On Aug. 1, the Securities and Exchange Commission (the SEC) charged Commonwealth Equity Services LLC, dba Commonwealth Financial Network (Commonwealth), a registered independent investment adviser to private clients (but not a fund manager) and broker-dealer based in Waltham, MA, with failing to disclose material conflicts of interest related to revenue sharing arrangements that benefited Commonwealth for choosing certain mutual funds or certain share classes for its clients. Although the complaint concentrates on the selection of specific funds, it can be read as an outgrowth of the SEC's share class selection initiative that provided incentives (since expired) for advisers to self-report improper share class selections.
The SEC charged Commonwealth with violating the antifraud provisions of Section 206 of the Investment Advisers Act of 1940, thereby breaching its fiduciary duty to disclose material conflicts of interest, and with violating Rule 206(4)-7 for not having policies and procedures to prevent the violations.
In its complaint, the SEC claimed in particular that, per a September 2014 agreement (the Agreement) with National Financial Services (National), a Fidelity affiliate, Commonwealth was entitled to 80 percent of the mutual fund revenue that National received if Commonwealth invested its clients' money in the mutual fund share classes for which National shared revenue. As a result of the Agreement, Commonwealth's interests were in conflict with those of its advisory clients. The Agreement created financial incentives for Commonwealth to invest its clients' money in mutual funds in a manner that would generate additional multimillion-dollar revenue while other similar investment choices would have generated much less, or no, additional revenue for Commonwealth.
The SEC noted that the Agreement contained specific terms requiring disclosure of (i) "[a]ny conflicts of interest that may arise in connection with the [revenue sharing], including without limitation, any incentive arising in connection with [Commonwealth's] receipt (or prospective receipt) of compensation or other payments on balances or positions in mutual funds to favor those types of investments over others" and (ii) "[t]he nature, scope and other material terms of the payments that [Commonwealth] is eligible to receive pursuant to [the revenue sharing arrangement]." The SEC did not charge National in its complaint.
While Commonwealth made disclosures about some of its revenue sharing arrangements with third parties (including National) in its Form ADV, it failed to tell its advisory clients that it earned more when its advisors invested client assets in funds participating in National's no-transaction-fee program, which were typically more expensive than other options. In particular, Commonwealth failed to disclose that some funds in National's no-transaction-fee program had lower-cost share class alternatives available but that Commonwealth would receive less or no revenue sharing payments for investments in those. The proceeding demonstrated the importance of increasing disclosure of conflicts of interest to cover not only the specific financial incentives involved but also the available options that could otherwise be available assuming no incentives were in place.
The SEC sought (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.
The SEC complaint is available here.
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