On May 20, 2024, the SEC settled an enforcement action against a Registered Investment Adviser (RIA) located in San Rafael, California. The SEC alleged that the RIA and its owner breached their fiduciary duty and failed to provide accurate disclosures.
The RIA’s affiliated broker-dealer received compensation from various product sponsors as a result of investment recommendations made by the RIA. The owner of the RIA received that compensation in his capacity as a co-owner and registered representative of that affiliated broker-dealer. The compensation received came in the form of both revenue sharing and sales commissions from advisory clients’ investments. The RIA did not fully and fairly disclose and address the related conflicts of interest.
Specifically, according to the SEC, the RIA and its owner breached their fiduciary duty by recommending variable annuity investments that were sponsored by insurance companies that paid upfront sales commissions to the RIA’s affiliated broker-dealer and to the owner in his capacity as a registered representative of that brokerage firm. Certain variable annuities paid upfront sales commissions averaging 6.8 percent to the owner of the RIA and the affiliated broker-dealer he co-owned.
The complaint stated that variable annuity issuers charge fees that include annual mortality, expense, and administrative fees (ME&A fees). To compensate the insurance company for paying an upfront commission to the broker, investors in commission-based variable annuities pay higher ongoing ME&A fees, often for the life of the contract, than they would on fee-based variable annuities.
Insurance companies usually charge surrender fees on commission-based variable annuities when an investor withdraws more than the annual penalty-free maximum withdrawal. Because fee-based annuity contracts sold by investment advisers do not pay upfront commissions, they normally do not charge surrender fees. Therefore, investors are permitted to exchange or redeem the contract, in whole or part, without paying surrender fees.
The SEC alleged that this RIA did not fully and fairly disclose the conflict of interest the firm had when it recommended commission-paying variable annuities. The firm also breached its duty of care when it did not conduct an analysis to evaluate whether the commission-paying variable annuities it recommended were in clients’ best interest. In the majority of cases, these insurance companies offered variable annuities with the same features, which were typically made available to clients of RIAs. Those annuities did not charge upfront commissions and had lower ongoing fees.
In addition, the SEC determined that the RIA invested advisory clients’ assets in certain money market funds used as cash sweep vehicles. The RIA’s affiliated broker-dealer received revenue sharing without fully and fairly disclosing the conflict of interest arising from these payments. The SEC found that the RIA breached its duty of care when it did not conduct any analysis to determine whether lower-fee money market funds were available and in the best interest of its clients.
SEC’s complaint details numerous compliance deficiencies
The SEC attributed the RIA’s numerous compliance deficiencies to weak policies and procedures. The SEC contended that the RIA failed to adopt and implement written policies and procedures that were reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules. Those policies and procedures would have and should have required the RIA to disclose the conflicts of interest created by its variable annuity recommendations and cash sweep money market fund selection practices. Those policies and procedures might have ensured that the RIA’s recommendations of variable annuities and money market funds were in the best interests of its advisory clients.
Full disclosure is another important element of an investment adviser’s fiduciary duty. The RIA failed to disclose that its broker-dealer affiliate received commissions or that these payments created a conflict of interest.
Specifically, the RIA disclosed in Part 2A to its Forms ADV that the owner and other firm associates, in their capacity as registered representatives of the affiliated broker-dealer, “can receive compensation” for the sale of investment products, such as variable annuities. During that period, the broker-dealer and the registered representative did, in fact, receive fees that they would not have collected if the RIA’s advisory clients were invested in the available fee-based annuities issued by the same insurance companies. The broker-dealer paid the owner 92 percent of those commissions in his capacity as a registered representative.
Even after the RIA revised its Form ADV Part 2A, the firm did not disclose that for certain variable annuities, there were lower cost fee-based variable annuities issued by the same insurance companies with the same features available that did not pay its affiliated broker a commission. In addition, the RIA did not disclose that the affiliated broker-dealer’s received revenue sharing from cash sweep products in which the adviser had invested its clients’ assets. Furthermore, the RIA did not make clients aware of the conflicts of interest inherent in this arrangement.
An investment adviser’s fiduciary obligation includes a duty of care, which requires an RIA to provide investment advice in the best interest of its clients. The RIA’s choice of variable annuities that charged sales commissions violated that duty of care. Those same insurance companies offered variable annuities with the same features minus the sales commission. The RIA did not conduct an analysis as to whether a fee-based variable annuity contract was in the client’s best interest. With regard to cash sweep investments, the RIA failed to consider alternatives such as lower-fee government and prime money market funds offered by the clearing broker-dealer.
Takeaways
The SEC concluded that the RIA violated the antifraud and compliance provisions of Sections 206(2) and 206(4) of the Investment Advisers Act, as well as Rule 206(4)-7 thereunder. Without admitting or denying the SEC’s findings, the RIA agreed to pay disgorgement of $707,129.58, prejudgment interest of $183,236.60, and a civil penalty of $175,000. The RIA also agreed to a cease-and-desist order and censure. Finally, the SEC ordered the firm to take a number of corrective steps to make clients whole and avoid future financial harm to them.
The SEC’s enforcement 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 – sales@ria-compliance.com
Recent Comments