The SEC’s Division of Examinations recently issued a new Risk Alert (the “Alert”) on Staff observations regarding economic conflicts of interest found during examinations of SEC registered investment advisers. This is at least the third Alert issued by the Staff since 2018 that covers conflicts of interest in some capacity. The most recent Alert reiterates just how important it is for advisers to ensure compliance programs and client disclosures both mitigate and inform clients of actual and potential conflicts respectively.
The Alert covers numerous ways that adviser compensation streams create conflicts. Lack of detailed disclosures on all types of compensation in Form ADV Part 2A and client agreements is often found during examinations. Specifically, the exam teams want to see complete coverage of the following compensation types in both Form ADV Part 2A and client agreements, as applicable:
- Revenue sharing arrangements
- Cash sweep programs
- Money Market fund share class fees/selection
- Mutual fund share class fees/selection
- Rule 12b-1 fees
- Custodial credits
- Margin loans and credits
- Transaction fees/markups
When conflicts cannot be eliminated or mitigated then adequate disclosure becomes necessary in order for an adviser to ensure the client has informed consent to the conflict. The best way to prove informed consent is to ensure all major conflicts are disclosed within the client agreement. A secondary disclosure in Form ADV Part 2A is also required in order to appease examiners during an actual exam.
The SEC explicitly mentioned Items 10 (financial affiliates) and Item 12 (brokerage transactions) of the Form ADV brochure as specific areas for conflicts disclosures. This is a rather clear heads up to advisers that these sections will be reviewed specifically for conflict areas during examinations.
Fee disclosures and calculations were also highlighted in the Alert. Compliance policies need to cover how fees are calculated on all asset types as well as account types. Any proration of fees needs to be part of the fee calculation policy and importantly, disclosed in both Form ADV and client agreements. Exams found instances of fees being improperly calculated by:
- Clients having fees prorated upon deposits or withdrawals within a billing period, but the firm has no written policies or disclosures on how fees are prorated
- Including exempt assets within the advisory fee calculation
- Assessing incorrect fee rates on accounts
- Not applying fee rebates in accordance with disclosures (i.e. mutual fund transaction fees)
Another common deficiency found involved unearned advisory fees. Fees can be deemed “unearned” when accounts are not managed actively after a financial advisor leaves his or her firm and the account sits for too long without it being managed. It can also happen if an account is terminated, and the fees are not refunded on the unearned portion when fees are paid in advance.
Examination teams want to see that advisory firms are testing and monitoring fees for accurate calculations, especially on how rebates and refunds are applied to accounts.
All in all, this Alert is quite proscriptive on how advisers should be calculating and disclosing fees and other compensation streams to clients. Now is the time to test your fee calculation process thoroughly so your firm can prove that fees are being handled correctly during an actual SEC exam.
