The dually-registered IA/BD affiliate of a large investment bank agreed to reimburse clients over $12 Million and agreed to pay a $1.5 Million fine because its advertised system failed to recommend the most economical fund share classes. The respondent marketed an automated mutual fund share class selection system that purported to pick the least expensive share classes for certain retirement plan and charitable organization customers. The SEC asserts that the system had programming and design flaws and that the respondent failed to adequately test and validate whether the system worked as advertised. Over the course of a 7-year period, the respondent overcharged over 18,000 clients.
Automated compliance systems are helpful, but they are not a cure-all. Like any tool, a compliance technology is only as good as the people using it. Bad inputs cause bad outputs. Also, firms can’t just “set it and forget it,” hoping that the system works.
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?
The IA/BD subsidiary of a large bank agreed to pay almost $1.3 Million in disgorgement and a $1.1 Million fine for putting wrap fee clients in funds that paid a 12b-1 fee back to the selling reps. The SEC faults the firm for failing to recommend that clients move assets into lower-fee share classes as those classes became available over time. Although the firm disclosed that it may receive 12b-1 fees, it did not disclose that it actually received those fees and that lower classes were available. The SEC noted that the IA/BD made changes to qualified accounts but failed to implement similar changes to non-qualified accounts. In addition to best execution, fiduciary, and disclosure violations, the SEC criticized the firm’s compliance program because the respondent failed to update its compliance policies and procedures as institutional share classes became available.
OUR TAKE: A compliance program is not a static exercise that you can set and forget. As the markets and the business changes, firms must continuously review policies and procedures to determine if they still make sense given new realities. In this case, the wider availability of institutional share classes necessitated changes to the firm’s compliance practices.