Compliance Team Takes the Hit for MNPI Process Failures; and SEC Continues Crusade Against “Inadequate Disclosure”: Lessons Learned from SEC & FINRA Cases and Worth Reading for July 2020

Hardin Compliance Consulting LLC

Lessons Learned

Another Adviser Nailed for Inadequate Handling of Material Nonpublic Information. This is the second enforcement recently where the SEC fined an adviser for inadequate policies and procedures for handling material nonpublic information without alleging actual insider trading. (See Hardin’s analysis of the SEC’s enforcement action against Cannell Capital in March.) In this case, private equity adviser, Ares Management LLC (“Ares”), invested in debt and equity of a public company. Ares’ equity position gave it the right to appoint two directors. The employee-director appointed also served on Ares’ investment committee. Ares’ policies and procedures included use of a restricted list, and the public company was added when the Ares’ employee was appointed to the board. If the Investment Committee wanted to trade the public company’s shares, pre-clearance was required and enforced through “hard restrictions” coded into the firm’s order management system (“OMS”). The pre-clearance process entailed compliance (1) confirming with the issuer that the trading window for directors was open and (2) verifying with the employee-director whether the firm possessed material nonpublic information at that time. Procedures then required compliance personnel to document the pre-clearance process in the OMS.

Despite the risk profile associated with this situation, the Investment Committee decided to invest in public equity of the issuer, to the tune of 17% of the issuer’s shares outstanding. As required for each trade, compliance verified that the trading window for insiders was open and the employee-director stated that the firm was not in possession of MNPI. However, procedural breakdowns occurred according to the SEC:

  • The Firm did not deploy existing optional information barrier procedures to wall off the director from the firm’s investment decision making process.
  • Compliance testers responsible for confirming the existence of MNPI with the employee-director were left to self-determine whether the information described by the employee-director was material or not. This review was found to lack the depth warranted by the level of risk. Policies and procedures also lacked sufficient detail to guide compliance personnel in this analysis and there was insufficient oversight for more experienced professionals to jump in.
  • While the OMS was updated consistently with a hard restriction for securities on the restricted list, documentation of the pre-clearance process was inconsistent and sometimes missing.

Similar to the Cannell enforcement, the SEC again focused solely on procedural failures in the compliance department. Although we are not privy to what else may have been going on here, it’s safe to say that CCOs should be on alert. Documenting careful and thoughtful completion of procedures is advised. But CCOs should also be cautious that front-line compliance reviewers are not left with too much responsibility and too little guidance or oversight when performing complicated analyses. For example, if a tester is responsible for determining whether information is material, then the tester needs extensive training and development opportunities. Alternatively, if the tester is not responsible for the higher-level review, then the procedures should include instructions on when to escalate. This case demonstrates again that simply “checking the box” without thinking deeper is not going to cut it. Finally, CCOs should take steps to limit the compliance department’s responsibility for the firm’s conduct. Tis action makes no mention of potentially faulty judgment of the employee-director or the investment committee – all of this fell on compliance. Ultimately, compliance is everyone’s responsibility and a firm’s compliance manual should support this by distributing responsibility where appropriate. Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

The Fat Lady Has Not Sung Yet… the SEC Continues its Crusade against “Inadequate Disclosure” of Mutual Fund Fees. In April, the SEC settled the last three share class selection cases with advisers who self-reported under its Share Class Selection Disclosure Initiative. But the SEC is not stopping there, continuing to bring cases against advisers for failing to “adequately disclose all material facts” resulting from investing clients in mutual fund share classes that generate 12b-1 fees and shareholder servicing fees where the adviser and its representatives benefited from those fees. For example, in settlements with Vescio Asset Management LLC and William Vescio, US Bancorp Investment, Inc. (USBI) and Oxbow Advisors, LLC, the SEC appears to be taking a cut and paste approach, using essentially the same language in all three cases describing the disclosure failures:

To meet this fiduciary obligation, [the Investment Adviser] was required to provide its advisory clients with full and fair disclosure that is sufficiently specific so that they could understand the conflicts of interest concerning [the Investment Adviser’s] advice about investing in different classes of mutual funds and could have an informed basis on which they could consent to or reject the conflicts. [The Investment Adviser] did not adequately disclose all material facts regarding the conflict of interest that arose when it invested advisory clients in a share class that would generate 12b-1 fee revenue for [the Investment Adviser’s IARs] as registered representatives of a broker-dealer while a share class of the same fund was available that would not provide [the Investment Adviser’s IARs] with that additional compensation.

In the US Bancorp Investment, Inc. (USBI) case, USBI, as a dual registrant, also received shareholder servicing fees from mutual funds. USBI did not share these fees with its representatives. Nonetheless, the SEC found that the firm failed to adequately disclose the conflict that resulted from recommending fund share classes that paid out those fees, since USBI received them and had a financial incentive to recommend share classes that paid these fees.

