(Article from Registered Funds Regulatory Update, July 2023
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On April 7, 2023, a Massachusetts District Court ruled that Commonwealth Financial Network negligently breached its fiduciary duties to its advisory clients for failing to disclose material conflicts of interest relating to a revenue sharing agreement in violation of the anti-fraud provisions of the Advisers Act. In 2014, Commonwealth and National Financial Services, a clearinghouse affiliate of Fidelity Investments, agreed that NFS would pay Commonwealth 80% of NFS’s received mutual fund revenue as long as Commonwealth invested client assets in specific mutual fund share classes for which NFS shared revenue. Between 2014 and 2018, Commonwealth received around $135 million from NFS as part of this revenue sharing agreement. The SEC brought an enforcement action against Commonwealth in August 2019, alleging that while Commonwealth did disclose a revenue sharing arrangement with a clearing broker in a “no-transaction fee” program, it did not adequately disclose that the arrangement incentivized Commonwealth to select more expensive investments for its advisory clients. In its Complaint, the SEC focused on three main facts: (i) in some instances, the mutual fund shares classes purchased by Commonwealth’s clients had at least one lower-cost share class available that Commonwealth received less or no revenue sharing; (ii) in some instances, Commonwealth purchased transaction fee mutual fund share classes for its clients, NFS charged a transaction fee on the purchase and sale of such shares, and the mutual funds paid a portion of the ongoing fees to NFS that it then shared with Commonwealth; and (iii) there were certain mutual funds that Commonwealth had no incentive to select because it did not receive any revenue sharing. In response, Commonwealth argued that the SEC failed to allege facts showing a conflict of interest, insufficient disclosure, and deception and also did not provide Commonwealth with fair notice of its disclosure obligations.
The Court agreed with the SEC, taking particular issue with Commonwealth’s use of “may” in its disclosure of potential conflicts of interest. Specifically, it noted that Commonwealth presented the revenue sharing payments as hypothetical payments it may receive and that Commonwealth may have an incentive to select investments for which it received compensation when both should have been presented to investors as “as a matter of fact.” Furthermore, without having more information regarding the cost differences between share classes, Commonwealth’s clients did not have access to the ‘total mix of information’ necessary to make informed investment decisions. As such, the Court determined that Commonwealth’s disclosures were inadequate under the Advisers Act.
SEC v. Commonwealth Equity Services, No. 1:19-cv-11655 (D. Mass. Apr. 7, 2023).