SEC Continues Focus on Conflicts Disclosures in Enforcement Actions Totaling $106 Million in Fines and Disgorgement
The U.S. Securities and Exchange Commission (the “Commission”) recently entered into four consent orders (collectively, the “Orders” and each, an “Order”) with registered investment advisers (“RIAs” and each, an “RIA”) that sanctioned the RIAs for failures to provide full and fair disclosure regarding conflicts of interest. Notably, the Orders highlight the RIAs’ various efforts to correct disclosure issues, and the Commission’s ultimate position that each additional disclosure was still inadequate. These Orders again demonstrate the Commission’s continuing focus on ensuring firms provide full and fair disclosure of conflicts of interest, and the difficulty for practitioners in pegging what the Commission will deem a complete and accurate disclosure.
A summary of each Order and its key takeaways is set forth below.
a. Conflicts Arising from Incentive Compensation on Rollovers at Dual Registrant1
On July 13, 2021, the Commission sanctioned a dually registered investment adviser and broker-dealer for its alleged: (1) failure to adequately disclose conflicts of interest; and (2) dissemination of inaccurate and misleading statements, in connection with recommendations regarding the rollover of retirement assets into a managed account program called “Portfolio Advisor”2 between 2013 and 2018. While many of the issues followed from common complications of so-called “hat switching” by dually registered representatives (which have since been addressed through the firm’s compliance with the Department of Labor’s first fiduciary rule and Regulation Best Interest), the Order still provides helpful guidance for RIAs more broadly.3
Specifically at issue in the Order was: (1) an incentive compensation plan that paid the firm’s representatives more in variable compensation for signing up rollovers into Portfolio Advisor compared to other rollover options that did not generate as much revenue for the RIA; and (2) negative consequences—including the threat of termination—for representatives who failed to meet targets. Also at issue in the Order was eye-catching verbiage in training that purportedly taught representatives to “use the rollover process to discover areas of vulnerability for these clients, called ‘pain points’ to ‘create pain’ by helping clients ‘self-realize’ their financial vulnerability, and then to recommend Portfolio Advisor as the solution to their problem.”4
In the Order, the Commission found it misleading to describe the firm’s representatives as objective, non-commissioned fiduciaries because those representatives were compensated more when their clients’ rollovers went into Portfolio Advisor (even though that compensation differential was also disclosed).5 While the firm’s policies and procedures required representatives to present clients with four rollover options, the Commission found that representatives commonly presented managed accounts as the only option for a rollover and that they were, in certain instances, trained to avoid discussing fees.6
Even though the firm’s policies and procedures required representatives to discuss fees with clients in connection with rollover recommendations, the Commission found the procedures violative because they “did not take sufficient steps to ensure that [representatives] conducted and memorialized those fee discussions.”7 Similarly, before 2015, the group responsible for supervising all product recommendations did not have procedures that required confirming the representatives had the required fee and expense discussions with (prospective) clients.
As to disclosures, the Commission found that the firm’s written and verbal disclosures:
The firm was censured and ordered to pay a total of $97 million, including disgorgement of almost $74 million, prejudgment interest of roughly $14 million, and a civil penalty of $9 million.
b. Cash Sweep Conflicts and the Perils of the Word “May”12
On July 8, 2021, the Commission sanctioned an RIA (“SG-IA”) for failing to adequately disclose a revenue sharing arrangement or the related conflicts of interests to its advisory clients.13 According to the Order, SG-IA’s affiliated broker-dealer (“SG-BD”) received cash sweep revenue sharing from the unaffiliated clearing broker used by SG-IA. SG-IA disclosed in its Form ADV that it “may utilize … funds for cash sweeps”, but did not disclose that SG-BD actually received cash sweep revenue.14 Later, SG-IA amended its Form ADV to disclose that “St. Germain”15 received a monthly payment from its sweep program, and described how such payment was calculated. However, the Order stated that these disclosures were inadequate because they failed to identify or address the financial conflict arising from the receipt of the cash sweep revenue sharing.
SG-IA subsequently amended its Form ADV again to: (i) state that SG-BD received cash sweep revenue, but that SG-IA and its individual advisory representatives did not receive any portion of that revenue; and (ii) identify the financial conflict of interest arising from the cash sweep revenue sharing, in that it could cause SG-IA to provide investment advice that was not disinterested regarding the best client sweep account.
SG-IA was ordered to pay disgorgement, pre-judgement interest, and a civil penalty totaling $1,925,000.
c. Disclosures Regarding Revenue Sharing with Brokers16
On June 9, 2021, the Commission sanctioned two RIAs (“KA” and “KP”, respectively, and together, “K”) for, among other actions, failing to provide adequate disclosures of conflicts regarding: (i) revenue sharing arrangements between K’s affiliated broker-dealer (“B”) and an unaffiliated clearing broker; and (ii) “fee-markups”, where B would have the clearing broker charge B’s customers (who were also K’s clients) fees that were higher than what the clearing broker charged B for the clearing broker’s services.
At issue were several instances where the clearing broker would share revenue with B in an amount tied to B’s customers’ (K’s clients’) assets invested in certain mutual fund share classes, but would not share revenue with B for other mutual funds or share classes of mutual funds.17 For example, B had a sharing arrangement with the clearing broker where B would receive a portion of the recurring fee the clearing broker received from mutual fund investments that were a part of the clearing broker’s “no transaction fee program.”18 B’s revenue share percentage increased with the level of B’s customers’ (including K’s clients’) assets invested in the mutual fund share classes that were a part of this program. Meanwhile, B would have received lower or no revenue sharing payments from the clearing broker for lower-cost share classes of the same funds.19
The Commission also found that B marked up its brokerage fees for several services. For example, B had the clearing broker charge B’s customers $20.00 more for an annual custody fee than what the clearing broker charged B for custodial service, and charged a higher rate of interest on margin lending.
K initially failed to disclose that B shared any revenue with the clearing broker based on K’s clients’ investments. In subsequent Form ADVs, K disclosed the different revenue sharing agreements, but the Commission found that these disclosures generally were insufficient. The Orders offer little detail about the deficiencies other than to say that disclosures never included an explanation that some mutual funds, and certain share classes of other mutual funds, that were available to K’s clients did not generate any revenue share for B. Further, the Orders state that K never identified any of these new disclosures in the summary of material changes section of the Form ADV, and thus existing clients were not notified of the new disclosures.
The Commission similarly found that K initially failed to adequately disclose the conflicts that arose when K recommended that clients use B and, in some instances, execute transactions that K recommended through B.20 K later updated its Form ADV to disclose these fee markup conflicts, but again did not identify these disclosures in the summary of material changes provided to existing clients.
KA was ordered to pay disgorgement of $7,229,802, prejudgment interest of $1,273,370, and a civil penalty of $1,500,000, while KP was ordered to pay disgorgement of $208,187, prejudgment interest of $31,382, and a civil penalty of $60,000.
If you have any questions about conflicts of interest disclosure obligations or about the regulation of RIAs, broker-dealers, and registered investment companies generally, please feel free to contact us.
By the Investment Management and Broker-Dealer Team at Kilpatrick Townsend & Stockton
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