J.P. Morgan Settlement Demonstrates SEC’s Conflict of Interest Focus
Financial giant J.P. Morgan learned the hard way that the SEC wasn’t just talking when a top enforcement executive said a few months ago that it was targeting conflicts of interest. Two of its wealth management subsidiaries on December 16 not only agreed to pay $267 million to settle the case – they had to admit wrongdoing.
Admissions of wrongdoing are sought by the agency only in cases where there was, in the SEC’s view, egregious harm to investors or where lessons can be learned. Advisers and their lawyers are reluctant to admit to bad behavior, not only because of the hit to a firm’s reputation and credibility, but because it leaves them open to lawsuits from other parties.
Nor was the SEC settlement the last word to date. In a parallel action, one of the two J.P. Morgan subsidiaries, JPMorgan Chase Bank, agreed to pay an additional $100 million penalty to the CFTC in a separate settlement.
The SEC charged that J.P. Morgan Securities and JPMorgan Chase Bank failed to disclose conflicts of interest to clients. An agency investigation found that the two subsidiaries preferred to invest client assets in J.P. Morgan’s own proprietary investment products – without properly disclosing the preference. In doing so, the agency said, the two subsidiaries "impacted two fundamental aspects of money management – asset allocation and the selection of fund managers – and deprived J.P. Morgan’s clients of information they needed to make fully informed investment decisions."
"Firms have an obligation to communicate all conflicts so a client can fairly judge the investment advice they are receiving," said Division of Enforcement director Andrew Ceresney. "These J.P. Morgan subsidiaries failed to disclose that they preferred to invest client money in firm-managed mutual funds and hedge funds, and clients were denied all the facts to determine why investment decisions were being made by their investment advisers."
The Division’s Asset Management Unit co-chief Julie Riewe noted that, "in addition to proprietary product conflicts, J.P. Morgan Securities breached its fiduciary duty to certain clients when it did not inform them that they were being invested in a more expensive share class of proprietary mutual funds, and JPMorgan Chase Bank did not disclose that it preferred third-party-managed hedge funds that made payments to a J.P. Morgan affiliate. Clients are entitled to know whether their adviser has competing interests that might cause it to render self-interested investment advice."
But there are other perspectives. Stern Tannenbaum partner Aegis Frumento noted that even if one accepts that the two J.P. Morgan subsidiaries did not disclose that they "preferred" their own proprietary funds, the SEC’s administrative order does state that J.P. Morgan Securities disclosed the conflict of interest and that the firm and/or its affiliates would receive "additional compensation" as a result.
"That fact would seem to be sufficient to put any reasonable investor on notice that J.P. Morgan exercised a bias towards its own products," Frumento said. "What is added to the total mix of information by requiring a disclosure that J.P. Morgan exercised or had a preference for its own proprietary funds? Once J.P. Morgan disclosed that it stood to make more money by steering the customer to its own proprietary funds, the added disclosure amounts to nothing more than an admission that J.P. Morgan prefers to make more money. Don’t we all know that anyway?"
"We have always strived for full transparency in client communications, and in the last two years have further enhanced our disclosures in support of that goal," said a J.P. Morgan spokesperson. "The disclosure weaknesses cited in the settlements were not intentional and we regret them. We remain confident in our investment process and are proud of the way we manage money."
Is the settlement a big deal? Foley Hoag partner Daniel Marx is not so sure, noting that "$367 million in settlements ($267 million to the SEC and $100 million to the CFTC) is a big number, as far as administrative settlements go, but that as the SEC order notes, J.P. Morgan Asset Management had $1.7 trillion in assets under management in 2014. In addition, press reports indicate that the asset management unit made more than $1.1 billion selling its proprietary investment products to clients in 2012."
Conflicts of interest and the SEC
It was Riewe who, in a March 2015 speech (ACA Insight, 3/23/15), described conflicts of interest as an "overarching concern" at the Asset Management Unit, and a risk area into which many smaller risk areas, such as disclosure, fit. She described conflicts of interest as "material facts that investment advisers, as fiduciaries, must disclose to their clients."
