Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
Recently, we declared that revenue sharing was dead. Although, in theory, sufficient disclosure should allow advisers to receive revenue sharing, in practice, the SEC attacks revenue sharing in all its forms regardless of the extent of the disclosure. Our conclusion is that the SEC has effectively banned revenue sharing. As support for our position, below are ten types of revenue sharing outlawed by the SEC (cases hyperlinked).
Revenue sharing is dead. We don’t think an adviser could include enough disclosure to satisfy the SEC where the adviser recommends a share class more expensive that a comparable share class that does not result in adviser payola. Also, this case is another example of the failed dual-hat Chief Compliance Officer model.
This case reads like a compliance what-not-to-do handbook. Conflict of interest? Check. Undisclosed payola? Check. Reducing client returns? Check. Failing to implement procedures or testing? Check. Dual-hat, conflicted CCO? Check. Ignoring OCIE deficiencies? Check. The adviser has already withdrawn to state registration. We expect a bleak litigation future for these alleged wrongdoers.
In a recent FAQ, the staff of the SEC’s Division of Investment Management suggests that investment advisers consider rebating revenue sharing received from third parties against account-level fees. The FAQ purports to offer disclosure and mitigation guidance for advisers that receive payments or benefits from third parties for recommending certain classes of mutual funds. The staff requires extensive disclosure including the share classes available, differences in expenses and performance, limitations on the availability of share classes, conversion practices, how the adviser recommends different share classes, and the existence of incentives. The staff also encourages advisers to disclose “[w]hether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction” such as ERISA accounts.
We believe that, through these extensive disclosure requirements, the SEC staff is effectively outlawing revenue sharing unless the adviser rebates the compensation to clients. Disclosure alone may never be sufficient for an adviser to satisfy its fiduciary obligations. This standard would conform with how ERISA treats qualified accounts.
It is unclear whether this group of cases is the beginning, middle, or end of the Share Class Selection Disclosure Initiative. Regardless, firms are on notice that they must clean up their disclosures and reimburse investors if they have recommended higher expense share classes.
The SEC censured and fined an investment adviser for paying solicitors without complying with the solicitation rule (206(4)-3). The adviser had networking relationships with over 300 banks whereby the adviser paid the banks a substantial portion of the advisory fees received from clients referred to the adviser. The SEC asserts that the adviser did not comply with the solicitation rule, which requires separate disclosure about the solicitation relationship, the specific terms, and the compensation received. The adviser erroneously relied on a 1991 no-action letter, which stated that a bank need not register as investment adviser. The no-action letter did not hold that bank solicitors were exempt from the solicitation rule.
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.