Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

Posted on July 19, 2016, by Mary P. Hansen and John S. Yi in Civil Penalties, Investment Advisers, Neither Admit Nor Deny, Settlements, Strict Liability. Comments Off on Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

On July 14, 2016, RiverFront Investment Group, LLC (“RiverFront”) agreed to settle charges brought by the SEC for failing to “properly prepare clients for additional transaction costs beyond the ‘wrap fees’ they pay to cover the cost of several services bundles together.” Press Release No. 2016-143. According to the SEC, participants in wrap fee programs usually pay an annual fee “which is intended to cover the cost of several services ‘wrapped’ together, such as custody, trade execution, portfolio management, and back office services.” Release No. 4453. The SEC found that under these wrap programs, a sponsoring firm will offer clients a selection of third-party managers, referred to as subadvisors, to have discretion over the clients’ investment decisions. When subadvisors execute trades on behalf of clients through a sponsor-designated broker-dealer, the transaction costs associated with the trades are included in the wrap fee. On the other hand, if a subadvisor sends a trade to a non-designated broker-dealer, a practice known as “trading away,” clients incur additional transaction costs beyond the wrap fee.

RiverFront, a registered investment adviser, served as a subadviser in various wrap fee programs since mid-2008.  According to the Order, beginning in late 2009, RiverFront substantially increased the amount it traded away, and by 2010, it was trading away a majority of the trades it executed on behalf of clients in wrap programs. The Order indicates that RiverFront claimed trading away allowed it to obtain “improved execution prices.” The SEC found, however, that RiverFront’s trading away resulted in clients incurring “millions of dollars’ worth of transaction costs charged by non-designated broker-dealers that were not covered by the wrap fee.” For its failure to disclose the extent of its practice of trading away, the SEC charged RiverFront with two rules-based strict liability provisions. Registered investment advisers are required to file a Form ADV to be amended annually or whenever information on the form becomes “materially inaccurate.” When RiverFront significantly increased its trading away activity, it failed to update its Form ADV subsequently causing misleading statements in future Forms ADV. As a result, the SEC found RiverFront violated Sections 204(a) and 207 of the Advisers Act. Unlike Section 206 of the Advisers Act, the SEC does not have to prove RiverFront acted with scienter or even negligently to prove that RiverFront violated the provisions. The SEC merely needs to show that the Form ADV was “materially inaccurate.” Without admitting or denying the SEC’s findings, RiverFront agreed to pay a $300,000 civil penalty, be censured, and publicly disclose on its website “the volume of trades by market value executed away from sponsor firms and the associated transaction costs charged by non-designated broker-dealers and passed onto clients” on a quarterly basis.

Typically, where the SEC finds that advisers have failed to disclose fees or costs paid by clients, it charges either scienter-based fraud or negligence-based fraud under Section 206 of the Advisers Act. See, e.g., In the Matter of Cherokee Inv. Partners, LLC, et al., Release No. 4258 (Nov. 5, 2015) (settling fraud-based charges based on a failure to disclose certain expenses charged to private funds by the adviser); In the Matter of Taberna Capital Mgmt., LLC, et al., Release No. 4186 (Sept. 2, 2015) (settling fraud-based charges based on the retention of fees received from underlying borrowers in CDOs managed by the adviser and the failure to disclose certain fees to CDO investors); In the Matter of Dion Money Mgmt., LLC, Release No. 4146 (July 24, 2015) (settling fraud-based charges based on a failure to disclose terms of certain compensation arrangements that benefited the adviser at the expense of the private funds). One reason that the SEC may not have charged fraud in this action is because it does not appear that RiverFront received any portion of the “millions of dollars” clients paid in connection with its practice of trading away. It is also not clear whether, or to what extent, the improved execution prices offset the “millions of dollars” in fees.

Finally, the relatively modest $300,000 civil penalty likely reflects RiverFront’s cooperation and remedial efforts which the SEC expressly referenced in its Order.

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