SEC Announces Share Class Selection Disclosure Initiative

The Division of Enforcement (Division) of the U.S. Securities and Exchange Commission (SEC) on February 12, 2018, announced a Share Class Selection Disclosure Initiative (SCSD Initiative). Led by the Division’s Asset Management Unit, the SCSD Initiative is a new self-reporting program under which the Division is offering to recommend to the SEC standardized settlement terms for investment advisers that self-report failures to disclose conflicts of interest in connection with certain mutual fund share class selection practices.¹ The SCSD Initiative targets advisers’ alleged failures to make necessary disclosures relating to the advisers’ receipt of 12b-1 fees² for investing client funds in, or recommending that clients invest in, a 12b-1 fee-paying share class when a lower-cost share class of the same fund was available for the clients. The Division has offered similar self-reporting incentives in the past.³ 

Background 

Interpretations of the Investment Advisers Act of 1940 (Advisers Act) have held that investment advisers must disclose conflicts of interests to their clients. In the Division's Announcement, the SEC staff stated that Section 206(2) of the Advisers Act imposes a fiduciary duty on investment advisers to act for their clients’ benefit, as well as an affirmative duty to disclose conflicts of interest to their clients.⁴ Section 207 of the Advisers Act prohibits advisers from willfully making untrue statements of material fact in registration applications or reports filed with the SEC and willfully omitting any material fact required by such applications and reports. 

A conflict of interest may arise when an adviser selects a 12b-1 fee-paying mutual fund share class for an advisory client when a lower-cost share class of the same fund is available for the client. In such a scenario, the adviser or an affiliate would receive either direct or indirect compensation from the share class in the form of a 12b‑1 fee, while, in the view of the Division, it is usually in the client’s best interest to invest in the lower-cost share class. The Division has taken the position that such a conflict of interest is a material fact that must be disclosed explicitly in the adviser’s Form ADV, and the Division may commence enforcement proceedings alleging violations of the Advisers Act for failure to disclose the conflict of interest. 

Advisers disclose conflicts of interest in Form ADV, Part 2A. Per Item 5(e) of Form ADV, Part 2A, advisers must (i) disclose whether they or their supervised persons “[accept] compensation for the sale of securities or other investment products,” (ii) “[e]xplain that this practice presents a conflict of interest and gives . . . an incentive to recommend investment products based on the compensation received, rather than on a client’s needs” (emphasis in original), and (iii) describe generally how the adviser addresses conflicts that arise. 

The Division developed the SCSD Initiative following a series of recent SEC enforcement actions in which the Division alleged that investment advisers failed to make the required disclosures when selecting 12b-1 fee-paying mutual fund share classes on behalf of clients for whom a lower-cost share class of the same funds was available.⁵ In some cases, the Division charged advisers with not making any disclosure to clients about the circumstances giving rise to these conflicts of interest.⁶ In other cases, the Division charged advisers with making selective, inadequate disclosures that suggested a potential conflict of interest but did not explicitly put clients on notice about actual conflicts of interest.⁷ For example, the Division has taken the view that an adviser’s disclosure that it “may” receive 12b-1 fees, or that the receipt of such fees “may” pose a conflict of interest, does not adequately disclose a material conflict of interest.⁸ Collectively, these actions raised what Division staff described as “significant” concern that “many investment advisers have not been complying with their obligation under the Advisers Act to fully disclose all material conflicts of interest” with respect to mutual fund share class selection practices, resulting in potentially “widespread” harm to investors.⁹ 

It is important to note that these actions generally center on alleged disclosure failures, rather than cases where an adviser and its client have agreed that additional 12b-1 fees represent part of the adviser’s compensation. Further, while not emphasized in the Announcement, in other cases SEC enforcement actions asserted that investment advisers failed to provide best execution when recommending a share class that was not the least expensive class for which a client was eligible. Accordingly, such conduct has led not only to charges of violations under Section 206(2) and 207 of the Advisers Act, but also to charges of failure to seek best execution, as well as deficiencies in policies and procedures under Section 206(4) and Rule 206(4)-7 of the Advisers Act.¹⁰ 

Eligibility for Share Class Selection Disclosure Initiative 

To qualify for the SCSD Initiative, an adviser must have directly or indirectly received 12b-1 fees in connection with “recommending, purchasing, or holding” 12b-1 fee-paying share classes for advisory clients when a lower-cost share class of the same fund was available to the clients. To have “received” 12b-1 fees for purposes of the SCSD Initiative, the adviser must have, during the period beginning January 1, 2014: 

1. Directly received the fees; 
2. Supervised persons who received the fees; or 
3. Been affiliated with a broker-dealer that received the fees. 

