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What You Don’t Know Can Hurt You

London, England

Nov. 5, 2019

Keynote Remarks at the 2019 SEC Regulation Outside the United States Conference

Introduction

Good morning and thank you for inviting me to speak today. Before I begin, let me give the required disclaimer that the views I express here today are my own and do not necessarily represent the views of the Commission or its staff.[1]

I am honored to be the speaker for the first talk in the Scott Friestad lecture series. I know Scott was an active participant in this conference and that many of you knew him well, and I ask your indulgence while I say a few words about him. 

Scott was a good friend and he was a beloved leader. What you all saw of Scott – his generosity of time, his good nature, and his love for the United States Securities and Exchange Commission – is who he was. Scott was a true gentleman and we at the SEC are fortunate that he represented us here at this conference for so many years. He was a great friend and we miss him. Thank you for establishing this lecture series in his name – he would have been incredibly moved by this honor.

I am also sure that Scott would have approved of my remarks here today, as the heart of what I am going to talk about is something that was important to him – thinking about how we at the SEC can protect retail investors.

From the time Chairman Jay Clayton joined the SEC, he has been clear about his top enforcement priority – it is to protect retail investors. In the Enforcement Division, we have embraced this focus on retail investor protection, including by creating the Retail Strategy Task Force, whose mandate is, in part, to develop data-driven efforts to identify and pursue conduct that adversely affects retail investors. The same type of strategy has been applied across the Division – with many people exploring potential ways to identify and address conduct that harms retail investors. 

The issue I plan to discuss today is how we in the Enforcement Division are thinking about how to identify and address misconduct and illicit practices that are harmful to retail investors. While many of you in the audience are associated with non-U.S. based entities, and the regulatory scheme here in the U.K. differs from that in the U.S., I am hopeful this topic is one that will provide useful perspective for those who do operate to some degree in the United States.

One area the Enforcement Division is spending a lot of time on is identifying material financial conflicts of interest, particularly those conflicts that are harmful to investors. Given that a substantial part of this audience is comprised of advisory firms, my remarks today focus on the advisory space. But what I am talking about today is applicable across the securities markets. 

So what are some of the things we are doing?

We are actively looking for circumstances where an adviser is financially conflicted by incentives that could affect investment recommendations to clients. When we find those circumstances, we are asking: Has the adviser explained the conflict to the client? Does that explanation cover how the conflict may affect the recommendation? Does the client have sufficient information to make an informed decision? And I will tell you: the more we look, the more undisclosed or inadequately disclosed financial conflicts we find. So I thought I would share with you some of what we have seen.

At the outset, let me be clear about what we are not doing.  We are not making value judgments on financial incentives, the scope of services provided, or the fees that are charged to investors. The scope of a client relationship and the extent to which an adviser charges fees to a client are subject to agreement between the adviser and the client – the terms of the client relationship, including these financial incentives and the amount of fees, or in what form fees are paid, is not what I am talking about.

Nor are we looking for issues that are not material to investors. Instead, we are looking at issues that may directly affect an investor’s return on an investment. These issues are typically material to investors. Our experience is that advisers who are recommending products to clients typically understand the fee structures and know how much they – the investment advisory representative and the advisory firm – are getting paid.  And the advisers know how much of a client’s money is going to work for the client. This is information that may directly affect the client’s return and the client should know that information.

A stark example of the type of financial conflicts I am talking about is seen in the Share Class Selection Disclosure self-reporting initiative (Share Class Initiative) that the Enforcement Division undertook last year. The Initiative was designed to identify and address harm resulting from undisclosed conflicts of interest in the sale of mutual fund shares by investment advisers.  In just over a year and a half, the Initiative resulted in 95 Commission enforcement actions that ordered the return of more than $135 million to investors – most of whom were retail investors – and required that these advisers’ practices be reflected in their disclosures to clients, which will inure to the benefit of investors for years to come. 

What Was the Issue in the Share Class Cases?

