The SEC breaks new ground in this complaint by suggesting that the firm should have invested client assets in other funds (including funds sponsored by an affiliate of the clearing broker) that did not offer revenue sharing. Most prior revenue sharing cases have focused on the use of higher fee share classes of the same fund. This line of argument raises a concern that the SEC is implicitly advocating for the lowest cost fund regardless of investment mandate or performance. For example, would an adviser violate its fiduciary duty, absent revenue sharing, if it recommended a higher cost fund for reasons other than total expense ratio?
The interesting twist here is that the SEC doesn’t really describe why the compensation should be characterized as transaction-based, triggering broker-dealer registration, rather than permissible asset-based compensation. Instead, the SEC relies more on the source of the compensation (e.g. the product sponsor) rather than a direct fee charged to the client. Could the firm have avoided the broker-dealer registration charges if it assessed the 1.25% fee on the client rather than collect it as revenue sharing from the product sponsor? This may be an economic distinction without a difference, but the SEC will view it through a different regulatory lens.
SEC fined a large commercial bank for failing to disclose that it only
recommended hedge funds that paid a portion of the management fee back to the
bank. The bank marketed a robust due
diligence process conducted by a purportedly independent, in-house research
group performing a multi-step due diligence process to select hedge funds from
an “extremely large universe.” In fact,
the bank only recommended hedge funds that paid back management fees that it
called “retrocessions.” Although the
bank disclosed that it might receive revenue sharing and the amount actually received
from each hedge fund, the actual due diligence process did not comport with
marketing promises. The bank, which is
not a registered adviser or broker-dealer, was charged with violating the Securities
Act’s anti-fraud provisions (17(a)(2)).
Check the marketing team’s enthusiasm at the door. The SEC doesn’t allow firms an exception from the securities laws for product hype, regardless of how clients/investors may perceive the statements. Rather than caveat emptor (buyer beware), caveat venditor (seller beware) governs sales of securities products.
Once the SEC identifies possible wrongdoing, don’t compound the problem by further misleading clients during the remediation process. It is possible that this firm could have avoided the $400,000 in fines had it not lied to clients about its past practices.
We expect several enforcement actions this year based on the failure to offer the lowest mutual fund share class available. We recommend that advisers conduct an internal reviews of recommendation practices and take action to reimburse clients.
“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements. The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest. Perhaps, the firm never considered that its longstanding practice violated the securities laws. This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm.
An investment adviser platform was fined and censured for receiving fund revenue sharing from a custodian and clearing firms it recommended without proper disclosure. The platform had more than 150 independent investment adviser representatives and 200 registered representatives working out of more than 100 offices. The SEC criticizes weak disclosure that failed to fully describe the conflict of interest when the firm recommended a custodian that kicked back 2 basis points on assets. The SEC also maintains that the firm violated disclosure, fiduciary and best execution obligations when it recommended mutual fund share classes that paid back 12b-1 fees to the firm and its reps when lower fee share classes were available. The firm did not meet its obligations with vague website disclosure that described how the firm “may” receive compensation but failed to fully inform all clients about how fees were paid or calculated.
OUR TAKE: The RIA platform business is extremely competitive, with many firms competing to recruit successful RIA teams. The real cost of an enforcement action like this is the reputational and competitive threat during the recruiting process. Also, as platforms compete for business and margins shrink, the incentives to accept (questionable) revenue sharing increases.
OUR TAKE: Inter-company payments among affiliates raise the same regulatory conflict of interest concerns as payments received from non-affiliates. Compli-pros should follow the money to all of an adviser’s revenue sources in order to assess possible conflicts. Also, non-U.S. entities, perhaps less sensitive to the Adviser’s Act’s requirements, should hire qualified lawyers or compli-pros to avoid tripping over the regulatory wires.
OUR TAKE: The best solution for avoiding compensation conflicts is to include all compensation in the disclosed management fee and avoid any payola from third parties. Receiving payments from third parties raises such a significant conflict of interest that the SEC may not be satisfied with mere disclosure, no matter how fulsome.
Three investment advisory firms will pay nearly $15 Million in fines and disgorgement for recommending more expensive mutual fund share classes that paid revenue sharing. The SEC faults the firms for failing to fully disclose that recommending higher-fee fund share classes in exchange for revenue sharing presented a conflict of interest. The SEC also alleges that recommending the higher-fee classes violated the firms’ best execution obligations. An SEC official “strongly encourage[s]” eligible firms to participate in the recently announced Share Class Disclosure Initiative amnesty program.
OUR TAKE: Given the number of cases in this area, it may be that, as a practical matter, an adviser can never include enough disclosure that would justify recommending anything other than the cheapest share class available. We recommend that compli-pros conduct an internal sweep of their firms’ mutual fund recommendation practices.