A large dual registrant agreed to pay over $15 Million in fines, disgorgement and penalties for failing to convert inactive fee-based advisory accounts into traditional brokerage accounts. The firm had policies requiring its financial advisers to conduct ongoing suitability reviews and flag those accounts without significant trading activity during the prior 12 months. According to the SEC, the FAs, without an imposed deadline, failed to respond to requests from the Compliance Department to complete the reviews. As a result, over a 5-year period, the firm failed to properly review nearly 8,000 accounts. Once the SEC began an investigation, the firm converted 1700 accounts to brokerage and closed an additional 2000 accounts. The SEC faults the firm for failing to have specific escalation procedures when they failed to respond to compliance inquiries and for neglecting to impose deadlines. The SEC also charged the firm with unsuitable UIT recommendations.
Dual registrants (and parent companies of dual registrants) have this unique suitability compliance obligation that overrides the specific compliance programs for the investment adviser and its broker-dealer affiliate. The firm must determine which product line – fee-based account or traditional brokerage – is suitable and then continuously monitor the accounts to avoid either churning or, as in this case, reverse churning (i.e. inactive fee-based accounts). Many industry observers used to think that fee-based accounts would displace bad brokers who churned accounts. We have now come full circle as the regulator targets reverse churning.
A large REIT manager, together with its CEO and CFO, agreed to pay over $60 Million in disgorgement, interest and penalties for inflating incentive fees and taking reimbursement for significant expenses. The SEC asserted that the defendants, contrary to disclosures and agreements, used their insider positions to calculate incentive fees in a manner that unjustly enriched themselves over the investors to whom they owed a fiduciary duty. The SEC also charged the defendants with collecting millions in expense reimbursements as part of various merger transactions. The SEC accused the defendants of securities fraud and falsifying books and records.
Firms should use some third party (e.g. fund administrator, LPA committee) to calculate, or at least confirm calculations, of fees collected from clients. When management can exercise arithmetic discretion to pay itself, regulators will scrutinize the calculations.
A large custody bank agreed to pay almost $89 Million in fines, disgorgement, and interest to settle charges that it overcharged investment company clients by marking up purported out-of-pocket expenses for nearly two decades. The most significant markups occurred on SWIFT messages as the bank failed to adjust the charges as its internal costs decreased over time. The SEC also maintains the bank overcharged investment company clients on 12 other classes of expenses, collecting $170 Million in profit during the period. The SEC charges the custody bank with causing its fund clients to maintain inaccurate books and records.
This case should prompt fund financial officers to review the charges imposed by the custody bank. That nickel and diming on everything from wire fees to foreign custody reports may be unlawful. Service providers should also take note that the SEC will initiate enforcement for overcharging registrants even where the service provider itself is not an SEC registered or regulated entity.
The principal of a venture capital firm, registered as an exempt reporting adviser, was barred from the industry for taking fees that exceeded the amounts permitted by the operating agreements. The VC firm imposed a front-loaded fee structure whereby investors paid fees on committed capital in early years to approximate the amount they would pay over the possible 10-year life of the funds. The first fund charged an upfront management fee of 17.75% of invested capital, although later structures deferred some of the fees. The SEC asserts that the defendants collected more than $7 Million in unauthorized fees while commingling funds and entering into conflicted transactions.
Imposing an unusual fee structure raises a red flag for regulators. Skeptical examiners will spend significant time and resources to understand the fees and ensure they are properly calculated and collected.
A private equity firm agreed to pay over $6.5 Million in disgorgement, interest and fines for failing to adequately disclose, before commitment of capital, that it would receive accelerated portfolio consulting fees upon IPO or sale of the applicable portfolio company. The PE firm did disclose in the Limited Partnership Agreement that it received portfolio consulting services and disclosed in its Form ADV that it received accelerated fees. Fees were also described in the funds’ annual reports and in a side letter for one of the funds. Also, the PE firm credited a large percentage of the accelerated fees against future management fees. However, the SEC faults the firm for neglecting to inform all limited partners before committing capital that it would accelerate portfolio consulting/advisory fees upon IPO or sale for based on the present value of contract fees that could extend up to 10 years. The SEC asserts that only the limited partnership committee could approve these potentially conflicted transactions.
OUR TAKE: The SEC has brought several cases charging PE firms with taking various forms of ancillary fees (e.g. portfolio monitoring, broken deal expenses, overhead expenses). PE firms should reconsider these ancillary fees in favor of a more inclusive management fee.