Mutual funds routinely offer different classes of shares. Each share class represents an interest in the same portfolio of securities with the same investment objective. But each class has different shareholder services and distribution arrangements with different fees and expenses – a portion of which are often shared with the adviser or its affiliates. While this multi-class structure allows an investor to select the fee and expense structure that is most appropriate for their investment goals, including time horizon, it is not without cost. Because of the different fees and expenses, each class will likely have different performance results. With that in mind, it is critical for an investor to be fully informed about potential conflicts associated with an adviser’s share class recommendation. Put plainly, if an investment adviser receives some or greater compensation for selecting certain share classes over others, the adviser has a conflict of interest. Under the federal securities laws, that conflict must be fully and fairly disclosed.

This is not a new concept or statement of the law. The obligations of an investment adviser are well established. Section 206(2) of the Investment Advisers Act of 1940 expressly prohibits investment advisers from directly or indirectly engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client,” and it imposes a fiduciary duty on investment advisers to act in their clients’ best interest at all times. The Supreme Court affirmed this principle more than 50 years ago in SEC v. Capital Gains Research Bureau, Inc.,[2] when the Court stated that an investment adviser, as a fiduciary, has an affirmative duty to fully and fairly disclose all conflicts of interest that might incline the adviser – consciously or unconsciously – to give advice that is not disinterested.[3] So, for decades, investment advisers, as fiduciaries, have had an obligation to make full and fair disclosure to clients and prospective clients concerning their conflicts of interest and material facts relating to their advisory relationship, including conflicts and material facts arising from financial incentives, and to act consistently with those disclosures.[4] There is no question that information concerning the differences in the cost structure of two classes of a multiple-share class mutual fund is material. The Commission articulated this principle in 2006 in a case called IFG Network Securities. In that case, the Commission said that where the only bases for the difference in rate of return between share classes are the cost structures of those share classes, information about this cost structure would “be important to a reasonable investor.”[5] Four years later, in 2010, the Commission amended its Form ADV to require the disclosure of conflicts related to the receipt of compensation – including the receipt of service fees from the sale of mutual funds.[6]

The applicability of these principles to the conflicts we saw in the share class cases is clear. When an adviser selects a mutual fund or mutual fund share class that results in a financial benefit to the adviser, the adviser has a conflict of interest. And that conflict needs to be fully and fairly disclosed to the client. How could the client make an informed investment decision otherwise?

So Why A Self-Reporting Initiative?

When the Division announced the Share Class Initiative in February 2018, the Commission had already brought more than 15 enforcement actions against advisers for failing to disclose this conflict of interest (dating back to 2013).[7] Even before that, dating as far back as 2005, FINRA’s predecessor, NASD, had charged numerous broker-dealers for suitability and other violations relating to mutual fund share class selection – specifically, for failing to consider or adequately disclose that certain share classes would have generally been more advantageous to customers than others.[8]

At the time we announced the Initiative, we had roughly a dozen ongoing investigations, which took, on average, 22 ½ months to complete. At the same time, the Commission’s Office of Compliance Inspections and Examinations continued to see these disclosure failures in examinations of investment advisers, and to make enforcement referrals. This continued to be the case even after that Office had issued a 2016 risk alert that highlighted the risks surrounding conflicts of interest tied to an adviser’s compensation or financial incentives for recommending mutual fund share classes.[9] The problem was not going away. And this was concerning because the undisclosed conduct was continuing to harm investors.

We designed the Share Class Initiative to give firms the opportunity to address the problem as promptly as possible and to achieve our goals of identifying firms engaged in these violations and returning money to harmed investors. The Initiative achieved both goals. As of today, 95 investment advisory firms have collectively agreed to return over $135 million to affected mutual fund investors and to make full and fair disclosure of their share class selection practices.

And I should note that while the Initiative did identify numerous disclosure failures, the firms that participated in the Initiative represent a small fraction of the overall registered adviser population. Some firms had fulsome disclosure. Other firms chose not to take 12b-1 fees and did things like rebate the fees or credit the fees back to clients. And still others chose to recommend the lower-cost share class. 

