SEC Complaint Dissects Fee-Based Firm’s Revenue Sharing Strategy

The Securities and Exchange Commission takes issue with revenue sharing tied to a preferred broker’s “transaction fee” program, underscoring how fee-based advisers are not immune from allegations of conflicts of interest.

In August, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Commonwealth Financial Network, suggesting the firm has failed to disclose material conflicts of interest related to revenue sharing received for certain client investments.

Filed in the U.S. District Court for the District of Massachusetts, the complaint states that since at least 2007, Commonwealth had a revenue sharing agreement with the broker it required most of its clients use for trades in their accounts.

Under that agreement, the SEC alleges, Commonwealth received a portion of the money that certain mutual fund companies paid to the broker to be able to sell their funds through the broker, if Commonwealth invested client assets in certain share classes of those funds. 

Between July 2014 and December 2018, Commonwealth received over $100 million in revenue sharing from the broker related to client investments in certain share classes of “no transaction fee” and “transaction fee” mutual funds, the complaint states.

The SEC’s complaint alleges that Commonwealth breached its fiduciary duty to its clients by failing to disclose the conflicts of interest created by its receipt of compensation through the revenue sharing agreement. Specifically, the SEC’s complaint alleges that Commonwealth “failed to tell its clients that (i) there were mutual fund share class investments that were less expensive to clients than some of the mutual fund share class investments that resulted in revenue sharing payments to Commonwealth, (ii) there were mutual fund investments that did not result in any revenue sharing payments to Commonwealth, and (iii) there were revenue sharing payments to Commonwealth under the broker’s ‘transaction fee’ program.”

“As a result of these material omissions, Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives,” the complaint says.

Technically, the complaint alleges that Commonwealth violated the antifraud and compliance provisions of Section 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder.

“By failing to adopt and to implement written policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest, Commonwealth violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder,” the complaint alleges. “The Commission seeks: (a) a permanent injunction prohibiting Commonwealth from further violations of the Advisers Act; (b) an order that Commonwealth disgorge its unjust enrichment, plus prejudgment interest; and (c) imposition of a civil penalty due to the nature of Commonwealth’s breach of fiduciary obligation.”

Asked for comment on the lawsuit, a Commonwealth spokeswoman shared the following: “While the enforcement action proposed by the Securities and Exchange Commission is a pending legal matter, Commonwealth Financial Network vehemently denies the allegations and believes they are categorically without merit. We are confident we have operated both appropriately and justly and will vigorously defend our actions in this matter.”

As of April 2019, Commonwealth, in its role as an investment adviser, reported approximately $85 billion in assets under management, with approximately $60 billion of those assets owned by persons who are non-high-net-worth retail clients, meaning clients with less than $1 million in assets under management or a net worth of less than $2 million.

According to the SEC, Commonwealth is also an introducing broker, meaning that it accepts client orders, but has an arrangement with another broker, known as a clearing broker, to execute and clear client trades and maintain custody of the investments held in Commonwealth’s clients’ accounts.

The other relevant entity in the case is National Financial Services (NFS), registered with the Commission as a broker/dealer and investment adviser. Commonwealth contracted with NFS to maintain custody of Commonwealth’s clients’ assets and to act as a clearing broker. NFS is an affiliate of Fidelity Investments, which is a sponsor of Fidelity mutual funds offered by NFS.

Details from Commonwealth’s Operations

Case documents show Commonwealth offers its investment advisory services through approximately 2,300 investment adviser representatives located throughout the United States, and through three Preferred Portfolio Services (PPS) programs, called PPS Custom, PPS Select, and PPS Direct. It also provides clients advisory services through unaffiliated third-party asset manager programs.

According to the SEC, clients who receive investment advisory services through Commonwealth’s PPS programs or third-party asset manager programs generally pay management fees calculated as a percentage of their assets under management. These fees are periodically deducted from clients’ advisory accounts. The SEC reports that Commonwealth’s largest PPS program is PPS Custom. As of the end of 2017, Commonwealth advised 262,061 accounts with assets under management of approximately $71.7 billion in the PPS Custom program. In PPS Custom, investment adviser representatives typically act as portfolio managers, with full investment discretion to develop custom investment portfolios for advisory clients.

The next largest PPS program is PPS Select. As of the end of 2017, Commonwealth advised 61,561 accounts with assets under management of approximately $6.8 billion in the PPS Select program. In the PPS Select program, Commonwealth offers advisory clients a variety of model portfolios of particular share classes of pre-selected mutual funds. These model portfolios are created and managed on a discretionary basis by Commonwealth’s internal teams. Once the investment team creates these model portfolios, Commonwealth makes them available to its adviser representatives and its client base through the PPS Select Program.

SEC says the smallest of the three PPS programs is PPS Direct. As of the end of 2017, Commonwealth advised 6,096 accounts with assets under management of approximately $2 billion in the PPS Direct program. Similar to PPS Select, the PPS Direct program offers clients access to a variety of model portfolios. The model portfolios in PPS Direct, however, are not managed by Commonwealth. They are managed by one or more third-party portfolio managers.

According to the SEC, between 2014 and 2018, Commonwealth’s investment team, which was responsible for creating and managing the model portfolios that Commonwealth offered to advisory clients through the PPS Select program, had a practice of selecting the lowest-cost share class of mutual funds placed into the model portfolios.

“This practice was for the economic benefit of clients who invested through the PPS Select program,” the complaint states. “By contrast, during this same period, Commonwealth did not have a uniform practice of selecting the lowest-cost share class available of a mutual fund for clients in the much larger PPS Custom program.”

More on Revenue Sharing

The SEC complaint includes substantial detail on the revenue sharing arrangement in place between Commonwealth and NFS, which is used to argue that the revenue sharing arrangement created financial incentives for Commonwealth to invest clients in mutual funds in a manner that would lead to greater revenue sharing for itself.

“In particular, Commonwealth had an incentive to select and hold more expensive mutual funds for clients, and to select and hold more expensive mutual fund share classes when lower-cost mutual funds were available for the same fund,” the complaint alleges. “When Commonwealth invested in a mutual fund for a client, it had more than one mutual fund to choose from, and could select or continue to hold mutual funds for which it would receive less or no revenue sharing.”

Further, SEC alleges, when Commonwealth chose to purchase or hold a particular mutual fund for a client, it also sometimes had more than one mutual fund share class to choose from. These available share classes included those that charged a transaction fee and those that did not. The no transaction fee share classes often had higher internal expenses and paid more revenue sharing to Commonwealth than the transaction fee share classes.

“In light of the revenue sharing Commonwealth received from NFS based on client investments in mutual funds in NFS’s no transaction fee program, Commonwealth’s disclosures … were insufficient because they failed to disclose the existence of higher internal expenses that were present in some no transaction fee mutual fund shares, the existence of mutual fund share classes of the same funds with lower expenses, and the conflict of interest presented by this set of circumstances,” the complaint concludes. “These disclosure failures were omissions of material fact and were required to be disclosed to Commonwealth’s advisory clients, and Commonwealth knew or should have known that it had a duty to disclose such information.”

The full text of the complaint is here