SEC’s New Conflicts Risk Alert Comes Down to One Question: How Does Your Firm Make Money?

Most compliance problems don’t start with bad intentions. They start because nobody has a complete picture of how the firm operates or gets paid.

The owners understand the economics of the business. The portfolio managers know one piece. Operations knows another. The finance team sees the revenue. And compliance is trying to stitch the story together from advisory agreements, Form ADV disclosures, billing reports, custodial contracts, and conversations that may or may not happen.

That’s why the SEC’s new Risk Alert on economic conflicts of interest deserves attention. Not because it announces a new rule. It doesn’t. And not because the deficiencies are particularly surprising. Most experienced compliance professionals have seen some version of these issues before.

It’s important because it reveals where advisers continue to stumble. And after reading the alert, one theme stands out: many firms still haven’t fully identified the economic incentives embedded in their own business models.

That’s a problem. Because when SEC examiners start reviewing conflicts, they’re ultimately asking a simple question:

What financial incentives could influence the advice being given to clients?

If your firm can’t answer that question clearly, you’re already behind.

The SEC Is Focused on Economic Incentives

The Division of Examinations makes its focus clear from the beginning of the Risk Alert. Examiners continue to prioritize reviewing the economic incentives advisers and their personnel may have when recommending products, services, account types, custodians, or investment strategies.

Those incentives can come from a lot of places:

• Revenue-sharing arrangements
• Custodial relationships
• Cash sweep programs
• Mutual fund share classes
• Margin lending programs
• Transaction markups
• Affiliate compensation arrangements
• Advisory fee structures

None of these arrangements are inherently problematic. The issue is whether the adviser understands them, evaluates the resulting conflicts, and provides clients with full and fair disclosure sufficient to give informed consent. And that’s where many firms get into trouble.

Cash Management Programs Continue to Draw Scrutiny

One of the largest sections of the Risk Alert focuses on cash management arrangements.

The staff observed advisers recommending programs that automatically swept client cash into interest-bearing accounts, sometimes through affiliated entities, while generating revenue for the adviser. In several instances, advisers received compensation based on client cash balances held at custodians or through specific cash sweep programs.

The SEC’s concern isn’t that firms earned revenue. The concern is that clients often weren’t given a clear picture of the incentive. In some cases, advisers failed to disclose that they received compensation tied to client cash balances. In others, advisers did not disclose that they had a financial incentive to recommend the cash vehicle that generated the most revenue for the firm.

The staff also highlighted a disclosure issue that continues to appear in examinations: firms stating they “may” receive compensation when they are already receiving it. Think about that from a client’s perspective.

There’s a meaningful difference between “We may receive compensation” and “We receive compensation.”

One describes a possibility. The other describes reality. The SEC continues to make clear that disclosures should reflect reality.

Share Classes, Revenue Sharing, and Other Compensation Arrangements

The Risk Alert also revisits a familiar examination theme: advisers receiving economic benefits from product recommendations without fully explaining those incentives to clients.

The staff observed situations where advisers, affiliated broker-dealers, or adviser representatives received compensation through Rule 12b-1 fees even though lower-cost share classes were available. The conflict wasn’t necessarily the compensation itself. The conflict was that the recommendation created an incentive that clients may not have fully understood.

The SEC identified similar disclosure concerns involving:

• Custodial credits
• Margin loan markups
• Clearing relationships
• Transaction fee markups
• Revenue generated through affiliated entities

Again, the lesson isn’t that these arrangements are prohibited. The lesson is that advisers must identify the incentive, understand the conflict it creates, and disclose it clearly.

Form ADV Still Matters More Than Many Firms Realize

The Risk Alert contains several observations involving Form ADV Part 2A. The staff found advisers that failed to adequately disclose financial industry affiliations, compensation arrangements involving affiliates, and revenue-sharing relationships with clearing firms and custodians.

Here’s what I think many firms miss: Form ADV is not simply a disclosure document.

It’s a reflection of how well the firm understands itself. When examiners find missing disclosures about compensation arrangements, the problem often isn’t limited to the ADV. The disclosure issue is usually a symptom of something larger.

The firm never fully identified the conflict in the first place. That’s why annual ADV reviews shouldn’t be treated as a drafting exercise. They should be treated as a business-model review.

Every year, advisers should ask:

• How does the firm generate revenue?
• How are adviser representatives compensated?
• What incentives exist?
• What affiliate relationships create economic benefits?
• What has changed since the last ADV update?

Those questions are often more valuable than the drafting process itself.

The Fee Billing Findings Should Get Every Adviser’s Attention

Some of the most concerning observations in the Risk Alert involve fee billing practices.