At the end of the day, what we saw in the Share Class Initiative cases were firms that had the choice of investing their clients’ money in different classes of the exact same investment and chose the more expensive option – the option that paid the firm additional compensation and cost the client more money – and they did not fully disclose this to the client. This situation is not unique. The same principles and disclosure obligations can apply in other circumstances. Because of that, we are not resting on the success of the Share Class Initiative. Let me assure you, we are looking for other undisclosed material conflicts – and we are finding them. Let me give you some examples.

One is revenue sharing. Clearing brokers charge some mutual funds fees for access to the clearing broker’s platform. These fees are paid by the mutual fund, are part of the fund’s overall expenses, and may vary across mutual fund share classes. As these fees are incorporated into the fund’s expenses, they are ultimately paid by the client. In some cases, a clearing broker may enter into an agreement to share a portion of these fees received from a mutual fund with an introducing broker – which may also be a dually-registered adviser or affiliated with an adviser. Depending on the fee structures and revenue sharing agreements, there may be certain share classes on a platform for which the adviser gets some or more revenue sharing whereas other share classes pay less or no revenue sharing. A dually-registered adviser or an adviser affiliated with an introducing broker has a conflict of interest when selecting between funds or share classes of funds that pay revenue sharing and those that do not. Specifically, the adviser has an incentive to invest clients in mutual funds that pay more revenue sharing than those that do not. This conflict of interest must be fully and fairly disclosed. The Commission has brought several actions against advisers for failing to disclose this type of conflict[10] and we in the Enforcement Division are continuing to actively look at advisers’ practices and disclosure around revenue sharing.

We are also looking at cash sweep arrangements. Cash in advisory accounts is often automatically swept into a money market mutual fund or a bank deposit sweep program. A dually-registered adviser or an adviser with an affiliated broker-dealer may have a financial interest, a conflict, in recommending one cash investment over another. For example, some money market mutual funds carry 12b-1 fees or make revenue sharing payments that may be shared with a dually-registered adviser or an adviser’s affiliated broker-dealer, while other money market funds do not carry those fees. Advisers recommending or choosing between different money market funds must make full and fair disclosure of these types of conflicts to their clients. The Commission has brought enforcement actions in the past where advisers have failed to make appropriate disclosure.[11]

As another example, some clearing brokers offer bank deposit cash sweep programs where an investor’s un-invested cash is swept into an interest-bearing bank account. In some cases, the bank, often an affiliate of the clearing broker, agrees to share a portion of the revenue the bank earns on the investor’s deposits with the clearing broker. The clearing broker may, in turn, agree to share a portion of the revenue it received with the investor’s dually-registered investment adviser or with the adviser’s affiliated broker-dealer. In some cases, the revenue received by the adviser or the adviser’s affiliate far exceeds the interest earned by the client on its cash. In fact, in some cases, these arrangements may actually lower the interest paid to the client. These types of cash sweep arrangements create an obvious incentive for an adviser to recommend products where revenue sharing will result in larger payments to the adviser and lesser returns for the adviser’s client. This is a clear conflict and, without full and fair disclosure, investors cannot make an informed investment decision to agree to the adviser’s cash sweep vehicle selection.

Yet another area we are exploring involves investments in unit investment trusts, or UITs. These investment companies are typically offered in a single public offering and hold a fixed portfolio of securities for a specific period of time, after which the UIT terminates and the proceeds are distributed to UIT investors. Interests in any particular UIT are often sold with multiple fee structures. For instance, UITs are often offered with one fee structure intended for broker-dealer customers and another structure intended for investors who will hold the UIT in a fee-based advisory account. The broker-dealer fee structure may include significant sales charges that are not charged to purchasers under the fee-based account structure. Most of these sales charges are ultimately paid to the broker-dealer that executes the trade. As with other investment companies that charge different fees for versions of the same product, an adviser that is dually-registered or that has an affiliated broker-dealer has a financial incentive to recommend purchases of UIT interests under the fee structure that generates more revenue for the adviser or its affiliate. These differences may be material and this conflict must be fully and fairly disclosed to the client.

