Investment advisers have a duty to disclose material conflicts of interest to clients. The more difficult question is: "how much disclosure is enough?" In a recent settled enforcement action, the SEC suggests that disclosure of material facts alone may not be sufficient, and that more explicit disclosure is needed when investment advice may result in additional compensation to the adviser. The case is Matter of Valentine Capital Asset Management.

The SEC's administrative order found that the adviser "fail[ed] to fully and adequately disclose a material conflict of interest" by not informing its clients that the adviser would receive an additional commission if its clients accepted its recommendation to switch from one series of a managed fund to another series in that same fund. The SEC reached this conclusion despite the fact that the adviser fully disclosed all commission costs to its clients.

According to the SEC order, the adviser advised clients to invest in a futures fund and commodity pool comprised of two different limited partnership units: Series A and a higher risk Series B. Clients paid the fund a 4% annual commission, which was then paid to the adviser. The adviser's commissions were capped at 10% of the client's initial investment in the fund. However, if a client switched from Series A to Series B, it would "reset the clock" on commissions, and the adviser could receive another 10% of the client's initial investment in Series B.

Initially in 2005, the adviser advised clients to invest in Series A. In 2007, the adviser advised many clients to exchange some of their Series A holdings for Series B holdings. Most of the clients that switched their investments had reached or were about to reach the 10% commission cap in Series A. All clients that switched their investments signed a Series Exchange Subscription Agreement which disclosed that the clients would have to pay the full 10% commission in Series B regardless of any previous investment in Series A.

Despite disclosure of the fees, the SEC found that the adviser was required to make "full and clear disclosure" about any conflict of interest in recommending the exchanges, and that it "failed to disclose to clients that [it] would receive additional commissions" if clients followed the advice. Consequently the SEC found that the adviser breached its fiduciary duty.

In a release publishing recent amendments to Form ADV, the SEC addressed this type of conflict issue. The SEC noted that Item 5 of the amended form requires that advisers receiving compensation, such as commissions, attributable to the sale of a security or other investment product, disclose the compensation as well as "the conflict of interest it creates, and . . . how the adviser addresses this conflict."

As a result of the Valentine case and in anticipation of complying with the new Form ADV requirements, registered investment advisers will want to review their disclosures to clients to ensure that they include information about fees as well as conflicts of interest that could result in higher fees. Providing clients with fee schedules alone may not be enough in certain circumstances.