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Two Stones, One Bird: SEC’s Double Whammy against Advisory Firm

In a pair of settlements announced on July 28, 2020, the SEC charged VALIC Financial Advisors (the “Firm”) with two separate sets of violations that allowed the Firm to obtain millions of dollars in fees without providing adequate disclosures about their practices and without having adequate compliance policies and procedures to disclose or protect against conflicts of interest presented by these practices. In total, the Firm agreed to pay approximately $40 million to settle both administrative proceedings. The SEC’s cases arise out of its initiatives:

  1. The Teachers Initiative: a SEC examination, enforcement, and investor education initiative, as previously described in this Faegre Drinker blog, that is designed to protect teachers and others in the education industry who participate in retirement plans established pursuant to Sections 403(b) or 457(b) of the Internal Revenue Code, against practices that may not be in the best interest of plan participants, focused on the practices of registered investment advisers and broker-dealers who work with third-party plan administrators to service such plans and the investment options offered to plan participants; and

  2. The Share Class Selection Disclosure Initiative for Previously Non Self-Reported Violations by Investment Advisers: a SEC examination and enforcement initiative designed to protect investors generally from improper recommendations of mutual fund share classes that may generate higher costs and other benefits to registered investment advisers and their broker-dealer affiliates when no or lower-cost share classes were otherwise available, thereby increasing costs to the impacted investor.

The first settlement charged the Firm with engaging in fraudulent conduct by willfully violating Section 206(2) and 206(4) of the Advisers Act. It also charged the Firm  with violating the Cash Solicitation Rule pursuant to Rule 206(4)-3, as well as Rule 206(4)-7 for inadequate policies and procedures under the Advisers Act. Over the course of more than 13 years, from 2006 to 2019, the Firm’s parent provided financial incentives to a for-profit company owned by the Florida K-12 teachers’ unions in connection with Section 403(b) and 457(b) retirement plans provided by Florida school districts to teachers and other eligible participants. That union-owned company received cash and other financial benefits in exchange for referring teachers to the Firm and its parent for both investment advisory services and the purchase of products. Because of these financial payments to the union-owned company, the Firm became the preferred financial services provider for members of the union. In addition, the Firm was given preferred status and increased opportunities to sell its investments to union members, and the union allowed the Firm’s parent to provide three full-time employees to attend and present at various retirement planning seminars and benefits events, while deceptively identifying these three employees as employees of the union entity. The Firm never disclosed the true nature of its relationship with the union-owned entity or the financial incentives that the Firm’s parent was paying to obtain this increased access to Florida K-12 teachers and other public education employees.

The second settlement charged the Firm with a series of violations related to its wrap fee arrangements that permitted the Firm to recommend portfolio models managed by third-party investment advisers. When adding a new fund to a model, the Firm required that such funds come from a no-transaction-fee program offered by the Firm’s clearing broker. Because of an agreement between the Firm and its clearing broker, the Firm received certain revenue sharing fees from the clearing firm related to the no-transaction-fee program, and also received 12b-1 fees paid on its client mutual fund investments. In many instances, the mutual funds that were recommended had lower cost share classes than were available to the clients, but such options were not utilized allegedly because they would have not generated revenue to the Firm through revenue sharing or 12b-1 fees. As a result of these practices, the Firm violated its duty to seek best execution for its clients’ transactions. In addition, while the Firm also  represented that it would pay execution costs for client trades as part of its wrap fee program, by directing mutual fund transactions to be executed through the no-transaction fee program by its clearing firm, the Firm saved itself from trade execution costs, even though many of these funds had higher expense ratios or generated revenue sharing or 12b-1 fees for the Firm, with no apparent benefit to, or disclosure of these practices or the conflicts associated therewith, to investors.

