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Federal Court Says that Outside Advice is Not a “Get-Out-of-Jail-Free Card”

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.

Adviser Failed to Disclose Personal Financial Problems

A state registered adviser was barred from the industry for failing to disclose a personal bankruptcy on Form ADV in addition to other charges. The Colorado Securities Commissioner cited a Form ADV that contained material omissions about the respondent’s 2017 personal bankruptcy and otherwise misrepresented his qualifications. The CSC also charged the respondent with overcharging clients and intentionally concealing the misconduct. The SEC also barred the adviser from the industry.

Form ADV, Item 18.B. specifically requires investment advisers to “disclose any financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.” Item 18.C. also requires the disclosure of any bankruptcy petition during the prior 10 years. As investment advisers struggle financially, compli-pros should assess whether the firm needs to enhance its financial condition disclosure.

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.

RIA Platform Will Pay $1.1 Million to Settle Fund Share Class Charges

An RIA platform was ordered to pay over $1.1 Million in penalties and disgorgement for recommending mutual fund share classes that charged 12b-1 fees when lower share classes of the same funds were available.  Although the firm disclosed that advisers could receive 12b-1 fees from the sale of mutual funds, the SEC faults the firm for failing to disclose that the advisers had a conflict of interest because they could recommend lower-fee share classes that did not pay revenue sharing.  The SEC also charged the firm with failing to implement its policies and procedures and with neglecting to ensure best execution.  An SEC Enforcement official warned, “Advisers must be vigilant in disclosing all conflicts of interest arising from compensation received based on investment decisions made for clients” and that the Enforcement Division is “continuing [its] efforts to stop these violations and return money to harmed as quickly as possible.”

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. 

SEC Proposes Summary Prospectus for Variable Products

The SEC has proposed allowing a summary prospectus for the sale of variable annuity and variable life insurance products.  The summary prospectus would include an overview of the insurance contract, fees, and risks.  An issuer could also deliver an updating summary prospectus for existing investors, which summary would disclose any material changes during the prior year.  The summary prospectus regime would mirror the summary prospectus adopted in 2009 for open end funds.  An issuer would make the full prospectus and information about underlying investments available online.  The comment period runs until February 15, 2019.

FINRA has consistently prioritized the regulation and disclosure of variable products and has issued multiple rules and notices to members about sales practices.  While we agree that the SEC should allow summary prospectuses, we are not sure whether this will materially improve investor knowledge or reduce sales practice abuses.

RIA Platform Failed to Disclose Mutual Fund Revenue Sharing

 

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.

Private Fund Manager Did Not Provide Notice or Obtain Consent for Principal and Agency Cross-Trades

 A private fund manager agreed to pay a $500,000 fine for failing to disclose, and obtain consent for, transactions for which it acted as a broker and principal.  The SEC maintains that the fund manager received compensation for two transactions whereby one advisory client purchased assets from another client.  The SEC also asserts that the fund manager engaged in a principal transaction when it caused a subsidiary to purchase assets from one client and then subsequently sell them to another client.  The SEC charges the firm with violating Section 206(3) of the Advisers Act for failing to provide written disclosure and obtain consent for the transactions.

OUR TAKE: Moving assets around among client funds may have been common practice before Dodd-Frank required private fund managers to register.  However, Section 206(3) specifically limits such transactions by requiring notice and consent.

Large Asset Manager Pays $97 Million for Over-Relying on Faulty Quant Models

 A large asset manager agreed to pay over $97 Million in disgorgement, fines and interest for over-relying and marketing faulty quantitative models and other portfolio management missteps.  The SEC maintains that the respondents rolled out registered funds and separate accounts based on un-tested quantitative models created by an inexperienced research analysist.  When the models failed to work as described to the Board and investors, the respondents discontinued their use without explanation or disclosure.  The SEC also accuses the firm of declaring dividends without proper disclosure of the percentage attributable to return of capital and for using third party performance data without verification.  The SEC charges violations of the anti-fraud rules, the compliance rule, and Section 15(c) of the Investment Company Act for lying to the funds’ Board.

OUR TAKE: This case reads like a cautionary tale for large firms trying to quickly roll out a product.  It appears that the portfolio management, marketing, legal, operations, and legal functions worked in silos, and, as a result, failed to properly vet or describe the products.  We recommend that firms create a cross-functional product assessment team that can ask the hard questions before launching a product.

Private Equity Exec Barred from Industry for Personal Transaction with Portfolio Company

 A private equity firm’s managing partner, who also served as its Chief Compliance Officer, was barred from the industry and fined for failing to disclose his personal interest in a portfolio company.  The SEC alleges that the respondent caused the fund to make a loan to the portfolio company on the condition that the company used a portion of the proceeds to redeem his investment.  The SEC faults the executive for failing to disclose the transaction or to obtain consent to it from the limited partnership committee.  Neither the fund nor the investors lost money because the portfolio company ultimately sold the notes to an unaffiliated third party.

OUR TAKE: Without proper disclosure and consent, a transaction that benefits the fund sponsor or its principals will violate the Advisers Act’s fiduciary duty whether or not the investors suffered any harm.  This case also highlights the perils of the CCO dual-hat model whereby a senior executive with a pecuniary interest also serves as the Chief Compliance Officer, thereby avoiding independent scrutiny.

 

Adviser Withheld Prepaid Fees and Concealed Deteriorating Financial Condition

The SEC fined an adviser and its principal for failing to timely refund prepared advisory fees to terminating clients and for neglecting to disclose its failing financial condition.  When two of the firm’s financial advisers left the firm and forwarded 63 client termination letters, the respondent declined to refund fees paid at the beginning of the quarter, claiming that it would not accept electronic signatures, notwithstanding the firm’s written policies.  The SEC also asserts that the firm suffered from chronic cash shortages late in every quarter because it received its fees at the start of the quarter.  The SEC faults the firm for failing to disclose its deteriorating financial condition including its default on several loans and its negative net worth and insolvency.  Item 18.B. of Form ADV requires discretionary advisers to “disclose any financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.”

OUR TAKE: As economic circumstances change, advisers should consider whether they need to make Item 18 disclosure, especially if creditors declare a default on outstanding loans.  Unlawfully withholding client funds turns financial problems into regulatory actions.