Sharing Revenue Can Give RIAs a Generous Share of Compliance Problems

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Although it’s good to share, sharing revenue can cause compliance problems for a Registered Investment Advisor (“RIA”). On August 2, 2021, the SEC resolved an enforcement action against a Missouri-based RIA, which was accused of breaching its fiduciary duty to advisory clients. The SEC’s complaint alleged that the RIA failed to disclose the following three types of compensation paid to the advisory firm’s affiliated broker-dealer:

  1. Mutual fund revenue sharing;
  2. Cash sweep revenue sharing; and
  3. Fee mark-ups.

The broker-dealer shares common ownership and management with the RIA.

Overview of revenue sharing compliance issues

The SEC’s enforcement action articulates the compliance mistakes made by the RIA. The SEC’s action can be found here.

For a number of years, the RIA’s affiliated broker-dealer received revenue sharing payments from an unaffiliated clearing broker. Those revenue sharing payments were tied to advisory clients’ investments in certain mutual funds. The funds selected by the RIA were generally more expensive than lower-cost share classes of the same mutual funds offered on the clearing broker’s platform. In addition, the RIA’s affiliated broker-dealer received compensation arising from the mark-up of fees by the clearing broker. The RIA did not adequately disclose the payments to its affiliated broker or the associated conflicts of interest.

The RIA did not fulfill its duty to seek best execution for clients’ transactions because it failed to select share classes of funds that gave clients more bang for their buck. Furthermore, the RIA failed to adopt and implement written compliance policies and procedures that were reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules. The SEC’s enforcement action charged that the RIA’s affiliated broker-dealer received three types of compensation that the advisory firm did not fully or adequately disclose.

  • Mutual fund revenue sharing

Specifically, the SEC’s complaint alleged that the RIA’s affiliated broker-dealer had a revenue sharing agreement with the clearing broker. The clearing broker made payments to the affiliated broker-dealer based on the amount of the RIA’s client assets invested in certain mutual funds and share classes. The RIA’s clients could have invested in lower-cost share classes of those same funds. Those share classes, however, would have paid little or no revenue to the RIA’s affiliated broker-dealer. Therefore, the RIA had an incentive to recommend the share classes that generated revenue for its affiliated broker-dealer.

The RIA was obligated to disclose all material facts to advisory clients that could affect its advice, including any conflicts of interest between itself or its associated persons and their clients. To satisfy its fiduciary duty, the RIA was required to provide its advisory clients with full and fair disclosure. Disclosures must be sufficiently specific so that clients can understand the advisor’s conflicts of interest. Full disclosure helps to ensure that clients have an informed basis on which to consent to or reject the conflicts of interest.

  • Cash sweep revenue sharing

The SEC determined that the RIA made recommendations to clients regarding sweep products that would temporarily hold uninvested cash in sweep accounts. A sweep account is a money market mutual fund or bank account used by broker-dealers to hold uninvested cash, such as incoming deposits, dividends and investment returns, until the RIA or the investor decides how to invest the money.

Money market funds usually invest in short term and highly liquid securities with minimal credit risk. They are frequently used in sweep accounts. The RIA had an incentive to recommend cash sweep products that brought revenue to its affiliated broker-dealer. The affiliated broker-dealer received the most revenue from certain money market funds available on the clearing broker’s platform. Those funds returned lower yields to clients.

The RIA did not provide full and fair disclosure of all material facts regarding its conflicts of interest. Those conflicts arose when advisory clients invested in a money market fund on the clearing broker’s platform made revenue sharing payments to the affiliated broker-dealer.

  • Fee mark-ups

The RIA’s advisory clients paid fee mark-ups. The clearing broker then credited the mark-ups to the advisor’s affiliated broker-dealer. The RIA did not disclose to clients that its affiliated broker received a portion of the mark-ups. The RIA’s disclosures did not clarify that its affiliated broker-dealer received a portion of the brokerage fees, or that this practice constituted a conflict of interest.

Conclusion

In addition to above deficiencies, the RIA failed to adopt and implement written compliance policies and procedures that were reasonably designed to prevent violations of the Investment Advisers Act and its rules. The SEC ordered the RIA to pay disgorgement, prejudgment interest, and a civil penalty.

Aside from this case, the SEC has recently demonstrated its concern about revenue sharing arrangements between clearing brokers and RIAs’ affiliated broker-dealer. On July 9, 2021, the SEC settled an enforcement action against a Texas-based RIA that breached its fiduciary duty to advisory clients by failing to provide full and fair disclosure regarding two types of compensation paid to its affiliated broker-dealer. The action is available here.

Similarly, on July 8, 2021, the SEC accused a Massachusetts-based RIA of breaching its fiduciary duty to advisory clients because it did not fully disclose that the firm’s affiliated broker-dealer received revenue from cash sweep accounts. The clearing broker made revenue sharing payments to the RIA’s affiliated broker-dealer based upon the amount that clients invested in a particular cash sweep vehicle. These payments created a conflict of interest, because the clearing broker also offered a cash sweep vehicle that would not increase revenue for the RIA’s affiliated broker-dealer. The RIA did not adequately disclose the existence of the revenue sharing arrangement or the related conflicts of interest. The enforcement action can be reviewed here.

These enforcement actions send the message that sharing isn’t always a good thing when it involves RIAs, affiliated broker-dealers, and clearing brokers. This is especially true when firms are covertly sharing money that is coming from the pockets of advisory clients.

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