Cash Sweep Programs Face Increasing Scrutiny from Regulators and Investors

• Recent months have seen a significant increase in litigation around, and regulatory scrutiny by the SEC and FINRA of, cash sweep programs offered to retail advisory clients and brokerage customers.
• Many of these enforcement actions and lawsuits allege that investment advisers and/or broker-dealers have failed to adequately disclose material conflicts of interest in connection with cash sweep programs, or that features of such cash sweep programs breach fiduciary or other duties owed to investors.
• While the SEC has not yet undertaken an enforcement action under Reg BI relating to a broker-dealer’s cash sweep program, the SEC staff has noted that such programs may pose significant conflicts of interest that broker-dealers must address, under Reg BI.

Uninvested cash in brokerage accounts can come from different sources — from dividends, interest payments and sales and purchases of securities, for example. Rather than allowing cash to sit idle in a low-interest account, investment advisers and broker-dealers often offer investors options to earn higher interest rates on uninvested cash by “sweeping” (i.e., automatically transferring) such cash into a bank deposit account or money market mutual fund.

Interest rates can vary greatly across cash sweep programs, particularly in a volatile economic environment. Investment advisers and broker-dealers also generally retain a portion of the interest received from the cash sweep program based in part on the risk they bear, even if the cash is deposited into bank accounts insured by the Federal Deposit Insurance Corporation (“FDIC”).

In recent years, regulators have increasingly scrutinized the adequacy of the disclosures relating to cash sweeps, as well as specific features, policies and procedures relating to cash sweep programs. We discuss some of the resulting regulatory actions and lawsuits below, and likely areas of focus for the regulators and litigants going forward.

SEC Enforcement Actions and Examinations

The Securities and Exchange Commission (“SEC”) has pursued enforcement actions relating to cash sweeps under the antifraud provisions of the Investment Advisers Act of 1940, as amended (the “Advisers Act”).¹ SEC settlements have included charges under Sections 206(2)², 206(4)³, Rule 206(4)-1(a)(5)⁴ and Rule 206(4)-7⁵ of the Advisers Act for making misleading statements about cash allocations.

More recently, on August 12, 2024, the SEC announced settled charges against a dually registered investment adviser and broker-dealer, relating to the adviser’s receipt of compensation from a clearing firm based on advisory client investments.⁶ The SEC alleges, among other things, that the adviser made available to its clients as cash sweep options only those money market funds for which the adviser received revenue sharing payments from the clearing broker, despite other money market funds being available for which the adviser would have received a smaller or no share of the revenue.

According to the SEC’s order, the adviser failed to disclose (i) that it received revenue sharing payments on advisory clients’ money market fund holdings in sweep accounts and (ii) the conflicts of interest that arose from the arrangement, disclosing only that it “may” receive compensation in connection with money market funds. The SEC’s order also states that the money market fund options for which the adviser received revenue sharing payments generally charged higher fees and returned lower yields to clients, while the money market funds that paid no or lower revenue shares generally charged lower fees and at times returned higher yields to investors. The SEC found that the adviser had breached its duty of care and violated Sections 206(2)⁷, 206(4)⁸ and Rule 206(4)-7⁹ of the Advisers Act and ordered the adviser to pay disgorgement and civil penalties amounting to just over $6 million.

Although these enforcement actions are relatively recent, the SEC began scrutinizing cash sweep programs after the SEC’s Office of Compliance Inspections and Examinations (now the Division of Examinations) issued a risk alert in July 2016 that sought to identify conflicts of interest tied to advisers’ compensation or financial incentives for recommending mutual fund and 529 Plan share classes that have substantial loads or distribution fees.¹⁰ In 2018, the SEC’s Division of Enforcement announced its “Share Class Selection Disclosure Initiative,” under which it would recommend favorable settlement terms for investment advisers that self-reported possible securities law violations relating to their failure to make necessary disclosures concerning mutual fund share class selection.¹¹ It was during this scrutiny of various conflicts of interest around share class selection that the SEC also began examining conflicts and breaches of fiduciary duties around cash sweep programs run by broker-dealers and investment advisers.

