Coming on the heels of the share class initiative,1 the US Securities and Exchange Commission (SEC) is at the initial stages of another initiative involving concerns about adviser disclosures and conflicts related to bank deposit sweep programs (BDSPs). A recent speech by Stephanie Avakian, Co-Director of the Division of Enforcement, indicates where the SEC is heading.
We are also looking at cash sweep arrangements. Cash in advisory accounts is often automatically swept into a money market mutual fund or a bank deposit sweep program. A dually registered adviser or an adviser with an affiliated broker-dealer may have a financial interest, a conflict, in recommending one cash investment over another. For example, some money market mutual funds carry 12b-1 fees or make revenue-sharing payments that may be shared with a dually registered adviser or an adviser’s affiliated broker-dealer, while other money market funds do not carry those fees. Advisers recommending or choosing between different money market funds must make full and fair disclosure of these types of conflicts to their clients. The Commission has brought enforcement actions in the past where advisers have failed to make appropriate disclosure.
As another example, some clearing brokers offer bank deposit sweep programs where an investor’s uninvested cash is swept into an interest-bearing bank account. In some cases, the bank, often an affiliate of the clearing broker, agrees to share a portion of the revenue the bank earns on the investor’s deposits with the clearing broker. The clearing broker may, in turn, agree to share a portion of the revenue it received with the investor’s dually registered investment adviser or with the adviser’s affiliated broker-dealer. In some cases, the revenue received by the adviser or the adviser’s affiliate far exceeds the interest earned by the client on its cash. In fact, in some cases, these arrangements may actually lower the interest paid to the client. These types of cash sweep arrangements create an obvious incentive for an adviser to recommend products where revenue sharing will result in larger payments to the adviser and lesser returns for the adviser’s client. This is a clear conflict and, without full and fair disclosure, investors cannot make an informed investment decision to agree to the adviser’s cash sweep vehicle selection.2
Bank Sweep Accounts as Part of Advisory Programs. In connection with their advisory programs, dual registrants often make available programs for cash in an account to automatically be swept into an interest-bearing Federal Deposit Insurance Corporation (FDIC)-insured deposit account or a money market fund. While press reports and related staff statements have referred to “advisory account” cash sweep programs, a cash sweep program is offered via broker-dealer accounts which underlie an advisory program. It is also noteworthy that investments through a cash sweep program are specifically addressed and permitted by the Securities Exchange Act of 1934 and in particular, the net capital rule.
Bank sweep accounts have been associated with advisory programs for many years. In this environment, in which advisory conflicts are under intense regulatory scrutiny, what the SEC is now reacting to is the potential for undisclosed conflicts related to the compensation received by the adviser or its affiliates in connection with bank sweep accounts.
SEC Focus. In various exams and based on Ms. Avakian’s speech, the SEC examination and enforcement staff has expressed concerns about BDSPs, including the following:
- value of FDIC insurance The SEC staff has questioned whether FDIC insurance provides much, if any, value to clients. Among the issues raised by the SEC is that both BDSPs and money market funds both invest significantly in US Government securities, which are protected because they are backed by the full faith and credit of the United States Government. Therefore, the protections offered by BDSPs may be overstated.
- requirement that clients must monitor FDIC accounts In many BDSPs, clients need to monitor for FDIC coverage limitations. The SEC staff has questioned whether it is reasonable to expect clients to monitor such investments, particularly because clients are hiring advisers to advise and monitor client investments.
- rates of return The SEC staff has expressed concerns about the rates of returns paid to investors, noting that BDSPs offer low yields and that some firms retain a majority of the interest revenue.
- incomplete FDIC coverage FDIC insurance has individual and per-bank caps. Therefore, the SEC staff has expressed concerns that it is theoretically possible that clients could hold deposits in excess of the FDIC insurance, exposing them to risk.
- liquidity concerns Program banks may reserve the right to require seven days’ notice before permitting a client to transfer out of the BDSP. Therefore, the SEC staff has expressed concerns that a firm could purchase securities for a client using the cash balance but the bank could decline to provide funds within the settlement period for the securities being purchased.
- inappropriate charging of advisory fees The SEC staff has expressed concerns that firms are charging management fees on cash balances even though firms do not provide advice on these balances.
OCC’s Related Focus. The SEC staff is not alone is raising concerns regarding BDSPs. The Office of the Comptroller of the Currency (OCC) has indicated that it will examine banks and trust companies that, use BDSPs as part of their asset management fiduciary activities.3 The OCC staff has noted that key risks to consider include:
- Are these programs structured and documented to be consistent with the FDIC’s requirements to ensure deposits are fully insured via pass-through insurance? Where applicable, do they comply with Regulation DD, Truth in Savings?
- For fiduciary accounts, has the bank fully identified any conflicts of interest and are these conflicts authorized and appropriately disclosed? Is the sweep vehicle in the best interest of the fiduciary account?
- For both fiduciary and nonfiduciary accounts, is the compensation received by the bank or its affiliates reasonable and fully disclosed?
OCC staff has advised that bank fiduciaries should seek the advice of counsel before entering into these or any other sweep arrangements for which the bank may be receiving compensation, and that counsel should specifically address the permissibility of these compensation arrangements for accounts subject to the Employment Retirement Income Security Act.
Steps to Take Now. In anticipation of regulatory scrutiny, firms may want to assess all potential conflicts related to their sweep account options they recommend or select. Disclosures should be reviewed to assure that material conflicts are fully and fairly disclosed, including a discussion of the nature and magnitude of the conflicts, its impact on clients, and how the firm is managing the conflicts. Beyond this, firms will want to assess their processes to assure that recommendations and selections regarding sweep account options satisfy their adviser’s dusty of care to clients. Firms may also want to assess their books and records to see how well they document the basis for the investment advice provided regarding sweep account options. Advisers may also want to review their policies and disclosures regarding charging advisory fees on cash balances and their processes for monitoring cash account levels.