On February 12, 2020, the SEC filed a civil enforcement action against a Registered Investment Adviser (RIA) in California, as well as the firm’s co-owners, for breaching their fiduciary duty and defrauding their advisory clients. The RIA and its co-owners allegedly failed to disclose significant financial conflicts of interest when they recommended investments in private real estate funds. The defendants recommended that clients put their money in the funds and keep it there, so they could receive additional compensation.
The SEC’s complaint alleged that the defendants advised their clients to invest more than $16 million in four private real estate investment funds. The defendants did not disclose that the fund managers paid them more than $1 million in fees. Those payments were over and above the fees charged directly to clients. This side compensation incentivized the defendants to recommend these funds to their clients. Because the side compensation payments were recurring, the defendants also had an incentive to keep their clients in the funds instead of deploying their capital elsewhere. For two of the private placement funds, the undisclosed compensation arrangements had a negative impact on advisory clients’ investment returns.
As investment advisers, the defendants owed their clients a fiduciary duty to act with loyalty, fairness, and good faith. According to the complaint, the defendants breached their fiduciary duty and defrauded their clients by failing to disclose glaring financial conflicts of interest and by keeping them in the dark regarding material facts. Furthermore, these undisclosed compensation arrangements caused the RIA’s Form ADV filings to be materially misleading. The general instructions to Form ADV Part 2A require RIAs to disclose all material conflicts of interest between the adviser and clients. Furthermore, Item 14 of Form ADV Part 2A requires RIAs to disclose all conflicts of interest pertaining to economic benefits provided to the firm from external sources.
In addition, the firm did not adopt and implement policies and procedures to prevent these compliance failures. The complaint also alleged that the RIA did not conduct annual reviews of the firm’s policies and procedures. Those annual reviews help RIAs to determine whether their policies and procedures are thorough and effective.
Among the many allegations made by the SEC, the Commission’s complaint asserted that the defendants did not inform their compliance consultant that the RIA was receiving side compensation from fund managers or that these payments represented a substantial portion of the firm’s overall income. If the compliance consultant had known these facts, the compliance consultant could have recommended enhanced disclosure of the arrangements, because side compensation creates material conflicts of interest that must be disclosed and, the Specifically, the defendants should have disclosed the risk that their receipt of additional compensation might not be in the best interest of their clients. The defendants should have also disclosed the risk that they would recommend that clients remain invested in the fund, because it meant they would continue to receive commissions.
The SEC charged the defendants with violating the antifraud provisions found in Sections 206(1) and 206(2) of the Investment Advisers Act of 1940, as well as Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder. The SEC also alleged that the RIA violated Section 207 of the Advisers Act and accused the firm’s co-owners of aiding and abetting the firm’s violation.
Takeaways
Failure to disclose financial conflicts of interest and hidden compensation can result in serious consequences for RIAs. Investment advisers should provide sufficient information to their compliance consultants, so they can help the RIA to fully disclose all material conflicts of interest, which is an integral part of an RIA’s fiduciary obligations.
The SEC’s complaint can be found at https://www.sec.gov/litigation/complaints/2020/comp24738.pdf.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com
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