Further to the Securities and Exchange Commission (“SEC” or the “Commission”)’s ongoing review of investment advisers offering wrap fee programs, on December 23, 2020, the Commission announced a settlement with Pruco Securities, LLC (“Pruco”) related to alleged breaches of fiduciary duty in connection with its wrap fee programs.  Pruco agreed to pay disgorgement, interest, and civil penalties totaling over $18.2 million to compensate for its alleged breaches of its fiduciary duties to its advisory clients that participated in its wrap fee programs.[1]  In short, the SEC alleged that Pruco breached its fiduciary duties and violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 (the “Advisors Act”), and Rule 206(4)-7 thereunder, by failing to disclose certain fees, savings, and revenue sharing payments it received in connection with its wrap fee programs, and the associated conflicts of interest related thereto, and by failing to assess whether the wrap fee programs were and remained suitable for the clients participating in them, as it represented it would.

This latest action is a continuation of the Commission’s focus on the recommendation of wrap fee programs, wherein an investor is charged a single, bundled or “wrap” fee for investment advice, brokerage services, administrative expenses and other fees and expenses.  This case concerned the alleged suitability of wrap fee programs (as compared to brokerage accounts where customers may be charged only transaction-based fees), supervisory procedures related to selection of wrap fee programs as well as the imposition of undisclosed fees and costs in addition to wrap fees or that otherwise should have been included, as alleged.  This action, and previous Commission guidance, reinforces the importance of advisory product committees for risk mitigation purposes, which are used not only to implement adequate supervisory and suitability determinations when a product like a wrap fee program is offered, but also ongoing monitoring to ensure that potential risks, as identified in the Pruco case, are identified before an SEC examination.  Links to previous Commission guidance regarding wrap fee programs and other previous enforcement actions are here.

Alleged Violations of the Advisers Act

In a cease-and-desist order issued December 23, 2020, the SEC alleged that, at various times beginning in January 2014, Pruco breached its fiduciary duties in the following ways.

First, the SEC alleged that although Pruco represented in its Form ADVs that it would review wrap fee program accounts for suitability both prior to opening those accounts and on an ongoing basis thereafter, it failed to do so.  Wrap fee programs generally offer advisory clients several investment management services, including trade execution services, for one asset-based fee.  Though the programs are beneficial for certain clients, other clients—such as those with infrequent trading activity—may pay higher fees on a wrap fee program than they would if they maintained their assets in a traditional brokerage account which charged only transaction-based fees.

The SEC alleged that Pruco’s policies and procedures in effect since at least January 2014 required IAR supervisors to monitor its advisory clients’ accounts to determine whether the accounts were suitable.  Yet, they provided no parameters to IARs or their supervisors concerning how to assess the suitability of wrap fee programs.  And, though the procedures required IARs to conduct annual reviews of their clients’ wrap accounts, they did not require the IARs’ supervisors to review either the substance of the annual reviews or the IARs’ conclusions.  And, though Pruco revised its supervisory procedures in 2015 to address certain of these deficiencies, its revised procedures still failed to require supervisors to review the substance of the annual reviews or the IARs’ conclusions, or to require that clients’ historic trading activity be reviewed before a wrap fee account was opened.  Pruco ultimately determined that, between 2014 and 2017, over 1,400 advisory clients held assets in wrap fee programs even though those accounts had little or no trading activity, and Pruco received over $1.7 million in additional management fees as a result of maintaining those advisory clients in wrap fee accounts.[2]

Second, the SEC alleged Pruco charged fees on certain client accounts which were contrary to its disclosures.  Specifically, between June 2014 and March 2017, Pruco stated in its Form ADV concerning its Managed Assets Consulting Services (“MACS”) wrap fee programs that its program fee was based upon the assets in those accounts, except that no program fee would be charged on certain cash assets.  Yet, contrary to this disclosure, Pruco charged 1,475 MACS accounts over $800,000 in advisory fees on those clients’ cash holdings.  In the same vein, Pruco represented in its client agreements and Form ADVs concerning its PruStrategist Portfolios (“PSP”) and PruUMA wrap fee program accounts that it would not charge program fees for its proprietary mutual funds.  Yet, Pruco failed to exclude one proprietary mutual fund from its program fee calculations for its PSP and PruUMA accounts and, consequently, between June 2016 through March 2019 charged over $269,000 in fees based on the accounts’ holdings of that mutual fund.

Third, the SEC alleged that from January 2014 through March 2016, Pruco recommended that certain of its PruChoice wrap fee program clients purchase or hold mutual fund share classes that paid Pruco fees pursuant to Rule 12b-1 of the Investment Company Act of 1940 (“12b-1”), including in some circumstances when lower-cost share classes of those same funds, which would be more beneficial to the clients, were available to those clients.  The SEC also alleged that, in breach of its fiduciary duty to disclose all material facts to its advisory clients including any conflicts of interest, until June 2014, Pruco made no disclosures to its clients concerning its receipt of 12b-1 fees as a result of client investments.  And, though Pruco revised its PruChoice Form ADV in June 2014 to disclose its receipt of 12b-1 fees and the conflicts of interest related thereto, it failed to identify that new disclosure in the “Material Changes” section of its Form ADV wrap program brochure until March 2016.  As such, Pruco’s legacy clients, who received a Form ADV brochure before June 2014, were not on notice of the conflicts of interest associated with Pruco’s receipt of 12b-1 fees until March 2016.  During the relevant period, Pruco received over $7 million in 12b-1 fees.

