In recent years, the US Securities and Exchange Commission (SEC) has initiated several probes into how advisory firms manage their cash sweep programs, which are designed to transfer idle cash from investment advisory accounts into interest-earning sweep vehicles to generate additional interest income for the investors. While broker-dealers also provide cash sweep programs, the SEC probes have been limited to an investment advisor's use of cash sweep accounts and potential breaches of an advisor's fiduciary duty to its managed accounts. The most common sweep options offered by investment advisors are bank deposit accounts and money market funds.
Cash sweep programs have been on the SEC's radar since July 2016, when the SEC Division of Examinations (then named the Office of Compliance Inspections and Examinations (OCIE)) issued a risk alert — "OCIE's 2016 Share Class Initiative" — giving notice of a sweep exam focused on conflicts disclosure and compliance with fiduciary duties.
In February 2018, the SEC's Division of Enforcement Asset Management Unit launched a Share Class Selection Disclosure Initiative. That initiative offered amnesty and standardized settlement terms (without civil penalties) to eligible investment advisers that self-reported improper selection of fund share classes with 12b-1 fees when lower-cost share classes were available to the clients. Once the amnesty program sunset in June 2018, the SEC moved forward to bring a significant number of enforcement actions as part of the Share Class Selection Disclosure Initiative.
Around that same time, the SEC also took a deep interest in disclosures and conflicts related to cash sweep arrangements, with a particular focus on the potential for breaches of fiduciary duties, undisclosed conflicts, and revenue-sharing payments received in connection with cash sweep programs.
In recent weeks, there have been reports of ongoing probes by the SEC into how advisory firms are managing their bank deposit sweep programs. While these inquiries are said to focus on an advisor's fiduciary duties relating to the interest rates clients receive through such sweep programs, recent SEC exams and public comments by the regulator point to eight areas of focus for the agency:
- Conflicts of Interest — Failure to disclose conflicts of interest where revenue-sharing payments incentivize advisers to recommend cash sweep options to clients;
- Inappropriate Advisory Fees — Charging advisory fees on cash balances where arguably no investment advice is offered on cash positions;
- Low Rates of Return — Sweep programs paying below-market interest rates when other investments offer significantly higher rates;
- One-Size Fits All — Programs in which the only automatic sweep option available to clients does not allow the firm to manage client-specific risk tolerance/investment objectives;
- Liquidity Concerns — Concerns regarding banks reserving the right to require seven days' notice before transferring funds;
- Monitoring Responsibility — Affirmative duty placed on clients to monitor bank balances to avoid having incomplete FDIC coverage as a result of FDIC insurance limits;
- FDIC Coverage — The benefit of FDIC coverage for bank deposit sweep programs may be overstated, as many money market funds invest in low-risk government securities. Any benefit could also be diminished if clients hold deposits in excess of FDIC coverage limits, resulting in additional exposure; and
- Risk of Breaking the Buck — Although money market funds are typically low-risk, money market funds do carry a risk of "breaking the buck" when the net asset value of a money market fund falls below $1 and the fund's investment income does not cover operating expenses or investment losses.
Separately, cash sweep programs are subject to the watchful eye of the Financial Industry Regulatory Authority (FINRA), albeit for different reasons. FINRA's 2020 Risk Monitoring and Examination Priorities Letter focuses on operational matters for cash sweep programs (such as proper customer reserve formula computations), but also reminds FINRA member firms to properly disclose the manner in which their brokerage cash sweep programs operate, including the availability of alternatives and the extent to which FDIC protection applies.
Finally, recently filed class action lawsuits by investment account customers allege breaches of contractual and fiduciary duties and, in some instances, state consumer protection laws for failing to pay reasonable interest rates on sweep account assets, presenting yet another risk for financial firms that employ a cash sweep program.
Katten continues to monitor the ongoing circumstances and field potential questions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.