In the Dire Straits song, Money for Nothing, a group of appliance movers express their envy of rock stars who get paid handsomely for doing no work. Even if an advisor is a rock star in the financial world, the SEC will not look kindly upon Registered Investment Advisors (“RIAs”) that charge fees without providing advisory services.
Charging clients for work that did not occur
On September 16, 2021, the SEC charged an RIA and two of its principals for breaching their fiduciary duties to advisory clients. The Michigan-based RIA and two of its principals charged advisory fees to 81 client accounts, even though they did not provide advisory services to them after the clients’ original Investment Advisor Representative (“IAR”) left the firm.
The RIA often failed to notify clients that their original IAR had left the firm and had been replaced by the two principals. Some clients were not contacted by anyone at the RIA after this change occurred.
From at least July 2015 through April 2021, the RIA was accused of improperly charging $85,432 in advisory fees to client accounts for which the firm failed to provide advisory services after the departure of the IARs who were responsible for them. The RIA’s standard practice was to assign two of the firm’s owners as the IARs for these so-called “house accounts.” These house accounts received varying levels of advisory services from the two principals, ranging from regular account reviews and contact with clients to no account reviews or client contact over a number of years.
The RIA continued to charge advisory fees on all house accounts, regardless of the level of service provided. In many instances, the two principals acting as IARs for the house accounts failed to provide any advisory services.
Because the two principals shared responsibility for managing these accounts, each received a portion of the fees based on their ownership interest in the firm. Beginning in 2019, the principals began splitting the fees equally. They collected these fees,
Failure to fully and fairly disclose the RIA’s financial interest in a portfolio company
The RIA and its principals were in dire straits because of other compliance deficiencies. According to the SEC’s order, the principals had an ownership interest in, and received compensation from, a portfolio management company that the RIA recommended to clients. The RIA and its principals failed to disclose the conflicts of interest created by their receiving compensation from an affiliated portfolio management company. Furthermore, the RIA did not fully and fairly disclose its financial interest in the portfolio management company whose services the firm recommended to certain clients.
From at least July 2015 through July 2019, the RIA created and provided its clients with marketing materials, as well as investor updates, that described the portfolio management company’s services and investment strategy. According to those materials, the portfolio management company was independent of the RIA. In fact, the portfolio management company was not independent. The majority owner was an IAR of the RIA. One hundred percent of the portfolio management company’s revenue was derived from the RIA’s clients who were the only users of its services.
To meet its fiduciary duty, the RIA was required to provide its advisory clients with full and fair disclosure that was sufficiently specific, so they could understand the conflicts of interest regarding the firm’s advice. Clients would then have an informed basis on which to agree to or reject those conflicts of interest. The SEC alleged that the firm’s disclosures were insufficient.
Ineffective policies and procedures contribute to compliance problems
When things go wrong at an RIA, the SEC usually pins the blame on weak and ineffective policies and procedures. According to the SEC’s complaint, 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 governing the management of house accounts and the disclosure of conflicts of interest.
Until November 2019, the RIA lacked written policies and procedures to address the transition of client accounts when IARs ended their association with the firm. According to the SEC, the RIA failed to adopt and implement written policies and procedures regarding how it would handle the departure of IARs. The firm’s policies and procedures also did not address who would review and manage the accounts of an IAR who left the firm.
In November 2019, the RIA adopted a policy that required it to send a notification letter to clients that remained at the firm more than 90 days after the departure of their IAR. It also adopted a written policy stipulating that clients would not be charged a fee during the 90-day transition period. The letter would notify clients about the departure of their IAR and provide them with alternatives, such as an option for their investments to be managed as a house account. However, even after the RIA adopted this new policy, the firm:
- Failed to notify clients about the departure of one IAR until six months after his termination;
- Sent notifications to clients of another IAR nearly eleven months after his departure; and
- Waited nearly a year before sending notifications to clients about a third IAR who left the firm.
In addition, policies and procedures did not address disclosure of all conflicts of interest.
The SEC’s order found that the RIA and its two principals violated Section 206(2) of the Investment Advisers Act. Furthermore, the RIA violated, and one of the principals caused, the firm’s violations of Section 206(4) of the Investment Advisers Act and Rule 206(4)-7 thereunder.
Without admitting or denying the SEC’s findings, the RIA agreed to pay disgorgement of $595,899, prejudgment interest of $100,875, a civil penalty of $150,000, and to perform certain undertakings. The two principals agreed to pay penalties of $50,000 each. The principal who caused the RIA’s violations agreed that he would not apply to act as a Chief Compliance Officer (“CCO”) until after three years from the date of the order. That principal had served as the firm’s CCO until July, 2021. All of the parties agreed to cease-and-desist orders and to be censured.
In certain respects, the actions of the RIA and its principals were counter-intuitive. When IARs leave the firm, most RIAs will be very hands on with their clients to lower the risk that they take their business to another investment advisor.
The enforcement action is available at https://www.sec.gov/litigation/admin/2021/34-93035.pdf.