Retail Investment Advisers Beware – The SEC Is Watching

09 January 2019 Law360 Publication
Author(s): Margaret Gembala Nelson Kathryn Marie Throo

This article originally appeared in Law360 and is republished here with permission.

Two years after the demise of Operation Broken Gate, the U.S. Securities and Exchange Commission is an agency of limited resources with a seeming laser focus both on protecting Main Street investors from fraudulent acts and the hot topics of the day (e.g., ICOs and cybersecurity). That has left many sophisticated, SEC-registered entities breathing a sigh of relief. But that is not the case for retail investment advisers. Even without the Share Class Disclosure Initiative targeting 12b-1 fees, retail IAs are within the SEC’s sightlines, with the Enforcement Division bringing a significant number of cases against them in apparent coordination with the Office of Compliance, Inspections and Examinations, or OC.

Indeed, according to the Enforcement Division’s FY 2018 Annual Report, standalone actions against investment advisers and investment companies increased 32 percent on a year-over-year basis, with 108 actions brought in FY 2018 as compared to 82 actions in FY 2017. These actions represent a larger percentage of total enforcement actions on a year-over-year basis, increasing from 18 percent of total cases in 2017 to 22 percent in 2018.

Of the 108 actions brought in 2018, over forty were brought against retail IAs, with nearly half of those being brought within the last quarter of FY 2018. And there’s no sign that this momentum is slowing, with several new cases against retail IAs being instituted during the first few months of FY 2019.

This article describes some of the major themes of retail IA cases recently brought by SEC Enforcement. These themes should provide guidance and reminders to retail IAs’ compliance departments as they prepare for their annual compliance reviews required by Section 206(4) and Rule 206(4)-7 of the Investment Advisers Act of 1940 (otherwise known as the Compliance Rule). With these themes in mind, retail IAs will be better equipped to avoid getting sideways with the SEC in the future.

Conflicts of Interest

Consistent with OC’s examination priorities, numerous enforcement actions were based on retail IAs’ failures to inform clients of conflicts of interest.[6] For example, in a settled order, the SEC claimed that Knowledge Leaders violated Section 206(4) of the Advisers Act when it failed to disclose its use of “soft dollars” to pay a company owned by Knowledge Leaders’ managing director. Knowledge Leaders agreed to purchase with soft dollars approximately $1 million in research regarding an investment algorithm from the managing director’s company.

The SEC asserted that this relationship required disclosures. The SEC additionally found that Knowledge Leaders’ policies and procedures were not reasonably designed to identify conflicts of interest. Although Knowledge Leaders voluntarily self-reported the conflict and cooperated with the investigation, the SEC imposed a $50,000 civil money penalty.

The SEC charged Financial Fiduciaries LLC in a March 2018 settled order for failing to disclose conflicts of interest created by its financial arrangement with a third party trust company, Investors Independent Trust Company, or IITC. Under the agreement, Financial Fiduciaries’ sole member firm, WTC Inc., arranged for Financial Fiduciaries to be the exclusive provider of investment advisory services to IITC’s trust clients.

WTC and IITC shared office space and a “dual employee.” Because Financial Fiduciaries had financial incentives to recommend its clients use IITC as a trustee, the SEC found the arrangement created a conflict of interest that was required to be disclosed under the Advisers Act.

Improper Trading Practices

The SEC has also brought several recent cases against retail IAs for engaging in, and failing to implement policies to prevent, improper trading practices. These cases include the August 2018 action against Hamlin Capital Management LLC for mispricing cross trades among client accounts for nearly five years.[10] The settled order described HCM as executing over 15,000 cross trades of thinly-traded, tax-exempt municipal bonds over which HCM often had controlling interests at the securities’ bid price, rather than the midpoint between the bid and ask price.

This practice — which was contrary to the policies in HCM’s compliance manual and its Form ADV disclosures — resulted in favoring the buying clients over the selling clients, with selling clients missing out on over $400,000 in proceeds. HCM also influenced certain broker-dealers to increase their price quotations for certain municipal bonds without adequately documenting the basis and contrary to recent secondary market activity. Subsequent cross trades executed at these higher prices caused HCM’s buying clients to overpay nearly $195,000 for the bonds. HCM agreed to settle to charges under the Advisers Act’s anti-fraud provision and the Compliance Rule and pay a $900,000 penalty, in addition to repaying affected clients.

The SEC’s focus on improper trading practices is further reflected in the Enforcement Division’s initiative on cherry-picking activities, which uses data analytics to detect this behavior. In one such case, the SEC charged BKS Advisors LLC for failing to supervise and failing to implement policies and procedures reasonably designed to prevent cherry-picking by its advisory representatives.[12] Specifically, a BKS representative placed block trades in an omnibus account, waiting until later in the day to unfairly allocate the profitable trades to his favored advisory clients and the unprofitable trades to other advisory clients.

This occurred despite BKS’s daily review of the representative’s trading, and its policy requiring the use of an average price to allocate block trades among clients. In the settled administrative order, the SEC concluded that BKS violated the Advisers Act’s anti-fraud provisions, the Compliance Rule and the failure to supervise requirements, ordering BKS to pay a civil penalty of $75,000.

Advertising/Marketing Violations

Other Enforcement cases have focused on retail IAs’ marketing to investors. As part of this focus, the SEC brought actions alleging violation of the Advisers Act’s “testimonial rule,” which prohibits registered investment advisers from publishing, circulating or distributing any advertisement that includes any testimonial or endorsement of the adviser.

In a settled matter against HBA Advisors LLC, the SEC found that a retail IA’s advertisements on a review website violated the testimonial rule. HBA’s third-party marketing consultant requested HBA clients post reviews of HBA’s advisory services on social media and the public review website, HBA then purchased advertisements on that, when clicked, linked users to the website’s reviews. HBA personnel responded to certain reviews, challenging negative comments. The SEC concluded that HBA’s advertisements violated the Advisers Act Section 206(4) and ordered civil penalties of $15,000.

The SEC also brought charges against Romano Brothers & Company based on the testimonial rule. To celebrate its 50-year anniversary, Romano Brothers compiled a video, which included clients’ statements about their experiences with the firm. In the video, some clients stated that Romano Brothers’ services provided them with income and security. The video was shown at an anniversary party, and was later posted to and the firm’s website. In the settled order, the SEC found that Romano Brothers willfully violated Section 206(4), and, despite remedial efforts, imposed a $15,000 penalty.

Fees Inconsistent With Disclosures

As part of its efforts to protect the Main Street investor, Enforcement has been focused on the accuracy of fee disclosures. This can be seen in the recently-settled case against Retirement Capital Strategies Inc., which agreed to charges under the anti-fraud provisions and the Compliance Rule for charging fees inconsistent with its fee schedule.

Specifically, the firm charged an annual fee based on a percentage of assets under management that decreased when a clients’ AUM hit certain breakpoint levels. But, in certain instances, RCS failed to apply these decreased percentages as prescribed by the fee schedule, which was referenced in RCS’s advisory agreements and included in its Form ADV brochure. As a result, RCS overcharged 293 client accounts approximately $304,000. In addition to voluntarily refunding the excess fees and hiring a compliance consultant, RCS agreed to pay a $50,000 penalty.

The SEC sanctioned Beverly Hills Wealth Management LLC for not following procedures disclosed in its Form ADV brochures regarding the refund of advisory fees to clients who terminate their advisory relationships. Although BHWM’s brochures stated it would refund unearned advisory fees within five business days upon “written notice” of termination with no physical signature requirement, the SEC found that BHWM refused to recognize termination notices via email and other digital notices that had electronic signatures, delaying refunds to clients. The SEC censured BHWM, and imposed a civil money penalty of $100,000 for failing to follow its refund disclosures and other misconduct.

Recommendations and Conclusion

Given the SEC’s continuing focus on retail IAs, compliance departments would be well-served to include the following areas within their annual compliance review:

Perform a detailed review of arrangements with third parties to screen for revenue streams and other financial incentives requiring disclosure as conflicts of interest;

Test trading practices regarding cross trading, principal trading and trade allocations to ensure that they are being executed in accordance with firm disclosures;

Design and monitor controls screening the company’s and personnel’s use of social media to avoid publishing testimonial materials; and

Ensure that the fee structure disclosed to advisory clients is actually being followed.

As noted in many of the cases described above, SEC Enforcement will regularly tie back any alleged misconduct to a retail IA’s compliance program, asserting that the firm either had inadequate compliance policies or failed to implement such policies. By addressing the above themes during compliance reviews and adequately documenting such reviews, a retail IA can build ammunition to combat such assertions.


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