SEC case against RIA puts hybrid firms' conflicts under the microscope

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A new revenue share class case shows that the SEC is scrutinizing the disclosure of a conflict dually registered RIAs have with their custodians: cash sweep arrangements.

On Aug. 13, the SEC charged SCF Investment Advisors, a $1.4 billion hybrid RIA, over failure to disclose conflicts in the cash arrangement its broker-dealer had with Fidelity’s National Financial Services. The regulator also charged the firm with advising clients to invest in expensive share classes when cheaper alternatives were available, according to an SEC order.

As a result, the SEC ordered SCF to pay over $767,000 in disgorgement, prejudgment interest and a civil monetary penalty, according to the regulator.

The revenue-sharing case comes 10 months after Stephanie Avakian, the regulator’s co-director of enforcement, said the SEC would investigate the disclosure of a “clear conflict” at dually registered RIAs that accepted revenue sharing from their custodians in cash sweep programs.

“These types of cash sweep arrangements create an obvious incentive for an advisor to recommend products where revenue sharing will result in larger payments to the advisor and lesser returns for the adviser’s client,” Avakian said in a November speech.

She continued that dually registered firms also have an incentive to recommend one money market fund over another due to 12b-1 fees and other revenue sharing arrangements. Earlier this year, FINRA weighed in, saying it would also scrutinize cash sweep arrangements.

‘Asleep at the switch’
In the case of SCF Investment Advisors, the firm offered clients three money market share classes in which to keep their uninvested cash. Fidelity — SCF’s clearing firm, according to FINRA BrokerCheck — paid the RIA’s affiliated broker-dealer, SCF Securities, the most revenue sharing when clients invested in the most expensive option, the Capital Reserves share class. Capital Shares had annual expenses of 0.95% compared to the retail share class annual expense of 0.42%, according to the SEC order.

Without disclosing the conflict of interest to clients, SCF selected the Capital Reserves share class as its default option for clients, even though it provided clients the lowest-net performance, according to the SEC. SCF’s broker-dealer received more than $400,000 in cash sweep revenue sharing over the two-year period ending in March 2019, the regulator said.

In addition, since at least 2014, SCF Securities allegedly made over $137,000 after its registered advisors recommended clients purchase mutual fund share classes that charged 12b-1 fees, even though cheaper alternatives were available, according to the order. The firm did not self-report in the SEC’s share class initiative, according to the regulator.

Cash sweep arrangements between broker-dealers and clearing firms are less frequent than they used to be, according to Pete Crane, who evaluates money market fund data and performance at Crane Data.

“You don’t see as many brokerage sweep relationships as you used to,” Crane says. “Over the past number of years, most brokers use bank deposit sweep products, where the disclosures are a lot more opaque.”

SEC action regarding these programs has historically focused on disclosure, not the conflicts themselves. In 2011, the SEC also charged JSK Associates over not disclosing clearing firm payments.

“[SCF] must have been just asleep at the switch during all the other times where the SEC said you can do it, but you have to disclose it,” Crane says.

Spokespersons for SCF Securities and Fidelity did not respond to a request for comment.

SCF Investment Advisors completed converting client mutual fund investments to lower-cost share classes in October 2018, according to the SEC.

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Clearinghouses/custodians RIAs SEC SEC enforcement Money market funds Fee disclosures Fidelity National Financial Fidelity Compliance