SEC’s Investment Management Division posts FAQ clarifying compensation-related disclosure obligations of investment advisers

October 25, 2019

Securities Law Alert

Author(s): Erensu Altan

On October 18, 2019, the Securities and Exchange Commission’s Division of Investment Management published an FAQ page on its website regarding how advisory firms should address certain financial conflicts of interest. The FAQ provides the division staff’s views on compensation-related conflicts that an investment adviser should disclose to its clients, based on the adviser’s fiduciary duty and the requirements of Form ADV. This also supplements the SEC’s recent interpretation release regarding the standard of conduct for investment advisers. While much of the discussion focuses on 12b-1 fees (annual marketing or distribution fees associated with mutual funds) and revenue sharing, the FAQ is intended to apply more broadly to other forms of compensation that an investment adviser, its affiliates, or its associated persons receive in connection with the services it provides. Below are some key takeaways from the FAQ:

  • In order to meet its duty of loyalty, 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.”
  • Disclosure materials must include “sufficiently specific facts” so that the client can understand the adviser’s conflicts of interest and business practices, and give informed consent to such conflicts or practices or reject them.
  • When a conflict actually exists, an adviser disclosing that it “may” have a conflict is not adequate disclosure. Similarly, if a conflict or business practice exists for only certain classes of clients, advice, or transactions, the adviser must “indicate as such rather than disclosing that [the adviser] ‘may’ have the conflict or engage in the practice.”
  • The adviser should disclose conflicts that result in it or any of its affiliates, supervised persons, or associated persons receiving compensation, directly or indirectly, in connection with the securities it recommends. Further, where there is a conflict that is being addressed, disclosure should be given as to how the adviser addresses the conflict, such as whether there will be an offset of other fees.
  • Where a mutual fund has different share classes and recommends one over another, there may be conflicts pertaining to differing financial incentives and how returns might be affected. By extension, this could also apply to private equity-style closed-end funds with respect to co-investment vehicles and opportunities, among other things.
  • Fee-sharing arrangements also have their own conflicts, and the adviser should discuss with specificity the existence of specific incentives that the adviser directly or indirectly may receive. This could extend to fund managers that use certain service providers across the board and either provide kickbacks or volume discounts.

While the FAQ does not impose any new obligations on investment advisers and largely repeats what the SEC and the staff have been saying for years, it may serve as a helpful reminder of an adviser’s fiduciary requirements and requirements under Form ADV.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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