The IA/BD subsidiary of a large bank agreed to pay almost $1.3 Million in disgorgement and a $1.1 Million fine for putting wrap fee clients in funds that paid a 12b-1 fee back to the selling reps. The SEC faults the firm for failing to recommend that clients move assets into lower-fee share classes as those classes became available over time. Although the firm disclosed that it may receive 12b-1 fees, it did not disclose that it actually received those fees and that lower classes were available. The SEC noted that the IA/BD made changes to qualified accounts but failed to implement similar changes to non-qualified accounts. In addition to best execution, fiduciary, and disclosure violations, the SEC criticized the firm’s compliance program because the respondent failed to update its compliance policies and procedures as institutional share classes became available.
OUR TAKE: A compliance program is not a static exercise that you can set and forget. As the markets and the business changes, firms must continuously review policies and procedures to determine if they still make sense given new realities. In this case, the wider availability of institutional share classes necessitated changes to the firm’s compliance practices.
An RIA was censured and agreed to pay disgorgement for failing to offer the lowest-fee mutual fund share classes available and failing to adequately disclose compensation paid to its affiliated broker-dealer. The RIA recommended third party mutual funds to 403(b) and IRA clients, who directed the investments. The SEC faults the respondent for recommending Class A shares that paid 12b-1 fess to its affiliated broker and failing to make available lower-fee institutional shares. The SEC also cites the insufficiency of various disclosures that generally discussed payment of 12b-1 fees but failed to specifically explain that an affiliate would receive the trailers. The SEC charges the RIA with violations of the compliance rule (206(4)-7) for failing to adopt and implement adequate policies and procedures around conflicts of interest, disclosure, and mutual fund share class selection.
OUR TAKE: We believe that the SEC wants advisers to offer the lowest share class available and refrain from accepting any form of revenue sharing compensation. We think that the SEC will find inadequate even the most robust disclosures and procedures because of the inherent conflict of interest.
A fund manager was barred from the industry and ordered to pay $550,000 for multiple breaches of fiduciary duty including failure to observe the fund’s investment limitations. According to the SEC, the respondent did not comply with the fund’s investment concentration policies, including the fund’s status as “diversified,” as described in the Registration Statement and as disclosed to the fund’s Board of Directors. The SEC also accuses the respondent, the sole proprietor of the fund manager, with double-charging separate account clients invested in the fund. Additionally, the SEC charges that the respondent cherry-picked trades for his personal benefit to the detriment of clients. The SEC cites violations of the anti-fraud provisions of the Exchange Act, the Advisers Act, and the Investment Company Act.
OUR TAKE: Registered funds are highly-regulated investment vehicles that require strict adherence to the Investment Company Act, SEC rules, the Registration Statement, and the Board of Directors. Advisers have much less flexibility with respect to disclosure and fees than separate accounts or private funds.
Another mutual fund manager was censured and penalized ($22.6 Million) for paying distribution and marketing fees mis-characterized as sub-TA fees, in violation of Section 12(b) and Rule 12b-1 of the Investment Company Act. The SEC alleges that the fund sponsor, through the manager and distributor, used fund assets to pay for distribution but told intermediaries and the Board that such amounts were for sub-TA (shareholder) services and would be paid out of the manager’s revenue rather than fund assets. Additionally, the SEC charges that, even if the amounts were paid for legitimate sub-TA services, such amounts exceeded the caps set by agreements with the funds.
OUR TAKE: Many in the fund industry were waiting for the regulatory shoe to drop after the SEC first announced the distribution-in-guise sweep two years ago. This makes 2 cases in 2 days against large fund companies. Compliance officers must do their own sweep to determine whether fund sponsors are properly compensating intermediaries.
A mutual fund manager agreed to pay a $4.5 Million fine and reimburse the funds another $1.25 Million for making unlawful distribution and sub-transfer agency payments to intermediaries. The SEC maintains that the fund company claimed to make payments solely out of its revenues but, as a result of a technical misclassification, paid amounts directly out of fund assets in violation of Rule 12b-1. The SEC also asserts that the respondent paid sub-TA fees in excess of Board-approved caps disclosed in the registration statement. The SEC charges violations of the antifraud provisions of the Advisers Act and the Investment Company Act (Sections 206(2) and 34(b), respectively) and Section 12(b) and Rule 12b-1 of the Investment Company Act for making distribution payments without proper Board and shareholder approval and disclosure.
