Commonwealth Financial Network has been fighting the Securities and Exchange Commission's revenue-sharing disclosure case for nearly five years. After three rulings against the firm, it's facing a potential final judgment ordering fines and restitution of $111.5 million.
In a February 23 ruling in Boston federal court, U.S. District Judge Indira Talwani rejected Commonwealth's motion to reconsider her summary judgment last April finding that its registered investment advisory firm failed to adequately disclose the conflicts of interest from revenue-sharing with a trade-clearing arm of Fidelity Investments. The February decision followed her denial earlier in the month of the company's request to seal "confidential business information" from public view.
Dually registered brokerage and RIA firms like Commonwealth
With Talwani ruling in the SEC's favor and tossing Commonwealth's motions, many of "the next steps will likely be out of the view of the public" as the regulator oversees the entire industry and the firm "should be interested in sustainability and resuming business within the constraints of any settlement," according to regulatory expert Louis Straney of
"The ultimate resolution can take several forms," Straney said in an email. "It really depends on the facts and circumstances and clearly will somewhat depend on whether the firm cooperates in the commission's investigation. The term 'mea culpa' comes to mind. With a $100 million claim at stake, the ultimate resolution could possibly result in several formulas and outcomes, including the SEC holding firm at that number and requiring a 'fair fund' to compensate customers for their losses. The final number could be negotiated lower, but this situation doesn't seem to be one open for significant negotiation."
Representatives for Commonwealth, which at $2.07 billion in annual revenue is the No. 7 firm on
"As a matter of company policy, we do not discuss ongoing and pending legal matters," Peggy Ho, the firm's general counsel and chief risk officer, said in a statement.
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Industry revenue-sharing arrangements
Revenue-sharing payments from fund companies pay clearing firms (like the Fidelity unit) and "introducing" wealth management companies (like Commonwealth) for account services expenses linked with the level of client assets invested in the investment products. Clearing firms "share" the payments with the wealth management companies.
"Fund advisors often distribute revenue-sharing payments in return for brokers distributing funds in particular ways or in certain volumes," according to
Commonwealth and the Fidelity unit's 2014 agreement called for the clearing firm to give the introducing company 80% of the gross revenue "based on assets or positions invested in non-Fidelity funds and held in Commonwealth customer accounts," according to Talwani's description of the facts of the case in her ruling last year. Under the contract, the Fidelity unit paid Commonwealth more than $189 million in revenue sharing across all types of brokerage and advisory accounts between July 2014 and December 2018, she noted.
In its filing against the firm seeking a final judgment, the SEC noted that Commonwealth generated combined pretax income of more than $400 million between 2014 and 2018 as its RIA assets soared to $85.2 billion from $48.2 billion. The company's annual profits more than doubled in that time.
"If Commonwealth had disclosed its economic self-interest to have clients hold more expensive share classes despite the availability of cheaper share classes in the same funds, then its clients would have had a clear economic incentive to convert to lower cost alternatives that would have paid less or no revenue to Commonwealth. Instead, Commonwealth withheld this material information from deceived clients who continued to hold more expensive share classes while unaware of both the conflict of interest and the cost to their investments," the SEC said. "In light of the clear, long-standing fiduciary standard of 'full and fair disclosure,' it is egregious that a registered investment advisor of Commonwealth's size failed to disclose these economic conflicts of interest. This is especially true when, as here, Commonwealth expressly promised the third-party paying the conflict-generating revenue sharing, NFS, that Commonwealth would honor its disclosure obligations as they related specifically to revenue sharing."
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Commonwealth's arguments
Talwani will be weighing the SEC's estimates of the company's alleged unjust enrichment against those submitted by Commonwealth, which said in its own filing last July that an "accurate and reliable" amount would be $14.1 million. The company has repeatedly pointed out that the more than 2,000 Commonwealth financial advisors received none of the revenue-sharing payments. Between 2014 and 2018, the firm spent $136.5 million to "facilitate the day-to-day operations" of the advisory accounts through tasks such as account opening, processing and reporting that "would otherwise be performed" by the Fidelity unit, according to a declaration by Chief Operating Officer Trap Kloman.
In addition, three mutual fund families that do not pay Commonwealth any revenue sharing tied to the investments of its clients — Vanguard, Fidelity's own products and Dimensional Fund Advisors — each made the top 10 in customer holdings in those years, CEO Wayne Bloom said in another declaration. "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.
The SEC's request for a judgment of $111.5 million "is staggering in its overreach and audacity," the company's lawyers argued in its filing last summer. In the motion to reconsider, Commonwealth described the case as "a regulatory agency's attempt to impose a multimillion-dollar liability in a densely complex factual situation under an infrequently-litigated statute of uncertain application." The company called for the case to be decided by a jury.
"Given that Commonwealth disclosed that it had entered into an arrangement with NFS, that it received compensation from NFS pursuant to the arrangement, and that the arrangement created a potential conflict of interest, and the fact that the IARs [investment advisory representatives] who provided advice to clients did not receive any part of the compensation paid to Commonwealth by NFS, there is a genuine dispute of material fact as to whether Commonwealth's disclosures were adequate and the court must leave a resolution of this matter to a jury," the firm's lawyers wrote.
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Judge's orders
Thus far, the company has failed to convince Talwani of its claims. In the ruling last month against Commonwealth's request to "impound" documents from public view, she said that the company had "provided no explanation beyond its vague assertion that disclosure would cause competitive harm and disadvantage" and did not "satisfy its burden to show good cause." In the denial of the firm's motion to reconsider two weeks later, she said that Commonwealth "has neither established that the court's summary judgment decision contained a manifest error of law, nor identified an intervening change in relevant case law, new evidence or any other meritorious grounds for reconsideration."
Last April, she ruled that the SEC had provided fair notice of the disclosure obligations and that they still applied to the firm, regardless of whether advisors received any additional compensation or not based on their mutual fund recommendations.
"The court finds that Commonwealth's disclosure of certain details related to the revenue sharing arrangement or the revenue sharing arrangement only as a hypothetical is inadequate under the Advisers Act," Talwani wrote. "Where the court has found that Commonwealth's revenue paying arrangement with NFS created undisclosed conflicts of interest, and that Commonwealth made material omissions in its disclosures related to the arrangement, the court finds that Commonwealth was negligent in its failure to fully disclose its economic conflicts."
While the potential timing for any resolution remains uncertain, the case could have ripple effects, according to Straney.
"A firm can't bury a potential conflict disclosure in fine print. Customers have the right to rely on the firm and their advisor to perform proactively in these matters. It's an issue that a reasonable person would need to know in order to make an informed decision," Straney said. "Settling with the SEC is not the only regulatory body involved. The allegations could lead state security regulators to file similar charges which could result in various sanctions including financial and possible loss of licenses to conduct business in the state. Serious allegations like this seldom improve with time."