Application of Regulation Best Interest to Cash Sweep Programs

While the SEC has not yet undertaken an enforcement action against a broker-dealer under Regulation Best Interest (“Reg BI”) in the context of a cash sweep program, SEC staff have commented on the application of Reg BI to such programs. For example, a 2022 Staff Bulletinentitled Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest (the “Staff Bulletin”) notes that compensation, revenue or other benefits to the broker or its affiliates can constitute a common source of conflicts of interest. The Staff Bulletin notes that such compensation or benefits can be financial or otherwise and may include fees and other charges for the services provided to retail customers (for example, compensation based on assets gathered and/or products sold, including but not limited to cash sweep programs).¹²

According to the Staff Bulletin, disclosure around these conflicts arising from such compensation arrangements should describe:

(i) the nature and extent of the conflict;

(ii) the incentives created by the conflict and how the conflict affects or could affect the recommendation or advice provided to the retail investor (for example, where the availability of products that can be recommended to the retail investor is limited as a result of the financial professional only recommending products from certain preferred providers);

(iii) the source(s) and scale of compensation for the firm and/or financial professional;

(iv) how the firm and/or financial professional is compensated for, or otherwise benefits from, their recommendation or advice (for example, through revenue sharing or other compensation related to cash sweep programs) and what, if any additional benefits they may receive (for example, cost reductions, merchandise, gifts or prizes) under the arrangement; and

(v) the nature and extent of any costs or fees incurred, directly or indirectly, by the retail investor as a result of the conflict.¹³

Beyond the SEC, the Financial Industry Regulatory Authority (“FINRA”) too has weighed in on various aspects of cash sweep programs. FINRA’s 2020 Risk Monitoring and Examination Priorities Letter notes that FINRA will consider various factors in reviewing broker-dealers firms’ cash sweep programs including:

• Whether the firm clearly communicates the nature of the sweep arrangement.
• Whether the firm clearly communicates the alternatives for cash management available to customers, the terms of the cash sweep program and any alternatives.
• Whether the firm has incorrectly implied that a brokerage account is similar to or the same as a “checking and savings account” at a bank.
• Whether the firm has incorrectly implied that the brokerage accounts themselves are bank deposit accounts insured by the FDIC.
• Whether the firm has a documented process to perform reconciliations of customer balances held at each destination bank in the bank sweep program.¹⁴

Recent Lawsuits Related to Cash Sweep Programs

Regulatory scrutiny of cash sweep programs has also led to increased interest from the class action bar. For example, on July 17, 2024, a class action was filed in the U.S. District Court for the Southern District of California against a dually registered investment adviser and broker-dealer.¹⁵ According to the complaint, the adviser operated two cash sweep programs (the “Programs”) during the relevant period: one for non-IRA customer accounts, and the other for IRA accounts. In both programs, any uninvested cash in customer accounts was swept daily into a series of bank accounts, and interest on the cash swept into the bank accounts was earned and allocated between the adviser and its customers. According to the complaint, customers were required to participate in the Programs to open an account with the adviser.

The complaint alleges that the adviser received substantial returns on the cash held in the Programs’ bank accounts while paying minimal interest to customers. Alleging that the adviser has “continuously acted in its own interests and sought to maximize its own profits” at the expense of proposed class members, the complaint also claims that the adviser failed to fully disclose to its customers:

(i) the percentage of the total interest that the adviser retained;

(ii) the fees the adviser received for placing its clients’ cash through the Programs; and

(iii) the amount of interest that would be paid to its clients if those clients were to directly deposit their funds into accounts at the same banks chosen for the Programs.

The suit in the Southern District of California is not the first of its kind. Since 2021, several similar lawsuits have been brought against registered investment advisers and broker-dealers with respect to their cash sweep programs. These lawsuits have made similar allegations, claiming that various prominent investment advisers kept higher portions of interest received from their cash sweep programs than their clients, and/or failed to disclose material facts regarding their programs, thus allegedly violating their fiduciary duties to their clients.

