A recent enforcement action against two affiliated wealth management businesses raises concerns over whether and how other registered investment advisers will be subject to sanctions for issues that arise in the ordinary course of operating their businesses.

Facts and Circumstances

In 2008, Wells Fargo Clearing Services LLC and Wells Fargo Advisors Financial Network LLC (collectively, "Wells Fargo") acquired a wealth management business from Wachovia Corporation, a systemically important national bank on the brink of failure. A Federal Reserve official testified that "the consequences of an insolvency and unwinding of Wachovia" during the then-unfolding Great Financial Crisis, would have had "disastrous effects for an already weakened economy."

With the approval of the federal banking regulators, Wells Fargo bought Wachovia and, as a part of that purchase, quickly incorporated Wachovia's wealth management system - including fee billing information - into the corresponding Wells Fargo platforms.

Financial advisors of Wells Fargo predecessor firms AG Edwards and Wachovia relied on standardized advisory agreements. They occasionally negotiated lower fees with qualifying clients, and those discounted fees were sometimes hand-written or typed on paper agreements. This practice continued for several years after the Wachovia acquisition.

In late 2018, Wells Fargo discovered that its centralized billing systems did not reflect all those individual discounts. An internal review determined that 10,800 (of a total of 2.2 million) accounts had been overcharged. Wells Fargo's response was:

  • To correct its system to reflect the correct fees.
  • To reimburse affected advisory clients for over $26 million of overcharging.
  • To pay approximately $13 million of interest to the overcharged clients.

SEC Settlement

Both Wells Fargo entities are registered with the Securities and Exchange Commission (SEC) as investment advisers. On August 25, 2023, the SEC and Wells Fargo entered into a settlement that asserted Wells Fargo violated:

  • The antifraud obligations of Section 206(2) of the Investment Advisers Act of 1940 ("Advisers Act") - a violation of which may rest on a finding of simple negligence only.
  • The policies and procedures requirements of Advisers Act Section 206(4) and Rule 206(4) 7.

Despite Wells Fargo's corrective action and significant interest payment to make affected accountholders whole, the SEC nevertheless held Wells Fargo accountable for the fee miscalculations. Wells Fargo, which neither admitted or denied the charges:

  • Was fined $35 million for the (reimbursed with interest) $26.3 million error.
  • Received a censure.
  • Is subject to an ongoing cease-and-desist order.

Takeaways and Next Steps

This enforcement action carries several takeaways that investment advisers should keep in mind, including the following:

First, it is critical to correctly and accurately calculate fees and expenses. This is easier said than done, as many managers and advisers have multiple share classes, fee structures, hurdle rates and other arrangements, not to mention individualized loss-carry forwards and high water marks. In the Wells Fargo case, the SEC's view that retroactive reviews and testing of fees was insufficient was a key factor.

Second, while some aspects of this settlement are undoubtedly idiosyncratic, it does fit within a broader trend of more enforcement actions against registered investment advisers and higher fines and stricter penalties for the resulting settlements. When making risk assessments on various situations, risk and compliance officers may need to rely less on historical enforcement and settlement precedent and more on a worst-case scenario.

Third, given the recent position taken by the SEC and the Staff in the Private Funds Rule, the distinction between mistake, simple negligence and gross negligence will be increasingly scrutinized and questioned. As the SEC noted in the enforcement action, "A violation of Section 206(2) [of the Advisers Act] may rest on a finding of simple negligence; scienter is not required."

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