The Securities and Exchange Commission is cracking down on dually registered advisors’ use of more costly money markets and cash sweep arrangements when less expensive products are available, a top SEC enforcement official said yesterday.
“The more we look, the more undisclosed or inadequately disclosed financial conflicts we find,” said Stephanie Avakian, co-director of the SEC’s Division of Enforcement, speaking to advisory firm executives at a London conference.
Since interest started to rise in 2016, sweep money market accounts that pay far less than other money market funds have been a huge source of profits for broker-dealers, banks and custodians. At some BD's, sweep accounts could be generating more than 25 percent of profits. Many fiduciary advisors view them as suitable only as a place to park very short-term cash.
In some cases, SEC examiners are finding that dually registered advisors and brokers are making more than investors on the money markets they recommend because of the incentives advisors are paid and the higher costs that are passed on to investors, Avakian added.
When it comes to cash sweep arrangements, “in some cases, the revenue received by the advisor or the advisor’s affiliate far exceeds the interest earned by the client on its cash,” Avakian said.
“In fact, in some cases, these arrangements may actually lower the interest paid to the client,” she added.
Cash sweep accounts are advisory accounts where uninvested funds are automatically swept into a money market mutual fund or a bank deposit. The problem comes in when the bank offering the sweep account charges more for the account and/or pays less in interest to investors in order to pay advisory firms a portion of the revenue the bank earns on the investor’s deposits. A portion of that revenue is then passed on to the dually registered investment advisor or broker-dealer to incent him or her to choose these accounts.
Avakian noted that a dually registered advisor or an advisor with an affiliated broker-dealer may have a financial interest, a conflict, in recommending one cash investment over another. For example, some money market mutual funds carry 12b-1 fees or make revenue-sharing payments, while other money market funds do not carry those fees.
“Advisors recommending or choosing between different money market funds must make full and fair disclosure of these types of conflicts to their clients,” Avakian told advisors.
The SEC is “actively looking for circumstances where an advisor is financially conflicted by incentives that could affect investment recommendations to clients,” she added.
“We are not resting on the success of the share class initiative,” Avakian said, referencing the agency’s wildly successful self-reporting program that has resulted in 95 broker-dealers returning some $135 million in mutual fund fee overcharges to investors.
“Let me assure you, we are looking for other undisclosed material conflicts—and we are finding them,” Avakian added.
These types of cash sweep arrangements create an “obvious incentive” for an advisor to recommend products where revenue sharing will result in larger payments to the advisor and lesser returns for the advisor’s client, she said.
“This is a clear conflict, and without full and fair disclosure, investors cannot make an informed investment decision to agree to the advisor’s cash sweep vehicle selection,” Avakian added.
“When we find those circumstances, we are asking: Has the advisor explained the conflict to the client? Does that explanation cover how the conflict may affect the recommendation? Does the client have sufficient information to make an informed decision?” the SEC enforcement official said.
“I will tell you: The more we look, the more undisclosed or inadequately disclosed financial conflicts we find,” Avakian said. “So I thought I would share with you some of what we have seen.”
She suggested firms and advisors think like SEC examiners and ask themselves the following questions in order to proactively disclose or mitigate costly conflicts of interest:
- Are there other areas where advisors might have a financial or other incentive to recommend a particular product to an investor?
- Is the advisor making money at the investor’s expense? Is the client paying more for this product?
- Is the same product available for less or no cost to the client? Is a substantially similar product available for lower or no cost?
- Can investors figure out how much they are paying?
“Advisors need to be proactive in evaluating how changes to their business affect their disclosure obligations. They also need to take action once a conflict is identified,” Avakian concluded.