The SEC recently took enforcement actions against three Registered Investment Advisers (RIAs) that breached their fiduciary duty to advisory clients. In particular, the SEC took disciplinary action against RIAs over issues related to 12b-1 fees, revenue sharing arrangements and wrap fee programs.
The SEC found that one of the firms failed to report compensation from 12b-1 fees and revenue sharing. The firm agreed to a $2.4 million settlement. The two other RIAs avoided paying transaction fees in wrap accounts by recommending 12b-1 paying mutual fund share classes and were fined approximately $390,000 and $900,000. In all cases, the firms failed to adopt and implement written compliance policies and procedures to prevent violations of the Investment Advisers Act. SmartRIA helps your company avoid those issues – and the steep fines – by helping compliance officers track accounts and fees, as well as easily update compliance policies and procedures.
12b-1 fees and revenue sharing problems continue to plague RIAs
So-called “12b-1 fees” are fees paid out of mutual fund assets to cover the costs of advertising, marketing, and distribution, and sometimes to cover the costs of providing shareholder services.12b-1 fees get their name from the SEC rule that authorizes a fund to charge them.
When an investment adviser receives 12b-1 fees or revenue sharing in connection with investments they recommend, a significant conflict of interest arises. In that situation, an adviser has a financial incentive to recommend that a client invest in share classes paying 12b-1 fees or that will generate revenue sharing payments. The compensation paid can be directly or indirectly to the adviser.
The conflict of interest is more pronounced when multiple share classes of the same fund are available to the client, and each provides different compensation to the adviser. Generally, the only difference between the share classes is the cost to the client and the benefits to the adviser.
On Sept. 13 the SEC settled an enforcement action against a dually-registered investment adviser and broker-dealer that breached its fiduciary duty by failing to disclose two types of compensation it received based on advisory clients’ investments. The firm received fees derived from clients’ investments in certain mutual fund shares, including 12b-1 fees and revenue sharing payments from an unaffiliated clearing broker. The firm received compensation based on the sweeping of advisory clients’ uninvested cash into certain money market funds.
The RIA did not provide full and fair disclosure of these fees and revenue sharing payments and the related conflicts of interest. With regard to the 12b-1 fees, the RIA did not self-report even though it was eligible to do so pursuant to the Division of Enforcement’s Share Class Selection Disclosure Initiative in 2018.
The RIA also breached its duty to seek best execution by causing advisory clients to invest in more expensive share classes of mutual funds or share classes of cash sweep money market funds. Certain cash sweep money market funds offered more favorable revenue sharing terms to RIAs. In addition, although the RIA determined that certain money market funds were appropriate cash sweep vehicles for its advisory clients, the firm failed to consider alternative funds with similar strategies that were offered by the clearing broker and featured lower costs and higher yields. For five years, the RIA did not disclose in its Forms ADV or other documents that it received revenue sharing payments from the clearing broker on clients’ sweep account money market investments. Furthermore, more than 85 percent of the RIA’s clients had their uninvested cash directed to money market funds that paid revenue sharing.
The enforcement action also alleged that the RIA failed to adopt and implement written compliance policies and procedures that were reasonably designed to prevent violations of the Investment Advisers Act and the rules thereunder. The firm’s policies and procedures were inadequate regarding mutual fund and cash sweep money market fund selection practices and its disclosure of the associated conflicts of interest.
The firm was ordered to pay disgorgement, prejudgment interest, and a civil penalty totaling $2,471,667.
Wrap fee programs are also on the SEC’s radar
On Sept. 8 the SEC resolved an enforcement action against an RIA that engaged in undisclosed investment selection practices that frequently placed their clients in higher-cost mutual funds. The RIA did not fully disclose the conflicts of interest associated with these investment selection practices. In addition, the firm inaccurately described the manner in which the RIA calculated advisory fees for certain clients who maintained multiple accounts.
The RIA provided advisory services to clients through a wrap fee arrangement. Pursuant to the wrap fee arrangement, the RIA was responsible for client trading costs, including transaction fees on mutual fund investments. The SEC’s complaint alleged that the RIA avoided paying transaction fees the firm would have been required to pay by recommending mutual fund share classes for advisory clients that charged 12b-1 fees. Although the RIA did not receive compensation by placing clients in these higher-cost share classes, the firm’s selection of them allowed it to avoid transaction costs.
The RIA did not adequately disclose this conflict of interest and breached its duty to seek best execution for these transactions, because it invested clients’ money in higher-cost mutual fund share classes when other share classes offered more favorable terms. In addition, the RIA inaccurately disclosed that it aggregated the assets of certain clients who maintained multiple accounts at the firm to determine advisory fees. Those clients agreed to pay the RIA a tiered advisory fee with a rate that declined as the value of their assets increased. In fact, the RIA never aggregated client accounts, and clients were overcharged.
The RIA also failed to adopt and implement written compliance policies and procedures that were reasonably designed to prevent violations of the Investment Advisers Act and its rules. The firm’s policies and procedures were deficient as to the RIA’s mutual fund share class selection practices and its advisory fee calculations.
The SEC ordered the firm to pay disgorgement of $343,203.04. as well as prejudgment interest of $46,900.94.
In another recent enforcement action, the SEC brought a complaint alleging a breach of fiduciary duty by an RIA related to its mutual fund share class selection practices, as well as the excess fees paid by advisory clients participating in its wrap fee program.
The RIA was responsible for paying transaction fees for clients participating in its wrap fee program. To avoid paying those transaction fees, the RIA recommended, or held for certain advisory clients, mutual fund share classes that charged 12b-1 fees. Clients could have invested in lower-cost share classes of the same funds. Because of these recommendations, advisory clients paid excess fees on their investments. The RIA, however, avoided paying transaction fees for trades placed in those clients’ accounts.
The RIA did not adequately disclose this practice or the related conflict of interest in its Forms ADV or other documents. The RIA also breached its duty to seek best execution by causing certain advisory clients to purchase mutual fund share classes that charged 12b-1 fees instead of ones that were a better value. Not surprisingly, the SEC determined that the RIA failed to adopt and implement written compliance policies and procedures that were reasonably designed to prevent violations of the Investment Advisers Act and the rules.
The RIA paid a steep price for its compliance mistakes. The SEC ordered the firm to pay disgorgement of $779,416 and prejudgment interest of $123,084. The case is available here.
These enforcement actions send a loud and clear warning to RIAs that may not be fulfilling their fiduciary obligations in these areas. Despite COVID 19, SEC examinations are still occurring at a brisk pace. In his testimony before the United States Senate Committee on Banking, Housing, and Urban Affairs on September 14, 2021, SEC Chair, Gary Gensler, testified that the Division of Examinations is again on track to complete approximately 3,000 exams. Although not all of these examinations involve RIAs, investment advisory firms must ensure that their compliance programs meet the expectations of examiners.
Aside from these enforcement actions, on July 21, 2021, the SEC published a Risk Alert entitled “Observations from Examinations of Investment Advisers Managing Client Accounts That Participate In Wrap Fee Programs.” Among its other findings, the SEC concluded that many of the examined advisers provided inadequate disclosures or omitted them. Disclosures were deficient regarding conflicts of interest, fees and expenses.
According to the Risk Alert, examiners discovered that supervised persons engaged in transactions that reduced costs to the adviser but increased expenses borne by the client. Examiners observed that supervised persons sometimes avoided ticket charges by recommending that clients purchase mutual fund share classes charging 12b-1 fees.
RIAs that participate in wrap fee programs can expect examiners to focus on the problems reported in this Risk Alert.