On August 13, 2020 the United States Securities and Exchange Commission (“SEC”) filed an order instituting administrative cease-and-desist proceedings to a dually registered investment adviser firm/introducing broker-dealer firm for allegedly failing to disclose material conflicts of interest related to its mutual fund share class selection practices, receipt of compensation pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“12b-1 fees”), and money market revenue sharing agreements.
According to the cease-and-desist order by the SEC, the investment adviser firm allegedly purchased or recommended that clients purchase mutual fund share classes that charged 12b-1 fees instead of lower-cost share classes of the same funds that were available to the clients. The 12b-1 fees were then paid to the investment adviser firm’s affiliated broker-dealer. Similarly, the investment adviser recommended or selected more expensive money market cash sweep accounts for its clients that were subject to revenue sharing agreements with the investment adviser, rather than less expensive money market accounts which did not share revenue with the investment adviser.
According to the SEC, these actions constituted a failure to seek best execution, failure to disclose material conflicts of interests, and failure to implement written compliance policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 and the rules thereunder. The SEC noted that the investment adviser firm failed to self-report pursuant to the Division of Enforcement’s Share Class Selection Disclosure Initiative (“Share Class Initiative”). Furthermore, despite ultimately updating its conflicts of interest disclosures, the SEC found that the investment adviser firm failed to timely notify existing clients or identify the updated disclosure as a material change.
The SEC censured the investment adviser and ordered disgorgement of over half a million dollars in 12b-1 fees and cash sweep money market revenue sharing, in addition to paying a fine of $200,000 to the SEC. The full administrative proceeding released by the SEC can be found at https://www.sec.gov/litigation/admin/2020/ia-5560.pdf.
All investment advisers have an obligation to seek best execution for clients and to fully disclose all material facts to advisory clients including any conflicts of interest. Share class selection and best execution remain high priorities for the SEC. In a November 2019 speech, Stephanie Avakian, Director of Enforcement at the SEC, cautioned that the Enforcement Division remains committed to identifying and enforcing material financial conflicts of interest that are harmful to retail investors, including 12b-1 fees, revenue sharing agreements, cash sweep arrangements, and unit investment trusts. Discussing the SEC’s 2018 Share Class Initiative, Avakian stated:
At the end of the day, what we saw in the Share Class Initiative cases were firms that had the choice of investing their clients’ money in different classes of the exact same investment and chose the more expensive option – the option that paid the firm additional compensation and cost the client more money – and they did not fully disclose this to the client. This situation is not unique. The same principles and disclosure obligations can apply in other circumstances. Because of that, we are not resting on the success of the Share Class Initiative. Let me assure you, we are looking for other undisclosed material conflicts – and we are finding them.”
The full speech, which includes a deeper discussion of the material conflicts identified above can be found at https://www.sec.gov/news/speech/speech-avakian-2019-11-05#_edn11
We Can Help
RIA Compliance Consultants has compiled a “Conflicts of Interest Checklist” to assist investment adviser firms in reviewing potential conflicts of interests. This checklist is available to Bronze, Silver, Gold, and Platinum Package clients as part of their package or available a la carte here. You may also view our recorded webinar “Identifying, Disclosing, and Mitigating Conflicts of Interest” via your online subscription account, or purchase it a la carte here.
If your investment adviser firm has questions about conflicts of interest and making disclosures we encourage you to speak with your compliance consultant. Or, if you are not an existing client of RIA Compliance Consultants, click here to set up an introductory call with our Business Development Team.