Compliance September 16, 2021

SEC Spotlights Revenue Sharing Disclosure Failures

A recent regulatory order filed by the Securities and Exchange Commission demonstrates some of the ways revenue sharing and disclosure failures can result in fiduciary breaches.

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The U.S. Securities and Exchange Commission (SEC) filed an order this week to commence administrative and cease-and-desist proceedings against MML Investors Services LLC (MMLIS), pursuant to section 15(b) of the Securities Exchange Act of 1934 and Sections 203(e) and 203(k) of the Investment Advisers Act of 1940.

Importantly, the order contains final findings and imposes remedial sanctions and cease-and-desist requirements on the firm, which the SEC accuses of several fiduciary breaches related to the use of revenue sharing. It also presents a learning opportunity for financial services professionals and their clients who use revenue sharing within fiduciary investment accounts and relationships.

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As summarized in the order, the proceedings arise out of breaches of fiduciary duties by MMLIS, a dually registered investment adviser (RIA) and broker/dealer (B/D), and MSI Financial Services Inc. (MSI), a former RIA and B/D that was integrated with MMLIS in March 2017. The order says these breaches came about as a result of third-party compensation that MMLIS and MSI received based on their advisory clients’ investments “without fully and fairly disclosing their conflicts of interest.”

“In particular, during certain periods since at least March 2015, MMLIS and MSI invested clients in certain share classes of mutual funds that resulted in the firms receiving revenue-sharing payments pursuant to agreements with their unaffiliated clearing broker (the ‘clearing broker’),” the order states. “In spite of these financial arrangements, MMLIS and MSI provided no disclosure or inadequate disclosure of the conflicts of interest arising from this compensation.”

According to the SEC, MMLIS and MSI also breached their duty to seek best execution by causing certain advisory clients to invest in share classes of mutual funds that paid revenue sharing when share classes of the same funds were available to the clients that presented a more favorable value for these clients under the particular circumstances in place at the time of the transactions.

“Furthermore, MMLIS and MSI failed to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder in connection with its mutual fund share class selection practices and disclosure of conflicts of interest arising out of its revenue-sharing practices,” the order states. “As a result of the conduct described above, MMLIS willfully violated Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder.”

The firm provided the following statement regarding the matter: “MML Investors Services takes this matter very seriously and cooperated fully with the SEC. Similar to other industry participants, we have reimbursed impacted accounts and are pleased to have resolved this matter.”

The SEC’s order explains that many mutual fund sponsors or other affiliates pay the clearing broker a recurring fee to have some or all of the share classes of funds they advise offered as part of the clearing broker’s mutual fund programs. In this particular case, the SEC says, the clearing broker had a no-transaction-fee mutual fund program (NTF program), through which investors, including clients of MMLIS and MSI, could purchase and sell certain mutual funds without paying a transaction fee. Clients generally paid higher expense ratios for mutual fund share classes sold through the NTF program and paid a higher recurring fee to the clearing broker than share classes offered by the clearing broker outside the NTF program.

“MSI received revenue sharing from the clearing broker’s NTF program from October 2015 to February 2017, and MMLIS received revenue sharing from the clearing broker’s NTF program from at least March 2015 to February 2017 and again beginning in October 2018,” the order states. “The clearing broker also had a transaction fee mutual fund program (TF program) that paid revenue sharing to MMLIS and MSI on some mutual fund share classes that charged transaction fees, and, like the NTF program, these transaction-fee, revenue-sharing share classes generally had higher expense ratios paid by clients and a higher recurring fee paid to the clearing broker than share classes offered by the clearing broker that did not pay revenue sharing.”

From here, the SEC’s order explains that, as investment advisers, MMLIS and MSI were obligated to disclose all material facts to their advisory clients, including any conflicts of interest between the investment adviser and/or its associated persons and clients that could affect the advisory relationship. To meet this fiduciary obligation, the SEC says, MMLIS and MSI were required to provide their advisory clients with “full and fair disclosure that was sufficiently specific so that they could understand the conflicts of interest concerning its investment advice and have an informed basis on which to consent to or reject the conflicts.”

Notably, between 2015 and March 2017, MMLIS and MSI generally disclosed in their Forms ADV Part 2A brochure or elsewhere in writing to clients that the clearing broker offered the NTF program and that mutual funds that were part of the NTF program paid a fee to the clearing broker and that the clearing broker would share a portion of these fees with MMLIS and MSI.

