Three related dually registered adviser/BDs agreed to pay a $7.5 Million fine and pay another $2+ Million in disgorgement and penalties for violations related to their wrap programs. The SEC charges the firms for recommending mutual fund share classes that paid 12b-1 fees to the firms when other share classes were available. Although the respondents’ Form ADVs included disclosure that they would receive 12b-1 fees from recommended products, the SEC faults the firms for not disclosing that they would not recommend the lowest share class available. The SEC also charges the firm with violations of the compliance rule (206(4)-7) for failing to follow their own policies and procedures requiring account reviews to protect against reverse churning (i.e. wrap fee clients that would be better suited in a traditional brokerage account because of low transaction volume). The SEC indicates that it “has been actively probing conflicts of interest and disclosure around mutual fund share class selection.”
OUR TAKE: We believe the SEC is implicitly outlawing revenue sharing with advisers, unless an adviser can shoulder the compliance burden of proof that the client could not have done better in the absence of the payments to the adviser. Here, the firm did in fact disclose that it would receive payments from underlying products, yet the SEC still found fault because the firm could have found lower fee share classes, which presumably would have precluded revenue sharing. The reverse churning charges make it difficult for dually-registered advisers to efficiently operate a wrap program without significant ongoing compliance oversight.