The Commission recently filed an action against an investment adviser that allegedly selected the UIT interests that generated more revenue for the adviser when its clients were eligible for the cheaper fee-based version. The complaint in that case – which is currently being litigated – alleges that the adviser’s selection of the more expensive UIT interests for its advisory clients caused those clients to pay unnecessary transactional sales charges that generated additional revenue for the adviser’s affiliated broker-dealer. This alleged failure to fully and fairly disclose the fees and conflicts, in essence, resulted in the adviser double-dipping by earning both advisory fees and transaction fees.[12]

Finally, as part of an agency-wide Teachers Initiative that was recently announced by the Commission,[13] we in the Enforcement Division are also looking at the administration of teacher retirement plans. This is another area where there may be undisclosed conflicts of interest, particularly in the area of fees and lower fee alternatives. Broadly speaking, we are looking at the compensation and sales practices of third-party administrators of teacher retirement plans – often known as 403(b) plans – as well as the practices of their affiliated advisers and broker dealers. Among other things, we are digging into how administrators and their affiliates choose and recommend investment options, how they are compensated – including whether they receive compensation for referring retirement plans to certain vendors or service providers – and how they deal with conflicts of interest. Again, we are focused on whether there are any material conflicts of interest that are not fully and fairly disclosed. These investors should have the information they need to make a fully-informed investment decision

These are some examples of the areas we are investigating. And we are actively considering other potential areas of inquiry. As we consider areas of the market where there may be undisclosed conflicts of interest, we are considering questions such as:  Are there other areas where advisers might have a financial or other incentive to recommend a particular product to an investor? Is the adviser making money at the investor’s expense? Is the client paying more for this product? Is the same product available for less or no cost to the client? Is a substantially similar product available for lower or no cost? Can investors figure out how much they are paying? 

What Does This Mean for Advisory Firms?

Investment advisory firms need to be proactive in evaluating potential conflicts of interest and assessing disclosures. This includes regularly assessing the compensation that they, their affiliates or their affiliated persons receive, and what decisions or recommendations they must make to their clients to receive that compensation. The same is true for expenses—firms must assess whether they can avoid paying certain expenses based on investment decisions they make for clients.

What we learned from the Share Class Initiative is that businesses change. Firms acquire other advisory firms or hire financial professionals who bring with them existing client investments.  Advisers need to be proactive in evaluating how changes to their business affect their disclosure obligations. They also need to take action once a conflict is identified. We saw instances where an undisclosed conflict of interest was identified, but nothing was done or it took too long – sometimes years – to fix it.[14] Markets may evolve and product offerings may differ, but the law still applies. This is an iterative process – as the market evolves or the business changes, you need to ask yourselves continually: are we being true to long-standing, fundamental principles, including full and fair disclosure? 

Let me wrap up by saying that these are just some examples of the types of things we are looking at. We of course do not know the full universe of potential problem areas. But as I said earlier, rest assured that we are looking. We will continue to allocate our resources towards making sure investors are fully informed when making their investment decisions. At the end of the day, keeping the markets fair is our top priority, and it should be yours too.   

Thank you for inviting me here to speak today. Enjoy the rest of the conference.

 

[1] The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.

[2] 375 U.S. 180, 194 (1963).

[3] Id. at 188.

[4] This is critical so that clients can provide informed consent to the conflicts and material facts. Nevertheless, disclosure and consent alone do not satisfy the adviser’s duty to act in the client’s best interest. See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. 5248 (June 5, 2019) at 23 (noting that “an investment adviser’s obligation to act in the best interest of its client is an overarching principle that encompasses both the duty of care and the duty of loyalty.”). My remarks here today are not meant to be a comprehensive discussion of an investment adviser’s fiduciary duty with respect to the scenarios described. For example, as discussed in the Commission Interpretation described above, an investment adviser owes its clients a duty of care that requires it to provide investment advice that is in the best interest of the client based on the client’s objectives.

