The U.S. Securities and Exchange Commission (SEC) is investigating several major investment advisor companies for failure to reveal conflicts of interest including revenue-sharing arrangements resulting in millions in income. In one recent lawsuit filed against Commonwealth Financial Network, The SEC says the firm has failed to disclose material conflicts of interest related to revenue sharing received for certain client investments. The Complaint says that since at least 2007, Commonwealth had a revenue-sharing agreement with the broker-dealer, National Financial Services through which, it required most of its clients use for trades in their accounts. Under that agreement, the SEC alleges, Commonwealth received a portion of the money that certain mutual fund companies paid to the broker to be able to sell their funds through the broker if Commonwealth invested client assets in certain share classes of those funds.
Between July 2014 and December 2018, Commonwealth received over $100 million in revenue sharing from the broker related to client investments in certain share classes of “no transaction fee” and “transaction fee” mutual funds, the complaint states. The arrangement between Commonwealth and NFS was also interesting as it was structured. According to the SEC Complaint, Commonwealth purchased or sold no transaction fee mutual funds share and clients did not pay a transaction fee. HOWEVER, clients did pay fees to the mutual fund for their share of fund expenses for as long as they held the fund and in turn the mutual fund paid a portion of these fees to NFS. NFS then shared a portion of those fees it received with Commonwealth.
The SEC’s complaint explains that Commonwealth’s receipt of the revenue sharing from NFS created significant conflicts of interest between Commonwealth and its clients. These conflicts included financial incentives for Commonwealth to invest clients in mutual funds which would lead to greater revenue for Commonwealth. The Complaint says that Commonwealth breached its fiduciary duty to its clients by failing to disclose the conflicts of interest created by its receipt of compensation through the revenue sharing agreement. Specifically, the SEC’s complaint alleges that Commonwealth “failed to tell its clients that (i) there were mutual fund share class investments that were less expensive to clients than some of the mutual fund share class investments that resulted in revenue sharing payments to Commonwealth, (ii) there were mutual fund investments that did not result in any revenue sharing payments to Commonwealth, and (iii) there were revenue sharing payments to Commonwealth under the broker’s ‘transaction fee’ program.”
“As a result of these material omissions, Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives,” the complaint says.
Technically, the complaint alleges that Commonwealth violated the antifraud and compliance provisions of Section 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder.
“By failing to adopt and to implement written policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest, Commonwealth violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder,” the complaint alleges. “The Commission seeks: (a) a permanent injunction prohibiting Commonwealth from further violations of the Advisers Act; (b) an order that Commonwealth disgorge its unjust enrichment, plus prejudgment interest; and (c) imposition of a civil penalty due to the nature of Commonwealth’s breach of fiduciary obligation.”
As of the end of 2017, Commonwealth advised 61,561 accounts with assets under management of approximately $6.8 billion in the PPS Select program. In the PPS Select program, Commonwealth offers advisory clients a variety of model portfolios of particular share classes of pre-selected mutual funds. These model portfolios are created and managed on a discretionary basis by Commonwealth’s internal teams. Once the investment team creates these model portfolios, Commonwealth makes them available to its adviser representatives and its client base through the PPS Select Program.
Some pundits and analysts commenting on the issue of revenue sharing believe that this practice is a known scheme which is infecting the financial advisory industry nation-wide. The SEC is closely examining other large financial advisory firms and similar lawsuits are expected to be filed. In the Commonwealth action, the SEC is seeking to require Commonwealth to disgorge its unjust enrichment plus prejudgment interest, In addition, it seeks an appropriate civil penalty as well as a permanent injunction. It is not clear how much this will cost the company if the SEC is successful but based on the sums collected as outlined in the Complaint it is likely to be quite a large sum. The full SEC COmplaint may be seen here: SEC-Commonwealth-Complaint
Jeffrey Newman represents SEC whistleblowers. His email address is firstname.lastname@example.org. His office telephone number is 617-823-3217