Revenue Sharing in Exchange for Investments May Be a Conflict
Perception counts. Consider a third-party broker-dealer offering an adviser compensation in exchange for investing client dollars in certain mutual funds available on the broker’s platform. The SEC is likely to perceive that compensation as a conflict of interest. It’s not so much whether the adviser follows through and makes those favored investments – it’s that the financial incentive to make them exists.
The SEC’s recent settlement with Seattle-based KMS Financial, a dually-registered adviser and broker-dealer may be a case in point. Since 1962, the advisory firm has worked with a clearing broker to provide trade execution, custody and reporting services with half of its investment clients. KMS itself limits its role to that of the introducing broker.
From at least 2002, according to the SEC, the clearing broker, with KMS’ okay, offered its no-transaction-fee (NTF) mutual fund program to advisers. For those KMS clients that took part, the clearing broker waived transaction fees that it and KMS would normally charge for the purchase of certain mutual funds available on its platform. "These payments provided a financial incentive for KMS to favor the mutual funds in the NTF program over other investments when giving investment advice to its advisory clients, and thus created a conflict of interest," the agency said in its administrative order instituting the settlement.
But that’s not all, the agency said. In 2014, KMS negotiated a reduction in the execution and clearing costs it paid the clearing broker, but neither passed on that cost reduction in brokerage costs to its clients nor analyzed whether its clients were obtaining best execution," the agency said.
"This case demonstrates that investment advisers should continue to be alert to any potential conflicts of interests in areas that are historical hot spots for the SEC, particularly those involving advisory fees, revenue-sharing and best execution," said Paul Hastings partner Thomas Zaccaro.
"Firm’s should be vigilant in considering any financial arrangements with third parties that could either create a conflict or potential conflict, so that various means of addressing the conflicts can be evaluated, including at a minimum, disclosure, let alone other options such as accounting for the arrangement in a way that directly benefits clients or avoiding the conflict altogether, said Faegre Baker Daniels partner David Porteous."
"A key takeaway for firms seeking to avoid these types of ‘conflict risks,’" he said, "is being able to demonstrate that they have a process to identify potential and actual conflicts as well as to mitigate and/or eliminate the conflict."
KMS was charged with willfully violating Section 206 (2) of the Advisers Act, which prohibits fraud; Section 206(4) and its Rule 206 (4)-7 for failing to adopt and implement a reasonable compliance program; and Section 207 for making untrue statements of material fact on its SEC registration application, the SEC said.
KMS took part in the clearing broker’s NTF program since at least 2002, the agency said.
Under one arrangement, the clearing broker agreed to share with KMS a certain percentage of revenues the clearing broker received from the mutual funds in its NTF program. "In particular, KMS waived transaction fees it and the clearing broker would otherwise charge clients for the purchase of certain mutual funds and instead would get a certain percentage of revenues the clearing broker received from certain mutual funds KMS recommended to its clients," the SEC said.
This created a "mutual fund platform revenue stream to KMS," the agency said, one that ran the risk that KMS would respond to the financial incentive of revenue sharing by sending more clients to the clearing broker’s mutual funds.
It should be noted that the SEC, in its settlement, does not state that KMS ever acted on this arrangement by improperly placing clients in the mutual funds. The agency simply states that the conflict of interest where this could happen was created, and that, apparently, was enough for the SEC to bring charges.
Further, the agency noted that KMS, in its Forms ADV from 2003 to 2014 "did not disclose that it received payments from the clearing broker based on KMS client assets invested in the NTF program mutual funds or that these payments presented a conflict of interest. Nor did KMS otherwise disclose this conflict of interest to its advisory clients."
Under another arrangement, KMS in February 2014 negotiated an amendment with the clearing broker that reduced the broker’s clearance and execution costs for equity, options and fixed income transactions by $1 per trade, "thus decreasing total clearing and execution costs KMS had to pay the clearing broker for KMS clients utilizing the clearing broker," according to the SEC’s administrative order.
Apparently, according to the agency, KMS, and not its clients, were the main beneficiary of this arrangement. The advisory firm "did not pass this reduction in clearing and execution costs on to its advisory clients, thereby providing KMS with $54,957 of additional revenue on certain transactions involving the clearing broker from April 2014 through December 2015," the SEC said.
The arrangement raised best execution questions. "When KMS entered into the 2014 amendment, which ultimately increased KMS’ revenue, KMS, in its capacity as an investment adviser, did not conduct an adequate analysis to consider whether those advisory clients continued to receive best execution in light of this increase," the agency said. "Thus, KMS failed to seek best execution for its advisory clients."
In terms of policies and procedures, the SEC charged that, in terms of both arrangements, the advisory firm fell short. "From 2002 to 2015," it said, "KMS did not have adequate written policies and procedures for disclosing all material conflicts of interest." In addition, the agency said, the firm’s written policies and procedures "did not address best execution analysis regarding introducing, clearing and execution brokerage costs charged to advisory clients as part of its overall best execution analysis."
The price paid
As part of its settlement, KMS agreed to notify advisory clients of the settlement. The firm will need to send advisory clients, and post prominently on its website, a link to the SEC’s administrative order instituting this settlement, and keep it on the site for six months. KMS also agreed to include a summary of the settlement, including a link to the administrative order, in the September 2017 quarterly statement from its clearing broker to KMS clients.
KMS, in addition to being censured, was ordered to pay disgorgement of $382,569, plus prejudgment interest of $69,518. Finally, the firm agreed, as part of the settlement, to pay a civil money penalty of $100,000. An attorney representing KMS did not respond to an email or voice mail seeking comment.