September 20, 2020

Volume X, Number 264

September 18, 2020

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SEC Cracks Down on Pension Fund Advisers’ Undisclosed Compensation and Conflicts

In August 2020, the SEC issued two orders against VALIC Financial Advisors Inc. (VFA) related to VFA’s management of 403(b) and 457(b) plans. These matters arise out of two of the SEC’s enforcement initiatives, the Teachers and Military Service Members’ Initiative and the Share Class Selection Disclosure Initiative. VFA is a registered investment adviser and broker-dealer with approximately $21.1 billion in assets under management and services defined contribution retirement plans for Florida public school teachers, among other plans. These two orders follow a sweep of letters sent by the SEC in fall of 2019 to several third-party administrators and affiliates, including broker-dealers and registered investment advisers that work with 403(b) and 457(b) plans. While these actions are the first to come out of the SEC’s Teachers’ Initiative, they are unlikely to be the last.

The Misconduct

The first order against VFA alleges that its parent company made undisclosed payments to a for-profit company owned by Florida K-12 teachers’ unions. In exchange, the company (1) made VFA its preferred financial services partner for members, who were teachers and other school employees, (2) gave VFA increased opportunities to sell its investment products and services to the members over other advisers, and (3) allowed three full-time employees of VFA’s parent, called Member Benefit Coordinators (who referred teachers to VFA), to be identified as the union-affiliated company’s own employees.

The SEC found that VFA’s failure to disclose this information to clients violated Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act), one of the Act’s anti-fraud provisions. In addition, the SEC found that VFA’s conduct violated Advisers Act Section 206(4) and Rules 206(4)-3 and 206(4)-7. Rule 206(4)-3, the “cash solicitation rule,” prohibits a registered adviser from paying a third party (such as the teachers union) to solicit clients on its behalf without complying with provisions of the rule. The rule includes provisions requiring the adviser to enter into a contract with the solicitor requiring the solicitor to deliver to the person being solicited a current copy of the adviser’s brochure and a statement by the solicitor that explains the source of its compensation. Rule 206(4)-7, the “compliance rule,” requires that registered investment advisers have compliance policies and procedures that are reasonably designed to prevent violations of the Advisers Act.

The second order alleges that VFA directed third-party managers in a wrap fee program it sponsored to allocate client assets to higher cost “no-transaction fee” share classes, when in most cases lower-cost share classes were available. The “no-transaction fee” share classes paid VFA higher 12b-1 fees or revenue sharing and permitted VFA to avoid sales loads and other transaction fees it was obligated to pay under the wrap fee program. The SEC alleged that VFA had provided false or misleading disclosure to its clients about the fees the clients were charged and that VFA had failed to disclose the payments VFA received.

According to the SEC, this conduct breached VFA’s fiduciary duty to the clients, including its obligation to seek best execution of client transactions, in violation of Section 206(2) of the Advisers Act. Additionally, the SEC found that VFA’s conduct also constituted willful violations of Section 206(4) of the Advisers Act and Rule 206(4)-7. The SEC asserted that the misconduct yielded VFA over $13.2 million in financial benefits since January 1, 2014.

The Remedies

VFA agreed to pay a total of $40 million as part of the two settlements. Additionally, VFA consented to be censured and to cease-and desist any further violations of Sections 206(2) and 206(4) of the Advisers Act and Rules 206(4)-3 and 206(4)-7. The $4.5 million penalty imposed under the second order presumably reflects the failure to self-report as part of the Division of Enforcement’s 2018 Share Class Selection Disclosure Initiative, which permitted advisers to avoid civil penalties by self-reporting. The order noted that VFA did not self-report its 12b-1 fee practices, although it was eligible to do so.

The first order has an additional, and more unusual, component worth noting. As part of the negotiated settlement, VFA agreed to an undertaking capping its management fees at 45 basis points for all Florida K-12 teachers who currently participate (and, in some cases, those who prospectively participate) in its advisory product in Florida’s 403(b) and 457(b) retirement programs. The cap will remain in effect for the duration of the clients’ enrollment in the programs.

The Takeaways

Be On Notice. As it has in recent enforcement initiatives, the SEC put market participants on notice that it would be looking closely at the administration of 403(b) and 457(b) plans whose beneficiaries are “main street investors,” despite that they are administered, in many cases, by large government agencies. And like other initiatives, the announcement was followed by examinations and investigations. We expect that the SEC will use these settlements as templates for future settlements coming out of the Teachers’ Initiative. These initiatives reflect SEC Chairman Jay Clayton’s continued focus on retail investors, whose protection was listed again in OCIE’s 2020 examination priorities.

