A recent filing by the U.S. Securities and Exchange Commission (“SEC”) against a California-based advisory firm should serve as a cautionary tale for compliance officers. It provides keen insight into the SEC’s ongoing effort to seek enforcement action against firms and their affiliated broker-dealers for misleading advisory clients in disclosures about fee markups on their transactions.
On September 30, 2021, the SEC filed a complaint against two affiliated firms and their CEO who also served as the firms’ CCO, alleging fraudulent misconduct regarding fee markups and lack of adequate disclosures.
Alleged Fee Markups of 360%
The advisory firm typically charged its advisory clients through hourly rates, fixed fees, and a percentage of clients’ managed assets. Most of the firm’s 30 investment advisers were also registered representatives of the firm’s affiliated broker-dealer.
The affiliated broker-dealer, however, did not have actual custody of any accounts. Instead, it was being used as the introducing broker, and a separate clearing broker operated as the third-party clearing and custody firm.
According to the SEC’s complaint, the CEO entered into a clearing agreement on behalf of the broker-dealer firm with the firm’s clearing broker that defined how much the clearing broker would charge the broker-dealer when executing and clearing trades on behalf of the investment advisory affiliate’s clients.
The complaint stated that in addition to the clearing broker’s standard fees and charges, the agreement allowed the broker-dealer affiliate, as the introducing broker, to include fee markups and to pass those on to the investment adviser affiliate’s advisory clients. The clearing broker would collect those fees and remit payment back to the broker-dealer.
The CEO allegedly created a fee schedule that marked up client transactions up to 360%. The SEC said that between 2015 and 2020, the investment advisory’s clients paid fee markups 60% of the time in connection with more than 10,000 executed transactions, resulting in the broker-dealer firm receiving more than $300,000 in transaction fee markups.
Materially False and Misleading
In its fee disclosure, the investment advisory firm allegedly assured clients that such fees were “uncertain” or that they were merely part of the typical fees the clearing broker charged. The SEC said the advisory firm had disclosures that stated the affiliated broker-dealer ‘may’ receive a portion of the fee markups when, in fact, the CEO knew, or was reckless and negligent for not knowing, that the affiliated broker-dealer had directed the clearing broker to charge all the investment advisory clients fee markups and had done so for up to six years. The complaint also alleged that the firm’s disclosure brochure deliberately lumped all the fees together so that clients could not identify transaction and non-transaction fees and failed to clearly disclose conflicts of interest.
According to the SEC complaint, the investment advisory firm also did not implement policies and procedures to prevent these types of disclosure and conflict of interest violations.
Fee Disclosure Must be Transparent
The SEC has taken the long-standing position that if you are receiving fees, you cannot use the word ‘may’ in fee disclosure.
The moral of this story is clear. Advisory firms must provide transparent disclosures to their clients, which outline among other things, fees that are directly and/or indirectly received by a firm and/or any of their representatives.
Have you checked your firm’s fee disclosure recently? If it uses the word ‘may’ or fails to disclose any conflicts or potential conflicts of interest, it’s time to make changes. Contact the specialists at Core Compliance & Legal Services, LLC today to schedule a consultation.