On August 1, 2017, Cadaret, Grant & Co., a Delaware investment adviser and broker-dealer, settled claims brought by the United States Securities and Exchange Commission (“SEC”) that it violated various provisions of the Investment Advisers Act of 1940 (“Advisers Act”) by failing, among other things, to invest its clients in lower-fee share classes of certain mutual funds and to disclose conflicts of interest regarding its incentives to invest clients in higher-fee share classes. In the Matter of Cadaret, Grant & Co., Inc., Admin. Proc. File No. 3-18087 (Aug. 1, 2017).

Under Section 206 of the Advisers Act, investment advisers have a fiduciary duty to act for the benefit of their clients. This duty includes, among other things, a duty to seek the best execution for client transactions. The SEC has interpreted that requirement to mean that an investment adviser may not cause a client to purchase a more expensive share class of a given mutual fund when a less expensive class of that same fund is available. See, e.g., In the Matter of Everhart Financial Group, Inc., Admin. Proc. File No. 3-17051, at 5 (Jan. 14, 2016) (settled matter); In the Matter of Pekin Singer Strauss Asset Management Inc., Admin. Proc. File No. 3-16646, at 2 (June 23, 2015) (settled matter); In the Matter of Manarin Investment Counsel, Ltd., Admin. Proc. File No. 3-15549, at 2, 6 (Oct. 2, 2013) (settled matter). Section 207 of the Advisers Act prohibits making any untrue statement of material fact in a registration application or report filed with the SEC, or failing to state any material fact that the filer is under a duty to disclose.

According to the SEC, from 2011 to 2016, Cadaret invested its advisory clients in mutual fund share classes that paid distribution and marketing fees (“12b-1 fees”). See 17 CFR 270.12b-1. 12b-1 fees are paid by funds pursuant to a written plan for marketing and distribution expenses, and are used for, among other things, compensating sales professionals. The SEC, however, alleged that Cadaret could have invested its clients in lower-fee share classes of those same funds, which were available without 12b-1 fees. By selecting the higher-fee share classes for its clients, Cadaret allegedly earned roughly $1.93 million more in 12b-1 fees. Cadaret also had an additional conflict of interest because it received additional “marketing support payments” pursuant to written agreements from two mutual fund complexes for clients who were invested in funds that paid 12b-1 fees. Although Cadaret disclosed that it received 12b-1 fees and marketing support payments from its clients’ mutual fund investments, Cadaret did not disclose the more specific fact that it had a conflict of interest concerning which mutual fund share classes it chose to invest client funds in, or that it would typically select share classes that carried 12b-1 fees even when its clients were eligible for lower-cost share classes of the same funds.

Although the SEC noted Cadaret’s remedial acts and cooperation, it nevertheless required Cadaret to pay $2,591,000 in disgorgement, $177,000 in prejudgment interest, and a $280,000 civil monetary penalty to settle its allegations. Cadaret was required to place the entire amount in a distribution fund for the benefit of clients that were affected by Cadaret’s conduct.

This action underscores the continued focus by regulators on mutual fund share class selection, and the fees paid by customers as a result. This is the third SEC enforcement action in the last eighteen months involving direction of client orders into more expensive fund share classes, and last year FINRA announced a sweep related to mutual fund share classes and fee waivers. https://www.finra.org/industry/mutual-fund-waiver. Regulatory enforcement in this area will likely remain active and industry participants should remain focused on processes and procedures aimed at ensuring that customers are offered the product most appropriate under the circumstances.

Click here to view In the Matter of Cadaret, Grant & Co., Inc.