The Securities and Exchange Commission has issued a FAQ illustrating disclosure obligations related to the types of compensation that investment advisors receive, such as 12b-1 fees and revenue sharing.
The agency’s Division of Investment Management, in releasing the FAQ, points out that it discusses certain compensation arrangements and related disclosure obligations arising from both the investment advisor’s fiduciary duty and Form ADV.
The IM division’s FAQ is seen as a response to complaints by the Financial Services Institute and former SEC Commissioner Paul Atkins, to address their concerns that the agency’s Share Class Selection Disclosure Initiative cracking down on 12b-1 fees is “regulation by enforcement.”
David Bellaire, FSI’s general counsel, told ThinkAdvisor on Monday in an email message that “While too late is better than never, the SEC’s information does nothing to alleviate the inherent unfairness of the SCSDI. This was needed in 2014 when the SEC’s views on appropriate disclosure apparently shifted.”
The FAQ specifies that it does not alter or amend applicable law and has no legal force or effect, and it creates no new or additional obligations.
The FAQ suggests advisors should consider rebating third-party revenue-sharing payments against clients’ account-level fees, Cipperman Compliance Services notes.
The IM staff requires “extensive disclosure including the share classes available, differences in expenses and performance, limitations on the availability of share classes, conversion practices, how the advisor recommends different share classes, and the existence of incentives,” Cipperman explains.
Advisors are also encouraged to disclose “[w]hether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction” such as ERISA accounts.
The FAQ also points to how advisors must report certain forms of compensation and conflicts of interest on Form ADV.
When “an advisor receives, directly or indirectly, 12b-1 fees in connection with mutual fund recommendations, it has a financial incentive to recommend that a client invest in a share class that pays 12b-1 fees,” IM states.
“The resulting conflict of interest is especially pronounced when share classes of the same funds that do not bear these fees are available to the client.”
An advisor’s disclosure on Form ADV must include “sufficiently specific facts” to allow clients to understand the advisor’s conflicts and business practices and give informed consent or reject them.
“This may require an advisor to disclose ‘information not specifically required by’ the Form or more detail than the Form otherwise requires,” the FAQ notes.
For instance, an advisor “disclosing that it ‘may’ have a conflict is not adequate disclosure when the conflict actually exists.”
IM states that in the in the course of administering Form ADV, as well as conducting compliance exams and enforcement investigations, IM staff “has observed a range of practices with respect to this type of disclosure.”
Examples of material facts that, in IM’s view, an advisor should disclose about its practices and conflicts “in plain English,” include:
- The existence and effect of different incentives and resulting conflicts.
- The fact that different share classes are available and that different share classes of the same fund represent the same underlying investments.
- How differences in sales charges, transaction fees and ongoing fees would affect a client’s investment returns over time.
- The fact that the advisor has financial interests in the choice of share classes that conflict with the interests of its clients.
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