Regulators bare their teeth on excessive fees

Moves this week by Finra and the SEC signal watchdogs are ready to pounce on anyone overcharging clients.

A regulatory crackdown on overcharging clients was amplified this week with a move by Finra against an investment company and by a response from an investment banker to Securities and Exchange Commission pressure.
The actions highlighted the emphasis that each regulator has put on ferreting out excessive fees, and could reverberate in the retail investment adviser sector. Both the Financial Industry Regulatory Authority Inc. and the SEC have made scrutiny of fees a regulatory and examination priority this year.
Finra, the industry-funded broker-dealer regulator, levied a $350,000 fine against Fidelity Investments for what it said was inappropriately charging more than 20,000 clients a total of $2.4 million for certain transactions in fee-based accounts in its Institutional Wealth Services Group.
In another example this week, the private equity firm KKR & Co. refunded money to investors in some of its funds after the SEC determined it had overcharged them, according to a Wall St. Journal analysis.
Although the two matters didn’t directly involve the retail client space, financial advisers should take heed of the regulators’ obsession with fees, said Jay Baris, a partner at Morrison & Foerster.
“The SEC’s concern about fees spills over to the retail side,” Mr. Baris said.
The regulators are attuned to how ordinary investors are hurt by high fees, even more so than the institutional clients that were allegedly hurt by KKR’s practices, said Kay Gordon, a partner at Drinker Biddle & Reath.
“On the retail side, it’s even more sensitive,” Ms. Gordon said. “It’s a more compelling case.”
The next shoe to drop may be the agency releasing results of its examination sweep regarding mutual fund distribution payments. Launched almost two years ago, the initiative is designed to determine whether payments to brokerage firms for marketing funds are being disguised as payments for other services.
Mr. Baris said the sweep has been completed and the SEC staff is preparing a report.
“I suspect that they are going to take a pretty strong stand on this,” he said. “I wouldn’t be surprised if we’ll see enforcement action and new rule proposals.”
The SEC is going after private equity firms because the agency has been finding in examinations “high rates of deficiency” on the collection of fees and allocation of expenses, Andrew Bowden, director of the SEC’s Office of Compliance Inspections and Examinations, told reporters recently.
Private equity firms have had to register with the SEC under a mandate in the Dodd-Frank financial reform law. They’re now getting the same scrutiny on fees that investment advisers and brokers have experienced for years, said Tom Potter, a managing partner at Burr & Forman.
Regulators have already made clear that they are taking a hard look at advisers who are dually registered as brokers and can move their clients back and forth from fee-based accounts to commission-based accounts.
They are zeroing in on so-called “reverse churning,” in which a client is put in a wrap-fee account that does little trading. That client pays a fee on assets that is likely to result in higher costs than if she paid commissions for each trade in the account.
“This is an area in the retail space that regulators are going to be on top of,” said Emily Gordy, a partner at Shulman Rogers and a former deputy chief counsel in the SEC Division of Enforcement.
It comes down to making sure the client and the firm are on the same side.
“If you put granny, who doesn’t do anything but hold investments, into a fee-based account, you’re charging her for a bundle of services she’s not using,” Mr. Potter said. “The interests of the house and the client aren’t aligned.”
The Fidelity case is important not because of the size of the fine assessed but because of the “systemic issues involved,” said Amy Lynch, president of FrontLine Compliance.
Advisory firms must ensure that their back-office systems keep track of fees for each type of client account.
“The more double-checks they have in the back office to make sure fees are being assessed correctly, the better,” Ms. Lynch said. “Firms really need to monitor anything having to do with fees because regulators are going to look closely at it.”
Daniel Bernstein, chief regulatory counsel at MarketCounsel, doesn’t foresee a major reverse-churning case emerging. Instead, the issue will pop up in enforcement ripples.
“I do think there will be a lot of small cases,” he said.
In order to avoid regulatory problems, advisers should continually review how they make their money and how they explain it to clients.
“Periodically, advisers should be looking at every revenue stream — whether it’s direct or indirect — to determine if there’s any benefit they’re receiving that amounts to a conflict of interest that they need to disclose,” Mr. Bernstein said.
A wave of actions on the opaque municipal bond markets may be next.
“You’re more likely to see the next fee cases in the municipal securities world,” Mr. Potter said. “That’s getting more attention than it ever has.”