RIA spars with SEC over charges of selling clients pricey mutual fund shares

The SEC is pursuing legal action against a prominent Tennessee RIA for allegedly failing to disclose conflicts of interest and overcharging clients for fees on mutual funds when lower-cost shares were available, the latest reminder that share classes and fees remain a top concern at the commission.

The commission's complaint against CapWealth Advisors contends that two members of the firm steered clients into share classes that carried 12b-1 fees, with those fees passing to an affiliated broker-dealer where the advisors served as registered representatives.

Both advisors allegedly neglected to disclose the conflicts of interest on their Form ADV documents, where they omitted any mention of their receipt of 12b-1 fees, the SEC claims.

The advisors, Timothy Pagliara and Timothy Murphy, each owed their "clients a fiduciary duty to act in their best interests and to fully disclose all material facts about the advisory relationship," the SEC says in its complaint. That includes any conflicts that could lead the advisors to put their interests ahead of their clients', as the commission alleges Pagliara and Murphy did.

The commission alleges that the then-affiliated broker-dealer, CapWealth Investment Services, paid some of the 12b-1 fees directly to Murphy as compensation. Pagliara instructed another portion of the fees to be paid to CapWealth's holding company, in which he holds a majority ownership stake, according to the SEC's complaint.

Pagliara, CapWealth's founder, chairman and CIO, flatly denies the charges, and rejected the SEC's proposal for a settlement, opting instead to fight the matter in court.

“We look forward to our day in court and will not be bullied by the regulatory thugs at the SEC," Pagliara says in an emailed statement.

He points to the section of the SEC's complaint where it offers examples of the overcharges, citing share classes of two funds that generated Pagliara and Murphy $6,500 in fees. During that same period, Pagliara says, his firm generated $18 million in revenue.

Pagliara, who is based in Franklin, Tennessee, was named onForbes' top wealth advisors and listed as having team assets of $873 million as of Aug. 25, 2020.

In filings responding to the SEC's probe, attorneys for CapWealth argued that unlike traditional cases involving share classes, Pagliara and Murphy used the 12b-1 fees to offset advisor fees, contending that they didn't pocket any of the money as the SEC alleges.

"In other words, unlike every advisor that the SEC has charged, CapWealth did not benefit in any way from its receipt of 12b-1 fees, and its clients did not suffer any financial detriment," the firm's attorneys wrote.

Nevertheless, the SEC's complaint comes as the latest action brought against firms involving share-class selection, a longstanding area of concern at the commission's Office of Compliance Inspections and Examinations.

"The SEC has listed share class selection as an examination focus area in each of its last four annual examination priority lists dating back to 2017," says GJ King, president of RIA in a Box, a compliance consultancy.

"Besides cybersecurity, no other regulatory focus area has received as much consistent attention," King says. "As such, it's safe to assume there will be continued focus on this issue for years to come in future regulatory examinations."

Advisors can't say they weren't warned that the SEC is concerned about share classes. In addition to citing the issue on its annual exam-priorities letter, the SEC's enforcement division orchestrated a novel self-reporting initiative, inviting advisors who had steered clients toward high-fee share classes to come forward, refund the fees and improve their compliance programs in exchange for favorable settlement terms with the commission.

The deadline for advisors to self-report under that program came in June 2018, and since then the SEC had been working through settlement agreements with the firms that came forward. As of April, when the SEC announced the final cases under the initiative, it said that it had returned more than $139 million to investors.

In the months leading up to the deadline for the self-reporting initiative, enforcement officials made it clear that they would not look kindly on firms that didn't come forward, but were later found to have been placing clients in costly share classes when a suitable cheaper option was available.

That appears to be the case with CapWealth, according to the SEC, which notes in a news release that the firm was eligible to self-report under the share-class initiative, but did not.

The SEC is seeking financial penalties from the firm, in addition to disgorgement of the money it collected from the 12b-1 fees and interest. That's is a fairly typical remedy for the commission to pursue, according to Craig Morsehead, managing director of advisor consulting services at Foreside, a compliance consulting firm. However, the decision to reject a settlement likely landed Pagliara and Murphy as named defendants in the SEC complaint, he says.

"The case filed last week fits this mold," says Morsehead, "but since the advisor has refused to settle and is fighting in court, the SEC has taken the additional step of charging individual executives with violations."