Adviser and Broker-Dealer Issues Play Out in Latest Share Class Settlement
The SEC on December 21 reached a settlement with a dually-registered advisory firm / broker-dealer that involves the issue of recommending higher-cost share classes of securities to clients when lower-cost share-classes of securities are available. This latest share-class settlement has an added wrinkle in that the firm may have had a conflict of interest because, in its capacity as a broker-dealer, it allegedly received the additional service fee from the purchase of the higher-cost shares.
Wisconsin-based Packerland Brokerage Services, a dually-registered adviser / broker-dealer with approximately $238 million in assets under management and an additional approximately $168 million in AUM at third-party advisers, settled the disclosure and best execution failure allegations with the agency. A second advisory firm, Indiana-based Atlas Capital Management Corporation, with approximately $131 million in AUM, was also part of the settlement.
As explained in the agency’s administrative order instituting the settlement, Packerland from 2012 through 2015 solicited individual clients for Atlas and other third-party investment advisers in exchange for a solicitor’s fee. Atlas would then execute trading strategies for these clients on a discretionary basis, typically in shares of mutual funds.
"Packerland recommended the purchase of a certain class of mutual fund shares that imposed a 1 percent annual service fee, while failing to disclose that a lower-cost but otherwise identical share class was available," the SEC said.
As for Atlas, it typically did not directly communicate with the advisory clients it received from Packerland, the agency said, "but was aware that it had purchased a more costly fund share class for the clients when an identical, but lower-cost share class was available. As a result, from January 2012 through December 2015, Atlas failed to seek best execution for its clients by failing to purchase the less costly share class that was available for clients."
"This enforcement action stems from the Commission’s ongoing review of share class issues," said Rogers & Hardin partner Stephen Councill. "The Commission found several missteps in senior management’s conduct, including that the firm’s senior staff began discussing the issue in late 2013 and did not address disclosure until early 2015. And when they did address the disclosure issue, they still failed to get it right because disclosure did not cure the best execution problem."
The SEC campaign
Placing clients in expensive share classes when less-expensive share classes are available is an ongoing SEC issue, with the Office of Compliance Inspections and Examinations issuing a risk alert on the subject in July 2016 and the Division of Enforcement settling a number of cases in the past few years.
The risk alert, "OCIE’s Share Class Initiative," stated that the examination arm of the SEC "intends to focus on certain registered advisers and their associated persons that may be receiving undisclosed compensation or other financial incentives. Such examinations will likely focus on the following topics applicable to the adviser’s share class recommendation practices: fiduciary duty and best execution disclosure; and compliance policies and procedures."
Recent settlements from the SEC have indicated that this initiative is alive and well. SunTrust Investment Services, also a dually-registered adviser/broker-dealer, settled share class charges with the agency in September 2017. That same month, Envoy Advisory, an advisory firm, reached a settlement with the SEC involving allegations of recommending higher-cost share classes without adequate disclosure to clients that lower-cost share classes were available, as well as a conflict of interest in that an affiliated broker-dealer would be the party receiving the additional fees. Credit Suisse Securities reached a settlement with the SEC centering on share-class allegations in April 2017, and the month before, advisory firm Allison reached a settlement involving share-class placement with the agency.
"Most mutual funds offer different share classes with varying fee structures, including, as in this case, Service Class shares and Investor Class shares," the SEC said in its administrative order settling the Packerland / Atlas case. "Service Class shares (similar to Class A shares) are available to all investors, but usually carry fees to cover fund distribution and shareholder expenses pursuant to Section 12(b) of the Investment Company Act and Rule 12b-1 thereunder." These fees can be deducted from mutual fund assets to pay for distribution (sales) services. The distributor typically passes them on to the broker-dealers whose customers own the shares, the agency said.
Investor Class shares, on the other hand, are available only to certain investors, such as those who invest certain minimum amounts or who invest through certain platforms. "These shares have no 12b-1 fees," the SEC said. "As a result, an individual who purchases share of a given mutual fund without 12b-1 fees will pay lower fees over time and keep more of their investment returns than an investor who purchases shares with 12b-1 fees. Therefore, if an investor meets a mutual fund’s criteria for purchasing shares without 12b-1 fees, it generally is in the investor’s best interest to select that share class."
"In order to avoid this kind of situation, dually-registered advisers should consider simply remitting any 12b-1 fees to customer accounts, rather than running the risk of appearing to get paid twice," said Pasquarello Fink partner William Haddad.
According to the SEC’s administrative order, Packerland’s individual account representatives, in soliciting clients for Atlas, provided those clients with Packerland’s advisory services agreement and with Atlas’ investment advisory agreement. These disclosed that clients would pay a 2 percent AUM fee to Atlas and that Atlas would share 50 percent of that fee with Packerland as a solicitor’s fee.
"Neither form disclosed that Packerland would receive an additional 1 percent fee paid from the distributor of the mutual fund directly to Packerland," the agency said.
It also noted that Packerland’s IARs had clients execute a "letter of understanding" that, among other things, "stated that all fees relating to the third-party manager and custodian had been explained, and that the client had received all required disclosure documents," the SEC said. The letter, however, also included a "selected share class" disclosure section, along with a space in which share class and fees could be disclosed. The agency said that "Packerland’s IARs did not disclose Packerland’s receipt of the 1 percent Service Class fee on this form until February 2015 at the earliest."
Nor was the problem that senior staff were unaware of the issue. Packerland’s senior staff responsible for reviewing disclosures and compliance matters "began discussing whether the 1 percent Service Class fee needed to be disclosed in approximately November 2013," the SEC said, "but they did not take action to ensure disclosure of the Service Class fee to clients until January 2015."
The SEC further criticized other communication attempts by Packerland, including a January 2015 letter to IARs that told them that they were required to disclose the 1 percent Service Class fee in writing in the letter of understanding that clients had to execute. "Packerland, however, never informed clients of its financial conflict of interest in recommending the purchase of the Service Class shares that paid Packerland a 1 percent fee, when a lower-cost share class was available," the agency said.
The agency also charged that Packerland’s Form ADV was "false and misleading" because it did not disclose to clients the firm’s receipt of the 1 percent fee.
Violations and penalties
As part of the settlement, Packerland and Atlas were each charged with willfully violating Section 206(2) of the Advisers Act, which prohibits fraud, and with willfully violating Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement reasonable written compliance policies and procedures. Packerland alone was charged with willfully violating Section 207 of the Advisers Act for making untrue statements of a material fact in a registration application or report.
Both Packerland and Atlas were credited by the SEC with having made remedial efforts, in both cases including their revision of their internal compliance policies and procedures, and implementation of new compliance training for employees.
Both firms were censured. Packerland was ordered to pay disgorgement of approximately $42,950 and prejudgment interest of $23,937, as well as a civil money penalty of $80,000. Atlas was also ordered to pay an $80,000 civil money penalty. One of the two defense attorneys in the case, when contacted, chose not to comment, while the other did not respond to an email or voice mail messages seeking comment.