The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert detailing investment adviser failures to properly calculate and disclose fees and expenses. OCIE cites failures to properly value assets, thereby leading to overbilling, using the incorrect fee rate, and billing based on the wrong time period. OCIE also details faulty disclosure practices including Form ADVs that do not reflect actual billing practices and failures to fully disclose compensation arrangements. OCIE also highlights fund sponsors that misallocate expenses. The OCIE findings result from issues identified in deficiency letters issued in recent SEC exams. The Risk Alert advises that firms take action by reimbursing clients and enhancing policies and procedures.
OUR TAKE: These Risk Alerts often precede enforcement actions. Compli-pros should review their fee billing and disclosure practices in anticipation of an OCIE sweep.
A large mutual fund manager agreed to pay $3.6 Million in disgorgement, interest, and penalties for failing to disclose that affiliates would receive tax deductions that would deprive fund investors of securities lending income. The fund manager told investors and the Board that it would engage in discretionary securities lending and told the Board that affiliates could benefit from certain tax deductions. The SEC faults the respondent for failing to tell either investors or the Board that it might recall securities before the dividend record date, which allowed affiliates to take a dividend received deduction and deprived the fund and its shareholders of additional securities lending revenue. The SEC cites violations of the Advisers Act’s antifraud rules, acknowledging that proof of intent is not required and that such charges “may rest on a finding of simple negligence.”
OUR TAKE: This type of fraud charge based on simple negligence looks a lot like the type of “broken windows” enforcement cases that former SEC Chairman Mary Jo White championed. The SEC does not allege that fund investors would have made a different investment decision if it included the SEC’s enhanced disclosure. The conflict of interest makes the disclosure insufficient notwithstanding any effect on investors.
A large BD/IA agreed to pay $2.2 Million in remediation, interest and penalties for failing to recommend the lowest mutual fund share class available to retirement plan customers. Instead of recommending load-waived “A” shares, the respondent recommended other higher-cost share classes that resulted in compensation paid to the BD/IA. The SEC faults the firm for failing to have adequate systems and controls in place to ensure that retirement clients benefitted from available discounts. The SEC also asserts that the BD/IA omitted necessary disclosures about revenue sharing and the impact on overall investment returns. An SEC Enforcement official warned that “these types of actions remains a priority for the Division” as evidenced by its recently-announced Share Class Selection Disclosure Initiative.
OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled. Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.
The SEC has commenced enforcement proceedings against an adviser that it alleges lied to his professional athlete client about management fees. The SEC asserts that the adviser told representatives of the client that the client paid between .15% and .20% of assets in management fees when the client actually paid 1.00%, resulting in significant payments to the adviser who received 60% of the revenue earned by his firm. According to the SEC, the adviser misled the client and his representatives by using false account statements, forged documents, an impostor acting as a Schwab representative, and multiple misrepresentations in emails and meetings. The client’s representatives ultimately contacted Schwab, who then informed his employer. The adviser tried to convince the client to lie on his behalf to protect his job, although the client refused.
OUR TAKE: This type of case shows the problem with assuming that wealthy people are financially sophisticated. Many wealthy people earn their income in fields (e.g. sports, medicine, technology) that would not necessarily make them qualified to make investment decisions. Instead, these successful professionals rely on advisers who are supposed to act as fiduciaries and protect their clients’ interests.
The SEC imposed a $3 Million civil monetary penalty on a dually registered RIA/BD for retaining prepaid advisory fees, collecting revenue sharing payments from fund companies, and failing to invest in the lowest-cost share classes available. The respondent billed clients at the beginning of each quarter, but the SEC charges that the adviser’s services – portfolio management, trade execution, performance reporting and account servicing – occurred during the quarter. Therefore, the SEC maintains that the respondent unlawfully retained the prepaid advisory fees when clients terminated before the conclusion of a quarter. The SEC also charges the firm for failing (i) to fully disclose conflicts of interest when receiving revenue sharing and marketing support payments from fund companies and (ii) to utilize the lowest share classes available. The SEC cites violations of the Adviser’s Act’s antifraud provision (206(2)) and the compliance rule (206(4)-7).
OUR TAKE: Charging advisory fees at the beginning of a period drops you into choppy regulatory waters. As the SEC asserts here, how does a firm justify this practice when it has not yet performed services? This practice comes under more scrutiny when a firm fails to refund the fees to terminating clients, thereby creating a financial penalty for clients to sever a relationship.