Sec. & Exch. Comm'n v. Cetera Advisors LLC

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. CETERA ADVISORS LLC, and CETERA ADVISORS NETWORKS LLC, Defendants.

Civil Action No. 19-cv-02461-MEH

UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLORADO

April 17, 2020

ORDER

Michael E. Hegarty, United States Magistrate Judge.

Before the Court are Defendants' Partial Motion to Dismiss the Amended Complaint (ECF 29) and Plaintiff's Motion to Exclude the Declaration of Martin Joseph Fehn, III (ECF 51). Defendants seek partial dismissal of the Amended Complaint pursuant to Fed. R. Civ. P. 12(b)(6), alleging that the First Claim for Relief fails to state a claim to the extent it is premised on certain alleged nondisclosures by Defendants. For the following reasons, the Partial Motion to Dismiss is denied, and the Motion to Exclude is denied as moot based on my decision not to consider the contents of or attachments to the Fehn Declaration.

STATEMENT OF FACTS

The following are relevant factual allegations (as opposed to legal conclusions, bare assertions, or merely conclusory allegations) made by Plaintiff in the Amended Complaint, which are taken as true for analysis under Fed. R. Civ. P. 12(b)(6) pursuant to Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009).¹

Cetera Advisors LLC ("CA") and Cetera Advisors Networks LLC ("CAN") (collectively "Cetera") are separately registered with the SEC as both investment advisers and broker-dealers. Combined they have approximately $30 billion of assets under management, a majority of which is held in discretionary client accounts in which they make investment decisions for their clients. CA and CAN are owned by the same entity, offered similar investment choices and advisory programs, shared compliance personnel, and had nearly identical policies and disclosures. Cetera provides investment advisory services to its clients through over 1,500 investment advisory representatives ("IARs"), including individual retirement investors. These services include investment advice and management of clients' investment portfolios. In exchange for these advisory services, Cetera's clients pay advisory fees to Cetera in the form of a percentage of the clients' managed assets. As an investment adviser, Cetera is a fiduciary to its advisory clients. Cetera received over $21 million as a result of its alleged breaches of fiduciary duty described in the Complaint and below.

Cetera recommended, purchased, and held, on behalf of its clients, shares in mutual fund "share classes" that charged 12b-1 fees. Some mutual fund share classes charge 12b-1 fees to cover fund distribution and shareholder service expenses ("Class A shares"). Such 12b-1 fees are includedin the total operating expenses for that particular share class and generally range from fifteen to twenty-five basis points per year. The 12b-1 fees are deducted on an ongoing basis from the fund's assets and are paid to the fund's distributor, who remits the 12b-1 fees to the broker-dealer that sold the shares, in this case Cetera. Many mutual funds offer share classes that do not charge 12b-1 fees ("Class I Shares"). While containing the same portfolio of securities, assuming all other fees are the same, Class I Shares are lower-cost than Class A shares of the same fund. Thus, investors who hold Class I Shares will pay lower total fund operating expenses and earn higher returns than those who hold Class A shares.

In violation of its duty to act in its clients' best interests, Cetera placed (and kept) its advisory clients into higher-cost share classes despite knowing lower-cost share classes were available for the same fund. This conduct also breached Cetera's fiduciary duty to seek best execution, which in this context means failing to seek to purchase the mutual fund share classes for clients in such a manner that the clients' total costs or proceeds in each transaction are the most favorable under the circumstances. Cetera had an incentive to have its clients invest in the higher-cost Class A shares, because it received and shared with its IARs the 12b-1 fees, which was contrary to its clients' interest to own the lower-cost shares.

Cetera was aware of the lower cost shares. From September 2012 it maintained and periodically updated a mutual fund buy list, which included firm-approved mutual funds and share classes that its IARs were directed to use to select mutual funds for their clients ("Mutual Fund Buy List"). For each fund family, the Mutual Fund Buy List included a firm-recommended share class, which typically was the lowest-cost share class. Beginning in 2012, Cetera obtained waivers to allow clients to purchase lower-cost share classes, and those classes were added to the Mutual FundBuy List (the "Initiative"). The Initiative was motivated by IARs' requesting access "to lowest cost shares for alignment with their fiduciary obligations."

In June 2013, CA's President and CEO announced to the firm's IARs that by the end of the first quarter of 2014, CA would remove higher-cost share classes from the Mutual Fund Buy List, and IARs would no longer be able to purchase higher-cost share classes. Further, in June 2014, the Initiative recommended that Cetera rebate all 12b-1 fees. Cetera did not implement this recommendation until December 2016. Because Cetera did not implement its own recommendations, its clients held assets in higher-cost mutual fund share classes when otherwise identical, lower-cost share classes of the same fund were available, and Cetera's clients paid and Cetera received $10 million in 12b-1 fees, which Cetera never rebated.

Cetera is required to file and update, at least annually, disclosures in a uniform registration application called a Form ADV. As part of this application, Cetera is required to make certain disclosures in an SEC-mandated Form ADV Part 2A ("Brochure"). The Form ADV, including the Brochure, is designed to provide disclosure to advisory clients so they can understand the firm's economic incentives that might influence the firm's decision-making on the clients' behalf. They also provide a way for clients to compare a firm's fees, compensation, and business practices with other firms. Cetera is required to provide its Brochure to its clients and prospective clients and provide updated Brochures or summaries of material changes to clients going forward.

Cetera's Form ADV Brochure included the following language from March 2013 through December 2016²:

Accounts may invest in load and no-load mutual funds that may pay the firm annual distribution charges, sometimes referred to as 12(b)-1 fees. . . . When 12(b)-1 fees are paid to us, for investments made in Preferred and Prime non-retirement accounts, a portion is passed to your advisor. The Firm will retain 12(b)-1 fees received for Premier non-retirement accounts. Because of the additional compensation that these payments represent, there is a financial incentive for your advisor to recommend funds that pay 12(b)-1 fees over funds that have no fees or lower fees.

Cetera failed to advise its clients that they were being invested in higher-cost share classes that paid 12b-1 fees when lower-cost share classes were available for the same mutual funds. By omitting any mention of share class distinctions, Cetera failed to inform its clients that as their investment adviser it was recommending share classes that paid it 12b-1 fees when a less-costly share class of the same mutual fund was available. Further, from March 2013 through December 2016, Cetera disclosed it "may" invest in load and no-load mutual funds that "may" pay 12b-1 fees. However, Cetera's Brochures said nothing about the existence of multiple share classes within mutual funds, or its conflict of interest associated with receiving additional compensation by placing client assets in higher-cost share classes when a lower-cost share class of the same fund was available. Moreover, the Mutual Fund Buy List allowed Cetera's IARs to purchase higher-cost share classes for clients who were already paying 12b-1 fees to Cetera, while also informing its IARs that they were required to invest new clients in the "recommended" lower-cost share class. Cetera did not disclose this disparate treatment of its clients. Finally, prior to June 2015, Cetera's Brochures falsely represented that "[t]o help mitigate this conflict of interest [from receiving 12b-1 fees], we monitor the sales activity of our [IARs] to ensure that the products and services they offer to you are appropriate for your specific situation." In fact, Cetera did not evaluate whether it had placed its advisory clients in the most favorable share class.

Cetera put its clients in mutual funds offered by a third-party broker-dealer (the "ClearingBroker"). The Clearing Broker offered its no-transaction-fee mutual fund program (the "NTF Program") to Cetera. The NTF Program had two sub-programs: (a) no-load mutual funds that did not pay sales commissions ("NTF A"), and (b) "load" mutual funds where the Clearing Broker waived the sales commissions if purchased in fee-based advisory accounts ("NTF B"). The amount of revenue that the Clearing Broker shared with Cetera was based on the amount of client assets Cetera invested in the mutual funds in NTF A. When Cetera selected an investment for a client, it had more than one mutual fund to choose from, including the choice of selecting other investments or mutual funds that did not participate in NTF A. Cetera's receipt of compensation through NTF A created a material conflict of interest, because it incentivized Cetera to invest client assets through NTF A over other investments.

Prior to June 2015, Cetera's Brochures did not have any disclosures related to the compensation it received from investing clients in mutual funds through NTF A. Both before and after June 2015, Cetera did not have any disclosures detailing the program or explaining the conflict of interest this arrangement presented. Starting in June 2015, Cetera misleadingly disclosed in its...