On August 12, 2024, the SEC announced that it had settled charges against a New York-based Registered Investment Adviser (RIA). The SEC ordered the RIA to pay over $6 million and to return funds to clients who were harmed by the firm’s undisclosed conflicts of interest.
On August 14, 2024, the SEC announced charges against 26 broker-dealers, RIAs, and dually-registered firms. The SEC’s complaints alleged widespread and longstanding recordkeeping failures. The firms and their personnel failed to maintain and preserve electronic communications. The 26 firms paid a combined amount of more than $390 million to settle the recordkeeping deficiencies alleged by the SEC.
On August 19, 2024, the SEC announced that it had settled charges against an RIA. The SEC’s complaint violations of Rule 206(4)-5 promulgated under Section 206(4) of the Advisers Act (the Pay to Play rule). The RIA consented to a cease-and-desist order and to a censure, and agreed to pay a $95,000 civil money penalty.
We have provided information about these disciplinary actions below:
RIA Was Ordered to Pay Over $6 million for Undisclosed Conflicts of Interest
The SEC alleged that the RIA breached its fiduciary duty by receiving third-party revenue without fully and fairly disclosing the firm’s conflicts of interest. Specifically, the RIA breached its fiduciary duty when the firm received:
- Revenue sharing payments from its clearing broker resulting from advisory clients’ investments in no-transaction fee mutual fund share classes;
- Revenue sharing payments from its clearing broker generated by sweeping cash into certain money market mutual funds; and
- Markups on its clearing broker’s transaction fees, which were paid to the RIA.
The RIA failed to provide full and fair disclosure of the conflicts of interest created by its receipt of this revenue.
Duty of care failures
Among their other fiduciary obligations, investment advisers owe a duty of care. One important requirement of their fiduciary duty is that advisers must provide investment advice that is in the best interest of their clients.
RIAs must seek best execution for their clients’ transactions. The RIA in this case breached its fiduciary duty to seek best execution by causing certain advisory clients to invest in share classes of no-transaction fee mutual funds, which resulted in higher revenue sharing payments from their clearing broker. The RIA recommended them, even though share classes of the same funds were available to clients and were a better choice under the circumstances at the time of the transactions. Mutual fund share classes sold through the no-transaction fee program often had higher expense ratios.
The RIA breached its duty of care by failing to undertake an analysis to determine whether the particular mutual fund share classes it recommended were in the client’s best interest. Furthermore, the SEC contended that the RIA breached its duty of care when it recommended and selected cash sweep accounts for clients’ funds.
According to the SEC’s order, the RIA also failed to adopt and implement written compliance policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules.
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 findings, the RIA agreed to a cease-and-desist order and censure. The RIA also agreed to pay disgorgement of $4,213,351 along with prejudgment interest of $828,075, as well as a civil penalty of $1,000,000. Those funds were distributed to harmed investors.
The enforcement action is available HERE.
Twenty-Six Firms Pay Over $390 Million to Settle SEC’s Enforcement Actions Based on Widespread Recordkeeping Failures
In yet another disciplinary action against 26 different firms, the SEC’s investigations identified pervasive and longstanding utilization of unapproved communication methods, such as texting and WhatsApp on personal devices. The use of unapproved written communication platforms is called off-channel communications. The firms admitted that their personnel, including senior management, sent and received off-channel communications involving records that were required to be maintained under the securities laws. The firms’ failure to maintain and preserve required records undermined the SEC’s ability to view these communications during its investigations. Personnel at multiple levels of authority, including supervisors and senior managers, utilized these off-channel communications.
The SEC charged each firm with violating certain recordkeeping provisions of the Securities Exchange Act, the Investment Advisers Act of 1940, or both. Each of the firms was also charged with failing to exercise reasonable supervision of their personnel in order to prevent and detect those violations.
The firms admitted the facts contained in their SEC orders. They acknowledged that their conduct violated certain recordkeeping provisions of the federal securities laws. Along with combined civil penalties of $392.75 million, the firms agreed to improve their policies and procedures. In addition to significant financial penalties, each of the firms was ordered to cease and desist from future violations of the relevant recordkeeping provisions and was censured.
Three firms self-reported and received significantly lower civil penalties than they would have otherwise.
Takeaways
Careless recordkeeping practices can come back to haunt RIAs and other firms. Aside from implementing robust policies and procedures to prevent off-channel communications, senior employees of RIAs and other firms must set a good example for subordinates by only using approved written communications platforms.
Links to the 26 enforcement actions are available HERE.
