SEC Sanctions Adviser, Broker-Dealer and Their Owner Over ETF Trades

The following post comes to us from Eric R. Fischer, partner in the Business Law Department at Goodwin Procter LLP, and is based on a Goodwin Procter Financial Services Alert by Jackson B. R. Galloway.

The SEC settled claims against a registered investment adviser (the “Adviser”), its affiliated broker-dealer (the “Broker-Dealer”), and the founder, owner, and president of each (the “CEO”) that related to (1) investments in Class A shares of underlying funds made by funds managed by the Adviser (the “Funds”) and (2) commissions paid by the Funds to the Broker-Dealer for trades in exchange-traded funds (“ETFs”). Without admitting or denying its findings, the Respondents agreed to the settlement order (the “Order”), available here, which this post summarizes.


The Adviser manages the Funds and roughly 1,300 separately managed accounts, with combined assets under management of approximately $549 million as of May 24, 2013. The Funds consist of a registered fund, whose president and chairman was the CEO prior to February 2012, and two privately-offered funds. Each of the Funds invests principally in mutual funds. The Broker-Dealer executes the Funds’ transactions in mutual funds. Between June 2000 and mid-2010 (the “Relevant Period”), although the Funds often met the criteria to purchase the institutional class of the mutual funds they purchased, which paid no 12b-1 fees, the Adviser and the CEO caused the Funds to purchase Class A shares of those funds, which paid 12b-1 fees. (The Funds did not pay any front-end sales charges when they purchased Class A shares.) During the Relevant Period, the Funds paid approximately $3.3 million in 12b-1 fees, which the distributors of the underlying mutual funds paid to the Broker-Dealer. In May 2010, following communications with SEC staff about the Broker-Dealer’s receipt of 12b-1 fees on investments made by the registered Fund, the Adviser converted the registered Fund’s Class A mutual fund holdings to institutional shares. The Broker-Dealer also refunded to the registered Fund all the 12b-1 fees it had received with respect to the registered Fund’s underlying mutual funds since the registered Fund’s inception. The Adviser subsequently converted the private Funds’ Class A mutual fund holdings to institutional shares, but the Broker-Dealer did not refund 12b-1 fees collected on those investments.

The Funds also invested on occasion in ETFs. The Broker-Dealer charged a commission of 0.25% on these trades, which in many instances resulted in commissions exceeding $0.10 per share. The SEC found that by no later than October 2008, the commissions the Broker-Dealer charged the registered Fund for such transactions substantially exceeded the usual and customary commissions charged by other broker-dealers. In October 2012, at the request of the registered Fund’s board, the Broker-Dealer refunded to the registered Fund an amount representing all commissions in excess of $.03 per share on the registered Fund’s ETF transactions between October 2008 and December 2011.

Disclosures—Best Execution and Broker-Dealer’s Receipt of 12b-1 Fees

The SEC found that the registered Fund’s registration statement, the private placement memorandums of the two private Funds, and the Form ADV of the Adviser contained misleading disclosures regarding the Adviser’s best execution policy and the circumstances under which the Broker-Dealer would receive 12b-1 fees as a result of the Funds’ investments in underlying mutual funds. In general terms, these documents stated that the Adviser would seek best execution for Fund transactions. The SEC found that while these disclosure documents stated that the Broker-Dealer could receive 12b-1 fees with respect to investments in underlying mutual funds, they did not state that the Adviser would select an investment in a fund paying 12b-1 fees to the Broker-Dealer even when lower-expense institutional class shares were available.


The SEC found the following violations of the federal securities laws:

  • willful violations by the Adviser and the CEO of the anti-fraud provisions of Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”) resulting from (1) the failure to seek best execution when selecting among underlying mutual fund classes for the Funds and (2) representations made to the board of the registered Fund that the Adviser sought best execution for its fund clients;
  • willful violations by the Adviser and the CEO of the anti-fraud prohibitions in Section 206(4) of the Advisers Act and Rule 206(4)-8(a)(1) thereunder (relating to the treatment of investors in pooled investment vehicles) resulting from materially misleading statements in the Funds’ respective offering documents regarding the Adviser’s policy of best execution;
  • willful violations by the CEO of the prohibitions in Section 34(b) of the Investment Company Act of 1940 (the “1940 Act”) against misleading statements in registered fund registration statements resulting from the misleading descriptions of the Adviser’s best execution policies in the registered Fund’s registration statement;
  • willful violations by the Respondents of the prohibition in Section 17(a)(2) of the Securities Act of 1933 against the offer or sale of securities by means of false or misleading statements; and
  • willful violations by the Broker-Dealer of Section 17(e)(2)(A)’s prohibition against any affiliated person of a registered investment company, or any affiliated person of such person, from receiving, in connection with transactions effected on an exchange for such registered investment company, any commission, fee, or other remuneration that exceeds the usual and customary broker’s commission for such transactions. (The SEC found that the registered Fund’s procedures for board review and approval of affiliated brokerage transactions were not reasonably designed to ensure that the Broker-Dealer’s commissions were “reasonable and fair” compared to commissions charged by other broker-dealers, and therefore the safe harbor provided by Rule 17e-1 under the 1940 Act did not apply.)


Each of the Respondents agreed to a cease and desist order and censure. The Broker-Dealer and the CEO also agreed jointly and severally to pay disgorgement and pre-judgment interest in the following amounts:

  • approximately $680,000 in disgorgement with respect to the private Funds plus approximately $263,000 in pre-judgment interest (the amount of disgorgement equaling the 12b-1 fees received by the Broker-Dealer with respect to underlying mutual funds that offered institutional shares); and
  • approximately $4,900 in prejudgment interest with respect to the amount voluntarily disgorged by the Broker-Dealer with respect to its receipt of excessive commissions on exchange transactions for the registered Fund in violation of Section 17(e)(2)(A) of the 1940 Act.

The CEO further agreed to pay a civil penalty of $100,000.

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