SEC Enforcement Action – Forgivable Loans

July 27, 2016

Reading time : 4 minutes

The U.S. Securities and Exchange Commission (“SEC”) recently fined an investment adviser firm located in Cedar Rapids, IA for its alleged failure to disclose $3 million in forgivable loans that the investment adviser firm received from its broker-dealer. In addition to allegedly failing to disclose the forgivable loan or the resulting conflict of interest to its clients as required under Rule 206(2), the investment adviser allegedly violated Rule 207 when it omitted any discussion of the forgivable loan from its filings with the SEC. In the enforcement action, the SEC noted that the first disclosures regarding the forgivable loan were made on the investment adviser firm’s Form ADV 2A a full three years after first receiving the loan. And even then, the SEC alleged that the disclosures were not truthful or complete: they failed to discuss terms or origin of the forgivable loan; stated that that new representatives “may” receive payments pursuant to the forgivable loan rather than stating that all representatives had in fact already received such payments; did not explain the conflict of interest arising from the payments and the investment adviser firm’s continued use of the broker-dealer; and failed to explain how the investment adviser firm managed this conflict of interest. Click here to read the SEC enforcement action.

In a similar action, the SEC also fined an investment adviser firm in San Diego, CA for its alleged failure to disclose loans it received on favorable terms from a broker-dealer. The SEC alleged that of four loans made to the investment adviser firm between 2012 and 2013, two were forgivable over a five year term, amounting to approximately a $1.1 million benefit to the investment adviser firm. The remaining two loans, amounting to nearly $800,000, were interest-free for six months and then incurred a favorable rate for the remainder of the term. Since all of the loans were conditioned on the investment adviser firm retaining the broker-dealer’s services, the SEC alleged a disclosable conflict of interest had arisen as soon as the agreement was executed. Instead of disclosing the conflict promptly, however, the investment adviser firm did not update its Form ADV Part 2A until nearly a year later when an SEC examination noted the deficiency. Click here to read the SEC enforcement action.

Forgivable loans to registered representatives are a common tool used by broker-dealers looking to entice new business or encourage retention. These recent enforcement actions, however, show that the SEC is taking note of the special conflicts of interest that can arise when loan forgiveness is made contingent upon the investment adviser firm or its dually licensed investment adviser representative/registered representative selecting or continuing relationship with a broker-dealer for investment advisory services. Based upon these enforcement actions, it appears that the SEC believes that the economic benefit inherent in forgivable loans can, for example, influence an investment adviser firm to recommend a particular broker-dealer to its clients.

In light of these SEC enforcement actions, investment advisers should be prepared to make an accurate and complete disclosure of all material facts relating to forgivable loans, including its terms, which individuals or entities receive payments in connection with the loan, and what conflicts of interest may arise as a result. The investment adviser should also discuss how it will address those conflicts of interests on behalf of its clients. If your firm, its representative(s) or control person(s) has a currently outstanding forgivable loan from a broker-dealer, we recommend that you promptly update your firm’s Form ADV Part 2A Item 10 and the applicable representative’s Form ADV Part 2B Item 5 disclosing this conflict of interest. RIA Compliance Consultants can assist your firm with drafting these disclosures.

Posted by Bryan Hill
Labels: SEC, Uncategorized