SEC to RIAs: You also have to worry about cash sweeps

As lawsuits keep piling up against brokerage firms over their “cash sweeps” policies, the SEC is reminding RIAs of their fiduciary duty to make sure clients get good returns on uninvested cash.

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In the latest of its periodic “risk alerts” calling attention to how firms may be running afoul of industry regulations, the Securities and Exchange Commission on Tuesday noted that many advisors are not adequately explaining how they make money to clients. Topping the SEC’s list of cautionary examples was firms’ handling of clients’ uninvested cash.

Too often, according to the SEC, advisors are failing to disclose that they’re making money from what it deems a conflict of interest. As fiduciaries with a duty to always put their clients’ interest first, advisors should have made sure any conflicts were “fully and fairly disclosed to clients in order for clients to provide informed consent,” the risk alert states.

Yet, staff members from the SEC’s Division of Examinations “observed advisers that did not fully and fairly disclose the fees, expenses, and conflicts of interest related to the advisers’ recommendations of cash management programs.”

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At least 35 brokerages targeted in cash-sweeps lawsuits

The SEC’s risk alert follows on a string of lawsuits alleging that large wealth managers failed to ensure that clients received fair treatment from their cash-sweeps policies. Cash sweeps refers to firms’ common practice of taking uninvested money sitting in brokerage accounts and moving over to banks to be lent out at high interest rates.

The recent lawsuits generally take firms to task for keeping too much of the resulting proceeds for themselves and letting too little flow to clients. The latest, filed against Janney Montgomery Scott on Tuesday, contends that Janney was able to lend out its clients’ cash for increasingly high returns as federal officials hiked interest rates a few years ago to combat inflation.

But, according to the suit, the portion of those gains shared with clients barely budged.

“Rather than keep their fees for administering the cash sweep program constant and pass through the increased earned interest to customers, Janney and its Partner Banks held customer interest rates low and increased the amount they kept,” according to the suit.

Janney declined to comment on the specific allegations but said similar suits have been filed against 35 firms.

“We believe our cash sweep program was appropriately designed and disclosed, and we intend to defend these claims vigorously,” Janney said in a statement.

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SEC concerned about revenue RIAs receive from mutual fund recommendations

The SEC periodically releases risk alerts to call attention to recurring compliance deficiencies its examination staff has uncovered in the thousands of advisory firms they subject to regulatory reviews every year. The alerts are generally viewed as a way to steer advisors away from violations that could eventually lead to enforcement actions.

Among other things, the SEC’s latest risk alert rebukes advisors for sending client assets to outside broker-dealers and asset custodians and then not disclosing the revenue they received as a result. The alert also said some firms failed to tell clients that their cash balances would be subject to asset-management fees and that those fees would diminish their expected returns.

Much of the content in the SEC’s latest risk alert echoes previous regulatory statements and enforcement actions. For instance, the SEC calls out advisors for failing to disclose that they received revenue in return for putting clients into certain mutual funds. 

In some cases, according to the alert, firms could have put clients in less-expensive versions of the same funds, but would have had to give up the shared revenue. Within the last decade, the SEC has hit many large wealth managers with penalties for failing to disclose just how they were making money from recommendations of mutual funds and similar investments.

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The SEC’s alert goes beyond disclosing conflicts, invokes ‘duty of care’

A. Valerie Mirko, the head of securities regulation and litigation at Armstrong Teasdale in Washington, D.C., said much of the SEC’s new risk alert does cover well-trodden territory, namely advisors’ duty to disclose conflicts of interest and obtain clients’ consent before acting on investment recommendations. But a footnote in the alert goes beyond that, noting that “such disclosure and consent do not themselves satisfy the adviser’s duty to act in the client’s best interest.” 

Mirko said the risk alert’s footnote invokes what’s known as the “duty of care,” which generally requires advisors to make sure their recommendations are tailored to meet the needs of individual clients. 

“It never quite goes as far as saying there are times where disclosure does not cure an issue,” Mirko said. “But in my experience as defense counsel, there are certainly times where disclosure does not cure an issue.”

One of the lawyers suing brokerage firms over their cash-sweeps policies — Alan Rosca of the Beachwood, Ohio-based firm Rosca Scarlato — said the SEC’s risk alert is a reminder to advisor firms that they can’t fulfill “best interest duties to their fiduciary clients simply by sending those clients pages upon pages of legal small print.”

“They really do need to put their clients’ best interests first and place their swept cash into products that are beneficial to the clients rather than the firm,” Rosca said. “It is certainly possible, in my view, that we’ll see claims filed by investors against RIA firms that fail to put their fiduciary clients’ interest first when it comes to the cash sweep products.”

Lori Weston, the head of compliance at the regulatory consultant STP Investment Services, said the SEC’s latest risk alert is the third since 2018 to discuss advisory fees and conflicts. This newest installment is a clarion call for advisors to “review their current cash sweep practices, including assessment of available cash management vehicles, to determine which vehicle is most appropriate for its clients without regard to revenue sharing arrangements, which create a conflict of interest.”

Recent settlements in cash-sweeps cases against big wealth managers

So far, individual clients’ cash-sweeps lawsuits have resulted in only one legal settlement with a big wealth manager. Oppenheimer agreed last month to pay $70 million to resolve complaints that its sweeps policies had treated investors unfairly.

Regulators, meanwhile, have reached a series of settlements on their own. Wells Fargo and Merrill, for instance, agreed in January to pay a total of $60 million to the SEC to settle allegations of their sweeps policies. The month before, the independent broker-dealer Osaic entered into a $5.1 million cash-sweeps settlement with the Financial Industry Regulatory Authority, the brokerage industry’s self-regulator.

Beyond cash sweeps and mutual funds, the SEC’s risk alert faulted advisors for not disclosing fees they make from recommending other investment vehicles like money market funds and margin loans. It also said firms did not always properly disclose their fees as required in an annual regulatory submission known as Form ADV.

It also found instances in which advisors were apparently collecting fees in ways that weren’t consistent with the ways they said they would charge clients. In some cases, the regulator wrote, firms were making money from services that weren’t actually rendered.

Advisors, for instance, were found to have collected fees on “inactive accounts that were not provided with any supervisory or management services, including instances where these inactive accounts predominantly held cash and remained open after the clients requested, in writing, to close their accounts.”

Mirko said SEC risk alerts almost always provide welcome insights into regulators’ priorities.

“To me, the most important thing about these alerts is they tell you what is top of mind for both SEC exams and enforcement staff,” Mirko said. “It’s a very valuable document to be working from and through with clients.