On January 11, 2022, a Registered Investment Adviser (RIA) in Rockaway, New Jersey, consented to the entry of an SEC order that sanctioned the firm for several compliance deficiencies. The RIA also agreed to be censured and to cease-and-desist from engaging in the noncompliant conduct identified by the SEC.
Without admitting or denying the SEC’s findings, the RIA agreed to pay over $375,000 in disgorgement and penalties. The penalties were probably higher, because this was the third SEC action brought against the firm since 2013. The SEC found in 2013 that the RIA violated the federal securities laws by failing to exercise reasonable supervision over an associated person who misappropriated over $16 million from investment advisory accounts managed by the firm. In 2019, the SEC instituted and settled administrative proceedings brought against the firm for breaching its fiduciary duty and for providing inadequate disclosures regarding its mutual fund share class selection practices.
In this third enforcement action, the SEC alleged that the RIA committed the following mistakes:
- Failure to rebate fees charged to certain retirement accounts held by the firm;
- Failure to maintain accurate records and implement required compliance policies; and
- Inclusion of an inappropriate hedge clause in its advisory agreements.
In addition, the RIA’s Form ADV was deficient in a number of ways.
Misstatements in Form ADV
Among the violations committed by the RIA, the firm misrepresented fee-related information and failed to disclose conflicts of interest in its Forms ADV Part 2A. From 2017 through March 2021, the RIA’s brochure contained misleading disclosures regarding commissions paid to an affiliated broker-dealer and its associated person. Specifically, the misleading statements negatively impacted clients who purchased variable annuities for their individual retirement accounts. Form ADV Part 2A stated that its affiliated persons would not receive commissions for the sale of those products, or the RIA would offset the advisory fees it charged by the amount of the commissions collected.
Contrary to the RIA’s disclosures, its affiliated broker-dealer and associated persons collected commissions on investment products purchased in clients’ IRA accounts. The firm also charged advisory fees on those same accounts. The RIA’s clients who purchased variable annuity products in their retirement accounts paid commissions to the firm’s affiliated broker-dealer at the time of sale and on an ongoing basis. In addition, these clients paid advisory fees to the RIA based on the amount of assets under management in their advisory account. Those assets under management included the variable annuity.
Failure to maintain accurate records and implement required compliance policies
Books and records must be maintained, so they can be easily located, accessed and retrieved. This particular RIA did not maintain accurate client and advisory account information. The firm was also unable to locate certain advisory firm records.
In addition, the RIA failed to maintain accurate records related to its discretionary accounts. Specifically, the RIA did not keep true, accurate, and current records of accounts in which it was vested with discretionary power over clients’ funds, securities or transactions.
Improper use of hedge clauses
A hedge clause is a liability disclaimer provision in an investment advisory agreement. A hedge clause leads clients to assume that they have given up a legal remedy to which they are entitled. For the most part, hedge clauses are misleading when incorporated in contracts with retail investors. In this case, the SEC decided that the RIA’s hedge clause breached the adviser’s fiduciary duty and violated Section 206(2) of the Investment Advisers Act.
This RIA’s advisory agreements contained the following hedge clause that misled clients into thinking they had waived a cause of action permitted by state or federal law. The hedge clause stated, in part:
“Client agrees to hold [Redacted], its officers, directors, employees, agents, independent contractors, and representatives forever harmless from all claims, liabilities, losses, damages, attorney’s fees, costs and expenses which may arise from any act (on Client’s behalf or for Client’s account), omission, or insolvency of any broker/dealer, agency, professional, independent contractor or financial products salesperson. […] The federal securities laws impose liabilities under certain circumstances on persons who act in good faith, and therefore nothing herein shall in any way constitute a waiver or limitation of any rights which the client or CCM may have under any federal securities laws.”
As a result of the hedge clause, the firm’s clients mistakenly believed they had waived their legal remedies under the contract. RIA neither highlighted nor explained its hedge clause to clients.
The problem is not corrected by adding a non-waiver disclosure, which states that compliance with state or federal securities laws is not waivable. The SEC takes the position that retail clients do not understand non-waiver disclosures.
As is often the case in enforcement actions, the SEC concluded that the RIA failed to adopt and implement written compliance policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act. The RIA also failed to implement the findings from its annual review of those policies and procedures. This firm had no policies and procedures in place to make certain that the hedge clause was understood by retail clients.
The SEC imposed a wide range of sanctions against the firm, because of its willful violations of the Investment Advisers Act. The SEC determined that the RIA violated sections 204(a), 206(2), and 206(4) of the Investment Advisers Act and Rules 204-2(a)(8) and 206(4)-7 thereunder. The enforcement action can be found here.
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.