On March 14, 2016, the SEC announced settled administrative proceedings against Royal Alliance Associates, Inc., SagePoint Financial, Inc. and FSC Securities Corporation, each a dual-registered broker-dealer and investment adviser indirectly owned by American International Group, Inc. (collectively, the “Firms”), for breaches of fiduciary duty and compliance failures resulting from investing advisory clients in higher-fee mutual fund share classes instead of lower-fee share classes of the same funds.
According to the order, from 2012 to 2014, the Firms invested certain of their clients in the Firms’ largest fee-based advisory service in share classes that charged 12b-1 fees (for marketing and distribution expenses) when lower-fee share classes of the same funds without 12b-1 fees were available in many instances. As a result, the SEC found that, in their capacity as broker-dealers, the Firms received approximately $2 million in 12b-1 fees that they would not have collected had they invested those clients in available lower-fee share classes. The SEC also found that the Firms did not disclose in their Forms ADV or otherwise that they had a conflict of interest with respect to selecting mutual fund share classes due to a financial incentive to place advisory clients in higher-fee share classes over lower-fee share classes of the same fund. Consequently, the order states that the Firms breached their fiduciary duties to those clients that were invested in the higher-fee share classes. In addition, the SEC found that the Firms failed to adopt any written compliance policies or procedures governing mutual fund share class selection.
The SEC also found that the Firms failed to implement compliance policies and procedures requiring monitoring for “reverse churning.” Reverse churning generally refers to the practice where a client is charged an inclusive wrap fee that covers all advisory services and trading costs even though the client trades infrequently. As the order explains, a wrap fee account may not be in the best interest of a client with minimal or no trading activity as compared to a non-wrap fee account or brokerage account where the client would otherwise pay trading costs as incurred but a lower fee in a non-wrap account or no advisory fee in a brokerage account. The Firms were required under their advisory compliance policies and procedures to review “inactive” wrap fee accounts to ensure that such accounts remained in the best interest of advisory clients with minimal trading activity. However, the order states that during the course of examinations conducted by the SEC’s Office of Compliance Inspections and Examinations it was discovered that there had been several periods, ranging from 3 months to 18 months, when there was a lapse in inactive account reviews.
As a result of the foregoing conduct, the SEC found that the Firms violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any fraud or deceit upon any client or prospective client. The SEC also found that the Firms violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which requires a registered investment adviser to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder. In addition, as a result of the inadequate disclosure concerning mutual fund share class selection and the related conflict of interest, the SEC found that the Firms violated Section 207 of the Advisers Act, which makes it unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the SEC or willfully to omit to state in any such application or report any material fact which is required to be stated therein.
The Firms consented to the SEC’s order without admitting or denying the findings that they violated Sections 206(2), 206(4) and 207 of the Advisers Act and Rule 206(4)-7 thereunder. Pursuant to the terms of the order, the Firms agreed to retain an independent compliance consultant to conduct a comprehensive review of their policies and procedures. The Firms also agreed to pay disgorgement and prejudgment interest of slightly more than $2 million, as well as a civil monetary penalty of $7.5 million.
The SEC order is available at: https://www.sec.gov/litigation/admin/2016/34-77362.pdf.