The SEC charged Commonwealth Equity Services, LLC (d/b/a Commonwealth Financial Network), a registered investment adviser and broker-dealer, with failing to disclose material conflicts of interest related to revenue sharing Commonwealth received for certain client investments. According to the SEC’s complaint, Commonwealth had a revenue sharing agreement with its clearing broker for trades in their accounts. Under the agreement, Commonwealth received a portion of the money that certain mutual fund companies paid to the clearing broker to be able to sell their funds through the clearing broker’s programs, if Commonwealth invested its clients’ assets in certain share classes of those funds.
Commonwealth has not agreed to settle the SEC’s charges. At this point we just have the SEC’s side of the case. I thought it would be useful to look at the charges to see what bothered the SEC.
The SEC’s complaint alleges that Commonwealth negligently breached its fiduciary duty to its clients because Commonwealth failed to tell its clients that there were (i) 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) mutual fund investments that did not result in any revenue sharing payments to Commonwealth, and (iii) revenue sharing payments to Commonwealth under the clearing broker’s “transaction fee” program.
There is no inherent problem with revenue sharing as long as it properly disclosed. Using different share classes are okay as long as there disclosure and the reason for choosing the different classes. What savings you get from lower cost shares may be eaten up my more brokerage and custody costs.
The SEC alleges that Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives. The complaint also alleges that Commonwealth violated Section 206(4) and rule 206(4)-7 because it failed to adopt and implement policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest.
Here is the disclosure that the SEC didn’t like:
Additionally, NFS offers an NTF [no transaction fee] program composed of noload mutual funds. Participating mutual fund sponsors pay a fee to NFS to participate in this program, and a portion of this fee is shared with Commonwealth. None of these additional payments is paid to any advisors who sell these funds. NTF mutual funds maybe purchased within an investment advisory account at no charge to the client. Clients, however, should be aware that funds available through the NTF program may contain higher internal expenses than mutual funds that do not participate in the NTF program and could present a potential conflict of interest because Commonwealth may have an incentive to recommend those products or make investment decisions regarding investments that provide such compensation to Commonwealth.
The SEC didn’t like it because it used the world “may” indicating a potential instead of an actual conflict. I wish the SEC would get away from its hatred of “may” in disclosures.
Secondly, the SEC felt that the disclosure failed to point out that there were instances when lower fee funds were available but Commonwealth had an incentive to put investor into higher fee funds and would get revenue sharing.
The disclosures evolved and the arrangements got more complicated. The case will drag on. It’s far from a slam-dunk for the SEC. There does some seem to ways that Commonwealth’s disclosure could have been clearer.
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