The staff observed advisers:

• Charging fees inconsistent with advisory agreements
• Charging fees on assets that should have been excluded
• Failing to apply breakpoint discounts
• Charging for services not provided
• Continuing to bill inactive accounts
• Charging duplicative fees
• Failing to refund unearned prepaid fees upon termination

What’s striking about many of these examples is that they don’t require bad intent.

• A fee billing error can arise because a process wasn’t updated.
• An account wasn’t coded correctly.
• A manual calculation wasn’t reviewed.
• A fee schedule changed but wasn’t implemented consistently.

That’s why fee billing remains one of the most important testing areas in any compliance program. Small operational issues can become fiduciary issues very quickly.

The Part of the Risk Alert That Matters Most

For me, the most important section isn’t about cash sweeps or share classes. It’s the section discussing compliance programs.

The Division observed advisers whose policies did not adequately address billing practices, fee calculations, fee reductions, rebates, and monitoring controls. It also found inconsistencies among compliance policies, advisory agreements, and client disclosures.

And here’s what that tells me: Many firms are still treating conflicts as a disclosure issue. They’re not. Conflicts are a governance issue.

Because before you can disclose a conflict, someone has to identify it. Before someone can identify it, they have to understand the firm’s economics. And that leads to a conversation that doesn’t happen nearly often enough.

When Was the Last Time Someone Walked the CCO Through the Income Statement?

It’s a simple question. But it gets uncomfortable surprisingly fast.

Many Chief Compliance Officers are responsible for overseeing conflicts of interest. Yet many CCOs don’t have complete visibility into every source of firm revenue, every affiliate arrangement, every custodial credit, every referral relationship, every compensation structure, or every economic incentive embedded within the business.

That’s not a criticism of CCOs. It’s a reality of how many firms operate.

Information lives in different departments. Ownership understands certain relationships. Finance understands others. Operations understands others. Compliance often receives pieces of the puzzle rather than the entire picture.

The result is predictable:

• The conflict inventory becomes incomplete.
• Disclosures become stale.
• Policies fail to address certain risks.
• Everyone assumes somebody else has already looked at it.

The firms that do this well are usually the firms willing to have direct conversations about money.

Not just client fees. All the money. Where it comes from. Why it comes in. Who benefits. What incentives it creates.

Those conversations aren’t always comfortable. But they’re often where the most important compliance work gets done.

The Real Compliance Exercise

If I were turning this Risk Alert into a practical exercise for advisory firms, I’d start with one question:

Other than advisory fees, what are all of the firm’s sources of revenue?

Then I’d ask the same question separately to:

• Ownership
• Finance
• Operations
• The CCO
• Business leadership

If the answers are different, you’ve probably identified an area worth reviewing. Because that’s really what this Risk Alert is about.

Not cash sweep programs.

Not margin loans.

Not share classes.

Not even fee billing.

It’s about understanding the economic incentives that exist inside your business and making sure the people responsible for overseeing conflicts know they exist.

The SEC has been focused on economic conflicts for years. This Risk Alert is a reminder that the staff continues to view them as a core fiduciary duty issue and a routine examination priority.

The firms that fare best during examinations are usually not the firms with the longest disclosures. They’re the firms that truly understand how they make money, have documented the conflicts that arise from those arrangements, and have been willing to have the conversations necessary to address them.

Key Takeaways for Investment Advisers

• The SEC continues to view economic conflicts of interest as a core fiduciary duty issue and a routine examination priority.
• Many of the deficiencies highlighted in the Risk Alert stem from firms not fully identifying or understanding the economic incentives embedded within their business models.
• Compliance cannot oversee conflicts it doesn’t know exist. CCOs should have meaningful visibility into the firm’s revenue sources, compensation structures, affiliate arrangements, and other economic incentives.
• Conduct a periodic review of all firm revenue streams, not just advisory fees. Include revenue-sharing arrangements, custodial credits, margin programs, referral arrangements, affiliate compensation, and any other sources of economic benefit.
• Review Form ADV, advisory agreements, fee schedules, and compliance policies together. The SEC continues to find inconsistencies among these documents.
• Make sure disclosures describe actual conflicts, not hypothetical ones. If compensation is being received today, disclosures stating the firm “may” receive compensation are unlikely to satisfy exam staff.
• Periodically test fee billing practices against advisory agreements and disclosures. Many examination findings arise from operational breakdowns rather than intentional misconduct.

Most importantly, have the conversations. Sit down with ownership, finance, operations, and compliance. Walk through how the firm gets paid. Identify the incentives those arrangements create. Then determine whether those conflicts are fully understood, properly disclosed, and appropriately addressed.