On February 26, 2015, in her keynote address at the IA Watch 17th Annual IA Compliance Conference, Julie Riewe, Co-Chief of the Asset Management Unit within the Division of Enforcement (“AMU”), stated that, in nearly every ongoing matter, the AMU seeks “to examine, at least in part, whether the adviser has discharged its fiduciary obligation to identify conflicts of interest and has either (1) eliminated them, or (2) mitigated them and disclosed their existence to boards or investors. Over and over again we see advisers failing properly to identify and then address their conflicts.”
Identifying and managing your conflicts of interest is only half the equation; completely and accurately disclosing them in your Form ADV is of equal importance. Over the years, the SEC has remained steadfast in its view that actual and potential conflicts of interest are always material and require appropriate disclosure in a firm’s Form ADV. Through various recent SEC enforcement actions, the regulator has disagreed with advisers’ use of the word “may” when making disclosures in their Forms ADV. The SEC has initiated enforcement against advisers who describe an actual conflict of interest in terms implying that it “may” be a “potential” conflict of interest. The Commission has concluded that an adviser’s use of the word “may” in its Form ADV disclosure is misleading when it conveys that an activity is only a probability if the facts establish that the activity has already transpired.
In October 2016, Belvedere Asset Management LLC (“Belvedere”) was found to be in violation of Section 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”) when the adviser disclosed that a conflict of interest “may” occur when, in reality, the conflict already actually existed. According to the SEC’s order, the adviser failed to disclose material conflicts of interest to clients whose money the adviser used to fund an affiliated mutual fund. The SEC also found that some separate account clients were provided disclosure that the adviser “may” invest client assets in the adviser’s affiliated mutual fund and that this “may” create a conflict of interest relating to fees. The SEC, however, deemed this disclosure to be inadequate because at the time it was made, the clients’ assets had already actually been invested in the affiliated mutual fund and the adviser therefore had an actual conflict of interest (rather than a potential conflict of interest).
In another case where an action was brought against The Robare Group, Ltd. (“Robare”), the adviser disclosed in its Form ADV that it “may receive” certain compensation in a revenue sharing arrangement because the agreement provided that the payments could stop at any time and that any party to the agreement could cancel it. In contrast to the Belvedere case, an SEC Administrative Law Judge (“ALJ”) did not find the adviser’s disclosure that it “may receive” additional compensation as a result of the revenue sharing arrangement to be misleading, and noted that the word “may” accounted for the possible suspension of payments under the revenue sharing arrangement. Contrary to the conclusion reached by the ALJ, the SEC determined, on appeal, that Robare had violated section 206(2) of the Advisers Act by “negligently failing to fully and fairly disclose” the revenue sharing agreement with the unaffiliated custodian and by failing to disclose adequately and completely the material conflict of interest arising from the agreement even after disclosing the arrangement.
What makes the Robare case particularly interesting is that, on appeal, the SEC reversed the decision of the ALJ. Initially, the ALJ’s decision in Robare appeared to offer advisers some hope that cases brought over disclosures containing the word “may” won’t always be decided against the adviser. However, by reversing the ALJ’s decision, the SEC dispelled that pipe dream by maintaining the status quo that only through complete and accurate disclosures can advisers discharge their fiduciary obligation to put their clients’ interests ahead of their own.
Key Takeaways
An adviser should identify and disclose in its Form ADV all sources of compensation to ensure that any potential or actual conflicts of interest are fully disclosed to clients. Advisers should describe compensation that “is” received, fees that clients “will” incur and conflicts of interest that “are” posed.
Failing to properly disclose conflicts of interest to clients can lead to significant regulatory and reputational exposure and costly legal action. Advisers would benefit from avoiding the use of the word “may” (or even “might” and “could”) when disclosing circumstances that are already in existence. A more prudent approach would be to reconsider how you are using these terms in existing disclosure documents.
The Commission has recognized that economic conflicts of interest, such as undisclosed compensation, are material facts that must be disclosed.
Disclosure that an adviser “may” receive compensation that presents a potential conflict of interest could be insufficient when the adviser does, in fact, receive that compensation.
As you review your existing ADV, we suggest that you describe related conflicts of interest in a way that makes clear that the conflicts will, or do, exist if not for all clients, at least for affected clients and explain what you are doing to avoid or mitigate the conflicts.
Conclusion
The SEC has consistently maintained the view that conflicts of interest must be disclosed. In conclusion, “to fulfill their obligations as fiduciaries, and to avoid enforcement action, advisers must identify, and then address – through elimination or disclosure – those conflicts.”
For a discussion on how to adequately and completely disclose any actual and/or potential conflicts of interest in the provision of your services, call your NCS Regulatory Compliance consultant at 800-800-3204.
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