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Less Than Full Disclosure to Clients + the SEC Leads to More Compliance Problems

July 8, 2021
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full disclosure

Written by:  Les Abromovitz, Senior Director

Through recent enforcement actions and testimony by SEC Chair, Gary Gensler, the Commission has made it clear that Registered Investment Advisors (“RIAs”) are expected to provide full disclosure or risk the consequences. The fiduciary duty owed by RIAs and Investment Advisor Representatives (“IARs”) includes the obligation to provide full disclosure of all material facts pertaining to the advisory relationship. An advisor must endeavor to eliminate, if possible, or make full and fair disclosure of all material conflicts of interest. If an RIA does not make full and fair disclosure of its conflicts of interest, clients do not have the opportunity to give informed consent to receiving investment advice that is not disinterested.

An RIA must fulfill its general disclosure obligations as a fiduciary, as well as the specific disclosure requirements mandated by Form ADV. Disclosures must be sufficiently specific, so clients are able to understand the nature and scope of material conflicts of interest. Disclosing that an advisor “may” have a specific conflict of interest is not sufficient if it is already present. Using the word “may” might be appropriate when disclosing a potential conflict that does not exist right now but might reasonably be expected to arise in the future.

Full disclosure of financial benefits received by the firm

On June 11, 2021, the SEC resolved an enforcement action against an RIA that allegedly breached its fiduciary duty in connection with the mutual funds it recommended for clients. The firm’s affiliated broker-dealer benefitted financially from these recommendations. The RIA recommended, or held for advisory clients, mutual fund share classes that paid 12b-1 fees to its affiliated broker, even though lower-cost share classes of the same funds that were available. The RIA did not adequately disclose this conflict of interest to its clients. Furthermore, the RIA did not self-report to the SEC pursuant to the Division of Enforcement’s Share Class Selection Disclosure Initiative.

The RIA did not fully and fairly disclose that its affiliated broker-dealer was receiving revenue sharing, which was a clear conflict of interest. The RIA purchased, recommended, or held cash sweep money market funds and FDIC-insured deposits for advisory clients for which its affiliated broker-dealer received revenue sharing payments from its clearing broker. The money market fund share classes were more expensive than lower-cost share classes of the same funds that were available to clients through the clearing broker. The RIA’s affiliated broker-dealer changed clearing brokers but continued to receive revenue sharing on cash sweep products offered by the new clearing broker.

In addition, the RIA breached its fiduciary duty to clients by failing to disclose that clients in one of the firm’s wrap fee programs incurred ticket charges on certain transactions. The RIA’s affiliated broker-dealer received a portion of those ticket charges. In its wrap brochure, the RIA did not identify any transaction fees charged to wrap accounts over and above the firm’s advisory fee.

The SEC’s enforcement action can be viewed here.

SEC won’t forgive RIAs that don’t fully disclose forgivable loans

On June 7, 2021, the SEC settled an action against an RIA in Scottsdale, Arizona, that allegedly failed to disclose the conflicts of interest relating to IARs’ receipt of forgivable loans from a third-party broker-dealer, its affiliated investment advisor, and its parent company. Nineteen IARs, including the RIA’s owner, were registered representatives of the third-party broker-dealer and received roughly $1 million in forgivable loans. The broker-dealer’s affiliated investment advisor provided back office and administrative support services to the RIA in exchange for a portion of the firm’s advisory fees.

The RIA did not disclose the existence of the forgivable loans until it learned that the SEC’s Division of Enforcement was conducting an investigation. The firm did not disclose the conflicts of interest created by having its IARs receive compensation in the form of loan forgiveness. The forgivable loans gave IARs an incentive to remain registered with the third-party broker-dealer. The enforcement action is available here.

Investment advisors to private funds will need to provide enhanced disclosure

In his testimony on May 26, 2021, before the Subcommittee on Financial Services and General Government, U.S. House Appropriations Committee, Gensler testified that the SEC is seeing new strategies, structures, and business practices due to a significant growth in the number of private funds. Gensler noted that this trend creates new risks for markets and investors. Gensler told the Committee, “Given the growth and changes in private funds, I’ve asked staff for recommendations for consideration of enhanced reporting and disclosure through Form ADV, Form PF, or possible other reforms.”

In addition, Gensler testified that the SEC’s Divisions of Investment Management, Examinations, and Enforcement will continue to focus on advisors to private funds. The SEC will focus on disclosures of investment risks and conflicts of interest, fees and expenses, liquidity, asset valuation, and controls surrounding material non-public information. Gensler’s testimony can be found here.

Conclusion

Obviously, an RIA’s duty to make full disclosure goes well beyond the areas highlighted in these enforcement actions and Gensler’s testimony. Enforcement actions may await RIAs that fail to make full disclosure on Form ADV and breach their fiduciary obligations. Investment advisors should consider erring on the side of over-disclosure in situations where there is any doubt about their duty to disclose conflicts of interest.

This article is not a solicitation of any investment product or service to any person or entity. The content contained in this article is for informational use only and is not intended to be and is not a substitute for professional financial, tax or legal advice.