SEC Examines Municipal Advisers and Alternative Mutual Funds, Reviews “Wrap-Fee” Accounts

The Securities and Exchange Commission introduced a two-year plan to examine municipal advisers who assist localities and states to raise money in the $3.7 trillion municipal bond market. During this period, regulators plan to look at a significant chunk of the approximately 1,000 SEC-registered municipal advisers.

These advisers are usually small firms with one or two employees. They are not affiliated with banks. Municipal advisers are retained to time, price, and market muni-bond transactions.

The SEC has been clamping down on municipalities for not updating investors about their financial health. The regulator wants the U.S. Congress to give it more authority in the market. Right now, muni issuers are exempt from disclosure requirements that corporations have to make when selling securities. Now the agency wants to know whether municipal advisers are meeting their fiduciary duty and placing clients’ interests before their own.

It was the 2010 Dodd-Frank law that established this obligation. Also under the law, municipal advisers have to register with the SEC and follow the rules that the the Municipal Securities Rulemaking Board is developing.

In other SEC news, the regulator is conducting a broad examination of alternative mutual funds. This will include scrutiny of big investment firms, including BlackRock Inc. (BLK) and AQR Capital Management LLC, as well as smaller firms that didn’t use to offer mutual funds as investment products to customers. According to sources that spoke to The Wall Street Journal, the regulator’s focus appears to be more on collecting information about the industry rather than coming up with specific related enforcement actions.

Alternative funds, also known as liquid alternative funds, are a category of mutual funds that use hedge fund-like strategies. Fund companies tout them as vehicles for hedging against market risk that are usually less costly for individual investors who want to employ strategies previously reserved for sophisticated investors.

The SEC wants to look at the funds’ liquidity, the way they use leverage, and how much oversight the funds’ boards provide. Previously, the regulator expressed concerned with the risks involved in alternative mutual funds.

Meantime, the agency is also looking to suss out conflicts of interest involving the possible use of flat-fee wrap accounts at registered investment advisers. Customers pay a yearly or quarterly fee for wrap products that manage a portfolio of investments. They do this instead of paying individual commissions for traders.

The market includes mutual fund advisory programs, separately management accounts, unified managed accounts, and certain kinds of brokerage-based managed account. If an adviser is charging fees according to assets under management, money management charges for wrap products are additional.

With wrap accounts, reverse churning can happen. This involves placing a client that doesn’t trade often into an account that is fee-based instead of commission-based. Typically, there is hardly (if any) activity to justify the fee.

The SEC recently won a court case against an adviser that improperly placed clients into wrap programs. The investment adviser, Benjamin Lee Grant, was accused of improperly persuading clients to go with him when he left Wedbush Morgan Securities to establish Sage Advisory Group.

According to the regulator, Grant convinced clients to make the move by claiming they would save on fees. Rather than paying 1% plus commissions for trading like they did at Wedbush, they would just pay Sage a 2% wrap fee.

However, says the SEC, Grant did not tell clients that the brokerage expenses would be much lower at Charles Schwab & Co. (SCWH), which was the discount broker that Sage used. Grant then pocketed the savings.

Contact our securities fraud law firm today.

SEC cracks down on wrap accounts, InvestmentNews, August 14, 2014

SEC Launches Examination of Alternative Mutual Funds, The Wall Street Journal, August 12, 2014
U.S. SEC launches municipal adviser exams, Reuters, August 19, 2014
Federal jury sides with SEC against Boston investment adviser in fraud case, Business Journals, August 14, 2014

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