Best Execution | Conflicts of Interest | Disclosures | Mutual Funds | SEC News

SEC Offers “Favorable Terms” to Advisers that Self-Report Failure to Disclose Receipt of 12b-1 Fees

On February 12, 2018, the SEC Division of Enforcement announced a new self-reporting initiative – the Share Class Selection Disclosure (the “SCSD Initiative”).  The Initiative, led by the Commission’s Asset Management Unit, is designed to encourage advisers to self-report failure to disclose the receipt of 12b-1 fees from clients, and to promptly return money to harmed clients. In return for turning themselves in, the Enforcement Division has agreed to recommend “favorable settlement terms”, such as foregoing financial penalties.  The offer is good until June 12, 2018, and is available to advisers that meet the certain conditions (discussed later in this article).

Firms that have already been contacted by the SEC’s Enforcement Division about possible violations for failure to disclose conflicts of interest associated with mutual fund share class selection are not eligible to take advantage of this initiative.

The SEC is also threatening firms that would have been eligible for the terms of the SCSD Initiative but fail to participate with potentially greater penalties.  The SEC included this ominous language in its announcement:

Enforcement actions outside of the SCSD Initiative will likely result in the staff recommending violations and remedies beyond those described in the Initiative, including penalties.  A settlement against an eligible adviser that fails to self-report under the SCSD Initiative may include greater penalties than those imposed in past cases involving similar disclosure failures.

The SEC has been closely scrutinizing investment adviser practices for recommending certain mutual fund share classes and related conflicts of interest and disclosures.  By way of background, mutual funds pay 12b-1 fees for shareholder services, distribution and marketing expenses. The fees are typically paid to broker-dealers, investment advisers and other financial institutions.  Since the fees are paid out of fund assets, the 12b-1 fees reduce investor returns. The conflict of interest arises in situations where an investment adviser recommends that its client purchase a mutual fund share class that charges a 12b-1 fee, and the adviser’s affiliated broker dealer receives the 12b-1 fee from that mutual fund as compensation for its distribution activities.  In that situation, there is an incentive for an adviser to recommend a mutual fund share class that pays additional fees to its affiliated broker dealer.  In some situations, there may be another share class of the same mutual fund that does not charge a 12b-1 fee available to advisory clients.  Investing in this share class may be in the client’s best interest, since his or her returns would not be reduced by the 12b-1 fees.

The SEC has been bringing enforcement actions over the past few years, alleging that advisers have not sufficiently disclosed this conflict of interest to clients, as required by Section 206(2) of the Advisers Act.  The Commission has been particularly incensed by disclosures in advisers’ Forms ADV stating that an adviser (or its related broker dealer) “may” receive 12b-1 fees associated with the sale of certain share classes and that these fees “may” result in a conflict of interest, when, in fact, these firms were receiving such fees.   The SEC has also cited firms for failing to seek best execution when selecting mutual fund share classes.

Who May Self-Report under the SCSD Initiative?

The SEC is allowing “Self-Reporting Advisers” to take advantage of the SCSD initiative, which is defined as an adviser that:

  • received 12b-1 fees in connection with recommending, purchasing, or holding 12b-1 fee paying share classes for its advisory clients when a lower-cost share class of the same fund was available to those clients; and
  • failed to disclose explicitly in its Form ADV the conflicts of interest associated with the receipt of such fees.

The SEC clarified that an investment adviser “received” 12b-1 fees if it, its supervised persons or its affiliated broker-dealer received the fees.  Additionally, the SEC stated that “explicit” means “disclosures must have clearly described the conflicts of interest associated with (1) making investment decisions in light of the receipt of the 12b-1 fees, and (2) selecting the more expensive 12b-1 fee paying share class when a lower-cost share class was available for the same fund.”

Advisers with pending examinations are eligible to self-report; however, firms that have already been contacted by the Enforcement Division regarding possible related violations are not.  (This exclusion includes advisers that have been contacted by the Enforcement Division but have not yet received a Wells Notice.)

How and When to Self-Report

Advisers wishing to self-report must notify the SEC via email at SCSDInitiative@sec.gov or by mail (SCSD Initiative, U.S. Securities and Exchange Commission, Denver Regional Office, 1961 Stout Street, Suite 1700, Denver, Colorado 80294) by midnight EST on June 12, 2018.  But the SEC is expecting much more than a simple notice of intent to self-report.  Within 10 days of sending the notice, advisers will also need to submit a fairly daunting questionnaire that asks the Self-Reporting Adviser to disclose each mutual fund that paid it or its affiliated broker-dealer 12b-1 fees, the total amount of those fees, and the amount of 12b-1 fees (if any) that the adviser’s clients would have incurred if they had been invested instead in the lowest-cost share class available, from January 1, 2014 “through the date the misconduct stopped.”  The adviser is also required to disclose the amount of 12b-1 fees that it intends to disgorge.  The Self-Reporting Adviser is allowed to include any additional information to explain why the disclosures of these conflicts of interest did not make it into the Form ADV. The adviser must also consent to applicable standard settlement terms.

Standard Settlement Terms

Listed below are the “favorable settlement terms” being offered:

  1. Cease and desist order for violations of Sections 206(2) and 207 of the Advisers Act based on the adviser’s failure to disclose the conflict of interest;
  2. Censure;
  3. Disgorgement of 12b-1 fees received inappropriately and prejudgment interest on such amounts;
  4. Distribution of the ill-gotten gains to affected clients (and payment of all costs associated with the distribution);
  5. Agreement to undertake the following steps within 30 days of the settlement order:
  • Review and correct relevant disclosures;
  • Evaluate whether existing clients should be moved to a lower cost share class and move clients as needed;
  • Evaluate, update and review the adviser’s policies and procedures to ensure they are reasonably designed to prevent violations of the Advisers Act in connection with the adviser’s disclosures regarding mutual fund share class section;
  • Notify clients of the settlement terms in a “clear and conspicuous fashion”; and
  • Provide the SEC with a certification of compliance with the applicable undertakings within 10 days of completion.

Considerations

The decision whether to self-report under the SCSD Initiative is a very facts-and-circumstances based determination by each firm.  Firms undertaking this analysis would benefit by assembling a team that includes senior representation by legal, compliance, financial, operations and business stakeholders in order to ensure that the matter is appropriately evaluated from all angles.

The terms of the settlement order are troublesome.  Although advisers are not required to admit wrongdoing, the order will have to be disclosed on Form ADV Part 2A and sent to clients, which will undoubtedly cause reputational damage.  Additionally, this initiative only applies to eligible advisory firms.  The Enforcement Division made it clear that it may still go after individuals for violations of the securities laws.  And as previously discussed, the SEC has indicated that it will come down hard on advisers that could have self-reported but chose not to.

Providing the necessary information required under this SCSD Initiative may present significant operational challenges.   Depending on the size and complexity of the adviser and any affiliated broker dealer, it may be difficult to analyze and ensure the accuracy of a potentially large volume of data provided in disparate forms.  For example, firms that have acquired fund business with 12b-1 fees should ensure that any legacy data is appropriately analyzed with the rest of the firm’s fund business. Firms should also consider the “availability” of different share classes from a number of perspectives when conducting their analysis of whether a lower cost share class was available – which share classes are offered by the fund company, which share classes are offered on a particular platform, and which share classes were available to the adviser at the time.

Key Take-Aways

  1. Evaluate the Risk to your Firm.

All firms that select mutual funds for their clients are encouraged to thoroughly review their specific risks related to these activities.  For example, those firms only selecting or recommending institutional share classes will likely assign a different risk level than a firm that selects or recommends multiple share classes to clients in different types of programs or platforms, some that contain 12b-1 fees or front/back end loads.  Similarly, firms that only select or recommend institutional classes without 12b-1 fees will likely warrant simpler policies and procedures than a firm that selects or recommends load-waived share classes that still generate 12b-1 fees.  Finally, even those firms that simply select or recommend mutual funds for their clients in the absence of any other affiliation or potential to directly or indirectly profit from any load or 12b-1 fees are advised to assess this risk and ensure that its policies, procedures and disclosures related to how it selects or recommends mutual fund share classes to its clients are appropriate for its business practices.

