Undisclosed Fees, Conflicts Yield SEC Sanctions for Adviser

Undisclosed conflicts, fees and overcharges have become a recurring theme in Commission cases involving investment advisers. Frequently these cases arise out of inspections by OCIE. See, e.g., In the Matter of Credit Suisse Securities U.S.A), LLC, Adm. Proc. File No. -17899 (April 4, 2017)(fees in wrap fee program). While the origin of the Commission’s most recent case in this area is not disclose, it does emphasize the duty to disclose specific conflicts which can also impact the duty of best execution. In the Matter of Cadaret, Grant & Co. Inc., Adm. Proc. File No. 3-18087 (August 1, 2017).

The firm is a registered broker-dealer and investment adviser. It has 350 affiliated independent investment adviser representatives that provide services through 189 offices. Advisory services are made through two programs. One is an Investment Management System. The other is the Advisors Edge Program. The former is governed by management guidelines for the accounts regarding concentration and the types of mutual fund shares that can be acquired. The latter is a wrap fee account program for which Cadaret is the program sponsor.

The firm offers clients the opportunity to invest in a broad selection of mutual funds. Included in the offering is Class A shares which were purchased by clients from 2011 through 2016. Those shares are typically purchased by retail brokerage clients. They may have a “load” which can be waived. For both types of shares 12b-1 fees are paid by the fund.

Advisory clients in fee-based programs such as those in the Advisors Edge program were eligible for advisory or institutional shares or other similar shares. These shares are generally preferable for the client because the return is not reduced by the 12b-1 fees. During the five year period here Cadaret invested clients of its adviser representatives in mutual fund shares that carried 12b-1 fees despite the fact that the client returns were reduced. While the adviser’s Form ADV stated that it may receive 12b-1 fees, the disclosure did not detail the conflict between the types of shares. The firm received at least $1,933,000 in 12b-1 fees from these transactions. The firm failed to adopt and implement policies and procedures regarding mutual fund share selection.

During the same five year period the adviser also received payments from two mutual fund complexes. The fees were to support the marketing and distribution of those funds’ shares to advisory clients. The amount of the fees depended on the size of the investment. These fees were separate and apart from the 12b-1 fees. The firm received about $235,000 in fees through these arrangements.

The adviser also specified in its Form ADV that it would secure best execution for its clients. By placing clients in fund shares that carried the 12b-1 fees rather than when institutional shares were available, it failed to comply with this representation.

Finally, the firm failed to refund certain prepaid advisory fees. Specifically, the Form ADV stated that clients would pay an advisory fee for services such as portfolio management, trade execution, trade and performance reporting and account servicing. Those fees were billed in advance and not refundable, according to the firm’s disclosure because a significant portion of the functions performed were provided at the beginning of the quarter. This disclosure was not accurate, however, because in fact a significant portion of the fees were not earned at the beginning of the quarter. The firm did not disclose the fact that the adviser would retain unearned prepaid fees in the Advisor’s Edge program. The Order alleges violations of Advisers Act Sections 206(2), 206(4) and 207.

To resolve the matter Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order and a censure. In addition, the firm will pay disgorgement of $3,048,000 to compensate advisory client impacted by the conduct in the Order; additional disgorgement of $2,591,000 and prejudgment interest and a penalty of $280,000.

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