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.
The SEC fined an investment adviser and its two principals, including its dual-hatted Chief Compliance Officer, for failing to disclose the principals’ financial interest in a recommended investment. The two principals provided consulting services to a public company that they recommended to clients for investment. The principals received common stock in the company as compensation and also bought stock directly. The SEC alleges that neither the firm nor its principals disclosed their financial interests to clients who collectively owned 8.7% of the company. The SEC also accuses the principals with misleading an outside compliance consultant by failing to respond to requests for information about any business in which the principals had a financial interest.
This case shows the importance of hiring a full-time, independent Chief Compliance Officer who can dispassionately review firm and principal transactions and implement necessary procedures and disclosures. The dual-hat model, where a firm principal or executive officer half-heartedly owns compliance, does not work in today’s regulatory environment where the SEC and institutional clients demand an independent and experienced compliance officer
A fund sponsor agreed to pay over $32.5 Million in disgorgement and penalties because its tax planning strategy harmed the funds it managed. In 2005, the fund manager caused the underlying funds to convert to partnerships in order to benefit from certain deductions. However, the deductions required the unwinding of securities lending transactions that benefited the funds. The SEC asserts that the fund sponsor did not disclose this conflict of interest to the Board or the shareholders. The firm failed to resolve the internal dispute between the tax department and the securities lending group, until (10 years later) the securities lending group informed the Chief Compliance Officer, who prompted an internal investigation. The SEC also faults the firm for not reimbursing the funds for certain foreign taxes paid as a result of the conversion to a partnership. The SEC gave credit, which resulted in a lower fine, to the CCO and the firm for initiating the internal investigation and the self-reporting.
It’s never a good idea to keep Compliance in the dark about internal conflicts of interest. The Chief Compliance Officer is in the best position to protect the long-term interests of the firm and clients.
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.
An investment adviser and its principal agreed to pay over $1.3 Million in disgorgement, interest and penalties for misleading clients about the adviser’s relationship with a lender. Following the action, the adviser was sold to another adviser, and the principal was barred from the industry. According to the SEC, the adviser, through the principal, advised clients to invest in the lender’s promissory notes without telling them that the loan’s repayment terms depended on the amount invested. The adviser characterized its relationship with the lender as a “strategic affiliation.” The SEC also maintains that the principal misled a client into investing in the adviser for the purpose of acquiring other advisers but the client’s investment was instead used to pay the principal’s personal expenses. The scheme was uncovered following the SEC’s action against the lender for fraudulent securities sales.
Don’t engage in direct transactions with your clients. We do not believe any amount of disclosure could adequately mitigate such a significant conflict of interest and resulting breach of fiduciary duty.
The SEC charged an investment adviser’s principal, who also served as the firm’s Chief Compliance Officer, with multiple compliance violations. The SEC charges the respondent with (i) overcharging his client, (ii) overstating his assets under management, (iii) failing to disclose two client lawsuits, (iv) misrepresenting the reason he switched custodians, and (v) neglecting to maintain required books and records. The SEC also alleges that the principal aided and abetted violations of the compliance rule (206(4)-7) by purchasing a template compliance manual, omitting required policies and procedures, and failing to implement required procedures. The firm ultimately ceased operations, and the respondent agreed to pay over $500,000 in fines, disgorgement and interest.
The dual hat CCO model (i.e. a senior executive also serving as the Chief Compliance Officer) doesn’t work. The dual-hat CCO usually does not have the time, expertise, or interest to do the job properly. Also, a CCO must have enough independence from the business to properly enforce the applicable regulatory and compliance obligations.
The United States Court of Appeals for the D.C. Circuit upheld the SEC’s decision that an investment adviser failed to fully disclose mutual fund revenue sharing even if it sought and relied on the advice of outside compliance consultants. The Court found that the adviser acted negligently by failing to fully disclose the conflict of interest inherent by receiving shareholder servicing payments for investing in certain funds offered by its broker/custodian. Although the record was unclear about whether the adviser sought or relied on an outside compliance consultant’s advice, the Court decided that it didn’t matter because “any reliance on such advice was objectively unreasonable because [the adviser] knew of their fiduciary duty to fully and fairly disclose the potential conflict of interest.” The Court did, however, throw out the SEC’s claim that the adviser intentionally filed a misleading Form ADV, because the SEC failed to show that the adviser acted with the requisite intent to deceive.
As we have previously reported, this case argues in favor of seeking outside advice because it will help defend against the claim that you acted with intent, which would draw more punitive penalties. However, the Court here makes clear that relying on outside advice, even though you (should) know otherwise, will not exonerate you from claims that you acted negligently.
A bank-affiliated adviser agreed to reimburse clients over $600,000 and pay an additional $100,000 fine for failing to disclose that it had an incentive to recommend an affiliated wrap program. The affiliated wrap program paid a 2% up-front incentive to the adviser if its investment counselor recommended the program. If the client withdrew from the program within two years, the client would pay a termination fee. Approximately 78% of client assets were directed to the affiliate program even though two other third-party wrap programs were available. The SEC faults the firm’s disclosures for failing to fully describe the financial incentive to recommend the affiliate program and that the investment counsellor would retain the up-front incentive fee even if the client terminated. Although the adviser was state (not SEC) registered, the SEC maintains that the respondent violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction that operates as a fraud on any client or potential client.
OUR TAKE: Recommending proprietary products over third party products requires enhanced due diligence and disclosure because of the inherent conflicts of interest. When the adviser recommends proprietary products that benefit the adviser to the direct detriment of the client, the arrangement will draw heightened scrutiny and will often result in an enforcement action.
The SEC censured and fined a private equity manager for lowballing the price offered to liquidate limited partnership interests. The SEC asserts that the private equity manager, through its principal, offered to purchase remaining limited partnership interests at the December 2014 valuation. The SEC faults the firm for failing to revise the price or fully disclose that it had received financial information indicating that the NAV had increased during the first quarter of 2015. The SEC opines that the offer letter, termed “as an accommodation,” made it appear that the limited partners would receive full value for their interests. The SEC charges violations of Rule 206(4)-8, the Advisers Act’s antifraud rule.
OUR TAKE: We generally advise against principal transactions with clients/investors/LPs. Purchasing private interests directly from a client is so rife with conflicts that no amount of disclosure may be sufficient.
A large investment adviser affiliated with a global bank agreed to pay $8.9 Million in disgorgement, fines and interest for allowing affiliated investment banking relationships to influence the selection of a portfolio manager recommended to retail clients. The adviser’s due diligence team had recommended the termination of a third party money manager because of personnel changes. According to the SEC, senior executives, seeking an investment banking mandate with the third party, lobbied and influenced the due diligence group to delay the termination until after the awarding of the mandate. The SEC faults the respondent for allowing this conflict of interest to influence its fiduciary obligations to recommend investment products in the best interest of its retail clients.
OUR TAKE: Compli-pros face an enormous challenges in large, global institutions to ferret out multi-lateral business relationships and ensure that the firm adequately observes its fiduciary obligations.