OUR TAKE: This the SEC’s second major case pursuant to its distribution-in-guise initiative (See Fund Sponsor to Pay $40 Million for Using Fund Assets to Pay for Distribution). Fund firms must make sure that sub-TA payments do not include payments for any kind of distribution or marketing services. Also, Boards must vet and approve all such plans that make use of fund assets.
A large retail broker-dealer agreed to pay $2.3 Million in restitution because the firm failed to offer load-waived class A shares. Instead, the eligible customers – retirement plans and charitable organizations – either paid the loads or were directed to higher-expense Class B or C shares. FINRA faults the firm for over-relying on its financial advisers to determine the applicability of sales charge waivers while failing to properly notify and train them. Also, the firm failed to adopt adequate controls to detect clients that were entitled to the waivers. The firm was not fined, presumably because FINRA lauded the respondent for detecting and self-reporting the issues.
OUR TAKE: An adequate compliance program cannot rely on those that need to be monitored to effect proper compliance and surveillance. An independent function should be tasked with surveillance and implementation.
An investment adviser agreed to pay over $2 Million in disgorgement, interest and penalties for failing to buy the least expensive share class of recommended mutual funds. The SEC maintains that the respondent, an investment adviser representative of a large advisory firm, recommended Class A shares that carried a 12b-1 fee instead of lower-expense institutional shares. The adviser received a portion of the 12b-1 fees from the clearing firm as revenue sharing. The SEC did not absolve the adviser even though he received approval for the practice after consulting his firm’s management. The SEC asserts that the adviser violated his obligation to seek best execution for securities transactions.
OUR TAKE: The SEC requires advisers to recommend the lowest-expense share class available, which requires more diligence by advisers before making recommendations. It is also noteworthy that the SEC uses an expansive interpretation of an adviser’s best execution obligations, which historically has centered on brokerage commissions.
The staff of the SEC’s Division of Investment Management has provided no-action relief that allows open-end investment companies to invest in closed-end investment companies that hold themselves out as part of the same investment group. Without the no-action relief, a narrow reading of Section 12(d)(1)(G) and Rule 12d1-2 of the Investment Company Act would only allow open-end funds to invest in related funds only if such funds were open-end. In general, Section 12(d)(1) limits fund-of-funds structures, absent specific conditions, because fund-of-funds have the potential to create complex products with layered fees and conflicts of interest.
OUR TAKE: This no-action relief provides practical flexibility to create fund-of-funds structures within the same group of companies, which should save costs and avoid artificial product engineering.
The principals of an investment adviser/fund manager agreed to wind down their firm and pay fines for failing to properly disclose conflicts of interest when they invested clients’ money in an affiliated mutual fund. The SEC asserts the respondents invested 35% of client assets in an affiliated mutual fund, which resulted in clients paying an asset management fee of 1.3% of assets plus fund fees exceeding 2.95%. The firm did amend its Form ADV to describe the conflict, but, according to the SEC, the respondents did not deliver the amended Form ADV to clients before investing assets in the affiliated fund. The SEC also notes that the respondents failed to heed advice of a compliance consultant about Form ADV disclosure and delivery. The SEC claims the respondents violated Section 206(2) (anti-fraud), Rule 206(4)-7 (compliance rule), and Rule 204-3 (brochure delivery).
OUR TAKE: The real issue in this case is that the adviser was charging clients over 4.00% in fees and expenses, which may be a breach of fiduciary duty no matter how much disclosure is provided. The failure to deliver the Form ADV just made the case easier for SEC Enforcement. Also, you should always listen to your compliance consultant.
The United States Court of Appeals for the District of Columbia has vacated the SEC’s proxy access rule (14a-11) that would have required public companies including investment companies to include shareholder director nomination in proxy materials. The Court ruled that the SEC acted in an arbitrary and capricious manner in violation of the Administrative Procedure Act because it failed to adequately “consider the rule’s effect upon efficiency, competition, and capital formation” as required by the Exchange Act and the Investment Company Act. The Court opined that the SEC failed to quantify or justify the potential costs of the Rule, including the costs of proxy battles and the impact of special interests, and failed to offer empirical evidence of its benefits.
OUR TAKE: This decision, along with last year’s decision vacating the rule regulating equity indexed annuities, will make it much more difficult for the SEC to promulgate regulations because the Court is mandating empirical and economic analysis. Expect challenges to the raft of Dodd-Frank rules.