$72M Commonwealth judgment hammers home firms' disclosure duties

A more than $70 million judgment imposed on Commonwealth Financial Network late last month is an eye-popping reminder for an industry already on notice about its obligation to disclose conflicts of interest.

Louis Straney, a regulatory expert at Arbitration Insight, said the $72 million judgment the Securities and Exchange Commission won against Commonwealth on March 29 would have been big even for a Wall Street giant. For Commonwealth, a Waltham, Massachusetts-based firm with $2.07 billion in annual revenue and in the No. 7 spot on Financial Planning's IBD Elite list of the largest independent brokerages, it reaches "historical proportions."

The penalty comes as the culmination of the SEC's yearslong fight to prove that Commonwealth had failed to disclose conflicts that regulators alleged allowed the firm to make money at investors' expense. Regulators sued Commonwealth in August 2019 over accusations that it had failed to adequalty disclose to clients how much it received in fees for selling certain mutual fund products through an arrangement with National Financial Services — a trade-clearing arm of Fidelity Investments. 

The SEC contended there were cheaper alternatives to those funds but that Commonwealth failed to bring them to investors' attention in a proper way. Regulators also faulted the firm for not making "robust disclosures regarding the revenue it generated from the higher-cost shares," according to the March 29 court decision. 

The judgment, handed down by judge Indira Talwani of the U.S. District Court in Boston, is made up mostly of $65.6 million in disgorgement to be paid back to investors. The SEC had also sought a $20.6 million civil penalty against the firm. But Talwani knocked that down to $6.5 million after finding that an amount equal to 10% of the total disgorgement would still convey the seriousness of the violations.

The firm was also ordered to pay $21.2 million in prejudgment interest.

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Talwani took the SEC's side in the dispute in a summary judgment handed down in April 2023. She later rejected an attempt by Commonwealth to have her initial decision overturned. 

"Had Commonwealth's clients known they were invested in higher-cost shares of funds for which lower-cost shares existed, and that the higher cost resulted in greater profit for Commonwealth, there is reason to believe that at least some of those clients would have elected to move their money to the lower-cost funds," she wrote in her latest order in the case.

The SEC estimated Commonwealth obtained $100 million through these fees between mid-2014 and the end of 2018. The SEC said it was seeking only $62.5 million because that amount represents only fees that were not disclosed.

Commonwealth argued in various court pleadings that the amount of damage was overestimated and said the amount should be closer to $14.1 million. The firm noted that its financial advisors never directly benefited from the undisclosed compensation payments.

CEO Wayne Bloom noted that the top 10 holdings by the firm's clients during the years in question included three mutual fund families — from Vanguard, Fidelity's own products and Dimensional Fund Advisors — that provided Commonwealth with no revenue-sharing payments.

"Commonwealth did not attempt to influence advisors to avoid the selection of mutual funds and share classes that did not pay revenue sharing," Bloom said in a court filing.

A spokesperson for Commonwealth said the firm was "very disappointed" with the $72 million penalty handed down by Judge Tawani. 

"And we are exploring all options to continue to defend our position in the legal system," the spokesperson said.

String of disclosure disputes

The case is just the latest to stress advisors' obligations to disclose their conflicts of interest. In April 2023, the SEC hit the wealth management giant Merrill with a $9.5 million penalty over allegations that it had failed to notify clients of more than $4 million in undisclosed foreign exchange fees. The previous November, two subsidiaries of the large independent broker-dealer Cetera Financial Group were ordered to pay $8.6 million for not disclosing various fees and payments it received for the sale of mutual funds. 

The Cetera case came as the culmination of more than 100 suits regulators brought against firms alleged to not have properly informed investors of compensation from marketing and distribution fees, revenue sharing arrangements, markups and similar sources. The SEC's two bedrock conduct standards for the wealth management industry — the fiduciary rule for financial advisors and Regulation Best Interest for broker-dealers — call for disclosing conflicts of interest at a minimum.

But that's usually not enough. Financial advisors usually have to look for cheaper alternatives to any investment they're considering for a client. And if they find something less expensive but still plan to recommend the more costly option, they have to be able to offer a reasonable justification for that choice.

Straney said advisors should always ask themselves, "'Is there a conflict of interest between this product and your client?' Secondly, they should ask: 'What are my alternatives to this?' And then third: 'Does this fit both the risk tolerance and investment objectives of my clients?'"