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SEC Settles Charges Against Investment Adviser for Failing to Disclose Receipt of Revenue Sharing Payments from Third-Party Broker-Dealer

On July 19, 2017, the SEC announced settled administrative proceedings against KMS Financial Services, Inc. (KMS), a Seattle, Washington-based investment adviser, for failing to disclose to its advisory clients that it received revenue from a third-party broker-dealer (the Clearing Broker) for certain mutual fund investments that KMS selected for its advisory clients, and that it failed to seek best execution for its advisory clients.

According to the SEC order, since at least 2002, the Clearing Broker agreed to share with KMS certain revenues that the Clearing Broker received from the mutual funds in the Clearing Broker’s no-transaction-fee mutual fund program (the NTF Program).  As part of the NTF Program, the SEC alleged that the Clearing Broker waived the transaction fees it and KMS would otherwise charge clients, and instead KMS would get a percentage of revenues that the Clearing Broker received from the mutual funds in the NTF Program.  The SEC alleged that these payments provided a financial incentive for KMS to favor the mutual funds in the NTF Program over other investments when giving investment advice to its advisory clients and thus created a conflict of interest.

The SEC order also states that, in 2014, KMS negotiated a reduction in execution and clearing costs paid to the Clearing Broker but that KMS neither passed on the reduction in brokerage costs to its advisory clients nor evaluated whether its clients were obtaining best execution.  In addition, the SEC alleged that, in its Form ADV, KMS made inaccurate statements concerning best execution and omitted disclosure of compensation it received through the NTF Program.

As a result of the foregoing conduct and related compliance and disclosure failures described in the SEC order, the SEC found that KMS violated: (1) Section 206(2) of the Investment Advisers Act of 1940, which prohibits investment advisers from directly or indirectly engaging in any transaction, practice or course of business that operates as a fraud or deceit upon a client or prospective client; (2) Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require, among other things, that a registered investment adviser adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder by  the adviser and its supervised persons; and (3) Section 207 of the Advisers Act, which makes it unlawful for any person to make any untrue statement of a material fact in any registration application or report filed with the SEC, or to omit to state in any such application or report any material fact which is required to be stated therein.

Without admitting or denying the SEC’s findings, KMS agreed to pay disgorgement of $382,568.64, prejudgment interest of $69,518.43 and a civil money penalty of $100,000. KMS also agreed to cease and desist from committing or causing any violations and any future violations of the statute and rules cited in the SEC order and was censured. Lastly, KMS agreed to provide certain notices about the SEC order to its advisory clients on its website homepage, in its Form ADV brochures and in its September 30, 2017 quarterly statement from the Clearing Broker to KMS advisory clients, and to certify that it provided such notices.

© 2017 Vedder Price

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Vedder Price P.C. attorneys provide a full range of services to a diverse financial services clientele. Attorneys practicing in the firm’s Investment Services Group are experienced in all aspects of investment company and investment adviser securities regulations, broker-dealer regulatory and compliance matters, derivatives and financial product matters, and ERISA and tax matters. Clients include mutual fund complexes, hedge and other private funds, money managers, broker-dealers, independent directors, and many other types of institutions such as banks, savings and loans,...

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