In all three cases, the SEC found that the investment adviser firms:

  • Breached their fiduciary duty to seek best execution by putting advisory client assets into mutual fund share classes that charged 12b-1 fees and shareholder servicing fees when lower-cost share classes were available;
  • Failed to adequately disclose the conflict of interest in selecting share classes that paid 12b-1 fees and shareholder servicing fees (a violation of Section 206(2) of the Advisers Act); and
  • Failed to adopt and implement compliance policies and procedures reasonably designed to prevent violations of the Advisors Act (a violations of Rule 206(4)-7) when selecting mutual fund share classes.

Each firm was required to reimburse clients and pay penalties. USBI’s penalty was the largest at $2.4 million, OxBow’s was $90,000, and Vescio’s was $40,000.

The SEC is focusing very specifically on disclosing the conflict of interest the adviser and its financial professionals have when selecting mutual fund share classes that provide them with 12b-1 fees and shareholder servicing fees. Surprisingly, in the USBI case, its policy during the five years at issue was to recommend that clients purchase No-Transaction-Fee (NTF) load-waived Class A shares that paid 12b-1 fees and shareholder servicing fees. On the surface, this appears to be a fair policy, since clients are not required to pay a transaction fee or a front-end load. Moreover, Class A shares typically have lower expense ratios than Class C shares. The SEC’s greatest concern appeared to be the fact that clients were not told that USBI had a vested interest in selecting the mutual fund share classes since the firm would receive additional revenue. The SEC was also concerned that institutional share classes, which generally have no 12b-1 or shareholder servicing fees, were also not being considered for clients who might qualify.

The important takeaway here is that advisers need to provide “full and fair disclosure that is sufficiently specific” in Form ADV Part 2A. Most advisers have gotten the message that the SEC strongly frowns upon the receipt of 12b-1 fees attributable to mutual fund investments in advisory accounts. But advisers have a continuing obligation to look for the lowest cost share class. Here are my thoughts on what this disclosure might look like:

About Mutual Fund Investments

As an investment adviser, our firm has the discretion to select from various share classes offered by the mutual funds. Some share classes pay 12b-1 fees and shareholder servicing fees to broker-dealers and their representatives, including Class A, Class B and Class C shares. These fees are meant to compensate broker-dealers for distribution expenses and the costs of servicing client accounts, and are charged to fund shareholders as fund expenses. Generally, Class A shares charge lower 12b-1 fees as compared to Class B and C shares.

Our Firm’s Financial Advisors are also registered representatives of the broker-dealer and receive a portion of 12b-1 fees attributable to client assets invested mutual funds. This means that that our Firm and your Financial Advisor have a financial incentive to invest your assets in certain mutual fund share classes to receive these additional fees. [To mitigate this conflict, our firm now credits client accounts with any 12b-1 fees received.] [Our Firm, in its capacity as a broker-dealer/ or our affiliated broker-dealer also receives shareholder servicing fees from certain mutual fund share classes. This presents a conflict of interest for our [Firm]. Unlike 12b-1 fees, our Financial Advisors do not receive any part of the shareholder servicing fees which mitigates the conflict. [discuss range of shareholder servicing fees and whether this is a significant source of revenue for the firm.]

There are other share classes that do not charge 12b-1 fees and shareholder servicing fees, such as Institutional Class shares (I-Shares). Because I-Shares have lower expenses, they produce higher returns than other share classes of the same fund. I-Shares are only available to investors that can make a substantial minimum investment, ranging from $25,000 to $1 million. In some cases, mutual funds agree to waive the minimum investment requirement. Ask your Financial Advisor if I-Shares are available to you.

Clients may also buy mutual funds directly from a mutual fund company. Mutual Fund companies offer “investor class” shares to retail investors that do not charge any sales loads or commissions. Ask your Financial Advisor about this option.

Contributed by Jaqueline M. Hummel, Partner and Managing Director.

Former RIA COO Barred from Industry. In our May 2019 Regulatory Update we discussed this case where the SEC charged Richard Diver, co-founder and Chief Operating Officer of M&R Capital Management, for stealing $6 million from the firm and its clients over seven years. As COO, Mr. Diver was responsible for managing the firm’s revenues and expenses, including payroll and client billing. He used his position to inflate his salary and to overbill clients. Diver confessed when confronted by the CEO. Mr. Diver has settled the matter with the SEC, and has been barred from working in the industry indefinitely.

One of the main takeaways from this case is that higher risk activities should include a system of checks and balances. Even if you trust your COO, a second set of eyes reviewing client billing is an essential safeguard, both for preventing fraud and for revealing flaws in the process. Contributed by Jaqueline M. Hummel, Partner and Managing Director.

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Photo Credits: Photo by Nathan Edwards on Unsplash.

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Hardin Compliance Consulting LLC

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