Participants in these spaces should analyze potential risks and use these warnings as an opportunity to reflect on and closely examine their business practices. If shortcomings or misconduct are discovered, such early action will allow the investment adviser more time to consider options such as self-reporting or remedial actions in consultation with counsel.

Compliance Programs are Important. In both enforcement actions, the SEC alleged violation of Rule 206(4)-7 and, as is typical, did not explain the nature of the violation. One explanation is that the Commission assumes that if there is a violation of any provision of the Advisers Act or rules, a fortiori, there was also a violation of the compliance rule. In the cases involving VFA, however, it may be assumed that its chief compliance officer was not involved in the decision to direct third party managers to purchase no-transaction fee classes of shares (in the case of the second order) and to make what were essentially kick-back payments to the union-owned company (in the case of the first order). An effective compliance program led by a knowledgeable and involved chief compliance officer remain the best insurance policy for an investment adviser to avoid becoming a poster child in the SEC’s next enforcement initiative.

Disclosure is Key. None of the business practices of VFA would have been unlawful if they had been fully and fairly disclosed to clients and prospective clients; the SEC does not suggest otherwise in either of its two settlements. Last year, the SEC issued an interpretive release that suggested that the full and fair disclosure of all material facts regarding a conflict of interest may not be sufficient to satisfy the adviser’s fiduciary duty if the actions of the adviser were not in the best interest of the affected clients. The position, of course, begs the question of who is competent to determine what is in the best interest of the client if not the client who has consented to the conflict. To the knowledge of the authors of this blog posting, the SEC has never brought an enforcement action alleging violation of the Advisers Act anti-fraud provisions in such circumstances, and we suspect it never will. Unlike many other obligations imposed by the securities laws, full and fair disclosure is an inexpensive curative.

© 2020 Proskauer Rose LLP. National Law Review, Volume X, Number 224


About this Author

Alexandra Bargoot, Proskauer Law Firm, Boston, Litigation and Finance Law Attorney

Alexandra Bargoot is an associate in the Litigation Department and a member of the Private Equity & Hedge Fund Litigation Group. Her practice includes a variety of complex commercial litigation matters, with a focus on private investments funds, involving both private disputes and regulatory issues.

Alexandra assists clients on matters involving SEC investigations, pay to play violations, private actions, sales of investments, investigations of aiding and abetting, arbitration award enforcement, among other areas of expertise.

Robert Plaze, Investment Manager Attorney, Regulatory and Compliance

Robert E. Plaze is a partner and a member of the Investment Management team. He advises investment advisers and investment companies on an array of matters, with a particular focus on regulatory and compliance matters arising under the federal securities laws.

Bob previously served as Deputy Director of the Division of Investment Management of the U.S. Securities and Exchange Commission. During his nearly 30 years of service with the Commission, he was responsible for policy development and management of many of the key regulatory initiatives during that period affecting investment companies and investment advisers under the Investment Company Act of 1940 and the Investment Advisers Act of 1940, including rules governing fund and adviser compliance programs, fund corporate governance, personal trading, custody and brokerage practices, prohibitions on “pay to play” practices, and protection of investor privacy. Most recently, Bob was responsible for rulemaking to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act affecting investment advisers, including rules requiring advisers to hedge funds and other private funds to register with the Commission, rules implementing new exemptions from registration and rules requiring reporting by certain exempt investment advisers.

Samuel Waldon, Proskauer Law Firm, Washington DC, Corporate Law and Litigation Attorney

Sam Waldon is a partner in the Litigation Department and a member of the Securities Litigation, White Collar Defense & Investigations and Asset Management Litigation Groups.

Sam’s practice focuses on securities litigation, enforcement and regulatory matters. He represents corporations and financial institutions, and their officers, directors and employees, in investigations, exams, internal investigations and litigation. Sam has in-depth experience in a broad range of Securities and Exchange Commission (SEC) enforcement matters, including...

Joshua Newville, Proskauer Rose, regulatory enforcement attorney, industry compliance legal counsel, securities exchange commission lawyer

Joshua M. Newville is a partner in the Litigation Department in New York. His practice focuses on commercial litigation and regulatory investigations. Mr. Newville advises companies and individuals in securities litigation and compliance matters. He also focuses on internal investigations and enforcement matters. Prior to joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset...