Broker-Dealers In SEC Crosshairs For Pricier Funds
Advisory firms have spent a copious amount of time this year preparing for the Securities and Exchange Commission’s telegraphed focus on Regulation Best Interest violations, particularly the treatment of complex products. But the agency threw a fastball at the end of October—when it hit JP Morgan affiliates for a litany of infractions, including failing to explain why they used more expensive versions of investment products.
“This is the first time the SEC has brought Reg BI charges against a firm for the recommendation of more expensive non-complex products when less-expensive alternatives [existed],” said Parham Nasseri, president of InvestorCOM. He said this was a clear case when a well-documented analysis of reasonably available alternative funds and their price points could have helped.
On October 31, the SEC charged J.P. Morgan Securities, a dual-registrant subsidiary, with selling clone mutual funds to 10,500 retail clients when cheaper identical exchange-traded funds were available. The agency claimed that clients were charged more than $14 million in higher fees and expenses. The case included five separate enforcement actions against the firm for misleading disclosures to investors, breach of fiduciary duty and failures to make recommendations in the best interest of customers.
The agency said J.P. Morgan Securities recommended approximately 17,500 purchases of the clone mutual funds, when less expensive alternatives and nearly identical ETFs were available.
Without admitting to or denying the findings in the SEC’s orders, the JPMorgan affiliates, including JP Morgan Investment Management, agreed to pay more than $151 million in combined civil penalties and voluntary payments to investors to resolve the charges. No civil penalty was brought against the firm in the case of the alleged clone fund infractions because J.P. Morgan Securities self-reported the infractions and sought to reimburse customers, the SEC said.
“JP Morgan’s conduct across multiple business lines violated various laws designed to protect investors from the risks of self-dealing and conflicts of interest,” said Sanjay Wadhwa, acting director of the SEC’s Division of Enforcement. “JP Morgan is being held accountable for its regulatory failures.”
“When issues are identified, we fix them and engage with our regulators to resolve any concerns,” a spokesperson for J.P. Morgan said at the time.
The news of the charges should have sent shockwaves through the industry, Nasseri said. “We definitely have some firms reaching out for solutions, but some seem to not have noted the implications,” he said.
Nasseri said that both firms and advisors are vulnerable to regulatory action if they don’t have “clear and consistent system-wide documentation” showing product comparisons when they’re choosing the more expensive vehicles.
Two years ago, his firm set out to analyze whether advisors’ best interest can be measured, and more importantly, if it can improve over time. They found it can.
“We examined two years of recommendation data from financial professionals using our PeerCompare technology, and the results of our analysis show that automating the analysis and documentation can make a positive impact on helping the industry improve outcomes,” Nasseri said.
Firms that automate their approach to assessing costs and reasonably available alternatives, instead of using manual or limited comparisons of a small number of product alternatives, should be able to give advisors a quick comparison of all relevant fund and ETF peers when deciding whether a recommendation is in a client’s best interest and if they can justify pricier recommendations, he added.
Good technology should shrink the universe of reasonably available alternatives to “a meaningful and manageable set of alternatives, providing instant ratings of a product relative to its peer group, while keeping the ultimate decision regarding the recommendation in the advisor’s hands,” Nasseri said.
Automating the process is critical when broker-dealers are adding a significant number of new products to their already extensive fund menus.
Over the summer, Merrill Lynch announced plans to triple the number of actively managed ETFs, including ETF clones, on its recommendation list. Wells Fargo announced in September that it would double the number of ETFs on its platform.
With more identical ETFs being added to brokerage platforms, advisors and brokers should prepare for more enforcement actions like the one announced against JPMorgan in October, Nasseri said.
“We believe that decisions regarding price are going to come into much sharper focus going forward,” he added.
______________________________________
This article, authored by Tracey Longo, first appeared in Financial Advisor Magazine