The SEC recently
announced sanctions against a broker-dealer in New York for ignoring red flags and making improper soft dollar payments to a San Diego-based registered investment adviser. The broker-dealer paid more than $400,000 to the RIA, even though the advisory firm failed to make full disclosure of those payments to clients and should not have been compensated.
WHY SOFT DOLLARS RAISE COMPLIANCE ISSUES
Soft dollars are credits or rebates from a brokerage firm on commissions that clients pay for trades executed in an RIA's client accounts. Regulators are skeptical of soft dollar arrangements because they might cause an RIA to breach its duty to seek the best execution of securities transactions. Receipt of soft dollars might also cause the client to pay more than the lowest available commission.
Soft dollar credits raise questions as to whether an RIA has breached its fiduciary duty. Because soft dollar credits are derived from commissions paid by advisory clients, they are viewed as their assets. Subject to a number of restrictions discussed at length
in the SEC's interpretive release, an RIA may use soft dollar credits to pay for brokerage and research services that benefit clients. These soft dollar arrangements must be fully and accurately disclosed on form ADV.
RED FLAGS OVERLOOKED BY THE BROKER-DEALER
The SEC's investigation of the broker-dealer found that the firm approved soft dollar payments to the RIA, even though there were bright red flags indicating that the payments were improper. The broker-dealer repeatedly ignored clear warning signs that the RIA and an investment adviser representative (IAR) were improperly using client funds for their own benefit. Marshall S. Sprung, co-chief of the SEC Enforcement Division's Asset Management Unit, warned firms, “Brokers perform a crucial gatekeeper function in approving soft dollar payments, and they cannot turn a blind eye to red flags that investment advisers may be breaching their fiduciary duty to clients.”
Among numerous red flags, the RIA provided the broker-dealer with inconsistent reasons for a payment of more than $329,000 to the IAR's ex-wife, which purportedly was employee compensation. The broker-dealer approved the payment even though the employment agreement was altered, and there was no proof that the ex-wife performed work for the RIA during the specified period. The payments were also used to pay for the IAR's timeshare expenses.
The broker-dealer made a number of other payments to the RIA that paid for the IAR's personal expenses including rent and travel. The IAR claimed the expenses were incurred during trips to evaluate potential investment opportunities.
The SEC found that the broker-dealer willfully aided, abetted, and caused the RIA's violations of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940, as well as Rule 206(4)-8. Although it did not admit or deny the SEC's findings, the broker-dealer agreed to a censure and a cease-and-desist order. The enforcement proceeding can be found
here.
ACTION AGAINST THE RIA
The SEC's Enforcement Division brought a separate enforcement action against the RIA and its president that was previously announced by the Commission on August 30, 2013. According to the SEC's order instituting administrative proceedings, the soft dollar scheme occurred from January 2009 to November 2011. Most of the money was funneled into the IAR's personal bank account.
The SEC also alleged in its complaint that the IAR engaged in a cherry-picking scheme from June 2008 to November 2009. The SEC alleged that the IAR usually waited to allocate trades until after the close of trading or the next day. This allowed him to see which securities had appreciated or declined in value. The IAR allocated the more favorably priced securities to the firm's
hedge fund accounts, which contained investments made by the IAR and his family.
The IAR reaped more than $200,000 in fees from one of the hedge funds, because it performed better due to the winning trades he allegedly allocated. He also used the inflated performance returns to market the hedge funds to prospective investors. In reality, those higher returns could be attributed to the cherry-picking scheme. The enforcement action against the IAR can be found
here.
Acceptance of soft dollars is one of many potential conflicts of interest that might arise in an RIA's business model, and disclosure alone may not be sufficient to avoid compliance problems. Examiners will always take a hard look at how RIAs deal with soft dollars and other conflicts of interest.
Les Abromovitz, an attorney and senior consultant with National Compliance Services, can be reached via email here. Mr. Abromovitz is also the author of The Investment Advisor's Compliance Guide.
