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Dual Registrant Failed to Convert Inactive Fee-Based Accounts to Brokerage


A large dual registrant agreed to pay over $15 Million in fines, disgorgement and penalties for failing to convert inactive fee-based advisory accounts into traditional brokerage accounts.  The firm had policies requiring its financial advisers to conduct ongoing suitability reviews and flag those accounts without significant trading activity during the prior 12 months.  According to the SEC, the FAs, without an imposed deadline, failed to respond to requests from the Compliance Department to complete the reviews.  As a result, over a 5-year period, the firm failed to properly review nearly 8,000 accounts.  Once the SEC began an investigation, the firm converted 1700 accounts to brokerage and closed an additional 2000 accounts.  The SEC faults the firm for failing to have specific escalation procedures when they failed to respond to compliance inquiries and for neglecting to impose deadlines.  The SEC also charged the firm with unsuitable UIT recommendations.

Dual registrants (and parent companies of dual registrants) have this unique suitability compliance obligation that overrides the specific compliance programs for the investment adviser and its broker-dealer affiliate. The firm must determine which product line – fee-based account or traditional brokerage – is suitable and then continuously monitor the accounts to avoid either churning or, as in this case, reverse churning (i.e. inactive fee-based accounts).   Many industry observers used to think that fee-based accounts would displace bad brokers who churned accounts.  We have now come full circle as the regulator targets reverse churning.

REIT Manager Overpaid Itself When Calculating Incentive Fee

 A large REIT manager, together with its CEO and CFO, agreed to pay over $60 Million in disgorgement, interest and penalties for inflating incentive fees and taking reimbursement for significant expenses.  The SEC asserted that the defendants, contrary to disclosures and agreements, used their insider positions to calculate incentive fees in a manner that unjustly enriched themselves over the investors to whom they owed a fiduciary duty.  The SEC also charged the defendants with collecting millions in expense reimbursements as part of various merger transactions.  The SEC accused the defendants of securities fraud and falsifying books and records.

Firms should use some third party (e.g. fund administrator, LPA committee) to calculate, or at least confirm calculations, of fees collected from clients.  When management can exercise arithmetic discretion to pay itself, regulators will scrutinize the calculations.      

Advisory Clients Did Not Receive Promised Fee Breaks


A registered investment adviser agreed to pay $354,000 in client reimbursements and penalties for failing to give clients the benefit of promised fee breakpoints over an 8-year period.  The adviser marketed a fee schedule that offered lower fees as assets increased and offered clients lower fees for aggregated household accounts.  According to the SEC, the respondent failed to apply the lower fees as clients reached the breakpoints or to aggregate household accounts for certain clients.  The SEC maintains that the firm overcharged 293 clients an aggregate of $304,000, which the firm voluntarily refunded following the commencement of the enforcement investigation.  In addition to alleging violations of the Advisers Act’s antifraud provisions, the SEC also faults the firm for failing to implement reasonable compliance policies and procedures.

Some very elementary supervision, operations and compliance infrastructure could have avoided the overcharging and the resulting enforcement action.  Emerging firms looking to squeeze out some profits should not skimp on the basic must-haves of running a proper firm. 

Unusual VC Structure and Excessive Fees Result in Industry Bar

The principal of a venture capital firm, registered as an exempt reporting adviser, was barred from the industry for taking fees that exceeded the amounts permitted by the operating agreements.  The VC firm imposed a front-loaded fee structure whereby investors paid fees on committed capital in early years to approximate the amount they would pay over the possible 10-year life of the funds.  The first fund charged an upfront management fee of 17.75% of invested capital, although later structures deferred some of the fees.  The SEC asserts that the defendants collected more than $7 Million in unauthorized fees while commingling funds and entering into conflicted transactions.

Imposing an unusual fee structure raises a red flag for regulators.  Skeptical examiners will spend significant time and resources to understand the fees and ensure they are properly calculated and collected. 

SEC Warns Advisers about Fee and Expense Practices

The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert detailing investment adviser failures to properly calculate and disclose fees and expenses.  OCIE cites failures to properly value assets, thereby leading to overbilling, using the incorrect fee rate, and billing based on the wrong time period.  OCIE also details faulty disclosure practices including Form ADVs that do not reflect actual billing practices and failures to fully disclose compensation arrangements.  OCIE also highlights fund sponsors that misallocate expenses.  The OCIE findings result from issues identified in deficiency letters issued in recent SEC exams.  The Risk Alert advises that firms take action by reimbursing clients and enhancing policies and procedures.

OUR TAKE: These Risk Alerts often precede enforcement actions.  Compli-pros should review their fee billing and disclosure practices in anticipation of an OCIE sweep.


