SEC Alleges Conflict of Interest In Adviser Favoring 12b-1 Funds Over Others
There’s nothing wrong with putting clients into funds that charge fees for distribution – as long as you first let your clients know of any other funds you manage that do not charge such fees. It’s also probably best to if your firm didn’t receive those distribution fees.
Ohio-based Everhart Financial Group on January 14 reached a settlement with the SEC over charges that it failed to disclose either situation: The Commission alleged that the adviser, since 2010, invested client dollars in a share class where the only meaningful difference over another share class was that it charged 12b-1 fees for distribution efforts. Nor, according to the SEC, did it inform clients that the fee was paid to EFG’s principal owners, who were also licensed registered representatives of a broker-dealer.
"Receipt of 12b-1 fees not only created a conflict of interest that was not adequately disclosed to EFG’s clients, but favoring 12b-1 funds over others was inconsistent with EFG’s duty to seek best execution for its clients," the SEC said in its administrative order instituting the settlement. In addition, it charged the firm with several compliance failures, including a lack of compliance reviews from 2008 through 2011, and again in 2013 and 2014, as well as insufficient disclosures in regard to the 12b-1 fees.
When mutual funds pay for distribution, they must do so in accordance with Investment Company Act Rule 12b-1, which means through a 12b-1 plan. That’s the only way by which a fund can pass on distribution costs to investors. And those fees must be clearly disclosed to investors. In addition, as part of their fiduciary duty to provide best execution to clients, advisers must let their clients know if less-expensive alternative investments are available that would meet their investment needs.
"The SEC has been focused on the issue of 12b-1 fees for some time," said Mayer Brown partner Matthew Rossi. "It included fees charged to retail investors and the disclosure of those fees in its national examination program priorities for the last several years and has done so again in 2016. The Division of Investment Management released guidance in January aimed specifically at 12b-1 fees."
Beyond that, he said, "agency examination and enforcement staff are always on the lookout for adviser representatives who place clients in share classes with higher fees when less expensive share classes are available. Any adviser representative who does so better have a good explanation and adequate disclosure."
EFG agreed to pay disgorgement and interest of more than $225,000, plus a civil money penalty of $80,000. Richard Everhart, the firm’s founder, president and chief compliance officer from July 1995 through November 2014, separately agreed to pay a civil money penalty of $40,000, and Matthew Romeo, a minority owner in the firm who also served as chief operating officer and chief compliance officer (after Everhart vacated that position), agreed to a $20,000 civil money penalty.
"The consent relates to past deficiencies which have been remedied, no client funds were impacted," said the attorney representing EFG, Everhart and Romeo.
EFG and the SEC
EFG, which was founded in 1995 and reported $250 million in assets under management as of December 2014, serves non-high net worth individuals and usually recommends mutual funds to non-retirement clients, the SEC said. While it receives an advisory fee based on a percentage of a client’s AUM, its investment advisory representatives, who also are licensed representatives of a broker-dealer, also receive 12b-1 fees from EFT’s clients who invest in mutual funds.
In addition to allegedly not performing annual compliance reviews in certain years, the firm also had inadequate periodic inspections performed by the broker it worked with, the SEC said. "These reviews were limited to EFG’s contractual obligations with the broker and focused on EFG’s employees who are registered representatives of the broker," the agency said. "These examinations did not cover EFG’s overall advisory business and therefore were inadequate under the Advisers Act compliance rule."
As far as best execution and disclosures, the SEC said that the advisory agreement the firm provided to clients from 2010 through mid-2013 did not disclose 12b-1 fees. "The agreement also did not disclose the conflicts of interest that are created by EFG’s IARs’ receipt of 12b-1 fees. There is also no mention about Everhart’s and Romeo’s practice of nearly always investing non-retirement advisory clients in share classes that generate 12b-1 fees ultimately paid to Everhart and Romeo."
Updates to the advisory agreements made some improvements, the agency said, but fell short until January 2014, after an SEC examination. "For the first time, EFG notified clients ‘[f]unds that include 12b-1 fees represent a conflict of interest,’" the agency said.
"This case is a reminder of the importance of an effective compliance program," said DLA Piper senior counsel Patrick Hunnius. "The SEC says the adviser failed to conduct reviews ‘for several years.’ As a result, the firm did not catch the discrepancy between what it was doing and what it told clients (e.g., that it was conducting ‘due diligence’ on every fund)."
"Investment advisers need to be sure their client agreements and marketing materials fully and accurately disclose any conflicts of interest before the SEC points out any deficiencies," said Greenberg Traurig shareholder Robert Horowitz. "As this order makes clear, correcting the information in response to an SEC examination, while better than not correcting it at all, will not avoid liability. Despite the SEC’s reference to ‘remedial acts promptly undertaken by the respondents and cooperation,’ the undertaking and sanctions were substantial."
Violations and penalties
EFG, Everhart and Romeo were each charged with willfully violating Section 206(2) of the Advisers Act, which prohibits fraud. EFT and Everhart were also charged with willfully violating Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for not conducting annual compliance reviews. EFG and Romeo were charged with willfully violating Section 207, for omitting a material fact on registration forms. Finally, EFG was charged with willfully violating, and Everhart and Romeo with causing the violations of, Section 204 and its Rule 204-3, which requires advisers to deliver a brochure and supplements to client that contain all information required by Part 2 of Form ADV.
In addition to the monetary sanctions, EFG agreed to retain an independent compliance consultant and also agreed to separate the position of chief compliance officer from other officer positions.