Financial Services Firm Affiliates Settle Five SEC Enforcement Actions for Allegedly Misleading Customers and Failing to Act in their Best Interests

Who may be interested: Registered Investment Companies; Registered Investment Advisers; Broker Dealers; Compliance Officers; Boards of Directors

Quick Take: The SEC recently settled five separate enforcement proceedings against two financial services firms that alleged, among other things, misleading disclosures to investors, prohibited joint transactions and principal trades, and failing to make recommendations in the best interest of customers. Without admitting or denying the findings, the affiliates agreed to pay more than $151 million in combined civil penalties and voluntary payments to settle the actions.

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Action Involving Mutual Fund Clones

In this action, the SEC’s order found that the firm, a dually registered broker-dealer and investment adviser, recommended mutual fund products to its retail brokerage customers when materially less expensive “clone” ETFs that offered the same investment strategy and portfolio to investors were also available. The SEC’s order found that the firm violated Regulation Best Interest because its registered representatives failed to consider the higher costs associated with the mutual funds and failed to have a reasonable basis to believe that their recommendations were in the best interest of their customers.

The SEC did not impose a civil penalty because the firm self-reported the issue, conducted its own internal investigation, provided substantial cooperation with the SEC staff, and, among other remedial measures, voluntarily repaid impacted customers approximately $15.2 million. This action underscores the SEC’s recent focus on clone investment products with pricing differentials.

The SEC’s order relating to this enforcement action can be found here.

Prohibited Joint Transactions – Section 17(d) Action

The SEC’s order found that the firm, a registered investment adviser to three U.S. money market mutual funds (Domestic Funds) and the delegated portfolio manager of an affiliated foreign money market fund (Foreign Fund), caused these funds to engage in joint transactions prohibited under Section 17(d) of the 1940 Act. According to the order, the transactions were intended to enhance the liquidity of the Foreign Fund during the COVID-19 pandemic, by using the Domestic Funds’ access to a liquidity facility (MMLF) established by the Federal Reserve Board. The firm executed joint transactions involving the Foreign Fund and Domestic Funds, working with investment banks and broker-dealers to structure transactions that provided the Foreign Fund with liquidity through the MMLF. While the Foreign Fund recognized a net realized gain of $1.5 million from the transactions in question, the Domestic Funds earned only one-tenth of the gain of the Foreign Fund, while bearing the risks associated with the transactions. The firm was required to pay a $5 million civil penalty.

The SEC’s order relating to this enforcement action can be found here.

Prohibited Principal Trades – Section 17(a) and Section 206(3) Action

The SEC’s order found that the firm, a registered investment adviser, engaged in or caused 65 prohibited principal trades, 15 of which involved registered money market funds advised by the firm, with a combined notional value of approximately $8.2 billion. The order found that a portfolio manager at the firm directed an unaffiliated broker-dealer to buy fixed-income securities from a broker-dealer affiliate of the firm, and the adviser then purchased these securities from the broker-dealer on behalf of one or more of its clients (including money market funds advised by the adviser). Principal trades are generally prohibited under Section 17(a) of the 1940 Act and Section 206(3) of the Advisers Act. Both Acts prohibit indirect prohibited principal transactions, such as the interpositioning of a broker in a transaction that otherwise represents a principal transaction. According to the order, the firm had received exemptive relief from the SEC to permit some types of principal transactions, but the firm failed to comply with the conditions of the relief in making any of the trades, and the firm did not make necessary pre-trade disclosures to other clients about the trades or obtain client consent. The SEC’s order also found that the firm failed to adopt and implement adequate policies and procedures to prevent unlawful principal trades by its investment personnel.

The firm was required to pay a $1 million civil penalty for violating provisions of both the 1940 Act and the Advisers Act. In establishing the dollar amount for the civil penalty, the SEC credited the firm for notifying the SEC staff promptly once the firm became aware of the principal trades and for cooperating fully with the investigation.

The SEC’s order relating to this enforcement action can be found here.

Portfolio Management Program Action

The SEC’s order found that the firm, a dually registered broker-dealer and investment adviser, failed to fully disclose the financial incentives that it and its financial advisors had in recommending the firm’s portfolio management program over third-party managed advisory programs (“wrap fee programs”) that the firm offered. Furthermore, according to the order, the firm failed to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder, in connection with the disclosure of conflicts of interests presented by the fee structure for its advisory programs or the compensation of its financial advisors.

The SEC’s order found that the firm violated the Advisers Act, and imposed a cease-and-desist order, censure, and a $45 million penalty on the firm.

The SEC’s order relating to this enforcement action can be found here.

Conduit Private Funds Action

The SEC’s order found that the firm, a dually registered broker-dealer and investment adviser, made misleading disclosures to brokerage customers investing in its “Conduit” products. The Conduit products pooled customer money and invested in private equity or hedge funds (which such customers were not otherwise eligible to access directly) that would distribute to the Conduit company shares that went public. Customers were allegedly told that the Conduit products would sell the newly public shares promptly. According to the order, investors were not told that an internal team at an affiliate actively managed these Conduit products and exercised complete discretion over when to sell and the number of company shares to be sold. In some cases, IPO shares were held for months before being sold. As a result, investors were subject to undisclosed market risk due to the timing of these sales.

The firm agreed to make a voluntary payment of $90 million to more than 1,500 investor accounts and to pay a civil penalty of $10 million, which would also be distributed to investors.

The SEC’s order relating to this enforcement action can be found here.

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The SEC’s press release announcing each of the settlements can be found here.