Large BD/IA Pays $2.2 Million for Recommending Wrong Mutual Fund Share Class

A large BD/IA agreed to pay $2.2 Million in remediation, interest and penalties for failing to recommend the lowest mutual fund share class available to retirement plan customers. Instead of recommending load-waived “A” shares, the respondent recommended other higher-cost share classes that resulted in compensation paid to the BD/IA.  The SEC faults the firm for failing to have adequate systems and controls in place to ensure that retirement clients benefitted from available discounts.   The SEC also asserts that the BD/IA omitted necessary disclosures about revenue sharing and the impact on overall investment returns.  An SEC Enforcement official warned that “these types of actions remains a priority for the Division” as evidenced by its recently-announced Share Class Selection Disclosure Initiative.

OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled.  Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.


Adviser Charged with Defrauding Professional Athlete

The SEC has commenced enforcement proceedings against an adviser that it alleges lied to his professional athlete client about management fees.  The SEC asserts that the adviser told representatives of the client that the client paid between .15% and .20% of assets in management fees when the client actually paid 1.00%, resulting in significant payments to the adviser who received 60% of the revenue earned by his firm.  According to the SEC, the adviser misled the client and his representatives by using false account statements, forged documents, an impostor acting as a Schwab representative, and multiple misrepresentations in emails and meetings.    The client’s representatives ultimately contacted Schwab, who then informed his employer.  The adviser tried to convince the client to lie on his behalf to protect his job, although the client refused.

OUR TAKE: This type of case shows the problem with assuming that wealthy people are financially sophisticated.  Many wealthy people earn their income in fields (e.g. sports, medicine, technology) that would not necessarily make them qualified to make investment decisions.  Instead, these successful professionals rely on advisers who are supposed to act as fiduciaries and protect their clients’ interests.


Mutual Fund Manager Fined and Barred from Industry for Investment, Disclosure, and Fee Violations

A fund manager was barred from the industry and ordered to pay $550,000 for multiple breaches of fiduciary duty including failure to observe the fund’s investment limitations.  According to the SEC, the respondent did not comply with the fund’s investment concentration policies, including the fund’s status as “diversified,” as described in the Registration Statement and as disclosed to the fund’s Board of Directors.   The SEC also accuses the respondent, the sole proprietor of the fund manager, with double-charging separate account clients invested in the fund.  Additionally, the SEC charges that the respondent cherry-picked trades for his personal benefit to the detriment of clients.  The SEC cites violations of the anti-fraud provisions of the Exchange Act, the Advisers Act, and the Investment Company Act.

OUR TAKE: Registered funds are highly-regulated investment vehicles that require strict adherence to the Investment Company Act, SEC rules, the Registration Statement, and the Board of Directors.  Advisers have much less flexibility with respect to disclosure and fees than separate accounts or private funds.


Wrap Sponsor Pays $97 Million for Inadequate Due Diligence

A large bank agreed to pay $97 Million, including a $30 Million fine, for compliance failures in its wrap programs.  The bank represented in marketing materials and Form ADV that it performed significant initial and ongoing manager due diligence.  However, according to the SEC, during a 5-year period from 2010 to 2015 (when it sold its wrap business), the respondent failed to perform such due diligence on several programs and managers because of a lack of internal resources and miscommunications between functions, even though the bank continued to charge significant account level fees to provide such services.  The respondent was also charged with overbilling clients as well as using more expensive mutual fund share classes when lower-fee classes were available.  As part of the settlement, the bank agreed to pay $3.5 Million in customer remediation and $49.7 Million in fee disgorgement in addition to interest and the fine.

OUR TAKE:  Over the last 2 years, the SEC has warned about wrap programs and has brought several cases against wrap sponsors alleging a number of violations: trading away, reverse churning, revenue sharing, mutual fund share classes.  In this case, the SEC adds a requirement that the fees charged must be commensurate with the due diligence services provided.  This analysis appears borrowed from mutual funds where Boards must ensure the reasonability of fees charged.  We recommend that compli-pros perform an internal sweep of wrap practices before the SEC shows up at the front door.


Private Equity GP Barred and Fined for Charging Undisclosed Fees

A private equity manager was barred from the industry and agreed to pay a $1.25 Million fine for taking £16.25 Million in unauthorized fees.  The respondents also agreed to reimburse the funds over $24 Million.  According to the SEC, the respondent, in its capacity as GP, invoiced the funds for real estate workout fees pursuant to an oral agreement it made with an affiliate.  The SEC asserts that the respondents needed additional cash because the financial crisis reduced their fees and increased their workload and expenses, but the LP advisory committee refused.  The SEC asserts that the purported agreement with the affiliate was never disclosed to the LPs or the auditors.  When the LPs objected to the additional fees, the respondent sued the limited partners but ultimately agreed to reimburse the funds after the SEC’s investigation commenced.

OUR TAKE: Way back when (before Dodd-Frank?), a GP may have had unfettered power to engage in conflicts of interest and assess undisclosed fees.   As a fiduciary under the Advisers Act, private equity GPs must seek approval for additional fees and fully disclose all potential conflicts.  Otherwise, they won’t be a GP for long.