Every Material Conflict, in Writing

An investment adviser must disclose every material conflict of interest that could affect its advice, so the client can decide whether to accept it. That includes how the adviser and its staff are paid, payments from third parties, affiliations with other financial firms, trading in the same securities as clients, principal and agency cross trades, soft dollar arrangements, referral payments and any disciplinary history.

The disclosure must be specific enough for a client to understand the conflict and how it could affect the advice. Saying the adviser “may” have conflicts is not enough when the conflict actually exists.

Most of these disclosures appear in Form ADV Part 2, the adviser’s brochure, and in Form CRS, the short relationship summary for retail clients. For the full route from the exam to a career as an adviser, our complete guide to how to become an investment adviser representative covers every step.

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Why Disclosure Is Required

The duty to disclose conflicts comes from the adviser’s fiduciary duty of loyalty under the Investment Advisers Act of 1940 and from state securities law. An adviser cannot put its own interests ahead of the client’s, and a client cannot judge whether that is happening without knowing where the adviser’s interests lie.

Disclosure allows informed consent. Once the client understands a conflict, they can accept it, ask questions or take their business elsewhere.

Our guide to what are an investment adviser’s duties of care and loyalty explains how disclosure fits into the wider duty. The Series 65 Exam Preparation course at FRC covers the disclosure rules as part of the laws and ethics section.

The Main Conflicts Advisers Must Disclose

Compensation conflicts come first. Advisers must explain their fees, how they are calculated and charged, and any other compensation they or their staff receive, such as commissions on products, distribution fees or revenue-sharing payments from fund companies.

Affiliation conflicts follow. If the adviser is affiliated with a broker-dealer, insurance company, fund sponsor or other financial firm, and that relationship creates a conflict, it must be disclosed, along with any arrangement to recommend affiliated products.

Trading conflicts round out the core list. Advisers must disclose if they or their staff buy or sell securities they also recommend to clients, trade as principal with clients, cross trades between clients, use soft dollars or direct client trades to particular brokers.

Conflicts and Where They Are Disclosed

Worked Example: Third-Party Compensation

An adviser recommends mutual fund share classes that pay a 0.25 percent annual distribution fee to the adviser’s affiliated broker-dealer. Clients hold $2 million in these share classes.

Step one: 0.25 percent of $2 million is $5,000 a year flowing to the affiliate. Step two: because that payment rewards the adviser’s group for using those share classes, it is a conflict that must be clearly disclosed, along with whether cheaper share classes are available.

Without disclosure, clients cannot see that the adviser’s choice of share class benefits the adviser’s group. Regulators have brought many cases where advisers failed to disclose exactly this kind of conflict.

Study Disclosure Rules With FRC

Questions on disclosure usually test which conflicts must be disclosed, what Form ADV Part 2 contains, when the brochure must be delivered and how state and federal delivery rules differ. Our Series 65 course works through each with exam-style examples.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

What Form ADV Part 2 Contains

Form ADV Part 2A, the firm brochure, is written in plain English and follows a set structure. It covers the adviser’s services, fees and compensation, performance-based fees, types of clients, methods of analysis and risks, disciplinary information, other financial industry activities and affiliations, code of ethics and personal trading, brokerage practices, account reviews, client referrals and other compensation, custody, investment discretion, proxy voting and financial information.

Part 2B, the brochure supplement, gives information about the individual representatives who advise the client. It covers their education, business experience, disciplinary history, other business activities and additional compensation.

Together, the brochure and supplement give a client a complete picture of both the firm and the person they deal with. Many Series 65 questions ask which part contains which information.

When the Brochure Must Be Delivered

Federally registered advisers must deliver the brochure to a client before or at the time of entering into an advisory contract. Each year, they must deliver either an updated brochure or a summary of material changes with an offer to provide the full brochure.

State-registered advisers follow rules that can differ. Under the model rule many states use, the brochure must be delivered at least 48 hours before entering into the contract, or at the time of entering into it if the client can terminate within five business days without penalty.

