Proper Disclosures are a Fiduciary Responsibility
One of the most important fiduciary duties of a Registered Investment Adviser (“RIA”) is that of disclosure. Current regulations require disclosure of many aspects of a RIA’s business including, among many things, ownership, business offerings, fees, business practices, investment approach, conflicts and disciplinary history. It is the responsibility of each RIA to accurately disclose the material facts a potential or current client would need to make a well-informed decision as to whether or not to invest through the RIA.
Not providing truthful and accurate disclosures and in particular, lack of proper disclosure, can lead to regulatory enforcement. Today, there are three main disclosures for RIAs, Form ADV, the new Form CRS, and the Investment Management Agreement. While there are many other areas requiring disclosure, these are the three main documents of concern to most RIAs.
What are your Requirements?
In order to stay in compliance and meet your regulatory responsibilities, Form ADV (in particular, Part 2A) the Investment Management Agreement, and for those RIAs required to file, Form CRS (also called the Customer Relationship Summary or Form ADV Part 3) must not only meet the minimum requirements for disclosure, but they must be in sync. This means that these three documents must essentially tell the same story regarding the required disclosures. For example, the description of fees and fee assessments detailed in Item 5 of Form ADV Part 2A, should match the description of Fees in the Investment Management Agreement, as well as in Item 3 of Form CRS. Errors can occur when these documents are updated separately.
The Securities and Exchange Commission (“SEC”) has taken enforcement action against Firms for missing, misstated, and/or inadequate disclosures. The following are some examples:
- The Securities and Exchange Commission charged Fieldstone Financial Management Group LLC and its principal Kristofor R. Behn, both of Foxboro, Mass., with defrauding retail investment advisory clients by failing to disclose conflicts of interest related to their recommendations to invest in securities issued by affiliates of Oregon-based Aequitas Management LLC. Without admitting or denying the Commission’s findings, Fieldstone and Behn consented to the issuance of the order, which finds that they violated the antifraud provisions of the federal securities laws, censures Fieldstone, orders them to cease and desist from future violations, and orders them to pay, on a joint-and-several basis, disgorgement and prejudgment interest of $1,047,971 and a penalty of $275,000, all of which will be distributed to harmed investors. Behn was also permanently barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization.[1]
- The Securities and Exchange Commission announced that two BMO advisers have agreed to pay over $37 million to settle charges regarding their failure to tell clients about certain aspects of how the advisers selected investments in their retail investment advisory program, known as the Managed Asset Allocation Program (MAAP), which included the selection of more expensive investments from which BMO advisers profited. In addition, the SEC found that BMO Harris failed to disclose its conflicts of interest arising from investing MAAP client assets in higher-cost share classes of certain mutual funds, including funds managed by BMO Asset Mgmt, when lower-cost share classes were available. By selecting the higher-cost share classes, BMO Harris received revenue sharing payments and avoided paying certain transaction costs, while clients received lower returns on these investments. The SEC’s order found that BMO Harris and BMO Asset Mgmt willfully violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder. Without admitting or denying the SEC’s findings, BMO Harris and BMO Asset Mgmt agreed to cease and desist from committing or causing any future violations of these provisions, to pay disgorgement and prejudgment interest of $29.73 million, and to pay a civil penalty of $8.25 million, amounts which will be distributed to harmed investors, and to be censured. [2]
- The Securities and Exchange Commission announced settled charges against MVP Manager LLC (“MVP”), a New York-based investment adviser to private funds, for failing to adequately disclose conflicts of interest. According to the SEC’s order, MVP advised and managed private fund clients that invested in the securities of venture-backed companies that had not conducted initial public offerings. The order finds that on three occasions between December 2014 and December 2015, MVP personnel arranged to receive a brokerage commission from the counterparty that was selling such securities to MVP’s client funds. Each of these arrangements created a potential or actual conflict of interest because MVP and its personnel had an economic incentive to cause the private funds to purchase the securities at the prices MVP negotiated with the counterparties, which would trigger the payment of the commissions. None of the disclosure documents that MVP provided to fund investors, however, revealed the existence of the arrangements or MVP’s attendant conflicts of interest. The SEC order found that MVP willfully violated the antifraud provisions of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder. Without admitting or denying the SEC’s findings, MVP agreed to settle by consenting to a cease-and-desist order and censure, disgorgement and prejudgment interest of approximately $170,000, and a civil monetary penalty of $80,000.[3]
As these examples demonstrate, it is apparent the Securities and Exchange Commission takes full disclosure seriously and does not hesitate to enforce disclosure regulations.
