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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.


Prepaid Advisory Fees and Revenue Sharing Cost RIA/BD over $3 Million

The SEC imposed a $3 Million civil monetary penalty on a dually registered RIA/BD for retaining prepaid advisory fees, collecting revenue sharing payments from fund companies, and failing to invest in the lowest-cost share classes available.  The respondent billed clients at the beginning of each quarter, but the SEC charges that the adviser’s services – portfolio management, trade execution, performance reporting and account servicing – occurred during the quarter.  Therefore, the SEC maintains that the respondent unlawfully retained the prepaid advisory fees when clients terminated before the conclusion of a quarter.  The SEC also charges the firm for failing (i) to fully disclose conflicts of interest when receiving revenue sharing and marketing support payments from fund companies and (ii) to utilize the lowest share classes available.  The SEC cites violations of the Adviser’s Act’s antifraud provision (206(2)) and the compliance rule (206(4)-7).

OUR TAKE: Charging advisory fees at the beginning of a period drops you into choppy regulatory waters.  As the SEC asserts here, how does a firm justify this practice when it has not yet performed services?  This practice comes under more scrutiny when a firm fails to refund the fees to terminating clients, thereby creating a financial penalty for clients to sever a relationship.