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Risk Alert: Investment Adviser Economic Conflicts of Interest
Overview:
The SEC’s Division of Examinations (the “Division”) published a Risk Alert (the “Risk Alert”) to assist investment advisers in developing effective compliance programs and disclosures with respect to economic conflicts of interest. Investment advisers are fiduciaries that owe their clients a duty of care and a duty of loyalty.They must make full and fair disclosure (in Form ADV and elsewhere) of all conflicts of interest such that clients provide their informed consent with respect to the manager’s handling of such conflicts.For example, the adviser has a conflict of interest in determining the basis for calculating management fees in the post investment period of private equity funds (“actively managed capital” and “permanent impairment”) that must be disclosed and calculated in accordance with fund documents.Financial incentives for supervised persons to recommend an investment product need to disclosed and be consistent across the Form ADV and other marketing materials. And asset valuations need to be calculated in accordance with the adviser’s valuation policies and procedures.
The Risk Alert follows previous alerts concerning fee calculations and fee and expense compliance issues and is also the subject of SEC examination priorities and senior SEC director speeches. We anticipate further scrutiny of fee and billing policies and procedures and the fulsomeness and consistency of disclosures around those fees and other sources of revenue.This is especially true if the adviser has a fee sharing arrangement or if an affiliate will profit in any way with the way the adviser operates or invests.
Observations Regarding Economic Conflicts of Interest:
The Division reviewed adviser activity that led to the discovery of a preponderance of economic conflicts of interest. Many of these economic conflicts of interest were undisclosed. Additionally, the Division reported multiple incidents of advisers’ acting in a manner that was inconsistent with advisory agreements. Additionally, the Division found that advisers’ compliances programs did not fully address the risks and costs associated with economic conflicts of interest.
An adviser’s fiduciary responsibility requires the adviser to disclose revenue received in exchange for cash management recommendations. The Division found that advisers had recommended moving uninvested cash into interest-bearing accounts at affiliated parties. Advisers that received compensation in exchange for these cash management recommendations created economic conflicts of interest, many of which were not disclosed; thus, clients were found to not have the requisite information needed to provide informed consent[1] when presented with these cash management recommendations. Once entered, cash management recommendations were found to have resulted in: (1) fees that were inconsistent with disclosures/advisory agreements, (2) economic conflicts of interest that were not covered by advisers’ compliance programs, and/or (3) non-disclosure or misleading information of material information.
The Division also identified that in making cash management recommendations, advisers were not fulfilling their fiduciary obligations. By recommending cash be invested in interest bearing accounts rather than being deployed as invested capital, advisers received revenue from custodians, thus incentivizing advisers to recommend cash sweep vehicles rather than exploring alternative investment schemes to maximize returns.
Disclosures: The Division found that advisers did not explicitly and completely disclose fees, expenses, and/or conflicts of interest associated with advisers’ cash management recommendations. The division found that some advisers omitted disclosures about client cash balances that were subject to advisers’ asset-based fees, and the impact of additional fees (resulting from the new interest baring account) on overall investment performance. The Division additionally identified examples of advisers that did not properly disclose their economic benefit that resulted from the cash management recommendation. Examples include revenue sharing programs with cash management affiliates. Similarly, advisers failed to disclose that lower cost shares of the same interest bearing accounts, that did not have a revenue sharing agreement (which would result in lower fees to the client), were available alternatives.
Registered investment advisers are required to provide clients with a narrative brochure that discusses minimum requirements, inclusive of the related conflicts of interest, that arise from an adviser’s compensation agreements with affiliates. The Division found that compensation related misstatements and omissions were present in various advisers’ brochures prepared pursuant to Part 2A of Form ADV.
Form ADV Disclosures, Item 10 and Item 12: Advisers are required to disclose financial industry activity and affiliation under Item 10, Part 2A, Form ADV. The staff found, however, that advisers did not fully disclose their activities and affiliations. Examples were a lack of disclosure surrounding newly created economic conflicts of interest that arose from cash management recommendations. Under Item 12, advisers are required to disclose, in detail, the criteria used to evaluate the selection of broker dealers, and the reasonableness of the ensuing cost of commissions reaped by the broker dealer. The Division found that these Item 12 requirements were either both incomplete and/or inconsistent with other disclosures produced by Advisers.
The Division identified that advisers’ assessment of advisory fees was inconsistent with executed agreements and disclosures once cash management recommendations were agreed to and acted upon.
Calculating Fees Consistent with Advisory Agreements and Disclosures: TheDivision identified advisory fee calculations were inconsistent with executed advisory agreements and/or disclosures in Form ADVs. Examples of inconsistencies ranged from: prorating fees without having a policy on prorating, charging asset-based advisory fees on assets excluded from fee collect per advisory agreements, assessing incorrect fee rates and not rebating transaction fees where advisory agreements stated that such fees were not applicable.
Additionally, the Division identified advisers that charged clients fees for services that were not rendered, and/or assessed higher fees than agreed to for services in executed agreements. Examples ranged from advisory fees for services not provided, advisory fees associated with inactive accounts and duplicative advisory fees on the same account. Further, the Division identified instances in which these erroneous fees were charged, and not refunded upon client closure of accounts/the end of billing periods.
The Division identified advisers that did not have certain policies and procedures that were designed and implemented to prevent violations of the Advisers Act. Written policies and procedures did not explicitly indicate how billing practices were executed accurately and in compliance with fiduciary obligations, disclosures and advisory agreements. Examples include adviser policies that did not address all applicable billing and fee arrangements, and inconsistent policies and procedures about advisory fee producing activity. Additionally, the Division identified advisers that lacked compliance monitoring policies, procedures and controls to ensure accurate billing and fee calculations. The lack of controls around billing resulted in clients being overcharged for advisory services.
Conclusion:
In sharing these findings, the Division emphasized the importance of advisers remaining mindful of their fiduciary obligations. Advisers should take this opportunity to review their compliance frameworks surrounding economic conflicts of interest, evaluate the adequacy of related disclosures, and assess billing practices to ensure they align with governing agreements, disclosed policies, and regulatory expectations.
Orical regularly assists advisers with these reviews, including identifying and mitigating economic conflicts, evaluating disclosure obligations, and testing for consistency among an adviser’s operations, compliance policies and procedures, Form ADV disclosures, and offering documents.
[1] See Fiduciary Interp., (“[W]here an investment adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.”).