Every compliance officers knows that undisclosed revenue sources at the expense of advisory clients is going to get their firm in trouble. (That’s probably not true. But If you’re a regular reader of Compliance Building, you know that it leads to trouble.) The latest charge comes against Criterion Wealth Management.
The SEC’s complaint alleges that from 2014 to 2017 the defendants recommended that their advisory clients invest more than $16 million in four private real estate investment funds without disclosing that the fund managers had paid them more than $1 million, which was on top of the fees that defendants were already charging their clients directly.
This just a charge by the SEC and Criterion has not had a chance to defend itself. I’m just writing about this case to expose what can get you in trouble with the SEC as a warning of what not to do.
Criterion arranged for investments with two different real estate private fund managers. In some investments, Criterion would get a large portion of the performance promote. In others, Criterion was paid a trailing fee based on it’s clients’ investment in the funds.
The first arrangement results in depressed returns to the clients and created more income for Criterion. The second arrangement created an incentive for Criterion to recommend their clients stay invested in the funds.
Both of those arrangements would be perfectly fine if properly disclosed by Criterion to its clients. Criterion did have a disclosure in its Form ADV.
“Associated persons of [Criterion] are registered securities representatives and investment adviser representatives of [BrokerDealer,] a registered broker-dealer … In these capacities associated persons may recommend securities, insurance, advisory, or other products or services, and receive compensation if products are purchased through [Broker-Dealer.] Thus, a conflict of interest exists between the interests of the associated persons and those of the advisory clients.”
The SEC thought that disclosure was inadequate. It also cited a statement in Item 14 of Form ADV (referrals) that Criterion did not accept compensation from non-clients in connection with its services.
The SEC noted this problem in an exam and issued a deficiency letter.
This is the second lesson from the case. Fix the problems in the deficiency to make the SEC examiners happy. Or else the lawyers get involved.
In response to the deficiency letter, Criterion sent a letter to its clients that the compensation arrangement had created potential conflicts of interest that were not fully disclosed. The SEC wanted more in the letter. The SEC wanted Criterion to state that it had steered its clients to less-favorable classes in the funds because of the compensation arrangement and that this resulted -and continued to result- in lower returns to Criterion’s clients than other fund investors.
I’m sure there was a lot more back and forth about this than is contained in the complaint. But take the lesson.
With the lawyers involved, they found more problems at Criterion. The firm failed to conduct annual reviews for many years and hadn’t updated its compliance manual in eight years. The SEC also claims that when Criterion used a compliance consultant the firm failed to disclose the compensation arrangement to the consultant.
The complaint also claims that Criterion’s two principals had scienter and should be held personally responsible for the alleged misdeeds. One of the principals also had the title of Chief Compliance Officer, so this case also involves CCO liability. I think this clearly puts in the prong 1 category of being involved in the wrongdoing.
Sources:
- SEC Charges Investment Advisers with Failure to Disclose Financial Conflicts of Interest
- SEC Complaint against Criterion Wealth Management Insurance Services, Inc., Robert Allen Gravette, and Mark Andrew MacArthur
