Two recent enforcement cases highlight the pitfalls of conversion from broker-dealer accounts to investment adviser accounts. In both cases, client accounts were converted from broker-dealer to advisory accounts, leading to a change in client fees. In both cases, the adviser was penalized for mismanaging the change in fee arrangements.
The first case relates to One Oak Capital Management, LLC (“One Oak”), a registered investment adviser, and its dually registered investment adviser representative, Michael DeRosa. DeRosa, who was simultaneously employed at a separate broker-dealer, counseled several clients to convert their accounts from broker-dealer accounts and products to advisory accounts with One Oak.
One Oak consented to the SEC’s Order Instituting Procedures without admitting or denying its allegations. The Order alleges that the previous broker-dealer accounts had transaction-based commission fees, while the new One Oak accounts had advisory fees calculated by percentage of assets under management. This meant that the many accounts high in assets and low in transactions would pay significantly more in fees to One Oak than they would have had they continued with their broker-dealer. Critically, the SEC also found that this account conversion came with no other benefits to the affected clients. Therefore, the Commission concluded, DeRosa’s advice to convert these accounts was not in his clients’ best interests and a willful violation of Section 206(2) of the Advisers Act and its prohibition on the engagement “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
Without admitting or denying the SEC’s findings, DeRosa agreed to a settlement that included $75,000 in civil monetary penalties and a nine-month suspension from association with any investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating.
Additionally, the SEC found that One Oak failed to properly monitor the accounts, their management, and their suitability for their clients. Not only did One Oak owe its clients a duty of care, which this failure would breach, but One Oak had advertised to new clients in their intake forms that they conducted such review, meaning One Oak misled its clients by failing to conduct the described review. The Commission found these to be willful violations of Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder and its requirement that an investment adviser “[a]dopt and implement written policies and procedures reasonably designed to prevent violation… of the [Advisers] Act and the rules that the Commission has adopted under the [Advisers] Act.”
One Oak agreed to a settlement that included a civil monetary penalty of $150,000 and its engagement of an independent compliance consultant to review its account suitability and submission of the consultant’s report to the Commission.
In a similar case, Edward Jones agreed to a Consent Order with the state of Arkansas without admitting to or denying the state’s findings. The state found that the adviser failed to sufficiently offset costs when converting from broker-dealer accounts to investment adviser. From 2016-2018, Edward Jones converted several accounts. Several of these accounts were structured to pay up-front load fees with low annual expenses, making a long-term “buy and hold” strategy most favorable. The new investment adviser accounts, however, had advisory fees calculated by percentage of assets under management. This meant that recently opened “buy and hold” accounts would incur higher overall expenses, with a heavy opening expense and early conversion to percentage-based fees. When Edward Jones converted these accounts, it offset these expenses “pro-rata.” While the order doesn’t explicitly describe this pro-rata offset, the state of Arkansas found it insufficient, as the advisory fee offsets Edward Jones granted did not reimburse clients 100% of their commission expenses, and Edward Jones still profited from the change in expense.
The state of Arkansas found that Edward Jones failed to “establish and maintain a system to supervise the activities of its broker-dealer agents that is reasonably designed to achieve compliance of the Act, Rules, and all applicable securities laws and regulations, including the establishment and maintenance of written procedures” as required by Ark. Code Ann. §§ 23-42-301(f) and Rule 301.01(c)(2) thereunder.
As part of its Consent Order, Edward Jones agreed to a settlement that included an administrative fine of $320,754.72.
Read together, the two cases illustrate the delicate balance required to convert client accounts from broker-dealer to investment adviser while remaining fully compliant with the state and federal securities laws. As always, one should consult an experienced attorney before executing such plans.
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