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Advisers, Brokers on Alert as SEC Looks into Revenue Sharing Arrangements

Two recent SEC actions on conflicts of interest in revenue sharing arrangements are putting the industry on notice. Trade publications such as Financial Advisor magazine say that the success of the SEC’s share class self-reporting initiative may have spurred “the beginning of a robust spate of legal complaints and a possible new initiative—this time zeroing in on RIA revenue-sharing activity.” The SEC recently chargedCetera Advisors, LLC, a registered investment adviser and broker-dealer, with breaching its fiduciary duty and defrauding its retail advisory clients by, among other things, failing to disclose conflicts of interest related to the firm’s receipt of over $10 million in undisclosed compensation from 12b-1 fees, revenue sharing, service fees and markups. Cetera did not participate in the share class self-reporting initiative. Another firm Commonwealth Financial Network agreed to pay $1.6 million in March under the SEC’s share class self-reporting initiative, but was charged in August with failing to disclose material conflicts of interest related to revenue sharing Commonwealth received for certain client investments. The SEC alleged that between July 2014 and December 2018, Commonwealth received over $100 million in revenue sharing from a broker related to client investments in certain share classes of “no transaction fee” and “transaction fee” mutual funds. Groups such as the Financial Services Institute, which represents independent financial services firms and independent financial advisers, have come out against the share class initiative, describing it as “drive-by regulating without rules.” The trade organization launcheda campaign calling for a halt to the enforcement cases on Sept. 4., and advisors and broker-dealer executives are expected to visit Capitol Hill to make their case directly to lawmakers, according to a report in Financial Planning. Morningstar columnist John Rekenthaler writes that revenue sharing is “an ongoing mess,” fraught with inherent conflicts and ineffective disclosure requirements that do not benefit the consumer and called for a rewrite of the rules.

Dear Board Doc: Board Culture Takes an Unfamiliar Turn

The MFDF’s Board Doc is an occasional feature of the Daily News Feed that features questions from our readers. The answers and commentary provided in our responses do not constitute legal advice and should not be treated as such. Please consult with your independent counsel on questions of compliance with the securities laws and director fiduciary duties. If you would like the Board Doc to consider your questions, please e-mail This email address is being protected from spambots. You need JavaScript enabled to view it..

Q. I have been on my current board for over a decade and I am the chair of a committee. Our board has developed a cordial, accountable relationship with management even as our complex continues to face serious challenges with competition from passively managed funds and cost pressures. We recently lost two long-tenured directors who were very vocal during meetings and, in my opinion, asked the difficult questions that kept management accountable. We replaced them with two new independent directors who are not as vocal during meetings and who take a more measured approach to challenging management. While I have faith in our board and its abilities, I fear that our board culture, the tenor of our meetings, and our overall effectiveness is at risk. Is there a way to re-direct our board culture toward what it once was?

A.  As our industry continues to evolve, it is important that boards take seriously their fiduciary duties to the fund. It is also important to acknowledge that advisers are under immense pressures to offer high-performing, cost-competitive funds. You say that you continue to have faith in your current board and its abilities, despite the loss of the two vocal members. As a first step, you may wish to review the board’s processes for overseeing how the funds are managed and serviced, the characteristics of the board’s relationship with management, and whether each director is contributing appropriately in meetings.

You may also wish to consider that a change in approach does not necessarily indicate a change in result.  A board’s duty involves not only asking the hard questions but also ensuring that there is follow up on issues of mutual board/management concerns.  There are many effective forms of engagement other than asking “hard” questions during meetings.  The board’s ongoing relationship and engagement with management throughout the year, outside of regular board meetings, is valuable to helping boards best advance the interests of the fund and shareholders. The new directors’ more measured approach should encourage and foster that deeper engagement with management on a board-wide basis and could add balance to the board culture.

The board self-assessment is also an excellent means to express concerns. You may also review the board’s onboarding process to ensure that new directors understand expectations.  The following materials from the MFDF website should be helpful in thinking about board effectiveness and onboarding generally.

