On April 27, 2022, the SEC announced that it settled charges against a Registered Investment Adviser (RIA) in Downers Grove, Illinois. The SEC alleged that the RIA breached its fiduciary duty to advisory clients by failing to:
- Fully disclose its conflicts of interest;
- Seek best execution for clients’ transactions; and
- Satisfy its duty of care.
According to the SEC, the RIA invested certain wrap program clients in higher-cost mutual fund share classes, despite the availability of less expensive alternatives, Furthermore, the RIA did not disclose the conflicts of interest related to those investment recommendations. Moreover, the firm’s compensation agreements with its Investment Adviser Representatives (IARs) provided that the firm would deduct any transaction fees IARs incurred for client accounts in the Wrap Program from the IARs’ pay; therefore, creating a conflict of interest whereby its IARs could avoid incurring transaction fees by recommending NTF Shares.
Like many wrap programs, the RIA was obligated to pay all of their clients’ trading costs, including fees for buying and selling mutual funds. The SEC determined that from January 2014 through 2019, the RIA and its IARs avoided transaction fees by recommending mutual fund share classes from a no-transaction fee (NTF) program offered by its clearing firm. Typically, the NTF shares had higher expense ratios. Therefore, they were more expensive for wrap fee clients than shares that were not part of the NTF program.
Although neither the RIA nor its IARs received the 12b-1 fees paid to the clearing firm, they had a conflict of interest when recommending NTF shares to wrap fee program clients. In that situation, the RIA and its IARs benefitted, because they avoided incurring transaction fees that they were responsible for paying. The problem for wrap fee program clients, however, was that they paid higher expense ratios in NTF funds. The SEC found that the RIA did not provide full and fair disclosure to clients concerning their recommendation of NTF mutual fund share classes and the related conflicts of interest.
Duty of care failures
An investment adviser’s fiduciary duty includes a duty of care. To fulfill this obligation, an RIA must provide investment advice that is in the best interest of clients based on the client’s objectives and must seek best execution for client transactions. The RIA caused advisory clients who had already opened a wrap account to invest those assets in NTF shares, even though there were shares available that presented a more favorable value under the circumstances. Therefore, the RIA violated its duty to seek best execution for those transactions.
The RIA failed to fulfill its duty of care obligations when it advised certain wrap clients to invest in NTF shares without undertaking any analysis to determine whether they were in the clients’ best interests. RIAs should keep documentation in their books and records to demonstrate their efforts to seek best execution.
Because of its conduct, the RIA violated the Investment Advisers Act of 1940. In addition, the RIA failed to adopt and implement written compliance policies and procedures in connection with its mutual fund selection practices in its wrap fee program and disclosures of related conflicts of interest that were reasonably designed to prevent violations of the statute and the rules thereunder. Specifically, the RIA was found to have violated Sections 206(2) and 206(4) of the Investment Advisers Act and Rule 206(4)-7 thereunder.
Without admitting or denying the findings, the RIA consented to a cease-and-desist order and to be censured. The firm also agreed to pay disgorgement of $508,995, prejudgment interest of $130,742, and a civil money penalty of $125,000.
When compliance problems like this occur, the SEC almost always finds deficiencies in the RIA’s policies and procedures. The SEC takes the position that these types of problems would not have occurred had the firm implemented robust policies and procedures.
In this enforcement action, the SEC disciplined the RIA for its share class choices, even though the firm received no additional compensation from 12b-1 fees. The firm’s choice of NTF shares appeared to be motivated by a desire to cut the transaction fees they owed pursuant to the wrap fee program. The action is available 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.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – email@example.com