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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.  

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. 

Deficient Compliance Will Cost RIA/BD $600,000; CCO Must Undergo Training

 A dually registered RIA/BD agreed to pay approximately $600,000 in disgorgement, penalties and interest because a deficient compliance infrastructure failed to ensure full disclosure of revenue sharing.  According to the SEC, the respondent engaged in a scheme since 1999 whereby its clearing broker would kick back a $20 markup fee on trades.  The clearing broker also paid trailer fees on NTF mutual funds.  The SEC alleges that the firm failed to properly disclose the revenue sharing and, in many cases, reps who didn’t know better told clients that the firm did not receive compensation from the clearing broker.  The SEC charges that the firm did not have adequate compliance policies and procedures and ordered the Chief Compliance Officer, the firm’s former receptionist, to complete 30 hours of compliance training.  The firm also agreed to hire an independent compliance consultant.

“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements.  The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest.  Perhaps, the firm never considered that its longstanding practice violated the securities laws.  This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm. 

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.

Adviser Failed to Disclose Kickbacks from Vendors

The SEC fined an investment adviser $8 Million for failing to disclose compensation received from vendors it recommended to clients.  The respondent and its investment adviser representatives routinely counselled clients with UK pension benefits to transfer those assets to offshore vehicles operated by third party custodians and trustees.  The SEC alleges that the adviser did not disclose that the third parties paid a portion of their fees back to the adviser and its IARs based on the business recommended.  The SEC faults the firm for inadequate disclosure and a compliance program that failed to address this inherent conflict of interest.

OUR TAKE: The best solution for avoiding compensation conflicts is to include all compensation in the disclosed management fee and avoid any payola from third parties.  Receiving payments from third parties raises such a significant conflict of interest that the SEC may not be satisfied with mere disclosure, no matter how fulsome.

 

Three Advisers Tagged for Recommending Higher-Cost Fund Share Classes

Three investment advisory firms will pay nearly $15 Million in fines and disgorgement for recommending more expensive mutual fund share classes that paid revenue sharing.  The SEC faults the firms for failing to fully disclose that recommending higher-fee fund share classes in exchange for revenue sharing presented a conflict of interest.  The SEC also alleges that recommending the higher-fee classes violated the firms’ best execution obligations.  An SEC official “strongly encourage[s]” eligible firms to participate in the recently announced Share Class Disclosure Initiative amnesty program.

OUR TAKE: Given the number of cases in this area, it may be that, as a practical matter, an adviser can never include enough disclosure that would justify recommending anything other than the cheapest share class available.  We recommend that compli-pros conduct an internal sweep of their firms’ mutual fund recommendation practices.

http://www.sec.gov/litigation/admin/2018/34-83004.pdf

http://www.sec.gov/litigation/admin/2018/ia-4876.pdf

http://www.sec.gov/litigation/admin/2018/34-83003.pdf

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.

 

RIA/BD Failed to Disclose Mark-Ups and 12b-1 Fees

The SEC has commenced enforcement proceedings against a dually registered adviser/broker-dealer and its CEO/CCO principal for taking undisclosed commissions and 12b-1 fees on discretionary accounts.  The SEC’s complaint avers that the respondent sold inventory securities, acquired at a discount as part of the selling syndicate, to clients at a mark-up.  The SEC alleges that the firm never obtained the required informed consent.  The SEC also charges the firm for taking mutual fund 12b-1 fees without telling clients.

OUR TAKE:  A principal transaction with a client requires an adviser fiduciary to obtain specific client consent following disclosure of all relevant information.  The SEC continues its crackdown on any form of revenue sharing received by advisers with respect to their fiduciary clients.