Nick D’Addio

In its first enforcement action against a robo-adviser under Chair Paul Atkins, the U.S. Securities and Exchange Commission (SEC) on March 23 announced settled charges against a registered investment adviser for disclosure failures related to the type of account that it typically recommended to clients opening new robo-adviser accounts.[1]

Beginning in September 2019, the adviser marketed and offered its “cash-enhanced” account as its default, no-advisory-fee offering in part to attract novice retail investors. The adviser allocated 30% of the total client assets in each cash-enhanced account to cash and 70% of such assets to a mix of securities. The client cash in the accounts was custodied by a non-affiliated clearing broker. The clearing broker deposited the cash portion of the cash-enhanced accounts at various banks, including the adviser’s affiliated bank. The clearing broker paid a portion of the interest it earned from the cash deposits in the form of a rebate to the adviser’s affiliated broker-dealer.

In its settled order, the SEC found that the adviser failed to adequately disclose material facts associated with setting the 30% cash allocation in the cash-enhanced accounts, including the resulting conflict of interest.[2] In particular, the SEC found that the cash allocation was selected, in part, to provide financial benefit to affiliates of the adviser in order to offset at least some of the revenue lost from not charging an advisory fee on the accounts. In addition, the adviser inaccurately disclosed the investment methodology it used to manage the cash-enhanced accounts by representing that the accounts were managed according to a methodology called the modern portfolio theory when that was the case only with respect to the 70% non-cash portion of the accounts.

As a result, the SEC found that the adviser breached its fiduciary duty in violation of Section 206(2) of the Investment Advisers Act of 1940. Without admitting or denying the SEC’s findings, the adviser — a registrant with roughly 80,000 advisory clients and $1.4 billion in assets under management — agreed to a cease-and-desist order, a censure, and a $500,000 civil penalty. The adviser also agreed to provide a copy of the order to all current and former affected investors and to certify its compliance with doing so.[3]

Key Insights

Absence of Financial Harm to Investors Is Not a Silver Bullet

The SEC’s order contains no finding of investor harm, imposes no disgorgement, and neither requires the adviser to provide financial remediation to clients nor acknowledges that the adviser engaged in any such remediation previously. Although the Atkins SEC has underscored its commitment to rooting out scienter-based fraud and misconduct causing financial harm to investors, with this action, the SEC has again signaled that it will continue to prosecute negligence-based breaches of fiduciary duty arising from disclosure failures even in the absence of such harm.[4]

Actionable Failures to Disclose Conflicts of Interest Must Be Material

Consistent with a notable U.S. Court of Appeals for the First Circuit ruling against the SEC last year,[5] as well as the Atkins SEC’s two most recent settled actions against advisers for disclosure deficiencies related to conflicts of interest,[6] the SEC expressly noted the materiality of the omitted information related to conflicts of interest in bringing charges in this matter.[7] Investment advisers should consider challenging SEC staff assertions of conflicts of interest during examinations or enforcement inquiries that are not accompanied by a showing that the conflicts are material.

Conflicts of Interest Disclosure Remains a Staple

Investment advisers should continue to identify and, where appropriate, mitigate and/or disclose conflicts of interest, including those arising out of portfolio construction decisions that directly or indirectly benefit affiliates.