On July 28, 2020, the Securities and Exchange Commission (“SEC”) announced it was charging Houston-based financial services firm, Valic Financial Advisors, Inc. (“VFA” or the “Firm”), a dually registered broker-dealer and investment adviser, in two separate actions for violations of Section 15(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 (“Advisers Act”).
In the first action, VFA was charged with failure to disclose its payments to a for-profit entity for promoting its services and products to a Florida-based teacher’s union and engaging in fraudulent and deceptive sales practices.
In the second-order, the SEC charged VFA with failure to disclose conflicts of interest due to the receipt of revenues and fees from the sale of more expensive mutual fund share classes to its clients; failure to maintain policies and procedures designed to reasonably prevent violation of the Adviser’s Act; and, breaching its fiduciary duty to its clients by failing to seek best execution on behalf of its clients.
Without accepting or denying the charges, VFA has agreed to cease-and-desist orders, censure, and to pay a $40 million penalty. Furthermore, VFA will cap its fees at 45 basis points for participants in its products in Florida’s 403(b) and 457(B) retirement programs, move its clients into lower fee and revenue sharing mutual fund share classes, and update and distribute its disclosure documents accordingly in order to comply with the orders.
Background on the SEC’s Orders
The first order describes how VFA failed to disclose that its parent company, the Variable Annuity Life Insurance Company (“VALIC”), paid a for-profit entity owned by Florida’s teachers’ unions (“The Teacher’s Union Entity”) to promote its services and products to the unions’ membership.
The Teacher’s Union Entity received cash payments and benefits for exclusively showcasing and promoting VFA’s products and services to the union membership, opportunities that were not extended to other broker-dealers and investment advisers.
Additionally, three (3) full-time VFA employees classified as Member Benefit Coordinators (“MBC”) were listed fraudulently as employees of the Teacher’s Union Entity and not employees of VALIC and engaged in dishonest and deceptive sales practices while attending benefits seminars and events allowing the MBCs to promote VFA products and services.
The resulting fraud allowed VFA to reap millions of dollars in profits from the sale of its products and services to union members, all while VFA failed to disclose that VALIC was paying the Teachers Union Entity to exclusively promote their products.
Mutual Fund Share Class Violations
As part of its services, VFA provides wrap-fee platforms that use portfolio models managed by third-party investment advisers.
In 2010, VFA instructed one of the third-party investment advisers to place clients into a no-transaction-fee (“NTF”) platform, which offered mutual funds sold through VFA’s clearing firm, mutual funds with whom the clearing firm and VFA had revenue-sharing agreements.
By placing clients into the NTF platform, VFA received a portion of the profits realized from these revenue-sharing agreements with the mutual funds on the platform as well as 12b-1 fees.
Furthermore, while VFA agreed to pay execution costs for clients as part of its wrap agreements, VFA was able to avoid having to pay execution costs by having the third-party investment advisers place the clients into the mutual funds on the NTF platform.
The receipt of these fees and revenues was not disclosed to clients and, in many instances, there were lower-cost share classes available in the same funds that did not charge 12b-1 fees and/or did not have revenue-sharing agreements with the clearing firm or VFA. As a result of VFA’s conduct, the firm realized over $13 million in financial payments.
VFA did update its disclosures in 2014 to include references to the revenue sharing agreements but the disclosures did not provide complete information about the nature of the revenue sharing agreements.
In 2018, VFA instructed its clearing firm to cease its revenue-sharing agreement but also left its clients in the higher-fee share classes until 2018 when it began to convert its clients to lower-fee share classes.
In 2019, VFA proceeded to refund 12b-1 fees to clients after being contacted by the SEC, but not through voluntary engagement in the SEC’s Share Class Selection Disclosure Initiative.
What Should I Consider When Evaluating My Firm’s Conflicts of Interest, Disclosures, and Mutual Fund Share Classes?
Investment advisers need to ensure that their compliance policies and procedures (“P&Ps”) clearly prescribe how their firms handle conflicts of interest including revenue sharing agreements, receipt of fees and compensation for the sale of certain securities and investment products, and updates to their disclosure documents including their investment advisory agreements, Form ADV Part 2As and Part 2Bs (“Brochures”), and Form CRS.
Firms should also create an inventory of their conflicts of interest and determine if additional disclosures need to be added to their investment advisory agreements, Brochures, and Form CRSs in order to ensure that they are providing clear and transparent information to their clients. It is determined that any of the aforementioned disclosure documents is materially inaccurate, the firm should make and file updates as soon as they are discovered and deliver the revised documents to their clients.
Lastly, when firms conduct their best execution reviews, they should include reviews of mutual funds share classes to ensure that clients are being placed into lower-cost mutual funds share classes when those share classes are available and suitable for the client and to determine if clients need to be converted to lower-cost share classes and/or receive refunds.
Should you or your firm have questions regarding how to address monitoring conflicts of interest, disclosures, and best execution and share class reviews in your P&Ps; updates to disclosures in your firm’s Brochure and Form CRS; and/or, how best to conduct best execution and mutual fund share class reviews, please contact us at (619) 278-0020 to schedule a consultation. Our compliance experts are standing by to help you.