Lawsuits against several major broker-dealers have alleged violations of Reg BI¹⁶ and breach of contract, alleging that the broker-dealers recommended sweep options for the broker-dealers’ own benefit, failed to disclose conflicts of interest associated with sweep recommendations and failed to obtain “reasonable” rates for customers.¹⁷ Actions by investors around cash sweep programs continue to be filed regularly, although most of these proceedings are yet to reach a hearing on the merits.

What’s Next?

In light of the recent wave of litigation and enforcement actions around cash sweep programs, regulatory scrutiny is likely to be focused on the following:

• Whether the features, risks, and financial details relating to their cash sweep programs have been adequately disclosed.
• The allocation of interest income to clients/customers and the firm, and whether such allocations are likely to raise concerns under fiduciary and/or Reg BI obligations.
• Whether cash sweep programs are sufficiently tailored to client/customer needs, and whether clients’/customers’ eligibility to participate in such programs has been duly assessed, particularly as market conditions change over time.
• The extent of any FDIC or other protection for cash sweep programs, and any available or appropriate alternatives to cash sweep programs.
• Conflict of interest disclosures and whether such disclosures adequately inform clients/customers of the potential conflicts of interest with respect to cash sweep programs.
• Whether policies and procedures are reasonably designed to address conflicts of interest.

The recent uptick in litigation and regulatory enforcement surrounding cash sweep programs underscores the heightened risk faced by investment advisers and broker-dealers. This trend highlights the critical importance of adhering to regulatory expectations and adequately disclosing material conflicts of interest. Previous guidance from the SEC and FINRA offers valuable insights into the regulatory focus. By following this guidance and ensuring transparent practices, firms can better navigate the complexities of preparing adequate disclosures regarding their cash sweep programs and reduce the risk of exposure to enforcement and litigation.

1. SeeIn the Matter of Aventura Capital Management, LLC, Inv. Adv. Act Rel. No. 6103 (Sept. 6, 2022); In the Matter of Trust Advisory Group, LTD., Inv. Adv. Act Rel. No. 6046 (June 7, 2022); In the Matter of Cowen Prime Advisors LLC, Inv. Adv. Act Rel. No. 5874 (Sept. 27, 2021).

2. Section 206(2) of the Advisers Act makes it unlawful to engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.

3. Section 206(4) of the Advisers Act makes it unlawful to engage in any act, practice, or course of business which is fraudulent, deceptive or manipulative.

4. Rule 206(4)-1(a)(5) of the Advisers Act prohibits investment advisers from referencing specific investment advice in a manner that is not fair and balanced.

5. Rule 206(4)-7 Advisers Act requires investment advisers to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act.

6. See In the Matter of Cadaret, Grant & Co., Inc., Inv. Adv. Act Rel. No. 6647 (Aug. 12, 2024).

7. See supra, n. 2.

8. See supra, n. 3.

9. See supra, n. 5.

10. See OCIE’s 2016 Share Class Initiative, (Jul. 13, 2016).

11. See Share Class Selection Disclosure Initiative, (May 1, 2018).

12. Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest (Aug. 3, 2022).

13. Id.

14. See2020 Risk Monitoring and Examination Priorities Letter, FINRA (Jan. 9, 2020).

15. Peters v. LPL Financial LLC, Docket No. 3:24-cv-01228 (S.D. Cal. Jul. 17, 2024).

16. Reg BI is a federal standard that in simple terms requires broker-dealers to act in the best interests of their retail customers. Regulation Best Interest: The Broker-Dealer Standard of Conduct, SEC Rel No. 34-86031 (June 5, 2019); 84 Fed. Reg. 33318 (Jul. 12, 2019).

17. McCrary v. Merrill Lynch, Pierce, Fenner & Smith Inc., Case No. 1:23-cv-10768-AT (S.D.N.Y. Dec. 11, 2023).