Worked example: step one, a state-registered adviser delivers the brochure at 9 a.m. on Monday and wants to sign the contract at 3 p.m. on Tuesday. Step two, that is only 30 hours, short of the 48 required. Step three, the adviser must either wait until at least 9 a.m. on Wednesday to sign or give the client five business days to cancel without penalty.

Keeping Disclosure Up to Date

Disclosure is not a one-time event. SEC-registered advisers must file an annual updating amendment to Form ADV within 90 days after the end of their fiscal year, and must then deliver either the updated brochure or a summary of material changes to clients within 120 days of the fiscal year end.

Some changes cannot wait for the annual update. If information in the brochure becomes materially inaccurate, such as a new disciplinary event, the adviser must amend it promptly and, for disciplinary information, deliver the update to clients.

A disclosure that was accurate when a client signed can become misleading as the firm changes. Keeping it current is part of the ongoing duty of loyalty, and regulators check that brochures match how the firm actually operates.

Form CRS for Retail Clients

Advisers and broker-dealers that serve retail investors must also provide Form CRS, a short relationship summary limited to two pages, or four for firms offering both brokerage and advisory services. It explains in plain language the services offered, the fees and costs clients pay, the firm’s conflicts of interest, its standard of conduct and any disciplinary history.

Form CRS uses set headings and conversation-starter questions, such as asking the professional how they will choose investments and what conflicts they have. The aim is to help retail clients compare firms and ask the right questions before they sign.

It does not replace the brochure. Form CRS gives the summary, while Form ADV Part 2 gives the detail, and advisers must deliver both.

Conflicts That Disclosure Cannot Fix

Disclosure is the usual response to a conflict, but it has limits. If a conflict is so significant that a client could not realistically understand it or give meaningful consent, the adviser must eliminate it or change its practices.

Fee and compensation conflicts in particular are often addressed by changing practices. Many advisers credit 12b-1 fees back to client accounts or move clients into the lowest-cost share classes available, rather than relying on disclosure alone.

The same distribution fees appear in the rules that govern how broker-dealers sell funds, as our comparison of FINRA Rule 2341 vs Rule 2342 explains.

Financial Condition and Prepaid Fees

Advisers must disclose financial conditions that are reasonably likely to impair their ability to meet commitments to clients. This applies especially when the adviser has custody of client assets or discretionary authority, or requires clients to prepay fees.

An adviser that requires prepayment of more than $1,200 in fees per client, six months or more in advance, must include an audited balance sheet in its brochure. That rule protects clients who hand over fees before receiving services.

Worked example: step one, an adviser requires a client to prepay a $1,500 annual fee twelve months in advance. Step two, because the fee exceeds $1,200 and is prepaid six or more months ahead, the adviser must include an audited balance sheet in its brochure.

Performance Fees and Side-by-Side Management

Advisers that charge performance-based fees to some accounts and asset-based fees to others face a particular conflict. They may be tempted to favor the performance-fee accounts, for example by giving them the best investment ideas or the best trade allocations.

This arrangement, called side-by-side management, must be disclosed, along with how the adviser addresses the conflict. Performance fees themselves are generally allowed only for qualified clients who meet set wealth thresholds.

Worked example: an adviser manages $800,000 for a client on a 1.2 percent asset-based fee and another $800,000 for a client paying a share of gains. Step one: the asset-based client pays $9,600 a year regardless of performance. Step two: the performance-fee account could pay much more in a strong year, so the adviser must disclose how it ensures both clients receive fair treatment.

Referral Arrangements

Advisers sometimes pay other people to refer clients, such as promoters, solicitors or other professionals. Under the SEC’s marketing rule, paid referrals are treated as endorsements or testimonials and must be disclosed, including the fact that the promoter is compensated and any material conflicts.

Worked example: a promoter refers a client with $500,000 to an adviser charging 1 percent a year and receives 20 percent of the first year’s fee. Step one: the first-year fee is $5,000. Step two: the promoter receives $1,000, and that payment must be disclosed so the client knows the referral was paid.

