Third Quarter Starts with Three Compliance-Related Cases from the SEC Worth Reviewing

This trio of cases could signal an increase by the SEC in mutual fund transactions involving fees to advisors. It may also indicate that the SEC may have been holding onto additional administrative orders, waiting for courts slowed by COVID-19 related delays to issue rulings. In any case, advisors should keep wary of these developments.

Typically, a review of recent Securities Exchange Commission (SEC) administrative orders and litigation releases will turn up the usual suspects - egregious cases of defrauding elderly investors, failing to register as a broker-dealer or trading in unregistered securities. But Q3 of 2021 shows a trend that advisors should review with their internal compliance team including a recent win by the SEC in federal court and two administrative orders one involving a $7.2 million disgorgement award.

First, a recent jury verdict in the federal district court in Connecticut concerning Westport Capital Markets LLC is notable for a few reasons, including reliance on an outside compliance company and the court’s decision against a permanent injunction that would have barred the principal from continuing in the financial advisory industry.

The jury verdict in that case signaled the end of what the court called a “a long-running civil enforcement action” that began with a complaint filed by the SEC alleging multiple claims. The predominant concern was a breach of fiduciary duties related to conflicts of interest based on seller dealer syndicate offerings and 12b-1 fees.  The SEC won an early victory on three of the five claims against Westport Capital, concerning the fees and transactions, leaving the level of knowledge and intent concerning the conflict of interest for the jury to decide. The final judgment was a fine against Westport Capital in the amount of $1.3 million and a fine against its owner, president, and chief compliance officer Christopher E. McClure of $1.02 million.

As to the conflicted transactions, the court explained that Westport “would buy for its own account an allocation of initial public syndicated share offerings at a discount from the public offering price and then resell these securities to its advisory clients at the public offering price, earning as it did so a selling concession for the shares that were sold to the clients… [and as to the so-called “12b-1 fees,”] which were distribution fees that were paid to Westport by mutual funds in conjunction with certain mutual fund investments and which were ultimately charged by the mutual fund to the investor client….” The court paid special attention to the fact that the fees were often avoidable noting that there were other share classes available for purchase that would not have garnered income to Westport Capital. While the firm allegedly disclosed these conflicts of interest, the court found that the statements on their Forms ADV were “too vague, conditional, and contradictory to suffice as a legally adequate disclosure of their receipt of the extra income and the conflict of interest….” Additionally, Westport Capital claimed that they did not engage in principal transactions and failed to disclose to the SEC the receipt of the fees, which amounted to about half of what they otherwise earned from their advisory clients.

But advisors should take special note that of the court’s treatment of Westport Capital’s reliance on an outside compliance firm. As a defense to the claims of inadequacy on their disclosures, Westport Capital claimed that they relied on advice from Regulatory Compliance LLC. The court found that this reliance did not change the level of Westport Capital’s negligence because “Westport’s contract with Regulatory Compliance, LLC … did not relieve Westport from its own responsibility to comply with the law and disavowed the consultant’s issuance of legal advice about compliance with the securities law.”

In addition, the court’s denial of the SEC’s request to bar McClure from working in the financial industry is noteworthy. The court found that certain elements weighed against the SEC’s request, including that Westport Capital was shuttering it’s business and that McClure would not continue in a “position of authority” negating the likelihood that he could continue to violate securities laws. The court also took special note of how and when the transactions ceased.  Westport and McClure stopped the transactions in 2015 and reported them to FINRA. Additionally, the court took notice of the impact the enforcement action had on McClure and found that to weigh against the bar.

Mere days later, the SEC released an administrative order against Kestra Advisory Services, LLC and Kestra Private Wealth Services, LLC for failing to disclose compensation received by their affiliated broker-dealer. This case was remarkably similar to the facts in Westport Capital: Kestra allegedly invested in “mutual funds that paid revenue sharing were more expensive than lower-cost options available to clients, including instances when there were lower-cost share classes of the same mutual funds available to clients that did not result in any revenue sharing…  the Kestra Advisers breached their fiduciary duties to advisory clients by failing to provide full and fair disclosure regarding the two types of compensation received by their affiliated broker-dealer and the related conflicts of interest.” The result was a $7.2 million disgorgement fee and $1.5 million in civil penalties. It is unclear on whether Kestra failed to disclose the transactions to FINRA or whether it relied on outside compliance firms as Westport Capital did. It’s possible that the SEC waited for the court’s ruling in Westport Capital before handing down the administrative order against Kestra.

And speaking of outside firms, in a separate administrative order released in July, the SEC found audit improprieties by the audit firm  PLS CPA. There, the SEC found that three auditors of that firm failed to prepare and retain audit documentation and, importantly, backdated documents to make them align with the dates in an audit report. The SEC also found a lack of diligence by PLS accountants. In addition to disgorgement of funds, the PLS accountants “consented to cease and desist orders imposing bars from appearing or practicing before the Commission as accountants.”

This trio of cases could signal an increase by the SEC in investigating mutual fund transactions involving fees to advisors. It may also indicate that the SEC may have been holding onto additional administrative orders, waiting for courts slowed by COVID-19 related delays to issue rulings. In any case, advisors should keep wary of these developments.

These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.

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