February 12, 2018: Investment advisers recommending mutual fund shares to advisory clients may have a disclosure problem. And yes, the U.S. Securities and Exchange Commission (“SEC”) is here to help address the problem. Yesterday the Commission announced its new self-reporting initiative, the Share Class Selection Disclosure Initiative (“SCSD Initiative”), to provide relief to advisers that have engaged in improper mutual fund recommendations on behalf of their clients. This initiative, forgiveness if you will, relates to certain mutual fund share class selections made by advisers relative to the formulation and execution of investment advice. If the offending firm promptly fesses up to the Division of Enforcement and promptly returns any non-compliant fees to harmed clients, the Division will agree not to recommend financial penalties against such advisers for violating federal securities laws.
Section 206(2) of the Investment Advisers Act of 1940, as amended (“Advisers Act”) prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client,” and imposes a fiduciary duty on investment advisers to act for their clients’ benefit, including an affirmative duty of utmost good faith and full disclosure of all material facts.
The Commission has long been focused on the conflicts of interest associated with mutual fund share class selection. Differing share classes have varied investment, expense, and fee attributes, the latter of which generally accrue to the adviser recommending the shares. The 12b-1 share class does not often compare favorably to other less expensive share classes in a specific fund, or family of funds for a long-term investor. From the adviser’s perspective, the income may be a welcome source of revenue, but clearly represents a conflict of interest when the less expensive “A” shares may generally provide the same investment risk-reward characteristics. To the extent the adviser does not disclose and/or does not fully rationalize the implications of the share class recommendation, the adviser is in non-compliance with Section 206 of the Advisers Act. This condition is often exacerbated when the undisclosed conflict is not appropriately monitored or measured (as permissible conflicts of interest must be) whereby the fee streams forthcoming to the adviser are difficult to reconcile.
Fiduciary Standard of Care
The fiduciary standard of care requires advisers to undertake a very explicit risk management process when confronted with a conflict of interest. The process entails initial identification and classification of the conflict as either permissible or prohibited in nature. Upon classification as a permissible conflict that is material, the adviser must develop and implement internal controls which monitor and measure the conflict of interest. To the extent the conflict cannot be removed, the adviser must disclose the conflict and steps for management or mitigation.
Of course, if the conflict is deemed to be of a prohibited nature, the conflict must be removed entirely. The Commission has already signaled that the referenced share class selection process is non-compliant, and it is now incumbent upon advisers to discontinue this practice. Indeed, this practice becomes even more problematic with ERISA qualified plans wherein certain share class selections could be viewed as prohibited transactions.
In the past several years, the Commission has brought enforcement actions against nine firms for failure to disclose these conflicts of interest. These actions included significant penalties against the investment advisers who were required to disgorge millions of dollars in 12b-1 and other fees to clients. Additionally, the SEC’s Office of Compliance Inspections and Examinations has repeatedly raised the red flag urging advisers to examine their share class selection policies and procedures and disclosure practices.
Who Should Consider Self-Reporting?
According to the Division of Enforcement’s press release, investment advisers that did not explicitly disclose in applicable Forms ADV (i.e., brochure(s) and brochure supplements) the conflict of interest associated with the 12b-1 fees the firm, its affiliates, or its supervised persons received for investing advisory clients in a fund’s 12b-1 fee paying share class when a lower-cost share class was available for the same fund should consider self-reporting.
Settlement Terms under the SCSD Initiative
Under the SCSD Initiative, the Enforcement Division will recommend standardized, favorable settlement terms to investment advisers that self-report that they failed to disclose conflicts of interest associated with the receipt of 12b-1 fees by the adviser, its affiliates, or its supervised persons for investing advisory clients in a 12b-1 fee paying share class when a lower-cost share class of the same mutual fund was available for the advisory clients. Among other things, for eligible advisers that participate in the SCSD Initiative, the Division will recommend settlements requiring the adviser to disgorge its ill-gotten gains and pay those amounts to harmed clients, but not impose a civil monetary penalty.
Investment advisers must notify the Division of Enforcement of their intent to self-report by 12:00 am EST on June 12, 2018, by email to SCSDInitiative@sec.gov or by mail to SCSD Initiative, U.S. Securities and Exchange Commission, Denver Regional Office, 1961 Stout Street, Suite 1700, Denver, Colorado 80294.
Consequences of Failing to Self-Report
We urge our clients who may be affected by this initiative to take full advantage of this opportunity, as it should be presumed that the Commission can target offending firms through new Form ADV disclosures and the regulator’s extensive use of compliance analytics software.
The Division of Enforcement stated in its February 12th press release that 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. Of course, the Staff’s decision to recommend enforcement action is based on a case-by-case assessment of specific facts and circumstances.
Follow this link for more information, including the SCSD Initiative share class reporting forms: https://www.sec.gov/enforce/announcement/scsd-initiative