"There is … no exception to disclosure: no ‘well-meaning or good-faith adviser’ exception for an adviser that legitimately believes it is putting its clients’ interests first notwithstanding any conflicts; no ‘mitigation’ exception for an adviser that believes it has taken adequate internal measures to account for potentially incompatible interests; and no ‘potential conflict’ exception for an adviser that did not act upon the conflict to enrich itself at the expense of its clients," Riewe said in her speech.
"One interesting question," Marx asked, "is how far the SEC will push this principle – will regulators increasingly try to dictate how, when and where advisers provide the requisite conflict disclosures? For example, the SEC could conceivably require advisers to describe conflicts in plain English in stand-alone notices or in some other form that requires clients to affirm that they have actually considered, understood and accepted the conflicts."
J.P. Morgan Securities and disclosures
New York City-based J.P. Morgan Securities is a dually registered investment adviser and broker-dealer, which offers mutual funds for retail investors in a program known as the Chase Strategic Portfolio, launched in 2008, which it offers though more than 2,800 financial advisers located in bank branches nationwide. The SEC alleged that the subsidiary failed to disclose the following conflicts of interest from 2008 to 2013:
Its preference for J.P. Morgan-managed mutual funds for retail investors in the Chase Strategic Portfolio,
The availability and pricing of services provided to the subsidiary by another J.P. Morgan affiliate was tied to the amount of Chase Strategic Portfolio assets invested in J.P. Morgan proprietary products, and that
Certain J.P. Morgan-managed mutual funds purchased for the Chase Strategic Portfolio offered a less expensive share class (institutional class) that would generate less revenue for a subsidiary affiliate than the share class (select class) the affiliate chose for Chase Strategic Portfolio clients.
J.P. Morgan Securities also failed to adequately disclose these conflicts of interest on Chase Strategic Portfolio’s Form ADV, the SEC said. In addition, the agency charged that the subsidiary failed to implement written compliance policies and procedures that would have prevented such conflicts of interest.
Frumento noted that, while the SEC made a "fair point" in its allegation that J.P. Morgan Securities failed to let some customers know that they could have saved fees by opting for institutional class investments, he asked, "Who is being protected?" After all, he said, the investors in this situation are "institutional investors making investments in a single fund of over $3 million. Those are frankly not the kinds of investors that need the SEC’s protection. They can bring their own lawsuits or arbitrations to protect themselves."
JPMorgan Chase Bank and disclosures
The nationally chartered bank subsidiary is an old one, incorporated in 1824. While the bank acts as an investment manager for certain clients, it is not registered as an adviser under the Advisers Act, as it is excluded from the definition of investment adviser, the SEC noted. Following are the conflicts of interest disclosure allegations made by the agency against the bank involving "certain high net worth and ultra-high net worth clients" of J.P. Morgan bank subsidiaries who invested in another group of products, the J.P. Morgan Investment Portfolio:
The bank, from early 2011 to early 2014, failed to disclose that it preferred JPMorgan-managed mutual funds for certain clients;
From 2008 to early 2014, the bank failed to disclose that it preferred JPMorgan-managed hedge funds for certain clients; and
From 2008 to 2015, the bank failed to disclose its preference to invest certain clients in third-party-managed hedge funds "that shared management or performance fees," known as "retrocessions," with a bank affiliate.
Violations and penalties
J.P. Morgan Securities was charged with having willfully violated Section 206(2) of the Advisers Act, which prohibits fraud; Section 207, for making untrue statements; and Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, which requires advisers to adopt and implement written compliance policies and procedures.
JPMorgan Chase Bank was charged with having willfully violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, which, respectively, prohibit making untrue statements and prohibit fraud.
The two subsidiaries, in addition to admitting guilt, agreed to pay disgorgement and interest of more than $139 million, and a civil money penalty of $127.5 million.