Advisors must be vigilant in avoiding conflicts of interest.
A recent enforcement proceeding by the Securities and Exchange Commission (SEC) against a federally registered investment advisor should serve as notice to advisors of the seriousness with which the SEC views certain activities of advisors and their duty to clients. This case and other recent SEC actions and statements also provide a road map to advisors of the kinds of preventative measures an advisor should undertake in order to avoid a similar fate and the obstacles that advisors face when considering partnering arrangements.
Jamison Eaton & Woods is a New Jersey based investment advisor with about 180 individual clients. It has more than $600 million under management and nondiscretionary assets of about $17 billion. Jamison has been providing investment advice in its present form since 1972 and has referral arrangements, in some cases going back 25 years, with various registered representatives of full service broker-dealers, among others. Pursuant to these arrangements, the broker reps referred their clients to Jamison for advisory services, with the quid pro quo that Jamison would continue to execute transactions through the full-service broker-dealer that had provided the referral. An SEC examination of Jamison found that clients who came to Jamison through the broker rep referral arrangement paid commissions of about $0.35 per share, while Jamison's other clients paid a commission rate of $0.08 per share through a lower-cost bank clearing service.
In what appeared to be a recognition of the conflict-of-interest issue and an attempt to address it incrementally, Jamison's disclosure to clients evolved over time. Prior to 1999, Jamison's one-page client agreement made no reference to any actual or potential conflict of interest regarding broker rep referrals, nor did its Form ADV. Between 1999 and 2002, Jamison used various vague references in an attempt to disclose away the issue. It was not until January 2002 that Jamison boldly informed clients that a potential conflict of interest could arise in situations where a client is referred from a broker rep. At no point did Jamison mention that this conflict would result in the client paying more for brokerage transactions.
Not surprisingly, the SEC found that Jamison failed to disclose a material arrangement to clients, and did not review the direction and placement of its client brokerage in light of its fiduciary duty to seek to obtain best execution in the evolving market for custody and execution services. By failing to disclose its potential conflict of interest and other brokerage options, and by failing to seek best execution, Jamison violated various provisions of the Investment Advisers Act of 1940 and incurred a fine of $100,000. In addition to paying a fine of $100,000, Jamison also entered into a settlement order with the SEC that obligates it to:
Maintain a director of compliance who has unrestricted access to the board of Jamison and is instructed to meet with legal counsel annually to review compliance procedures.
Disclose in its Form ADV that a conflict of interest may exist in obtaining best execution between the client and the advisor in situations where the client is referred by a broker rep.
Maintain a standard investment contract that has a separate paragraph entitled "Placement of Brokerage" and permits clients to direct brokerage to a particular broker.
Maintain a revised procedures manual that includes policies and procedures to ensure adequate disclosures to clients relating to broker referrals and conflicts of interest.
Mail Form ADV to all advisory clients who use a full-service broker and are not in an asset-based-fee program along with an explanatory letter that has been approved by the SEC.
Conduct periodic and systematic evaluations of its brokerage arrangements and the alternatives available for analyzing best execution.