A recent administrative proceeding involving a dual-registered investment advisor and broker-dealer demonstrates the importance of providing full and fair disclosure regarding any material conflict of interest and achieving best execution on behalf of advisory clients.
Overview
On July 19, 2017, the Securities and Exchange Commission (“SEC”) announced that KMS Financial Services, Inc. (“KMS”) agreed to settle charges relating to a number of violations of the Investment Advisers Act of 1940 (“Advisers Act”) and the rules thereunder. KMS consented to a censure, a cease-and-desist order from committing or causing further violations, and a payment of disgorgement and penalty.
Failure to Disclose Conflict of Interest
KMS was charged with, among other violations, failing to disclose to its advisory clients a conflict of interest resulting from a revenue sharing arrangement. Specifically, as an introducing broker and investment advisor, KMS had an arrangement with its clearing broker whereby the clearing broker agreed to share with KMS certain payments it received from mutual funds in its No-Transaction-Fee (“NTF”) program. As a result of these payments, KMS had a conflict of interest since it had an incentive to favor these mutual funds in the NTF program over other investments when providing investment advice to advisory clients. This conflict of interest and the receipt of the payments from the clearing broker were not disclosed in the firm’s Form ADV Part 2A, as required.
KMS was also found to not have adequate policies and procedures for ensuring that all material conflicts of interest were adequately disclosed, as required under Rule 206(4)-7 of the Advisers Act.
Failure to Seek Best Execution
KMS was also charged with not seeking best execution on behalf of its advisory clients. Although KMS managed to negotiate a reduction in the execution and clearing costs that the firm had to pay its clearing broker with respect to KMS clients, KMS neglected to pass on this reduction in transaction costs to its advisory clients. By not performing an adequate analysis to determine whether it was still achieving best execution with respect to its advisory clients, KMS was found to have failed to seek best execution on behalf of such clients. Moreover, the policies and procedures of KMS were found to not take into account execution and clearing costs paid by clients as part of the overall best execution analysis.
Recommendations
In light of the violations discussed above, investment advisors should take steps to ensure that all material conflicts of interest are adequately disclosed to advisory clients. Special attention should be given to the receipt of third-party compensation and any resulting conflicts of interest, which are required to be disclosed under Item 14.A of Form ADV Part 2A. The advisor’s policies and procedures should also require such disclosure. As a best practice, the chief compliance officer or a designee should be reviewing any new third-party agreements involving the advisor as well as any material changes to such agreements.
Advisors should also make sure that when they periodically conduct their best execution analysis, they take into account any changes in the costs both advisory clients and the advisor (e.g, if dually registered as a broker-dealer) will incur when advisory transactions are effected by the advisor. Other changes, such as the level and quality of services provided by a broker, should also be considered.
For more information about the violations and issues discussed above, please contact NCA Compliance.
Hayley Nelson is the President and Principal Consultant of NCA Compliance, Inc., a compliance consulting firm providing a wide range of customized compliance solutions for investment advisors. Ms. Nelson previously worked for the Securities and Exchange Commission and a large investment manager in New York.