Boston Fed Staff Assesses Liquidity Risk in Bank Loan and High-Yield Funds

A recent note by Kenechukwu Anadu of the Federal Reserve Bank of Boston and Fang Cai of the Fed Board of Governors examined certain indicators of mutual funds’ liquidity-risk profiles and a sample of bank loan and high-yield corporate bond mutual funds. Based on their observations, the authors conclude that: (1) a combination of rising hard-to-value, illiquid holdings in bank loan funds amid generally stable liquid holdings might indicate rising liquidity risks and (2) for high-yield funds, the average levels of liquid assets have increased, while illiquid assets have declined over the years. The authors write that investors’ interest in floating-rate instruments have contributed to increased net assets in bank loan mutual funds. According to their data:

  • As of March 2019, net assets in bank loan funds were $112 billion, up from about $24 billion at year-end 2009. Of that total, about $91 billion were invested in loans, up from less than $5 billion in 2008.
  • Net assets in high-yield mutual funds increased from about $157 billion in December 2009 to almost $250 billion in March 2019.

They note that during recent market volatility in December 2018, bank loan funds experienced record net outflows of $13 billion, or almost 10 percent of net assets, and high-yield funds experienced net outflows of $6 billion or almost 3 percent of net assets, although both fund types functioned well during the period. The authors cautioned, however, that the short duration of the volatility event and a strong economy may have cushioned losses. They acknowledge a “scarcity of comprehensive, high frequency market data and the lack of related disclosures” by mutual funds and write that it is too early to assess how the SEC’s liquidity risk management rule would affect liquidity transformation risks among mutual funds and ETFs. They also examined the credit profiles of bank loan and high-yield corporate bond funds and observed no extreme outliers in terms of liquidity risk.

MFDF Webinar: What Directors Need to Know about Regulation Best Interest and the Standards of Conduct Rulemaking Package

In June, the SEC adopted the long-awaited rulemaking package relating to the standard of conduct broker-dealers and investment advisers owe when providing advice to retail investors.  The package includes:
  • Regulation Best Interest – under which broker-dealers will be required to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
  • Form CRS – under which registered investment advisers and broker-dealers will provide retail investors a short relationship summary that is intended to allow for comparability among the two different types of firms.
  • Interpretation reaffirming and in some instances clarifying the SEC’s views of the fiduciary duty owed by investment advisers to all of their clients.
Sara Crovitz and Larry Stadulis will provide an overview of the package, focusing on practical implications for fund directors.
This webinar will be broadcast live from 2:00 to 3:00 Eastern Time on Thursday, September 12, 2019. Register online

Volcker Rule Amendments Approved

The FDIC approved a final rule to simplify and tailor requirements relating to Section 619 of the Dodd-Frank Act, commonly known as the “Volcker Rule.” The Volcker Rule generally prohibits banking entities from engaging in proprietary trading and from owning or controlling hedge funds or private equity funds. FDIC Chairman Jelena McWilliams in a release acknowledged the difficulty that has dogged the regulation. “Distinguishing between what qualifies as proprietary trading and what does not has proven to be extremely difficult. Meanwhile, banks that do relatively little trading are required to go through substantial compliance exercises to ensure that activities that have long been considered traditional banking activities do not run afoul of the Volcker Rule.” The amendments to the Volcker Rule are subject to the approval of other regulators including the Federal Reserve, SEC and Treasury. The final rule will, among other things:

  • Tailor the rule’s compliance requirements based on the size of a firm’s trading assets and liabilities, with the most stringent requirements applied to banking entities with the most trading activity;
  • Streamline the criteria that apply when a banking entity seeks to rely on the hedging exemption from the proprietary trading prohibition; and
  • Simplify the trading activity information that banking entities are required to provide to the agencies.

The changes will go into effect in January 2020 and banks are slated to comply in 2021. The Wall Street Journal reports that one FDIC member opposed the amendments saying they would weaken restrictions on banks engaging in speculative trading.

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