What can you do to help ensure your disclosures are full and accurate?
One of the first steps Firm’s should do to ensure proper disclosure across all disclosure documents is to perform a disclosure inventory. This is done by looking at the main focus areas of disclosure and identifying areas that need to be described to clients and prospects. These areas include:
Brokerage and Trading
- Custodian arrangements
- Best execution and use of soft dollars
- Directed brokerage arrangements
- Trading with affiliated broker-dealers
- Cross trading and principal transactions
- Prime brokerage arrangements and step out trades
- Trade aggregation, allocation, and rotation
- Trading in proprietary accounts
Code of Ethics
- Obtaining insider non-public information
- Political and charitable contributions
- Giving and receiving gifts and certain entertainment
- Outside business activities
- Employee personal trading
Compensation
- Performance fees vs. asset-based fees
- Compensation received by employees for their outside business activities
- Referral/Solicitation fees
- Revenue sharing arrangements
- Valuation of client holdings (fees charged based on valuations)
- Indirect benefits from custodial/brokerage arrangements
- Using affiliates to provide services to a firm and/or clients
- Expense payments
- Householding client assets to achieve a break point
Custody
- Adviser and/-or General Partner to a Private Fund
- Employees acting as trustee, co-trustee, or executor of client account
- Debiting fees directly from client accounts
- Receiving cash, checks or securities from clients or third parties
- Having custody (e.g., due to check writing authority, bill paying services, Standing Letters of Authorization (SLOA) arrangements, etc.)
Portfolio Management
- Side by side management of different types of accounts
- Allocation of investment opportunities
- Selecting investments on a discretionary basis that provide direct or indirect compensation to a firm and/or IARs
- Proxy voting
- Due diligence of investments
- Research (soft dollars, insider trading etc.)
- Selective disclosure of portfolio holdings
- Providing different services for similarly situated clients
Other Considerations
- Outside business activities
- Passive investments (including private securities transactions and ownership interests
- Loans to principals from the company
- Significant liability events
- Material disciplinary events pertaining to firm and/or employees
Once the disclosure inventory has been created, you should review your current Form ADV Part 2A (the “Brochure”). Are all disclosure items being addressed? Are your disclosures accurate and clear? If not, Firm’s should take steps to revise, edit, and file an amendment to Form ADV Part 2A. Firms that are required to File Form CRS should then compare the disclosures in its Brochure to ensure that the disclosures in both documents are in agreement and if revisions are required to Form CRS, revise, edit, and file a revision to Form CRS as well. Lastly, your Firm’s Investment Management Agreement should be reviewed to ensure the disclosures contained in the agreement agree with the Brochure and Form CRS. If not, the Firm should consider updating the Investment Management Agreement.
Registered Investment Advisers have a regulatory and fiduciary responsibility to have accurate disclosures of their business practices. Additionally, the various disclosure documents must be in sync with each other. As noted above, improper or missing disclosures can result in regulatory enforcement actions. Firms should ensure that proper time, resources, and consideration are given to disclosures and disclosure documents to avoid regulatory sanctions.
Author: 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.
[1] SEC Release 2019 -115 https://www.sec.gov/news/press-release/2019-115
[2] SEC Release 2019-199 https://www.sec.gov/news/press-release/2019-199
[3] SEC File No. 3-19334 https://www.sec.gov/enforce/ia-5319-s