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The Friday List: 10 Types of Prohibited Revenue Sharing

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).

10 Types of Prohibited Revenue Sharing

 

  1. 12b-1 Payments from Recommended Funds.  An adviser compounds the violation when lower expense share classes are available.
  2. A percentage of the GP’s carried interest.  Advisers cannot make backdoor compensation from a private fund GP.
  3. A percentage of the management fee.  Platforms have required both registered and private funds to kick back a portion of the management fee to obtain shelf space.
  4. Up-front payment from a fund sponsor.  A one-time, up-front or back-end payment from a product sponsor can also raise questions about required broker-dealer registration.
  5. Directing clients to affiliated brokers.  The SEC will punish this form of revenue sharing where it can prove that clients could have obtained better execution through a non-affiliate.
  6. Revenue-splitting with clearing brokers/custodians.  The SEC will attack firms that receive a portion of the ticket charge, commission, or other fees from clearing brokers or custodians.
  7. Internal allocations among affiliates.  Just because revenue sharing is hidden through internal accounting doesn’t make it less of a conflict of interest.
  8. Fees from recommended vendors.  Advisers must put the client first and should not recommend vendors that pay them or offer discounts.
  9. Sub-transfer agent or administrative fees.  The SEC has cracked down on so-called sub-TA fees ostensibly paid to reimburse advisers for client servicing.
  10. Forgivable loans from clearing brokers.  It’s a conflict of interest when reps have an incentive to steer business to a particular clearing broker to reduce loan principal.

Dual Registrant Will Pay Over $900,000 for Inadequate Mutual Fund Revenue Sharing Disclosure

 

A dual registrant agreed to pay over $900,000 to settle charges that it breached its fiduciary duty by collecting 12b-1 fees on recommended mutual fund share classes when lower expense share classes were available.  The SEC found inadequate the firm’s disclosure that it received 12b-1 fees because the firm failed to provide “full and fair disclosure that is sufficiently specific so that [the clients] could understand the conflicts of interest… and could have an informed basis on which they could consent or reject the conflicts.”  The respondent failed to self-report to the SEC pursuant to the Share Class Disclosure Initiative, which could have avoided penalties.  The SEC also charges the firm, whose principal serves as Chief Compliance Officer, with failing to implement reasonable compliance policies and procedures.

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. 

Advisers Steered Clients to Private Funds that Shared a Portion of the GP Carried Interest

 

The SEC has commenced enforcement proceedings against an adviser and its principals accused of recommending private funds for which they received revenue sharing without disclosure.  The SEC asserts that the respondents received upfront and ongoing asset-based compensation from the fund managers in the form of trailers and a percentage of the GP’s carried interest.  The client/investors were shuttled into feeder funds and/or separate share classes that offered lower returns to compensate the respondents.  The SEC charges that the adviser failed to properly disclose these conflicts of interest even after warned by OCIE examiners.  One of the principals served as CCO but failed implement or test procedures and failed to disclose the revenue sharing arrangements to an outside compliance consultant he retained.

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. 

SEC Staff Suggests that Advisers Should Rebate Revenue Sharing

 

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. 

Seventeen Additional Advisers Charged with Recommending Higher Cost Fund Share Classes

 

The SEC ordered the payment of over $125 Million in disgorgement and interest against 79 investment advisers who self-reported that they recommended share classes that paid back 12b-1 fees when lower-cost share classes were available.  Combined with the group of settlements back in March, the SEC has brought 95 total cases and ordered over $135 million returned to investors pursuant to its Share Class Selection Disclosure Initiative.  The largest restitution order of the most recent 16 cases exceeded $2.9 Million.  The SEC also settled an action against a firm that did not self-report, resulting in a $300,000 fine in addition to ordering over $900,000 in restitution.  The cases allege that the firms did not sufficiently disclose the conflict of interest arising by recommending a share class that paid back revenue sharing to the adviser, its affiliates, or their personnel.

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. 

SEC Fines Adviser for Paying Solicitors without Full Disclosure

 

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.

We had predicted that the SEC would bring cases alleging violations of the solicitation rule.  The rule is intended to fully disclose the potential conflict of interest when a trusted adviser refers the client to an adviser that has provided a financial incentive.   A solicitor need not be registered as an adviser under state or federal law to come within the rule. 

SEC Faults Adviser Platform for Failing to Promote Funds that Did Not Share Revenue

The SEC has sued a large RIA platform for failing to fully disclose that it had a material conflict of interest because it received revenue sharing from certain funds.  The SEC alleges that the defendant received ongoing revenue sharing through its clearing firm on certain funds and share classes.  Although the firm disclosed that it received revenue sharing and might have a conflict, it did not fully disclose that it actually received millions of dollars in revenue sharing and that lower cost funds and share classes were often available.  The SEC asserts that the firm should have described the incentive it received to select funds and classes that benefited the firm to the detriment of its clients.

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? 

Trailer Fees Required Adviser to Register as Broker-Dealer

 The SEC fined an investment adviser and its two principals for failing to disclose compensation received for recommending a third-party investment fund and for not registering as a broker-dealer.  The adviser received a 1.25% up-front payment and trailing fee from the manager of a private fund that the respondents recommended.  The adviser did disclose that it would receive compensation but did not disclose the conflict of interest resulting because the fees received exceeded its customary 1.00% asset management fee, thereby creating a financial incentive to recommend the fund.  Because the compensation was transaction-based, the respondent was required to register as a broker-dealer, and the principals needed to obtain their relevant securities licenses.

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.

Large Bank Lied about Hedge Fund Due Diligence Process

The 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.  

Dual Registrant Lied Twice to Clients about Share Class Practices

A dually registered RIA/BD and two of its principals agreed to pay nearly $1.7 Million in disgorgement, interest and fines for recommending mutual fund share classes that paid back 12b-1 revenue sharing when lower cost shares were available.  The SEC faults the firm for failing to disclose that lower share classes were available, and that the firm and its reps made the recommendations to increase revenue rather than consider the best interests of the clients.  The SEC also criticizes the firm for neglecting to disclose that it avoided clearing broker ticket charges by recommending higher fee share classes.  After an SEC exam uncovered the wrongdoing, the firm embarked on a campaign to convert clients to lower-fee share classes, but, according to the SEC, many reps lied about the prior availability of lower-fee classes in a scheme to convince clients to pay higher advisory fees. 

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.