  1. Review and Enhance Policies, Procedures and Disclosure Related to Share Class Selection.

Following a review of mutual fund share class selection risks and practices, all firms that select or recommend mutual funds for their clients would also benefit from a comprehensive review of their related policies and procedures.  Although the SCSD Initiative specifically targets share classes with 12b-1 fees and their use by advisers that have affiliated broker dealers, the SEC’s release of the SCSD Initiative specifically references three 2017 enforcement actions and suggests that advisers refer to them for details regarding what the SEC considers to be adequate mutual fund share class selection disclosures and related policies and procedures: In the Matter of SunTrust Investment Services, Inc. (STIS); In the Matter of Cadaret, Grant & Co. and In the Matter of Credit Suisse Securities (USA) LLC,

A review of these actions offers insight to firms “what not to do”, or more positively, what advisers should do to mitigate risk in this area.  Firms should maintain compliance programs that keep pace with industry practices. Consistent with industry trends, each of these firms increasingly made institutional or “load waived” share classes available to non-institutional buyers, while at the same time continuing to sell existing 12b-1 fee generating share classes to those same buyers.  Each of these firms failed to identify the conflict of interest resulting from recommending these different share classes, and therefore did not address it in policies and procedures.

Lessons learned from these cases include:

  • When evaluating a new fund for use with clients, assess the share classes available to clients, considering the existence of 12b-1 fees, front/back end loads and “load waived” classes.
  • Implement a process for recommending appropriate share classes for clients, based on what is in the best interest of the client. For example, there may be situations where a share class may have a front-end load, but lower overall expenses, so that class may be more appropriate for a client that intends to hold the shares for the long-term.  A different share class may be more appropriate for clients with shorter term goals.
  • Implement a periodic share class review in the event new share classes are available; and
  • Regularly review disclosures regarding share class selection and disclose any conflicts of interest.

Firms should document the selection and review process for mutual fund share classes.  Periodic testing and oversight should also be included in the process to ensure that any potential issues related to share class selection are detected and addressed promptly.

  1. Write Better Disclosures

As noted above, each of the firms named in these enforcement actions failed to adequately update their policies, procedures and disclosures to properly address the conflicts related to its share class selection practices.  Here are some tips for writing better disclosures:

  • Avoid the use of “may” if there is any doubt about it. For example, if the firm’s affiliates receive 12b-1 fees, be clear about it, and discuss the potential conflict of interest and what the firm does to mitigate that conflict;
  • Disclose any conflicts of interest concerning the selection of mutual fund share classes. For example, if your firm selects classes that carry 12b-1 fees for clients, disclose that fact, and whether clients are eligible for lower-cost share classes of the same fund.  All three parties in the enforcement actions were found to have inadequate disclosures and failed to disclose this practice directly.
  • Firms with affiliated broker-dealers that purchase mutual fund share classes with 12b-1 fees where other mutual funds with multiple share classes (including those that do not charge 12b-1 fees) are available should disclose that the firm has an incentive to purchase share classes with 12b-1 fees. The disclosure should also state that lower cost share classes are available.
  • Firms that receive payments from fund complexes for marketing and distribution support pursuant to marketing support agreements (outside of 12b-1 fees) should disclose these payments and the conflict of interest resulting from having a financial incentive to invest its client assets in higher-fee share classes of such funds. As described in the Cadaret enforcement action, the services Cadaret provided to the fund complexes under a revenue sharing agreement included providing fund sales data and information about its investment adviser representatives and offices.
  • Firms should include disclosure informing clients about their options to select mutual funds that do not make any revenue sharing or 12b-1 payments (if available).

Going Forward

Through the SCSD Initiative, the SEC has established a path for firms to self-report and established higher expectations for disclosing conflicts and meeting best execution obligations.  Whether your firm is a potentially eligible adviser or simply wishes to review its existing policies, procedures and disclosures related to mutual fund share class selection, do not hesitate to contact us at 724-935-6770, or contact us through our website at www.hardincompliance.com. Our experienced team is here to help.

Hardin Compliance Consulting provides links to other publicly-available legal and compliance websites for your convenience. These links have been selected because we believe they provide valuable information and guidance.  The information in this e-newsletter is for general guidance only.  It does not constitute the provision of legal advice, tax advice, accounting services, or professional consulting of any kind.

 

Want to Learn More?

Interested in learning more about our approach new SEC initiatives? Call us today at 1.724.935.6770, or visit our Contact Us page. We look forward to partnering with you to handle your company’s compliance needs.

Leave a Reply

Your email address will not be published. Required fields are marked *