A recent SEC enforcement action highlights the need for investment advisers to exercise prudence in selecting share classes for their clients. In the action, the SEC found that dual-registered broker-dealers and investment advisers invested advisory clients in mutual fund share classes with 12b-1 fees instead of lower-fee share classes of the same funds that were available without 12b-1 fees, breaching their fiduciary duty to their clients.

Key Takeaways: The following are key considerations for investment advisers:

  • Conflicts of interest must be fully disclosed to clients. The primary place for this disclosure is in Form ADV and in client service agreements. Other account documentation may also be used to provide needed disclosure to clients.
  • Err on the side of over memorializing actions required to be compliant with federal securities law. While the release that adopted the rule regarding compliance programs stated that the rule does not mandate that the policies and procedures memorialize every action that is required to be compliant with federal securities law, we find that increasingly the SEC exam staff is looking for more documentation, not less.
  • Ensure that when the SEC has noted a deficiency in a prior examination that the deficiency has been corrected. Failure to correct deficiencies can be the difference in being referred to enforcement versus not being referred to enforcement.

Summary: The dual-registered broker-dealers and investment advisers invested advisory clients in mutual fund share classes with 12b-1 fees instead of lower-fee share classes of the same funds that were available without 12b-1 fees, breaching their fiduciary duty to their clients. In their capacity as broker-dealers, these firms received 12b-1 fees paid by the funds in which the advisory clients were invested. By investing these non-qualified advisory clients in the higher-fee share classes, the firms received approximately $2 million in 12b-1 fees that they would not have collected from the lower-fee share classes.

The dual-registered firms failed to disclose in their Forms ADV or otherwise that they had a conflict of interest due to a financial incentive to place advisory clients in higher-fee mutual fund share classes. In addition, the firms failed to adopt any compliance policy governing mutual fund share class selection.

The dual-registered firms disclosed in their respective Forms ADV that the firms may receive 12b-1 fees from mutual fund investments in fee-based advisory accounts. However, 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 mutual fund. Neither the firms’ client service agreements nor any other account documentation included any such disclosure concerning mutual fund share class selection.

In addition, the dual-registered firms were found to be repeat offenders in failing to adhere to their compliance policies and procedures. Specifically, the firms failed to monitor advisory accounts quarterly for inactivity or “reverse churning” as required under their compliance policies and procedures to ensure that fee-based advisory or “wrap” accounts that charged an inclusive fee for both advisory services and trading costs remained in the best interest of clients that traded infrequently. They failed to do this even though SEC examination staff previously had cited the firms for failing to conduct such monitoring several years earlier.

As a result of the conduct described above, the SEC found that the dual-registered firms:

  • Willfully violated Section 206(2) of the Investment Advisers Act, which prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
  • Willfully violated Section 206(4) of the Investment 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.
  • Willfully 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 Commission ... or willfully to omit to state in any such application or report any material fact which is required to be stated therein.”

Penalties: The dual-registered firms were required to (1) retain an independent compliance consultant to assist in improving their compliance program, (2) pay a total of $2,049,859 consisting of disgorgement of $1,956,460 and prejudgment interest of $93,399, and (3) pay a civil monetary penalty in the amount of $7.5 million.