Identifying and Disclosing Conflicts of Interest: A How-To for Financial Advisors

Form ADV Part 2 is the primary document created and distributed by RIAs that explains in narrative format how the firm operates. It is created and provided to regulators during the initial registration process, distributed to clients at the commencement of any advisory relationship, and maintained as a publicly available document for the entire time the RIA is in business.

One of the most important functions of Form ADV Part 2 is to disclose to clients any conflicts of interest the advisor has identified during the course of evaluating their firm’s activities and operations.

These conflicts of interest may result from other business activities of the advisor, relationships the advisor has with business partners and third parties, or affiliations the advisor has established with other financial institutions.

For firms that are new to compliance or don’t have an experienced compliance officer on staff, identifying conflicts of interest can be challenging. Once the conflicts have been identified, disclosing them adequately presents an additional obstacle. Here are a few items to note while identifying and disclosing conflicts of interest.

What is a Conflict of Interest?

A conflict of interest exists when two or more parties are involved in a relationship and the interests, aims, or goals of the two parties are not aligned. In the investment advisory space, these conflicts most commonly arise surrounding fees to be paid by the client.

The most basic way to identify a conflict is to ask “Is there any way in which I can manipulate this relationship to my benefit that may be to the detriment of the client?”

Sure, this is a broad question that oversimplifies the concept, but this is the basic foundation upon which conflicts of interest can be identified.

The Practice 

At the center of every conflict is a practice. By practice, I mean the actions or system of procedures created by the firm’s operations that lead to a particular outcome or set of consequences.  

The firm’s practices are outlined in Form ADV Part 2. With every practice, there is a potential conflict of interest—one of the goals in drafting this document is to identify and disclose any conflicts that exist.  

Any situation in which the practices of the advisor are incompatible with the best interests of the client constitutes a conflict of interest. This is critical to understand as the industry evolves towards comprehensive financial planning services and away from the traditional assets under management (AUM) model.

Many financial-planning-focused advisors will also incorporate some element of AUM in their model. Based on feedback from regulators, it can be noted that perceived conflicts of interest are currently impeding upon the advisor’s ability to offer financial planning and AUM services under separate fees.

The rationale revolves around the idea that a client without significant AUM may not be able compensate an advisor for their services by billing on the assets. If the advisor offers both services under a separate fee, then there’s a possibility that the advisor can find the financial planning service more suitable than the AUM service not necessarily because the services are distinct, but due to the compensation the advisor would receive. In this instance, recommending a financial planning service simply because the client cannot afford AUM represents a potential conflict of interest. 

Conflicts of interests may also arise in relationships with other professionals and centers of influence. In Form ADV Part 2A Item 10, the firm must disclose any financial industry affiliations. The purpose of this section is to ensure that any other financial industry affiliations the advisor has are adequately disclosed and any conflicts of interest are addressed.

In this section, advisors must disclose if they have any insurance affiliations for which commissions or trails are received. Why does this matter? There have been cases in which advisors have sold insurance products to clients that were not suitable for the client to gain payouts, commissions, and trails.  

Unfortunately, despite being a very clear conflict of interest, this has occurred quite often throughout the financial services industry.

Form ADV Part 2A Item 10 also requires advisors to disclose whether or not they operate as a registered representative of a broker dealer to prevent the same type of potential conflict.

Later in Form ADV Part 2A Item 14, it is required that the advisor disclose any solicitation arrangements in which they are participating. Let’s consider this scenario:  

Case Study: A financial advisor (we will refer to them as the primary advisor) offers portfolio management services and charges 90 basis points (0.90%) for their services. The advisor is preparing to sign a client with $1,000,000 in AUM. In the first year of the relationship, the fees received by the advisor will be roughly $9,000 (give or take based on market conditions).  

The advisor also has a business partner who operates an RIA (we’ll refer to them as the outside RIA), for which they receive referral fees. That arrangement stipulates that the advisor will receive a one-time payment of $15,000 for every $10,000,000 they refer to the outside RIA. The outside RIA charges the client 1.25%, and the primary advisor is only $400,000 away from meeting the $10,000,000 benchmark in the solicitation arrangement.

If the services offered by the two advisors are essentially the same, it is clearly in the best interest of the primary advisor to refer the client to the outside RIA; by doing so, he/she will receive $6,000 more in the first year of the relationship. However, it would be in the best interest of the client to stay with the primary advisor and pay 0.90% for the service. Hence the conflict of interest.

The same is true of the rationale behind disclosing outside business activities. Although less often scrutinized than financial industry affiliations, the disclosure of non-financial related outside business activities is critical to full and fair disclosure of potential conflicts of interest.  

The Answer

As you can see, the aforementioned examples and underlying principles can be applied throughout the industry. Maintaining relationships with attorneys, accountants, sub-advisors, paraplanners, or any other professional service provider for which compensation is sent or received can create conflicts of interest.  

The answer is simply to properly disclose the conflict and outline how the conflict will be addressed. Fortunately, regulatory guidelines do not prohibit conflicts of interest. If they did, it would be difficult for advisors to operate in any useful capacity. After identifying the conflict of interest, the advisor can simply state how they will avoid manipulating the conflict to their advantage.

In the example above, a regulator would push back about the recommendation of financial planning versus AUM services; this conflict can be addressed by simply outlining the clear and distinct differences between the AUM and financial planning services. In doing so, the advisor creates a separate set of criteria for the recommendation that doesn’t involve the amount in fees they will receive from the relationship.

Similarly, the regulatory requirement to have the client sign an acknowledgement prior to the initiation of the relationship helps to adequately address any conflict surrounding the disclosure of solicitation arrangements.

Additionally, the disclosure requirement for ADV Part 2A Item 14 allows the client to ask any questions they may have about the arrangement in advance of their decision to hire the firm.

It is virtually impossible for an advisor to operate without discovering a conflict of interest. That’s just the nature of the business. By proactively identifying conflicts, firms can become proficient in providing adequate disclosures that will satisfy regulators, protect their clients, and help establish and sustain their professional reputation.

About the Author

Scott is a licensed Securities Principal with experience in both RIA and broker-dealer compliance. He began his financial services career in 2006 as a Registered Representative with E*Trade Financial in Alpharetta, GA. He has also worked with J.P. Morgan Private Banking in Chicago, IL and with Wells Fargo Advisors in Chapel Hill, NC.

Scott’s most recent role before joining Team XYPN was as Compliance Officer of Carolinas Investment Consulting, in Charlotte NC. He’s a graduate of The University of North Carolina at Chapel Hill and holds FINRA Series 63, 65, 24, 4 and 53 Licenses.

Scott lives in Charlotte, NC with his wife Meredith, and their two sons Tyson and Jackson and daughter Eva. In his free time, Scott enjoys watching sports, exercising, and operating the charitable organization he created upon his father’s passing.

You can connect with him on LinkedIn.