviser’s receipt of revenue-sharing payments. The FAQs also make clear that any amendments to share class or revenue-sharing arrangements made in annual updates are required to be highlighted on Form ADV.

General Compensation Disclosure

The FAQs restate the overarching principles that advisers must disclose financial incentives when recommending investments that are tied to compensation, and that the nature of the compensation affects the disclosure. Staff noted that conflicts are “especially pronounced” when certain share classes of the same funds that do not bear these fees are available.

The FAQs also describe more detailed disclosure obligations required under Form ADV, including the provision of “sufficiently specific facts” to enable clients to give informed consent. This includes “‘information not specifically required by’ the Form or more detail than the Form otherwise requires.”

Importantly, staff made clear (i) that merely reporting that the adviser “may” have a conflict is not adequate disclosure “if the conflict actually exists,” and (ii) that “an adviser should consider these disclosure obligations with respect to both recommendations to purchase and recommendations to continue holding an investment.”

Material Facts on Mutual Fund Share Classes

According to SEC staff, when recommending a mutual fund share class which is tied directly or indirectly to compensation, material facts include the existence and effect of different financial incentives that may lead to conflicts (e.g. those arising from shared incentives between the adviser and a clearing broker, various limitations on share class transactions within a fund, or adviser practices concerning transactions after the initial recommendations). It is also material to disclose how the adviser addresses the conflict, (e.g. on practices related to differences between share classes with different compensation structures for 12b-1 and transaction fees; or whether the adviser “has a practice of offsetting or rebating some or all of the additional costs to which a client is subject.”) The FAQs make clear that these examples are not comprehensive but rather should serve the broader message that all compensation arrangements are on the table.

Material Facts on Revenue-Sharing Payments

An investment adviser is required to disclose any arrangement they may have with anyone who provides an economic benefit for providing investment advice or other advisory services for clients. Under Form ADV, the adviser is obligated to “describe the arrangement, explain the conflicts of interest, and describe how it addresses the conflicts of interest.” The FAQs highlight examples of arrangements in which there are financial incentives provided to the adviser or shared between the adviser and clearing brokers, custodians, funds’ advisers or other service providers. SEC staff warns that such disclosures “should be concise and in plain English.”

Bates Experts Reflect

While the FAQs state explicitly that the interpretations provided do not alter or amend applicable law nor create any new or additional obligations for advisers, the SEC is clearly sending a message that the agency will continue its focus on disclosure and adviser compensation.

Bates Group White Collar, Regulatory and Internal Investigations Managing Director Alex Russell highlights several aspects of the new FAQs. He notes the SEC staff’s expansive view of adviser compensation (e.g. to include areas where a firm saved costs as well as earned fees) and the application of these staff interpretations to investments more broadly. He points out staff’s expectation as to the ongoing nature of the disclosure obligation “beyond point of sale,” underscoring the FAQ warning that “an adviser should consider these disclosure obligations with respect to both recommendations to purchase and recommendations to continue holding an investment.”

Bates Compliance Expert Robert Lavigne urges firms to work on the language of their disclosures to ensure not only that they are “concise, direct, appropriate to the level of financial sophistication of the adviser’s clients and written in plain English,” but that they also be explicit and specific (hence, the admonition against the use of the word “may” when a conflict of interests exists). Getting this right will require a deep dive into advisers’ policies and practices as firms can no longer rely on longer disclosures or references to “potential conflicts” to withstand examination or enforcement scrutiny.

About Bates:

Bates Group stands ready to support firms to ensure that their revenue sharing arrangements and other forms of compensation are consistent with SEC interpretations. Bates is actively engaged in providing assistance to firms responding to enforcement inquiries, providing analysis of large volumes of data to identify accounts that have been impacted by revenue-sharing arrangements, without inappropriately remediating those that have not been impacted.

Recently, on behalf of over twenty major national and regional financial institutions, Bates provided important assistance to firms and their counsel participating in the SEC’s Share Class Selection Disclosure Initiative and related SEC Examinations, as well as to firms addressing FINRA’s recent 529 Share Class Initiative. As a result, those companies have avoided unwarranted remediation costs as well as reputational harm.



Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations


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