The SEC settled public administrative and cease and desist proceedings against two affiliated SEC-registered investment advisers (“Adviser 1” and “Adviser 2,” collectively, the “Advisers”) and their owner, who also served as the president of the Advisers (the “Owner,” and collectively with the Advisers, the “Respondents”), related to findings regarding certain revenue sharing arrangement and their non-disclosure by the Respondents. This articles summarizes the SEC’s findings, which the Respondents neither admitted nor denied.
Background. Adviser 1 is a registered investment adviser that provides (i) non-discretionary investment advice through proprietary asset allocation models made up primarily of mutual funds and ETFs and (ii) back-office custodial support to both related and unrelated investment advisory firms. Adviser 1 provides “turn-key” asset management services and back-office custodial support to approximately 60 investment advisers (the “FAs”) who use Adviser 1’s advice with retail clients, representing approximately $1.7 billion in assets, most of which is custodied with a specific broker (the “Broker”). The majority of Adviser 1’s recommendations relate to “No Transaction Fee” mutual funds on which the Broker does not charge investors any form of commission (the “NTF Funds”). Adviser 1 also serves as an investment sub-adviser to a registered investment company (the “SA Fund”). The SA Fund’s primary investment adviser is a related party of Adviser 1 specifically created to serve in that capacity (the “Related Adviser”). Adviser 2 is a registered investment adviser that offers investment advisory services to retail clients, and receives investment advice and back-office support from Adviser 1.
Revenue Sharing Arrangement with Broker. In September 2007, Adviser 1 and the Broker entered into a “Custodial Support Services Agreement” (“CSSA”) pursuant to which Adviser 1 agreed to perform certain services, such as facilitating asset transfers, handling client account inquiries and assisting with client paperwork and account reconciliation. In exchange, the Broker agreed to pay Adviser 1 a certain percentage of every dollar that Adviser 1’s clients invested in the NTF Funds. Adviser 1 did not disclose the existence of this revenue-sharing arrangement to any of the FAs, nor did Adviser 1 disclose to the FAs that it had an incentive to favor NTF Funds in its recommendations. Adviser 1’s Form ADV also did not disclose this conflict.
Sub-Advisory Relationship. In mid-2009, the Related Adviser, which served as the primary investment adviser to the SA Fund, proposed that Adviser 1 serve as sub-adviser to the SA Fund and that SA Fund adopt a Rule 12b-1 distribution fee. Adviser 1 made several presentations to the Fund’s Board (the “Board”), which included statements that Adviser 1 would not receive payments or benefits from the SA Fund other than the fee paid pursuant to the sub-advisory agreement. In actuality, Adviser 1 had an arrangement with the Related Adviser pursuant to which the Related Adviser would pay Adviser 1 approximately 15 basis points. The Board was not aware of this arrangement and, accordingly, did not consider it when approving the sub-advisory agreement.
Affiliate’s Proxy Vote on Sub-Advisory Relationship. Following approval by the SA Fund’s Trustees, shareholders of the SA Fund were asked to approve the addition of Adviser 1 as a sub-adviser and the adoption of a Rule 12b-1 fee. The vast majority of the SA Fund’s shareholders were clients of Adviser 2, which had recommended the SA Fund to many of its clients. Because it was subject to a conflict of interest in voting on these matters, Adviser 2’s proxy voting policy called for its clients who beneficially owned SA Fund shares, rather than Adviser 2, to vote the proxies in question. Adviser 2 did not comply with this policy and voted in favor of the proposals for SA Fund to add Adviser 1 as a sub-adviser to the SA Fund and adopt a Rule 12b-1 fee.
Violations. The SEC found the following violations of law:
Section 206(2) and 207 of the Advisers Act – By failing to provide the SA Fund’s Board with information about Adviser 1’s separate arrangement with the Related Adviser and by failing to disclose the revenue sharing arrangement with the Broker, the SEC found that Adviser 1 willfully violated Section 206(2) the Investment Advisers Act of 1940 (the “Advisers Act”) prohibiting practices that act as a fraud or deceit on a current or prospective client and Section 207 of the Advisers Act prohibiting an untrue statement or omission of material fact in filings with the SEC, and that the Owner willfully aided and abetted and caused the foregoing violations by Adviser 1.
Section 15(c) of the 1940 Act – By misrepresenting to the SA Fund’s Board that the sub-advisory fees were the only compensation to be received by Adviser 1 in connection with the sub-advisory agreement with the SA Fund, the SEC found that Adviser 1 willfully violated Section 15(c) of the Investment Company Act of 1940 which sets forth the duty of an investment adviser to provide information to an investment company board considering the approval of an advisory contract, and that the Owner willfully aided and abetted and caused Adviser 1’s violation.
Sections 206(2) and 206(4) and Rule 206(4)-6 of the Advisers Act – By failing to implement proxy voting policies and procedures reasonably designed to ensure that shares of the SA Fund were voted in the best interests of its clients with respect to the approval of Adviser 1 as sub-adviser and the adoption of a Rule 12b-1 Plan, Adviser 2 willfully violated Section 206(2) of the Advisers Act, Section 206(4) of the Advisers Act prohibiting fraudulent or deceptive practices and Rule 206(4)-6 under the Advisers Act relating to proxy voting policies and procedures.
Sanctions and Remedial Undertakings. In addition to agreeing to cease and desist orders and censures, the Advisers and the Owner agreed to pay the following amounts: Adviser 1 agreed to pay disgorgement of $900,000, prejudgment interest of $25,813.92 and a civil money penalty of $100,000; Adviser 2 agreed to pay a civil money penalty of $50,000; and the Owner agreed to pay a civil money penalty of $50,000. Adviser 1 also agreed to provide a notice of the order settling this proceeding to its existing clients and for a period of one year, to prospective clients, and to retain an independent consultant to, among other things, review and make recommendations about Adviser 1’s compliance policies and procedures and disclosures to clients.