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News September 27, 2004 Issue

SEC to Brokers: If You Make a Mess, Clean it Up

If you lead small advisers into temptation, youíve got a responsibility to deliver them from evil (particularly if you have a written procedure to that effect).

That was the sermon delivered in the SECís settled enforcement proceeding against TD Waterhouse Investor Services, announced last week. The SEC alleged that Waterhouse, in an effort to entice advisers to trade their clientsí assets at Waterhouse, provided three small advisers with a range of hard dollar sales incentives. That, said the SEC, created potential conflicts of interest at the advisers, which the advisers allegedly failed to adequately disclose on their Form ADVs. The upshot: the SEC sued Waterhouse for causing the advisersí fraud, and hit each of the three advisers of an enforcement action of their own (two have settled, one is fighting the charges).

The cases against the advisers are certainly a good reminder that advisers have a fiduciary duty to seek best execution for their clients and that they must disclose conflicts of interest they face when making brokerage decisions (typically, in response to Form ADV Part II Item 12.B). Moreover, the cases remind us that advisers should not allow the prospect of personal gain to influence their investment decision-making process, as allegedly occurred at one of the advisers.

But the real story here is the SECís new view of brokersí responsibility vis-a-vis unsophisticated advisers

Compare the size of the civil penalties: the two advisers that settled paid $100,000 and $40,000 (admittedly huge sums for small advisers). Waterhouse, however, was asked to fork over a cool $2 million.

Guess who the SEC was really mad at.

Hereís a basic outline of the cases, based on the allegations in the SECís orders:

Like many other brokers that cater to smaller advisers, Waterhouse offered a range of "goodies" designed to attract and retain advisersí business. The amount of incentives offered to a particular adviser depended on the level of profits generated by the adviserís trading. In addition to things such as reduced commissions and free or discounted portfolio management software, Waterhouse, in at least three instances, provided hard dollar payments to advisers in return for their brokerage business. The payments took the form of direct credits to the advisersí operating accounts at Waterhouse, and were earmarked for items such as the adviserís marketing, payroll, or other operating expenses. Specifically, Waterhouse paid $49,500 to Kiely Financial Services, $20,000 to Rudney Associates, and $7,500 to Brandt, Kelly & Simmons (the firm that is fighting). The SEC alleged that Kiely, at Waterhouseís suggestion, agreed to recommend no transaction fee mutual funds to its advisory clients, which resulted in higher profits for Waterhouse, without weighing the potentially higher expense ratios of those funds against the needs of its clients.

Those payments, alleged the SEC, created potential conflicts of interest between the advisers and their clients. "By receiving compensation from [Waterhouse], each adviser compromised its ability to evaluate independently whether to choose or to keep [Waterhouse] as its clientsí broker." The SEC noted that the sales incentives provided no direct benefit to the advisersí clients.

The SEC alleged that Waterhouse recognized that it was creating the potential conflicts of interest.. The firm "knew that by offering compensation in exchange for an adviserís business, [it] was creating a potential conflict of interest between the adviser and its clients that the adviser had to disclose." However, said the SEC, Waterhouse "choose to address it" by implementing the following policy: Waterhouse "must ensure that advisors disclose the above payment arrangement on their ADV as required by securities regulators due to the potential conflict of interest" (the SECís order made much of the fact that the procedure actually used the word "ensure"). Despite the procedure, however, the broker allegedly did not review all of the advisersí ADVs to "ensure" that the payments had been adequately disclosed. "[A]fter creating this policy," said the SEC, Waterhouse "did not adequately follow through." A former compliance counsel at the firm "admitted that she merely Ďspot-checkedí advisersí disclosures," said the SEC.

To settle charges that it willfully "induced and was a cause of" the advisersí fraud and disclosure violations, Waterhouse agreed to pay the $2 million, as well as to be censured and ordered to cease and desist from committing or causing any future violations of Advisers Act Sections 206(2) and 207.

How will this change things for advisers? "I think the implication is that advisers are going to have brokerage firms looking over their shoulders," predicted Bingham McCutchen partner Hardy Callcott. He analogized to the SECís actions in the introducing/clearing broker context, where the SEC, through enforcement cases, gradually has expanded the obligation of clearing brokers to police introducing brokers. But Callcott pointed to a practical difficulty: many small advisers use more than one broker. He noted that there is an increasing trend among advisers to have relationships with more than one brokerage firm so they can comparison shop on issues like trade execution. Moreover, he noted, from a business perspective advisers are reluctant to be entirely reliant on one brokerage firm. "How is any one brokerage firm supposed to read [an adviserís] disclosure and know if itís accurate?" he asked.

Callcottís advice to smaller advisers: "disclose any benefits you are getting from your brokerage firm, whether it be hard dollar or something else." He predicted that going forward, advisers that use a Waterhouse-like platform may find that they are "second-guessed" on some items by their broker. Being overseen and supervised by a brokerage firm could have the potential to interfere with their day-to-day operations, he added.

Of course, brokers could take the opposite approach and clearly disclaim away any responsibility for opining on a particular adviserís compliance situation (while continuing to provide generic compliance guidance, in the form of speakers at conferences or quarterly compliance memos).