The adviser also must not have explicitly disclosed this conflict of interest on Form ADV. An adviser sufficiently discloses this conflict of interest for purposes of the SCSD Initiative when its disclosure “clearly” describes conflicts of interest with respect to both: 1) the effect the receipt of 12b-1 fees has on the adviser’s investment decision-making; and 2) the adviser’s selection of the more expensive 12b-1 fee-paying share classes for advisory clients when a lower-cost share class of the same fund was available to the clients. 

Recommendations for Standardized Settlement Terms 

The Division is incentivizing advisers to self-report by offering standardized settlement terms.¹¹ Most notably, if a self-reporting adviser meets the program requirements and the Division pursues enforcement, the Division will recommend that the SEC accept an offer to settle on terms that do not include a civil monetary penalty, but that do require the respondent to disgorge ill-gotten gains, and pay prejudgment interest, to affected clients. While the Division will recommend that such settlement terms include the respondent accepting a censure and agreeing to cease and desist from committing or causing any current and future violations of Sections 206(2) and 207 of the Advisers Act, it will not recommend that the respondent be required to admit or deny the SEC’s findings. Additionally, the settled order will either require a series of specific undertakings, including the review and correction of disclosure documents and moving clients to lower-cost share classes, as necessary, or acknowledge similar steps that the self-reporting adviser has already taken. 

The Division intends to recommend that the SEC accept settlement terms that do not include charges of failure to seek best execution or policies and procedures violations. Further, the Division will not recommend charges of failure to register as a broker-dealer under Section 15 of the Securities Exchange Act of 1934 in connection with self-reporting advisers’ receipt of 12b-1 fees. 

By contrast, the Division is warning advisers that it expects to recommend harsher sanctions, including the imposition of civil monetary penalties, in future enforcement actions against eligible advisers who do not self-report pursuant to the SCSD Initiative. In the past, the Division has recommended the imposition of civil monetary penalties in enforcement matters involving the mutual fund share class selection practices at issue in the SCSD Initiative.¹² The Announcement emphasized that mutual fund share class selection practices are priorities for both the Division and the SEC’s Office of Compliance Inspections and Examinations (OCIE),¹³ and that Division and OCIE staff “plan to proactively seek to identify investment advisers that may have failed to make the necessary disclosures related to mutual fund share class selection.”¹⁴ 

Notification of Self-Reporting 

The deadline for reporting is 12:00 a.m. EST on June 12, 2018, by which time eligible advisers must have notified the Division either by mail or by email.¹⁵ Within ten business days of notification, the adviser must then confirm its eligibility by submitting a completed questionnaire.¹⁶ The questionnaire calls for: applicable identification and contact information; any facts describing the circumstances surrounding the failure to disclose the conflicts of interest in question; and any information relating to the excess 12b-1 fees received as a result of those conflicts of interest. The questionnaire also calls for a statement that the adviser “intends to consent” to settlement terms under the SCSD Initiative. 

Limitations 

The standardized terms offered under the SCSD Initiative would only be the Division’s recommendations, subject to the SEC’s acceptance. Accordingly, the SCSD Initiative does not guarantee that self-reporting advisers will actually receive these standardized settlement terms. 

Advisers that the Division has already contacted about possible violations of this nature are ineligible for the SCSD Initiative. Advisers will not be deemed ineligible, however, merely by their being subject to pending examinations by OCIE. Provided that the Division staff has not contacted them about these potential violations, such advisers will be eligible for the SCSD Initiative. 

Significantly, the standardized terms offered under the SCSD Initiative do not extend to individuals associated with self-reporting advisers.¹⁷ As a result, the Division may pursue enforcement actions against individuals and may seek remedies in addition to those described in the SCSD Initiative. Similarly, the SCSD Initiative only applies to failures to disclose conflicts of interest arising out of the receipt of 12b-1 fees; similar settlement terms will not necessarily be available for any other misconduct the Division views as beyond the scope of the SCSD Initiative. 

The SCSD Initiative represents a clear attempt by the Division to change the mix of “carrots” and “sticks” that would incentivize advisers to self-report applicable conduct. However, in offering an additional “carrot” – the potential for no penalty – the Division has removed another – the potential to negotiate away individual liability. It is not clear that this switch, when combined with the additional “sticks” – heightened scrutiny and thus the higher likelihood of enforcement action, as well as the threats of best execution and broker-dealer registration charges that are essentially lesser included charges – significantly changes the mix of incentives. The Division does not change the primary “stick” – the impact of an SEC enforcement action on the adviser’s reputation. Moreover, in self-reporting initiatives such as this, the Division is trying to create the perception that many firms will self-report, which adds another “carrot” to the mix: the reputational damage of the enforcement action is mitigated when the defendant is one of many firms also charged. It remains to be seen whether the Division has been successful in creating this perception. 