[5] In the Matter of IFG Network Securities, Inc., et al., Exchange Act Release No. 34-54127, 2006 WL 1976001, at *11 (July 11, 2016) (Commission Opinion).

[6] See Amendments to Form ADV, Advisers Act Rel. No. 3060 (July 28, 2010). (In amending the Form ADV brochure in 2010 to require disclosure of compensation attributable to the sale of a security, including asset-based sales charges and service fees from the sale of mutual funds, and the conflicts it creates, the Commission stated: “an adviser that accepts compensation from the sale to a client of securities has an incentive to base investment recommendations on the amount of compensation it will receive, rather than on the client’s best interests, and thus involves a significant conflict of interest.”).

[7] See, e.g., Capital Analysts, LLC, Advisers Act Release No. 5009 (Sept. 14, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-5009.pdf; Envoy Advisory, Inc., Advisers Act Release No. 4764 (Sept. 8, 2017), available at https://www.sec.gov/litigation/admin/2017/ia-4764.pdf; AP Summary File No. 3-17899; 3-17900, SEC Charges Credit Suisse and Former IA Representative With Breaches of Fiduciary Duty (Apr. 4, 2017), available at https://www.sec.gov/litigation/admin/2017/34-80373-s.pdf; Press Release 2016-52, AIG Affiliates Charged With Mutual Fund Shares Conflicts (Mar. 14, 2016), available at https://www.sec.gov/news/pressrelease/2016-52.html; Press Release 2015-283, J.P. Morgan to Pay $267 Million for Disclosure Failures (Dec. 18, 2015), available at https://www.sec.gov/news/pressrelease/2015-283.html; Manarin Investment Counsel, Ltd., Advisers Act Release No. 3686 (Oct. 2, 2013), available at https://www.sec.gov/litigation/admin/2013/33-9462.pdf.

[8] See NASD News Release, NASD Fines Merrill Lynch, Wells Fargo and Linsco $19.4 Million For Improper Sales of Class B and C Mutual Fund Shares (Dec. 19, 2005), available at https://www.finra.org/media-center/news-releases/2005/nasd-fines-merrill-lynch-wells-fargo-and-linsco-194-million-improper.

[9] See U.S. Sec. & Exch. Comm’n, Off. of Compliance Inspections and Examinations, National Exam Program, Risk Alert: OCIE’s 2016 Share Class Initiative (July 13, 2016), available at https://www.sec.gov/files/ocie-risk-alert-2016-share-class-initiative.pdf.

[10] See, e.g., Litigation Release No. 24550, SEC Charges Investment Adviser for Failing to Disclose Conflicts Arising from Receiving Revenue Sharing on Clients Investments (Aug. 1, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24550.htm; Litigation Release No. 24643, SEC Charges Registered Investment Adviser and Broker-Dealer with Defrauding Advisory Clients (Oct. 15, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24643.htm.

[11] See, e.g., JSK Associates, Inc., Advisers Act Release No. 3175 (Mar. 14, 2011), available at https://www.sec.gov/litigation/admin/2011/ia-3175.pdf.

[12] See Litigation Release No. 24595, SEC Charges Investment Adviser for Defrauding Advisory Clients by Charging Improper Transaction Costs (Sept. 13, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24595.htm.

[13] See Press Release 2019-85, SEC Announces Enforcement and Investor Education Initiatives to Protect Teachers and Military Service Members (June 3, 2019), available at https://www.sec.gov/news/press-release/2019-85.

[14] See, e.g., AP Summary File No. 3-17899; 3-17900, SEC Charges Credit Suisse and Former IA Representative With Breaches of Fiduciary Duty (Apr. 4, 2017), available at https://www.sec.gov/litigation/admin/2017/34-80373-s.pdf.

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