Court Judgments Show SEC Focus on Conflicts of Interest and Fee Disclosure

An adviser should not move client dollars into new funds and fail to disclose that they will be charged additional fees. This is especially true when that same adviser created the new fund – and collects an additional fee from each client after doing so.

The U.S. District Court for the District of Connecticut made this point quite clear recently, when it issued final judgments against Connecticut-based adviser Momentum Investment Partners and its founder and CEO, Ronald Fernandes. The judgments settle a complaint originally filed with the court by the SEC in May 2016.

"It’s another example of the SEC focusing on conflicts of interests and fee disclosures," said Shearman & Sterling partner Mark Lanpher. "In the last several years the SEC has been laser-focused on these issues, as it seeks to ensure that investment advisers are never improperly advantaging themselves at the expense of unwitting investors. Even when fees charged may be consistent with the market, if the fees and any associated conflicts of interest are not adequately disclosed, investment advisers can find themselves in significant trouble."

"The SEC is particularly likely to act against an adviser when the undisclosed conflicts result in investors paying additional fees without receiving any corresponding benefit," said Mayer Brown partner Matthew Rossi. "It is important for investment advisers to have written policies and procedures for addressing and disclosing conflicts of interest. Advisers that move clients into accounts with high fees should also be prepared to explain how the higher fee accounts benefit the investors."

The complaint

The agency alleged that Momentum, doing business as Avatar Investment Management, and Fernandes in May 2013 failed to disclose material conflicts of interest in regard to investments Avatar made in new mutual funds that the adviser created and managed.

"Specifically, Avatar and Fernandes failed to disclose that moving clients’ assets into newly-created mutual funds would increase the total clients’ advisory fees paid to Avatar without changing the clients’ investment strategy," the SEC said in its complaint to the court. As a result, between May 2013 and March 2014, Avatar’s clients paid almost $111,000 in total additional fees, including approximately $61,000 in additional fees ultimately paid to Avatar, for no additional services."

Prior to May 2013, Avatar advised and managed approximately 20 individual accounts from eight different investor families, the agency said. Avatar used a proprietary investment strategy of allocating client assets in exchange-traded funds representing various industry sectors. In return, these clients paid annual management fees to Avatar that ranged from 0.10 percent to 0.60 percent of assets under management, according to the complaint.

In creating the new mutual funds, the SEC said, Avatar and Fernandes chose to use an investment strategy "that mirrored its ETF investment strategy. In other words, the [new mutual funds] used equivalent proprietary allocation models to allocate investments to particular sectors of the economy," the agency continued. In exchange, it said, Avatar charged annual management fees ranging from approximately 1.15 percent to 1.45 percent of assets under management – in many cases more than double the fees Avatar was already charging the clients for management.

"Avatar liquidated approximately 65 percent to 70 percent of each client’s total investment managed by Avatar (approximately $11,185,512 in all) and moved these funds into the [new mutual funds]," the SEC said.

"After the transfer, each client was exposed to an equivalent investment strategy as they were when invested directly in ETFs, but the move from ETFs to mutual funds caused these clients to pay higher fees and enabled Avatar to receive additional compensation for implementing an equivalent investment strategy," the agency charged. "Avatar required [its clients] to pay 1.15 percent to 1.45 percent in higher fees for no additional services and for investing in an equivalent investment strategy. Because Avatar advised the mutual funds, Avatar received the majority of these additional fees."

To top it off, the new mutual funds ultimately appear not to have been successful. Avatar was unable to raise additional capital for them from sources other than its own clients, the SEC said, and the funds eventually folded. Avatar withdrew its registration with the agency in March 2014.

Questions of disclosure and compliance

Much of this problem might have been averted had Avatar informed its clients that they would be transferring their money to the new mutual funds, and that they would be paying additional management fees. But Avatar did not do this, the agency said.

Nor was the adviser upfront in regard to this matter on its Form ADV filings, according to the complaint. "Avatar’s Form ADV, filed on March 11, 2013, contained various false, misleading or insufficient disclosures concerning Avatar’s conflicts of interest in investing [Avatar clients] in the [new mutual funds]," the SEC said. Specifically, the complaint points to three Form ADV items where Avatar’s answers are "misleading."

As for compliance, the agency said that despite the potential compliance risks and conflicts of interest associated with moving the clients into the [new mutual funds], "Avatar did not have policies or procedures to address this potential conflict of interest."

Charges and punishment

Avatar and Fernandes were together charged by the SEC with violating Sections 206(1) and (2) of the Advisers Act, both of which prohibit fraud. Avatar alone was charged with violating Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement written compliance policies and procedures. The advisory firm was also charged with violating Section 207 for making untrue statements of material fact on its Form ADV. Fernandes was separately charged with aiding and abetting Avatar’s violations of the above Advisory Act sections, as well as Rule 206(4)-7

In separate final judgments from the court, Momentum and Fernandes were ordered by the court to collectively pay disgorgement of $61,276, plus prejudgment interest of $7,401. Momentum was ordered to pay a civil money penalty of $125,000, while Fernandes was ordered to pay a civil money penalty of $40,000. An attorney who represented Momentum and Fernandes during the proceedings declined to comment.