Show Me the Fees: SEC Risk Alert Zeroes in on Economic Conflicts of Interest

The SEC’s Division of Examinations(Division) issued a Risk Alert on June 9, highlighting its observations during a review of the economic incentives that investment advisers and their financial professionals may have to recommend certain products, services, or account types to clients. As highlighted below in more detail, an adviser may be subject to claims that it has violated its fiduciary duty where, for example, the adviser fails to: (i) disclose or sufficiently disclose conflicts of interest in its cash management and other revenue-sharing arrangements; (ii) implement reasonably designed compliance policies and procedures regarding fee-related matters; or (iii) calculate and/or charge advisory fees and expenses consistent with client advisory agreements, governing documents, or related disclosures.  

Key Takeaways

• Advisers received revenue in connection with cash management recommendations (e.g., from custodians holding client cash or for recommending specific sweep vehicles), which often created economic conflicts of interest that were not fully and fairly disclosed to clients.

• Revenue-sharing arrangements with clearing broker-dealers and custodians remained a significant source of undisclosed conflicts, including when advisers used hedging language, such as “may,” to describe conflicts that in fact existed rather than affirmatively disclosing the arrangements.

• Advisers frequently failed to provide clients with sufficiently clear disclosure regarding fees and expenses, including under Items 10 and 12 of the Form ADV brochure, thereby limiting clients’ ability to understand the costs and economic incentives associated with the adviser’s recommendations and to provide informed consent.

• Advisers often employed fee calculation practices that deviated from their advisory agreements and Form ADV disclosures (such as prorating fees without disclosure, billing on excluded asset classes, failing to apply breakpoints, or charging for services not rendered), resulting in client overcharges and reimbursement obligations.

• Advisers implemented deficient compliance policies and procedures that did not specifically address the mechanics of fee billing, rebates, and refunds and, in some cases, contained inconsistencies with the adviser’s disclosures and client agreements, potentially in violation of Rule 206(4)-7 under the Investment Advisers Act of 1940.

Cash Management Conflicts

The SEC has long scrutinized cash sweep programs – an area that Katten has previously discussed. And the Division continues to identify concerns in this area – most recently, the Division observed advisers recommending programs that automatically sweep uninvested client cash into interest-bearing accounts, including accounts at affiliated parties, creating conflicts of interest that were not fully and fairly disclosed. In some cases, advisers failed to disclose revenue received from custodians based on client cash balances, as well as incentives to recommend cash sweep vehicles that generated higher compensation. 

The Division also noted instances where advisers stated they “may” receive revenue from third-party cash sweep programs when, in fact, they were already receiving such revenue. The SEC has indicated that such conditional disclosure is inadequate where the conflict currently exists. In addition, some advisers failed to disclose that client cash balances were subject to asset-based fees or did not adequately explain the impact of such fees on investment returns. In certain cases, clients experienced negative returns due to the fees and expenses associated with recommended cash management programs.

Although not specifically addressed in the Risk Alert, advisers should also consider their broader treatment of uninvested cash. Charging asset-based fees on uninvested cash balances raises fiduciary concerns absent a clear and documented basis for holding cash (e.g., where cash holdings are part of the client’s investment strategy). Advisers may handle uninvested cash in multiple ways — such as sweeping to FDIC-insured accounts, retaining interest, or sharing in interest earned — but in all cases, the adviser’s economic benefit and the treatment of cash should be clearly disclosed and consistent with the adviser’s policies and procedures. This is particularly important where the adviser has an incentive to sweep client cash into programs that generate revenue for the adviser without the client’s informed consent.

Revenue Sharing and Other Economic Benefits

The Division observed advisers with revenue-sharing arrangements involving clearing broker-dealers and custodians that were not fully and fairly disclosed. Some advisers failed to disclose that their broker-dealer affiliates received revenue in connection with interest rate markups on margin loans to advisory clients. Advisers also failed to disclose credits received in connection with custodial and clearing arrangements for client assets held at unaffiliated broker-dealers, including the existence of termination fees associated with ending such relationships. Some advisers did not disclose that they imposed additional fees and expenses on clients, such as markups on clearing brokers’ fees. Further, the Division noted inadequate disclosure of economic benefits associated with mutual fund share class selection, including the receipt of 12b-1 fees where lower-cost share classes were available – an area with extensive history and that has previously been actively pursued by the SEC.

Form ADV Disclosure Deficiencies

SEC-registered investment advisers must deliver a narrative brochure that satisfies specified disclosure requirements, including conflicts of interest arising from compensation arrangements, and may rely on the brochure to meet their disclosure obligations. Staff observed that some advisers failed to fully disclose financial industry activities and affiliations under Item 10 of the Form ADV brochure, including material conflicts of interest arising from compensation agreements with affiliates (e.g., where an affiliated broker-dealer indirectly benefits through revenue generated by clearing services provided to advisory clients). 

The Alert also identified deficiencies in Item 12 disclosures, which require advisers to disclose the factors they consider in selecting or recommending broker-dealers and assessing the reasonableness of their compensation. In some cases, these disclosures were incomplete or inconsistent with other disclosures. For example, advisers with revenue-sharing arrangements involving clearing firms did not disclose all material facts related to those relationships.

Fees Inconsistent with Agreements and Disclosures

The Division observed advisers calculating and charging advisory fees in ways that were inconsistent with their Form ADV disclosures and/or written advisory agreements. Examples included: prorating fees for mid-period deposits or withdrawals where agreements did not address proration; charging asset-based fees on holdings specifically excluded from billing per advisory agreements (e.g., initial cash inflows and fixed income assets); failing to apply reduced fee rates or householding breakpoints; and failing to rebate transaction fees that agreements indicated would not be charged to clients. In addition, the Division observed advisers charging fees for services not actually provided — including on accounts where advisory personnel departed and the accounts were never reassigned, on inactive accounts clients had requested in writing to close, and more than once for the same services due to internal asset transfers. Additionally, advisers failed to refund prepaid fees to clients who terminated prior to the end of the billing period.

Compliance Program Deficiencies

The Division observed compliance programs that did not adequately address fee-related risks. Compliance policies and procedures failed to address billing arrangements (e.g., prepaid fees, householding, margin); contained conflicting information across compliance policies, client disclosures, and advisory agreements; and lacked monitoring controls to test for fee calculation errors or validate that refunds were issued to terminated accounts.

Practical Takeaways

While the compliance areas identified by this Risk Alert are certainly not new (and in fact, remain within our recent memory as related to cash management/sweep accounts and mutual fund share class selection issues), advisers should take note of these observations, particularly when preparing for SEC examinations and preparing/updating Form ADV disclosures.

• Evaluate whether fee practices and revenue arrangements align with the adviser’s fiduciary duty, particularly where the adviser benefits from client cash or product recommendations.

• Review revenue-sharing and affiliate arrangements for completeness of disclosure, including indirect economic benefits.

• Scrutinize cash sweep and uninvested cash practices, including whether cash is fee-bearing and whether associated revenue is fully disclosed.

• Align billing practices with agreements and disclosures; identify and correct overcharges. Implement and test controls governing fee calculations, supervision, and refunds.

• Ensure disclosures are clear, complete, and written in plain English, enabling clients to understand conflicts and provide informed consent.

• Eliminate inconsistencies across disclosure documents that could undermine the adequacy of conflict disclosure.

Art Gasey, a JD candidate from the University of Illinois, contributed to the research, analysis and publication of this article.