In announcing the settlement, the SEC renewed its prioritization of the need for adequate disclosures by investment advisers. Stephanie Avakian, Co-Director of the SEC’s Division of Enforcement, said “By not disclosing these practices as well as the other financial benefits [the Firm] received, the firm deprived its clients of essential information about their relationship with their adviser and violated core fiduciary obligations.” Her Co-Director, Steve Peikin, noted that it was “critical” that investors “get the information they need to make informed decisions about their retirement options” and that “[i]nvestment advisers must disclose conflicts between their financial interests and those of their clients.” (Since the announcement of the settlements with the Firm, it was also announced that Co-Director Peikin will be leaving the SEC on August 14th.)

While the SEC will often charge multiple individuals or entities as the result of a single investigation, announcing two separate settlements simultaneously against a single firm is not a common occurrence. These settlements demonstrate the inherent danger created by practices, controls, or disclosures in one area of a regulated entity’s business, as regulatory scrutiny as to one issue can lead to the discovery of unrelated practices and procedures both at the adviser and its affiliates, the collective effect of which may not be in the best financial or other interests of investors, or which generate potential or actual conflicts of interest necessitating heightened disclosure and policies and procedures to identify and mitigate such conflicts. It is also noteworthy that the scope of sanctions levied by the second action appears to be heightened because the Firm did not independently identify and voluntarily report such violations pursuant to the SEC’s Share Class Disclosure Initiative. Indeed, the second settlement specifically notes that while the Firm was eligible to self-report under the Initiative, it failed to do so. If it had participated in the Initiative, the Firm would have been responsible for disgorgement, prejudgment interest, and certain undertakings related to its conduct, but it should been able to avoid being hit with civil penalties. Self-reporting would have saved this Firm $4.5 million.

With the deadline passed for self-reporting under the Share Class Selection Disclosure Initiative, we expect to see additional litigation and settlements against advisers who had problematic share class selection practices but who elected not to continue to come forward. It will be interesting to see whether any of those cases, like the situation with this Firm, result in additional misconduct being discovered, charged, and settled.

© 2022 Faegre Drinker Biddle & Reath LLP. All Rights Reserved.National Law Review, Volume X, Number 238

About this Author

James G. Lundy, Drinker Biddle, regulatory investigations lawyer, financial services compliance attorney

James G. Lundy represents clients in Securities and Exchange Commission (SEC), Commodities Futures Trading Commission (CFTC), self-regulatory organization, and other financial regulatory agency investigations and examinations, and compliance and governance counseling, white collar criminal investigations, and complex business litigation.

With 12 years of senior SEC experience and more than two years of in-house experience at a futures and securities brokerage firm, Jim has developed an in-depth working knowledge of the various...

Michael R. MacPhail Partner Denver Litigation White Collar Crime

Michael MacPhail defends clients against federal and state government agencies during civil and criminal investigations and litigation, primarily involving the securities industry. He represents public companies, registered investment advisers and broker-dealers.

Securities Litigation

Michael handles investigations and litigation by securities regulators including:

  • The U.S. Securities and Exchange Commission (SEC)

  • The FINRA

  • The Public Company Accounting Oversight Board (PCAOB)

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James Martignon Investment Attorney Faegre Drinker Law Firm

James Martignon counsels clients in the investment management, broker-dealer and financial services industries on regulatory enforcement proceedings and investigations, including proceedings by the U.S. Securities & Exchange Commission (SEC), FINRA, state securities regulators and other government entities. James assists clients with compliance and regulatory risk management and represents them in complex civil and securities litigation.

Regulatory and Compliance Counseling

James provides regulatory and compliance counseling on such matters as:

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Nicholas S. Feltham, attorney, Drinker Biddle, Philadelphia, criminal and civil litigation

Nicholas S. Feltham represents clients in both white collar criminal matters and complex civil litigation. Nick’s white collar experience includes representing witnesses, subjects, and targets of federal criminal cases - from the initial meeting through trial; counseling both companies and witnesses throughout SEC investigations; and conducting internal investigations. His experience in complex civil matters is also extensive. Nick has successfully represented clients in class actions, civil RICO actions, and civil environmental enforcement litigation,...