Referral payments can influence who recommends an adviser and why. Disclosure lets clients weigh a recommendation knowing the referrer had a financial reason to make it.

Disciplinary History

Advisers must disclose legal and disciplinary events that are material to a client’s evaluation of the adviser or the integrity of its management. That includes certain criminal convictions, regulatory actions and civil proceedings involving the firm or its management.

The brochure supplement covers similar events for individual representatives. Clients can also check a professional’s history through the SEC’s Investment Adviser Public Disclosure website.

Disciplinary disclosure is one of the most direct protections for clients. An adviser with a history of regulatory problems must tell clients about it rather than leave them to discover it later.

The Memory Aid

Remember “pay, affiliations, trading, history”: the main categories of conflict are how the adviser is paid, who it is affiliated with, how it trades and its disciplinary record.

For brochure delivery, remember “federal: before or at signing; state: 48 hours, or five days to cancel”.

For prepaid fees, remember “$1,200 and six months”: prepaying more than $1,200 six or more months in advance triggers an audited balance sheet.

Exam Traps to Avoid

The first trap is thinking generic disclosure is enough. Saying the adviser “may” have conflicts does not satisfy the duty when a specific conflict exists.

The second trap is mixing up federal and state brochure delivery rules. The 48-hour rule, with its five-business-day alternative, comes from the state model rule.

The third trap is confusing Part 2A with Part 2B. Part 2A covers the firm, while Part 2B covers the individual representatives. The fourth trap is forgetting that disclosure does not cure every conflict; some must be eliminated.

A Client Scenario

A prospective client meets an adviser who recommends a portfolio of the adviser’s affiliated funds. The adviser’s firm also receives revenue-sharing payments from one of the fund companies.

Before the client signs, the adviser delivers the brochure and Form CRS, which explain the affiliation, the revenue sharing and the fact that unaffiliated funds with lower costs are available. She walks the client through each conflict and explains how she decides which funds to recommend.

The client asks for a mix that includes some unaffiliated funds, and the adviser agrees. She records the disclosures, the client’s questions and the final allocation in the file.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the Investment Advisers Act of 1940 entry to see where the disclosure duty comes from, explained on video, and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: Which document is the investment adviser’s main disclosure brochure? Form ADV Part 2A.

Question two: Under the state model rule, how far in advance must the brochure be delivered if the client has no cancellation right? At least 48 hours before entering into the contract.

Question three: An adviser requires a client to prepay $1,500 twelve months in advance. What must the brochure include? An audited balance sheet.

Question four: Clients hold $2 million in share classes paying a 0.25 percent fee to the adviser’s affiliate. How much does the affiliate receive each year? $5,000.

Question five: Which part of Form ADV covers the individual representative’s background? Part 2B, the brochure supplement.

Turn Ethics Knowledge Into Career Evidence

Clear, honest disclosure is at the heart of every trusted advisory relationship, and firms look for candidates who understand why. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining how you would disclose a revenue-sharing conflict shows the integrity advisory firms look for.

Related Questions

Disclosure is one of the clearest differences between advisers and brokers, as our comparison of fiduciary standard vs suitability standard explains.

Key Points to Retain

Investment advisers must disclose all material conflicts of interest, including fees and other compensation, third-party payments, affiliations, personal and principal trading, brokerage practices, performance fees, referral payments, financial condition and disciplinary history. Disclosure must be specific enough for informed consent, and some conflicts must be eliminated rather than disclosed.

Most disclosure appears in Form ADV Part 2A for the firm, Part 2B for individuals and Form CRS for retail clients. Federal advisers deliver the brochure before or at signing, state advisers under the model rule at least 48 hours before or with a five-business-day cancellation right, and prepaying more than $1,200 six months or more in advance requires an audited balance sheet.

For the role the exam leads to, read our guide to what an investment advisor representative is.