RIA Ordered to Pay $90,000 for Pay to Play Rule Violations
Rule 206(4)-5, promulgated under Section 206(4) of the Advisers Act, is designed to address pay-to-play abuses involving campaign contributions made by certain investment advisers or their covered associates to government officials who are in a position to influence the hiring of investment advisers to manage government client assets, including the assets of public pension funds and other public entities. Among other things, Rule 206(4)-5 prohibits certain investment advisers from providing investment advisory services for compensation to a government entity for two years after the investment adviser or any “covered associates” of the investment adviser—defined to include certain of the investment adviser’s executives and any employee who solicits a government entity for the investment adviser—makes a campaign contribution to certain elected officials or candidates who can influence the hiring of certain investment advisers.
The SEC alleged that in December 2019, an individual made a campaign contribution to an incumbent for elected office in the State of Michigan. This office had influence over hiring investment advisers for a state public pension fund in Michigan. Over six months after that contribution, the individual was hired into a position in which the individual was a covered associate of the RIA and subsequently solicited investment advisory services from government entities for the RIA. Within two years after this contribution and after the individual became a covered associate of the RIA, the RIA provided investment advisory services for compensation to the state public pension fund. By doing so, the RIA violated Section 206(4) of the Advisers Act and Rule 206(4)-5 thereunder.
It is important to note that the investment was made prior to the date the individual joined the RIA. However, the SEC did not take this fact into consideration in deciding to discipline the RIA. According to the Order Instituting Proceedings, the individual’s participation in soliciting government entities triggered the two-year lookback provision, which captures not only contributions by persons who are covered associates at the time of the contribution, but also contributions by “a person who becomes a covered associate within two years after the contribution is made.” With the two-year lookback triggered, the RIA ran afoul of the pay-to-play rule because it continued to receive investment advisory fees from the state public pension fund’s longstanding investment in a closed-end fund advised by the RIA after the individual started soliciting government entities.
Under Advisers Act Rule 206(4)-5, the contribution had triggered a “time out” on the RIA providing investment advisory services for compensation to the state public pension fund beginning after the individual who made the contribution became a covered associate and continuing until two years had elapsed from the date of the contribution. However, during this period, the RIA continued to provide investment advisory services for compensation to the state public pension fund and received investment advisory fees.
As a result of the conduct described above, the SEC stated that the RIA willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-5 thereunder, which makes it unlawful for any investment adviser registered (or required to be registered) or an exempt reporting adviser, to provide investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.
The RIA agreed to cease and desist from committing or causing any violations and any future violations of Section 206(4) of the Advisers Act and Rule 206(4)-5 thereunder, was censured, and agreed to pay a civil money penalty in the amount of $95,000.
The enforcement action is available HERE.
Takeaways
Disclosures
As you update your Form ADV disclosure brochure to ensure that your disclosures are accurate, thorough, and complete, do not forget about your Form CRS. This RIA needed to revise its brochure and Form CRS to add disclosures regarding its transaction fee markups and the conflicts of interest arising from them.
Disclosure language must be precise. Initially, this RIA only disclosed in its Forms ADV Part 2A that it “may” receive compensation from the clearing broker in connection with its no-transaction fee program, even though the firm did, in fact, receive this compensation. In addition, even after the RIA removed the “may” language, the firm failed to disclose until January, 2020, that this program gave rise to a conflict of interest. Until that time, the firm did not disclose that revenue sharing payments gave the RIA an incentive to steer clients to the no-transaction fee program, which was more expensive.
Off Channel Communications
Based upon the large number of enforcement actions brought by the SEC in a relatively short period of time, it is clear that the Commission will focus on recordkeeping during examinations of RIAs. Recordkeeping failures undermine the SEC’s ability to exercise effective regulatory oversight, which may result in harm to investors.
One approach is for RIAs to adopt robust policies and procedures to ensure that Investment Adviser Representatives and other advisory personnel do not use personal devices for business-related communications. If an RIA utilizes that approach, members of the firm should be required to sign an attestation that they will not use off-channel communications for business-related matters. In addition, executives, supervisors, senior leadership, and compliance staff must lead by example and should avoid using off-channel communications.
If that approach is not palatable, many electronic communications archiving service providers are available to archive text messages. RIAs that are having difficulty implementing policies and procedures prohibiting electronic messaging on personal devices are strongly encouraged to utilize those services.
Political Contributions
As we approach another election season, RIAs must take their political donation reporting and review obligations under Advisers Act Rule 206(4)-5 seriously and must require the reporting of all political contribution made by covered associates (i.e., Managers, Officers, Directors, IARs, employees, promoters, or any political action committee controlled by the investment adviser or by any of its covered associates).
If any covered associates has made a political contribution in excess of $350, per election, to an elected official or candidate for whom the covered associate is entitled to vote, and up to $150, per election, to an elected official or candidate for whom the covered associate is not entitled to vote, it is the RIAs responsibility to abstain from providing advisory services for compensation, either directly to the government client or through a covered investment pool, for two years following a campaign contribution by the RIA or a covered associate to candidates or officials in a position to influence the selection or retention of the RIA to manage the assets of public pension funds or other public entities.
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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