“However, MMLIS and MSI did not disclose the conflicts of interest inherent in this NTF program arrangement, including that MMLIS and MSI had an incentive to recommend or favor certain mutual funds or share classes of mutual funds that were part of the NTF program instead of other mutual funds or lower-cost share classes of the same mutual fund when rendering investment advice to their clients,” the order states. “In addition, MMLIS and MSI did not disclose that they received TF program revenue sharing from client investments in advisory accounts or otherwise put clients on notice regarding the conflicts of interest inherent in this arrangement.”

Compliance September 16, 2021

Court Dismisses ERISA Suit Against CommonSpirit

The complaint had taken issue with the plan’s use of the Fidelity Freedom Funds TDF series and its recordkeeping fees.

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An Employee Retirement Income Security Act (ERISA) lawsuit challenging CommonSpirit Health’s use of the Fidelity Freedom Funds target-date fund (TDF) series and its recordkeeping fees has been dropped.

The U.S. District Court for the Eastern District of Kentucky granted the defendant’s motion to dismiss the complaint after agreeing that the plaintiff did not allege facts that proved imprudent conduct on the part of the defendants.

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CommonSpirit Health, a not-for profit corporation that provides hospital services, was facing litigation from a former employee of the company and participant of the plan, who alleged the company had provided an “inadequate selection of investment options” in the employer-sponsored 401(k) plan and allowed for “unreasonable expenses to be charged for the administration of the plan.”

The plaintiff claimed the company’s administration committee had violated its fiduciary duties of prudence and loyalty under ERISA after retaining Fidelity Management Trust Co. as the plan’s recordkeeper from July 2, 2014, to the present day. In exchange for its services, Fidelity charged recordkeeping fees that were paid by plan participants through a deduction of investment income.

The plaintiff had claimed that the committee selected investment funds with higher fees and subpar performance; offered an investment menu that was more expensive than that of comparable plans; and allowed the plan to pay excessive recordkeeping fees to Fidelity.

The complaint named the Fidelity Freedom Funds, a suite of 13 funds that are actively managed by Fidelity fund managers, as having higher operating costs compared with Fidelity’s passively managed index funds. As alleged in the complaint, while the expense ratio for the passive index suite was 0.08%, the expense ratio for funds in the active suite ranged from 0.42% to 0.65% for the K Share class, which the plan used until 2018. The plan now uses the K6 share class, with expense ratios ranging 0.37% to 0.49%.

As a result, the plaintiff alleged that plan participants who invested in the active suite would have collectively saved more than $1.24 million in fees in 2018 alone, had they invested in the index suite instead.

The plaintiff also claimed the active suite funds consistently underperformed compared with the passive index suite, citing lower rates by Morningstar and a 2019 report that showed rising investor demand for Fidelity’s index suite and falling demand for the active suite.

The defendants had filed a motion to dismiss the lawsuit, arguing that the plaintiff lacked Article III standing regarding her claim that the company imprudently chose investment vehicles that underperformed. Additionally, they stated that the plaintiff’s complaint, as a whole, “fails to state a claim upon which relief may be granted.”

Regarding the Article III issue, the court said that “contrary to the defendants’ contention, the plaintiff’s investment in one of the challenged funds is sufficient to confer standing to sue on behalf of plan members who invested in the remaining challenged funds.” It noted, however, that “standing is not dispensed in gross and a plaintiff must demonstrate standing for each claim he seeks to press and for each form of relief that is sought.”

In its dismissal, the court said the plaintiff had failed to “allege facts showing that the recordkeeping fees exceeded those of comparable plans or were excessive in relation to the service provided.” The court also stated that the plaintiff had “failed to identify another recordkeeper that would have been willing to conduct the same service as Fidelity,” at a reasonable rate.

On the claim that CommonSpirit Health had breached its duty of loyalty, the court found that the complaint did not differentiate between the defendant’s alleged violations of the duties of prudence and loyalty, as required when alleging disloyalty under ERISA. As a result, this claim was also dismissed by the court.

Other lawsuits challenging the use of the Fidelity Freedom Funds TDF suite have seen some success. In July, a federal district court judge denied the dismissal of two claims in a lawsuit against Prime Healthcare Services.

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