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News August 10, 2015 Issue

Compensation Arrangements: A Little Bit of Disclosure Does Not Go a Long Way

Don’t fall into the trap of thinking you can satisfy clients and the SEC by disclosing partial information about your firm’s compensatory arrangements. One adviser found this out the hard way when it settled a case for allegedly doing just that.

Dion Money Management, a Massachusetts-based adviser with more than $500 million in assets under management, on July 24 settled with the SEC after the agency said the adviser failed to provide adequate disclosure to clients and to the SEC about the compensation it received between 2010 and 2013 from distributors, brokers and other advisers. The adviser was censured and had to pay a $50,000 civil money penalty.

The problem was that Dion Money Management’s disclosure simply did not go far enough. "The adviser disclosed the existence of the (compensation) arrangements and the possibility that the arrangements could pose conflicts of interest for the adviser in the provision of investment advice to clients," the agency said in its administrative order instituting the settlement. "However, the adviser did not describe the interplay between the different arrangements, either in its filings or otherwise to clients."

Whether the adviser’s alleged failure to go into greater detail in its disclosure is viewed as a serious breach or a simple lapse of judgment on the adviser’s part, the lesson for advisers is the same: Disclose completely. Anything less may be considered a violation by the SEC.

"This case illustrates both that conflicts of interest truly are an enforcement priority this year and that the SEC staff is closely parsing fee disclosures," said DLA Piper senior counsel Patrick Hunnius. "In the SEC’s recent conflicts cases, the allegations have centered on undisclosed arrangements. Here, the adviser both disclosed the existence of the potential conflict and the fee agreements that the conflict arose from. However, the adviser did not (in the SEC’s view) adequately disclose how those agreements could work together."

The case may also "signal an increasingly strict view on the part of the SEC staff as to necessary disclosures, particularly where conflicts of interest are involved," said Sidley Austin partner Mark Borrelli. "Many SEC enforcement actions involve outright false statements or complete failures to disclose material facts. However, this action involves a situation in which a conflict was clearly disclosed, but in the view of the SEC the disclosures were not ‘complete and accurate.’ The decision to bring an enforcement action may have been influenced by the SEC’s view that the matter involved a very serious conflict."

Compensatory arrangements

Most of Dion Money Management’s clients were retail and high-net-worth individuals, family businesses or corporations, according to the administrative order. The adviser’s fundamental investment strategy, which the agency said evolved over time, "was to recommend portfolios of mutual funds with different risks or other profiles to clients," the agency said.

As part of its way of doing business, Dion Money Management had separate agreements with three entities: another adviser/administrator, a distributor and a broker-dealer. From each, Dion Money Management received payments calculated based on client assets invested in particular mutual funds. More specifically:

  • Adviser/administrator agreement. Dion Money Management entered into an agreement with this unnamed entity, identified in the administrative order as "Adviser B," in May 2002. Dion Money Management received a quarterly payment from Adviser B in exchange for Dion Money Management providing recordkeeping and administrative services for clients that invested in a certain group of mutual funds. By 2005, according to the SEC, Dion Money Management received a payment of 0.20 percent of applicable client assets up to $75 million, 0.25 percent of applicable client assets for assets from $75 million to $175 million, and 0.30 percent for assets in excess of $175 million.
  • Distributor agreement. Dion Money Management entered into an agreement with an unnamed distributor, identified in the administrative order as "Distributor C," in January 2006. Dion Money Management received a quarterly payment from Distributor C in exchange for providing account maintenance services to clients invested in mutual funds managed by an affiliate of Distributor C. Dion Money Management received compensation of up to 0.30 percent of applicable clients’ assets.
  • Broker agreement. In July 2007, Dion reached a custodial support services agreement with an unnamed broker, referred to as "Broker A" in the administrative order. As with the other agreements, Dion Money Management was paid quarterly by the broker, but in this case in an amount based on a percentage of Dion Money Management client assets held in custody with Broker A that had invested in mutual funds on the broker’s no-transaction-fee platform. Broker A’s platform included a selection of mutual funds across various fund families, including mutual funds covered by the adviser/administrator agreement and the distributor agreement discussed above, according to the SEC. Dion Money Management initially received a rate of compensation of 0.01 percent of applicable client assets, but in 2008 this was increased to 0.085 percent, and in 2011 to 0.095 percent.

Disclosure and non-disclosure

The SEC acknowledged that Dion Money Management did make disclosures to its clients and to the agency itself. For instance, the SEC noted that in the adviser’s 2011, 2012 and 2013 Form ADV, Part 2A, Dion Money Management disclosed that it had entered into service agreements with some mutual funds in which clients were invested, and that the compensation under these agreements could reach 0.30 percent per year of the mutual fund’s average daily net asset value of shares held by clients.

Further, in its Form ADV, the adviser stated that "as a result of these fees, Dion Money Management, LLC has an incentive to invest client assets in the mutual funds for which Dion Money Management, LLC receives this additional compensation. However, Dion Money Management, LLC shall maintain its fiduciary duty by only recommending mutual funds that it deems appropriate and suitable for clients."

However, this disclosure was not adequate, the SEC said. Dion Money Management "did not disclose to clients certain material terms of the service agreements, either in its Form ADV or otherwise." Specifically, the agency alleged that:

  • Combined payments. Dion Money Management’s statement that it could receive compensation of up to 0.30 percent of applicable client assets "was not complete." The adviser "did not disclose that, in certain circumstances, [it] could – and did – receive payments at a rate greater than 0.30 percent based on the same client assets." As an example, the agency suggested that, for a client investment in a mutual fund covered by the distributor agreement that was also available on the broker’s platform and held in custody by the broker, Dion Money Management would receive not only the 0.30 percent payment from the distributor, but up to a 0.095 percent payment from the broker, "for a total payment based on the same asset of up to 39.5 basis points."
  • Payments based on the same client assets. The adviser failed to disclose that "in certain instances, [it] could – and did – receive payments based on the same client assets from Broker A … as well as either Adviser B or Distributor C." In this regard, the SEC said, "to different degrees over different time periods," Dion Money Management incorporated mutual funds covered in the adviser/administrator agreement with some covered in the distributor agreement, and that it was eligible under the agreements to receive payments for those funds under both agreements. "Through 2011 and 2012, approximately 50-55 percent of [Dion Money Management’s] total client assets were invested in mutual funds within Fund Family B (the funds covered by the adviser/administrator agreement) and Fund Family C (the funds covered under the distributor agreement) combined."

"[Dion Money Management] was at least negligent in failing to make complete and accurate disclosures to clients about the compensation terms of the service agreements and the potential conflicts of interest arising from the service agreements," the SEC said.

Violations

The agency alleged that Dion Money Management willfully violated Section 206(2) of the Advisers Act, which prohibits fraud, as well as Section 207 for making an untrue statement of material fact in any report filed with the Commission. An attorney representing the firm chose not to comment on the settlement.