Fourth, the SEC alleged that Pruco failed to disclose that, beginning in June 2014, it received revenue sharing payments on client investments under an agreement with its clearing firm, which also allowed Pruco to avoid paying certain transaction fees for its clients’ purchases of mutual funds.  The clearing firm did not pay any form of revenue sharing on certain mutual funds.  Consequently, the payments Pruco received under its agreement with its clearing firm created a financial incentive for Pruco to make recommendations that would lead to greater revenue sharing.  However, Pruco failed to disclose that it received revenue sharing from its clients’ mutual fund investments prior to April 2017.  And, though it amended its applicable Form ADV wrap fee program brochure in April 2017 to disclose that it received compensation for certain client mutual fund investments, the SEC alleged its disclosure did not “fully and fairly disclose the conflict of interest,” including because Pruco failed to disclose that mutual share classes available in certain programs the clearing firm offered, for which it received revenue sharing, were more expensive than share classes of the same funds that were otherwise available to clients.  The SEC alleged that, during the relevant period, Pruco received over $4.3 million in revenue sharing payments, pursuant to its revenue sharing agreement with its clearing firm, as a result of the mutual funds purchased or owned by its clients.

The SEC further alleged that Pruco’s clearing firm did not charge Pruco transaction fees for certain mutual funds (the “no transaction fee” or “NTF” program), but it did impose transaction fees for others.  However, the NTF program funds generally were more expensive for Pruco’s clients.  As such, Pruco’s selection of the NTF program funds provided it with certain benefits that conflicted with its clients’ interests.  Yet, Pruco also failed to disclose the financial benefits it received from selecting the NTF program funds, or its conflicts of interest related thereto.

Fifth, the SEC alleged Pruco recommended bank sweep accounts[3] for which Pruco’s clearing firm paid it revenue sharing (the “Bank Sweep Program”), which Pruco did not disclose.  During the relevant period, Pruco received over $46,000 of revenue sharing payments from its clearing firm for client assets held in bank sweep accounts.  The payments Pruco received created a conflict of interest, because Pruco had an incentive to recommend that clients hold uninvested cash in the Bank Sweep Program, rather than other cash sweep vehicles that for which it did not receive revenue sharing payments.

Moreover, in its March 2016 Form ADV wrap program brochures, Pruco stated its clients with assets subject to the Employee Retirement Income Security Act (“ERISA”), and Individual Retirement Accounts (“IRAs”) would not be able to select the Bank Sweep Program for their uninvested cash.  Yet, over 19,000 ERISA accounts and IRAs from March 2016 through January 2019 held assets in that program, and Pruco received over $172,000 of revenue sharing payments from these clients’ assets held in the Bank Sweep Program.

Sixth, the SEC alleged that Pruco violated its fiduciary duty to seek best execution for client transactions by selecting or recommending mutual fund share classes when share classes of the same funds were available to the clients that presented a more favorable value or better performance.

The SEC further alleged that, during the relevant period, Pruco failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder and, particularly, the violations alleged above.

Advisers Act Provisions Allegedly Violated

The SEC alleged that, by its foregoing actions, Pruco violated Section 206(2) of the Advisors Act, under which it is unlawful for any investment adviser to “engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”  It also alleged Pruco violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require a registered investment adviser to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and rules thereunder.

Sanctions and Remedial Measures

Prior to entry of the SEC’s order, Pruco reimbursed affected investors for the fees charged, and revenue sharing received.  In addition, in its settlement with the SEC, it agreed to review and correct as necessary all relevant disclosure documents.  It agreed to evaluate whether its clients should be moved to a lower-cost or lower-revenue-sharing-paying share class, and move clients as necessary.  It also agreed to review, and update as necessary, its policies and procedures so they are reasonably designed to prevent violations of the Advisers Act, including in connection with disclosures regarding mutual fund share class selection, revenue sharing, and transaction fees in wrap fee accounts.  Pruco also agreed to notify its affected investors of its settlement agreement with the SEC.

In addition to the foregoing undertakings, Pruco agreed to cease and desist from any violations of Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7.  And, finally, Pruco agreed to pay disgorgement, prejudgment interest, and a civil penalty in excess of $18 million to compensate affected advisory clients.

Take-Aways

Pruco’s settlement with the SEC demonstrates the need for broker-dealers and investment advisors to remain vigilant in monitoring their disclosures for accuracy and, more critically, full and complete disclosures of all pertinent facts—including, but not limited to, all fees and conflicts of interests.  It further demonstrates the need for policies and procedures which provide not only objectives, but clear mechanisms by which compliance with securities laws can be ensured.

[1] See In the Matter of Pruco Securities, LLC, SEC Administrative Proceeding File No. 3-20190 (Dec. 23, 2020), available at https://www.sec.gov/litigation/admin/2020/34-90790.pdf.

[2] Pruco again revised its policies and procedures concerning wrap fee suitability and ongoing monitoring in 2017, and the SEC expressed no concerns with these procedures.

[3] A sweep account is a money market mutual fund or bank account used by broker-dealers to hold cash until the investor or its advisor decides how to invest the money.