SEC Announces Exam Initiative

On July 13, the SEC’s Office of Compliance, Inspections and Examinations (OCIE) announced that it is undertaking an initiative to address the risk that registered advisors may be making certain conflicted investment recommendations to their clients. More specifically, the OCIE will be creating examinations to prevent conflicts related to advisors’ compensation or financial incentives for recommending mutual funds and 529 Plan shares that have substantial loads or distribution fees.1

The OCIE staff examinations will focus on three areas:

  • Fiduciary Duty and Best Execution – An advisor must act in the best interest of the client and must disclose material conflicts of interest. The SEC has previously said that an investment advisor has violated its fiduciary duty if it causes a client to purchase a more expensive share class of a fund when a less expensive class of that fund is available.2 Registered Investment Advisors (RIAs) must also disclose in their Form ADV whether they accept compensation for the sale of securities or other investment products such as mutual funds.3
  • Disclosures – An advisor must disclose all material facts that may affect an advisory relationship, including disclosing when compensation is received for the sale of securities.
  • Compliance Policies – An advisor must develop written policies and procedures reasonably designed to prevent regulatory violations.

At the 2014 Investment Advisor Association Compliance Conference, OCIE Director Andrew Bowden expressed concern about undisclosed and unmitigated conflicts of interest among dually registered firms moving their clients’ assets from commission-based brokerage accounts to fee-based wrap accounts that offer advice and no-commission trading for one bundled asset-based fee. While he acknowledged that “there may be compelling and legitimate reasons why the move to a fee-based advisory account is in the best interest of the client,” Bowden questioned instances where “the value proposition to clients is not clear.”

These instances include when “securities are purchased, and portfolios are constructed or reconstructed, in commission-paying brokerage accounts at significant expense to the client, and then promptly transferred to a fee-based wrap account in which they could have done the same trades without paying commissions” or “accounts that consist primarily or entirely of cash or cash equivalents earning a few basis points that are transferred into a fee-based wrap account charging up to nearly 3% of AUM … and continue to remain invested in cash.”

The bottom line is that while investment advisors may charge both commissions and advisory fees, they must be sure to meet their best execution and anti-fraud obligations as established by the advisor. These obligations have been developed in a series of enforcement actions and other guidance. However, they are not made explicit in the instructions to Form ADV Part II and it is unclear that they can be met simply through disclosure. Instead, the SEC expects advisors to develop compliance policies and procedures designed to ensure the advisor acts in accordance with its best execution and anti fraud obligations. The SEC has indicated that it believes dual registrants present a higher risk of violation of these obligations. Along with a backdrop of general regulatory scrutiny of situations that may involve the overcharging of clients for mutual fund transactions, these concerns have caused the SEC to include the issue in its Exam Priority Letter for the last several years and to launch the current regulatory sweep.

[1] SEC, Office of Compliance Inspections and Examinations, National Exam Program Risk Alert, OCIE’s 2016 Share Class Initiative (July 13, 2016).

[2] SEC Administrative Proceeding 3-15549, Manarin Investment Counsel, Ltd. (October 2, 2013).

[3] See Part 2A of Form ADV, Item 5.E.


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