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Regulation and Compliance > Federal Regulation > SEC

SEC Slams RIA With $30M Fine Over 12b-1 Fees, Proprietary Funds

By Melanie Waddell

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What You Need to Know

  • CNR failed to inform clients of its practice of investing their assets in proprietary mutual funds that generate fees for the RIA.
  • CNR’s affiliated BD receives 12b-1 fees from certain clients’ investments in proprietary funds.
  • Most clients who invested with CNR through their own advisors paid 12b-1 fees while other clients didn't.

City National Rochdale LLC, an RIA, has agreed to pay more than $30 million to settle the Securities and Exchange Commission’s charges that it defrauded current and prospective clients through undisclosed conflicts of interest, including 12b-1 fees.

The RIA has about $45 billion in assets under management and is a unit of City National Bank, based in New York.

The SEC action against CNR concerns breaches of fiduciary duty by CNR relating to its use of proprietary mutual funds and share classes that charged some clients higher fees than others.

According to the SEC’s order, from at least 2016 through 2019, CNR, which has discretionary authority over client accounts, failed to inform its clients of its practice of investing their assets in proprietary mutual funds that generate fees for CNR and its affiliates, rather than in competitor funds whose fees may be lower.

The SEC’s order also finds that from at least 2016 until 2019, CNR failed to inform some prospective clients that they could invest in CNR’s proprietary funds at lower cost.

The proprietary mutual funds in which CNR invests client assets, the order states, “generally have at least two share classes: one that charges investors ’12b-1′ fees and one that does not. These fees are paid to an affiliate of CNR. The share class in which CNR invests its clients’ assets depends on how the clients chose to open their accounts with CNR. Clients who open accounts with CNR through City National Bank or City National Securities, Inc., which are affiliates of CNR, do not pay 12b-1 fees. However, most clients who invest with CNR through their own financial advisors do.”

Clients who opened accounts with certain CNR affiliates “did not pay annual marketing or distribution fees, known as 12b-1 fees, but most clients who invested with CNR through their own financial advisors did,” the order states.

According to the order, “As Proprietary Funds’ assets under management increases through clients’ investments, so do the fees that CNR and its affiliates receive. CNR earns additional advisory fees from certain proprietary funds when it invests clients’ assets in those funds. CNR’s affiliates receive shareholder servicing fees from clients’ investments in the Proprietary Funds.”

CNR’s affiliated broker-dealer receives 12b-1 fees from certain clients’ investments in proprietary funds.

Thus, the SEC states, the “more CNR invests clients’ money in Proprietary Funds, the more fees it and its affiliates receive.”

As an investment advisor with a fiduciary duty to its clients, “CNR is obligated to disclose all material facts to its clients that could affect the advisory relationship, including any conflicts of interest between itself and/or its associated persons (including its affiliates) and its clients, and how those conflicts could affect the advice CNR gives clients.”

Melissa Hodgman, associate director of the SEC Enforcement Division, said in a statement that “CNR’s failures to disclose its conflicts of interest deprived clients of their ability to make informed investment decisions while generating fees for the adviser and its affiliates. When investors entrust their hard-earned money with an adviser, it is crucial they receive full and fair disclosures to allow them to understand and reject any conflicts of interest, and if the adviser does not abide by these rules, then the SEC will hold them accountable so we can return that money to investors.”

‘Aggressive’ SEC

Ron Rhoades, associate professor of finance at Western Kentucky University and director of its personal financial planning program, told ThinkAdvisor Friday in an email that the CNR case “illustrates how aggressive the SEC is getting in going after breaches of fiduciary duty.”

In the case, “the dual registrant invested, on a discretionary basis (i.e., as an investment adviser) client cash in a proprietary mutual fund that made an affiliate of the investment adviser more fees,” Rhoades said. “There was no disclosure of the conflict of interest, nor was there a disclosure that lower-fee products were available.”

CNR ”invested in funds with 12b-1 fees, when a share class with lower fees was available. This is just a blatant violation of an investment adviser’s fiduciary duty,” Rhoades said.

“If you are an RIA, or if you are a dual registrant, you are likely to eventually get in trouble by recommending high-fee proprietary funds, or recommending any fund that has a 12b-1 fee,” Rhoades added. “If you are a fiduciary, you need to act like one — using your expertise to benefit the client, not your firm or affiliate firm (except for agreed-in-advance reasonable and professional-level compensation).”

Todd Cipperman of Cipperman Compliance Services added that the SEC “continues to attack all forms of revenue sharing. Paying back 12b-1 fees is one of the oldest forms of revenue sharing. If the SEC can’t/won’t outlaw the payment of 12b-1 fees, they are very willing to highly regulate and restrict the receipt of fees.”

Jim Lundy, partner at Faegre Drinker in Chicago and a former SEC attorney, said that the CNR settlement “delves deeper into somewhat of a new area. That is firms that offer proprietary products or have limited product offerings. The SEC has been discussing these types of conflicts in public statements more regularly since the release of the RIA Commission Guidance” and the Regulation Best Interest proposal in June 2019.

Added Lundy: “This is a very large settlement in this area. As has been happening when the SEC Division of Enforcement sends strong messages like this, we can expect similar cases in the future and firms with proprietary or limited product offerings may want to take notice and adjust accordingly.”

The SEC’s order finds that CNR violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder.

Without admitting or denying the SEC’s findings, CNR agreed to cease and desist from committing or causing any future violations of these provisions; be censured; provide notice of the settlement to affected advisory clients; retain an independent compliance consultant; and pay disgorgement, prejudgment interest, and a civil penalty totaling $30,361,803 that will be distributed to investors through a fair fund.

Melanie Waddell

@Think_MelanieW

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