During 2019, the Securities and Exchange Commission (“SEC”) issued an abundance of enforcement actions against financial firms, issuers, and auditors that involved disclosure deficiencies. For financial firms, a majority of these circled around inaccurate, incomplete, or lack of disclosures involving conflict of interests.
In June 2019, the SEC also showed how focused they are on ensuring that firms provide appropriate disclosures to retail investors by adopting Form CRS for investment advisers and broker-dealers. The SEC stated in the document’s release that Form CRS is designed to provide: “succinct information about the relationships and services the firm offers to retail investors, fees and costs that retail investors will pay, specified conflicts of interest and standards of conduct, and disciplinary history, among other things.”
In this month’s Risk Management Update, we discuss important conflict areas that need to be disclosed in Form ADV and provide guidance and compliance steps on creating and filing new Form CRS.
There are several business practices that create conflicts of interest between an advisory firm and its clients. Below is a list of the some of the more common ones that affect many firms:
- Discretionary Management
- Charging different advisory fees based on investment strategies or types of clients
- Investing clients in securities that provide compensation or benefit to the firm or its employees
- Allocation of Investments
- Allocating to proprietary and/or performance fee accounts
- Allocating limited offerings (g., IPOs and private investments)
- Trading Practices
- Use of soft dollars
- Principal and/or cross transactions
- Code of Ethics
- Employees investing in same securities as clients
- Outside business activities/affiliations
- Broker-Dealer Affiliations
- Advisory personnel that also serve as registered representatives
- Placing advisory client transactions for execution
- Service Provider Relationships
- Fee sharing arrangements
- Business and/or ownership affiliations
- Valuation and Billing
- Fair valuation of private investments
- Charging fees inclusive of margin balances
- Compensation Arrangements
- Receiving fees and/or commissions on recommended investment products
- Obtaining indirect benefits from custodian arrangements
Noteworthy is the fact that none of the activities mentioned above are specifically prohibited by regulation. However, they can cause firms to provide advice to clients that is not solely in their best interest, so advisory firms must implement mitigation steps surrounding these conflicts, with the first and foremost being detailed disclosure.
For conflict disclosure to be adequate, it needs to clearly outline the practice that creates the conflict and the steps the firm takes to address the conflict (e.g., applicable policies, procedures, and controls). It’s very important to avoid using the words “may” or “potential” when describing existing conflicts. It’s also important to always err on the side of disclosure when a conflict exists that doesn’t necessarily fit into any of the topics required to be addressed within the Form ADV.
The SEC mandates this through Form ADV Part 2 Instructions, which state:
“Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship. This obligation requires that you provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest you have and the business practices in which you engage, and can give informed consent to such conflicts or practices or reject them. To satisfy this obligation, you therefore may have to disclose to clients information not specifically required by Part 2 of Form ADV or in more detail than the brochure items might otherwise require.”
The SEC recently published frequently asked questions that provide guidance on disclosure by investment advisers on compensation arrangements and the applicable conflicts. In these FAQs, the SEC recapitulated that: (i) advisers are required to eliminate or at least expose, through full and fair disclosures, all conflicts of interest that might incline them to render advice that is not disinterested, (ii) disclosures must include "sufficiently specific facts" to allow clients to understand applicable conflicts and give informed consent or reject them, and (iii) disclosing that the firm "may" have a conflict when there actually is a conflict is not adequate disclosure.
Also referred to as Form ADV Part 3, the Form CRS is designed to serve as a short form disclosure document that will provide the reader with concise, plain English information on certain aspects of a firm’s business and conflicts. The document must contain five items, in order, addressing specific information. Below is a summary of each:
Item 1: Introduction - Company information, including the name, the registration status, and a statement that brokerage and investment advisory services and fees differ and it’s important for the retail investor to understand the differences. Also include reference to the Investor.gov website.
Item 2: Relationship and Services – A description of services, including monitoring of accounts, investment authority, limited investment offerings, and account minimums along with other requirements that pertain to retail accounts.
Item 3: Fees, Costs, Conflicts and Standards of Conduct – An outline of principal and other fees and costs associated with the services offered that are applicable to retail accounts. Also need to discuss the firm's standard of conduct and give examples of how the firm makes money and the associated conflicts.
Item 4: Disciplinary History – Include any disciplinary information outlined in Item 11 of Form ADV Part 1 and Item 9 of Form ADV Part 2A. Also, must direct the reader to visit the SEC Investor.gov/CRS website, and direct them to the search tool for researching financial professionals.
Item 5: Additional Information - Outline where retail investors can find additional information about the firm and the services, and provide a telephone number where the retail investor can request current information and a copy of Form CRS.
In addition, items 2 through 5 of the form must include specific questions referred to as “Conversation Starters”, which are geared to prompt the retail investor to discuss the topic with the adviser.
The deadline for filing Form CRS is June 30, 2020. However, as of the date of this RMU, the IARD/CRD system will not be set up to accept the filings until May 2020, so it’s important to take the time now to get prepared.
Form ADV season is here for most advisers, so while you are working on gathering data and drafting updates, implement the following additional steps:
- Review the Form CRS instructions issued by the SEC to fully understand all the requirements.
- Begin drafting now, don’t wait.
- Have senior management review the draft prior to filing.
- Train advisory and client service representatives on how best to answer all Conversation Starter questions contained within Form CRS.
- Adopt policies and procedures that outline the content, filing, and delivery requirements Form CRS.
Transparency through disclosures remains the mantra of regulators and it doesn’t appear that this will change any time soon. The more you disclose, the better-informed clients will be, so take the time to truly consider what conflicts apply to your business and ensure they are properly addressed and disclosed.
The Core Compliance team has many years of experience in helping firms identify conflicts and drafting disclosures. For assistance or more information about our services, please contact us at firstname.lastname@example.org, at (619) 278- 0020 or visit us at www.corecls.com for more information.
Author: Tina Mitchell, Lead Sr. Compliance Consultant; Editor: Tito Pombra, President, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
 See SEC’s “Division of Enforcement 2019 Annual Report” at https://www.sec.gov/files/enforcement-annual-report-2019.pdf
 Defined by the SEC as any “natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes.”
 Form CRS currently only applies to broker-dealers registered under section 15 of the Securities Exchange Act of 1934 and investment advisers registered under section 203 of the Investment Advisers Act of 1940.
 Form CRS is limited to only two pages, unless the firm is dually registered, then it can be up to 4 pages.
 Full details are contained in the Form CRS Instructions at https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf