The founder of a Tennessee firm plans to fight charges from the Securities and Exchange Commission that his firm failed to disclose conflicts arising from clients being invested in higher-cost mutual fund share classes for clients when lower-cost options were available.
The SEC’s complaint against Franklin, Tenn.-based CapWealth Advisors is the latest in a number of filings following the Commission’s Share Class Selection Disclosure Initiative.
“We always acted in the best interest of our clients,” CapWealth Founder and CEO Timothy J. Pagliara said. “(The SEC) asked the question, we answered it, and they ignored the answer. It’s a shameful exercise and an abuse of power.”
Mutual funds often offer different ‘share classes’ with similar objectives but starker differences in costs. A single mutual fund may have different share classes with higher total annual fund operating expenses, often because brokers are being paid more for purchases in a particular share class or they have higher fees, including 12b-1 fees. This could lead to a situation where clients are invested in mutual fund share classes with a higher cost, while more affordable options (with similar or identical objectives) are available.
According to the SEC, a portion of the 12b-1 fees raised as a result of CapWealth’s investments were paid to Tim Murphy, an investment advisor representative and the firm’s managing director of wealth management. Pagliara didn’t directly receive any 12b-1 fees, but the SEC said his personal share of the fees generated by client accounts went to CapWealth Group (of which he’s the majority stakeholder), which wholly owned CapWealth Investment Services.
Over the years, CapWealth’s affiliated broker/dealer continued to accept payments on 12b-1 fees, but as time went on, many of these mutual funds began offering share classes that did not charge such fees, according to the complaint.
“These share classes typically had lower costs to investors than 12b-1 share classes of the same funds because, among other things, they did not pay broker-dealers 12b-1 fees,” the complaint read. “The availability of these lower-cost share classes meant that CapWealth’s advisory clients could often hold the same mutual fund’s pool of securities and other assets, but pay less for precisely the same investment.”
Pagliara argued that the SEC’s allegations were absurd and amounted to a misunderstanding of the services firms should provide for their clients. He asserted that his firm’s obligation to clients was to provide them the lowest-cost delivery of a total service, and solely looking at the fees attached to a particular share class didn’t take into account tax advantages and deductions clients could take in particular situations. The SEC, he said, had spoken to more than a dozen clients of the firm, and none of them had taken issue with its conduct. The SEC’s actions and red lines continued to be aggravatingly opaque, he said.
“If the speed limit’s 35 miles per hour and you go 45, you know you’ve broken the speed limit,” he said. “But if the SEC sets what a safe and reasonable speed limit is, how do you know what it is if they don’t tell you?”
The SEC asserted in the complaint that since mutual funds publish information on lower-cost share classes in their prospectuses, Pagliara and Murphy either knew or should have known that clients could access lower-cost options, and the two should have worked to purchase those shares for their clients (and disclose that more affordable options were available). The SEC claimed that Pagliara and Murphy both sent or received emails about the existence of those lower-cost options, and even converted some client investments to those options.
According to the complaint, Pagliara said that he didn’t disclose the conflicts of interest concerning share class selection practices “because he did not believe that there was a conflict of interest.”
The CapWealth complaint is the latest in a number of litigation or administrative filings alleging firms’ insufficient disclosure of share class conflicts. Earlier this month, BancWest Investment Services was charged with receiving 12b-1 fees while failing to disclose that cheaper share class options were available. Capitol Securities Management also settled with the agency over similar issues, according to an administrative cease-and-desist order filed last month.
In both filings, the SEC noted the firms did not self-report in the Division of Enforcement’s Share Class Selection Disclosure Initiative, though they were eligible to do so. The Commission launched the initiative in February 2018 by agreeing not to recommend financial penalties against advisors who self-reported violations concerning mutual fund share classes, provided they agreed to return money to affected clients. Firms were required to self-report by June of that year, though the Commission announced an additional 16 firms had self-reported by the following September. In all, the initiative returned nearly $140 million to investors.
The final filings concerning firms who self-reported (including Merrill Lynch’s corporate RIA) occurred in April 2020. Since then, there’s been a number of SEC complaints against firms who didn’t self-disclose these conflicts with the SEC. In addition to BancWest and Capitol Securities Management, both SCF Investment Advisors and Pennsylvania-based RIA Ambassador Advisors were accused of similar lapses in complaints filed since April.
The self-disclosure initiative has generated some controversy from critics. Last month, at what will be his final testimony before the Senate as SEC Chair, Jay Clayton heard criticism from Sen. Tom Cotton (R-Ark.), who argued that the initiative meant advisors or firms could be fined based on things that might be “opaque or even unknown.” Clayton defended the initiative, arguing it was an attempt to deal with a disciplinary issue that was widespread through the industry.
“I understand that some people felt that they were within the bounds of the law, where we felt they were not,” Clayton said. “I’m hopeful there’s been more clarity brought to this, but I’m also comfortable that the Enforcement Division pursue this, having that belief that they were on the right side of the law.”
Pagliara decried the Disclosure Initiative as a form of intimidation on the part of the Commission, where firms were pressured to self-report in order to avoid civil fines. He said he planned to file a legal motion in response to the SEC’s complaint, and was willing to go to trial if need be.
“The whole thing is frivolous,” he said. “And it’s exploitative of their power.”
SEC spokeswoman Judith Burns declined to comment.