Footnotes 

_{1) See SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors (Press Release) (Feb. 12, 2018); see also Securities and Exchange Commission, Division of Enforcement, Announcement: Share Class Selection Disclosure Initiative (Announcement) (Feb. 12, 2018).
2) Rule 12b-1 promulgated pursuant to the Investment Company Act of 1940 prohibits open-end mutual funds from engaging “directly or indirectly in financing any activity which is primarily intended to result in the sale of shares issued by such company” unless all payments are made “pursuant to a written plan describing all material aspects of the proposed financing of distribution.”
3) See SEC Launches Enforcement Cooperation Initiative for Municipal Issuers and Underwriters, SEC News Release 2014-46 (Mar. 10, 2014). For further information, please refer to Dechert OnPoint, SEC Announces Further Enforcement Actions in the Municipalities Continuing Disclosure Cooperation Initiative.
4) See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-94 (1963), in which the Supreme Court held that the Advisers Act recognizes an investment adviser’s fiduciary duty to its clients.
5) See Press Release. The Division acknowledged that “[d]iffering share classes facilitate many functions and relationships.”
6) See e.g., In the Matter of Packerland Brokerage Services, Inc., Investment Advisers Act Rel. No. 4832 (Dec. 21, 2017) (Packerland) (adviser recommended share class paying service fee but did not disclose either its receipt of an annual service fee in its capacity as a broker-dealer or the availability of a lower-cost but otherwise identical share class); see also In the Matter of Cadaret, Grant & Co., Inc., Investment Advisers Act Rel. No. 4736 (Aug. 1, 2017) (Cadaret) (adviser invested advisory clients in 12b-1 fee-paying share classes when less-expensive share classes in the same funds were available, but did not disclose on Form ADV its conflicts of interest related to its receipt of 12b-1 fees or additional marketing support fees it received when investing clients in 12b-1 fee-paying share classes); In the Matter of Pekin Singer Strauss Asset Management Inc., Investment Advisers Act Rel. No. 4126 (June 23, 2015) (Pekin Singer) (Form ADV did not address that adviser kept or placed clients in a more expensive share class when a less-expensive institutional share class became available).
7) See e.g., In the Matter of SunTrust Investment Services, Inc., Investment Advisers Act Rel. No. 4769 (Sept. 14, 2017) (SunTrust) (adviser disclosed on Form ADV that it “may” receive 12b-1 fees, and that receipt of such fees would present a conflict of interest, but did not disclose its actual receipt of 12b-1 fees or that less-expensive share classes were available); see also In the Matter of Envoy Advisory, Inc., Investment Advisers Act Rel. No. 4764 (Sept. 8, 2017) (Envoy) (adviser made general disclosure about potential receipt of 12b-1 fees but did not make explicit Form ADV disclosures to its IRA holders about 12b-1 fees received by affiliated broker-dealer); In the Matter of Manarin Investment Counsel, Ltd., Investment Advisers Act Rel. No. 3686 (Oct. 2, 2013) (Manarin) (adviser disclosed on Form ADV that representatives of affiliated broker-dealer were “typically entitled to receive” a portion of 12b-1 fees but not that adviser would select shares paying 12b-1 fees even when lower-cost shares were available).
8) See SunTrust, supra note 7.
9) See Announcement.
10) See e.g., In re Credit Suisse Securities (USA) LLC, Investment Advisers Act Rel. No. 4678 (Apr. 4, 2017) (adviser charged with failure to seek best execution and failure to adopt and implement reasonably designed policies and procedures when its representatives purchased or held 12b-1 fee-paying Class A mutual fund shares for advisory clients eligible for lower-cost institutional share classes of the same mutual funds and did not disclose that “best execution might not be sought for mutual funds with multiple available share classes”); see also In the Matter of Sanford Michael Katz, Investment Advisers Act Rel. No. 4679 (Apr. 4, 2017) (individual adviser charged with failure to seek best execution for purchasing or holding 12b-1 fee-paying Class A mutual fund shares for advisory clients eligible for lower-cost institutional share classes of the same mutual funds; adviser did not address conflicts of interest or disclose method of share class selection, even in response to direct client inquiries).
11) In a similar effort, FINRA recently announced that it would consider providing additional guidance on Rule 4530 (the Extraordinary Cooperation Rule) in 2018. See Susan Schroeder, Remarks at SIFMA AML (Feb. 12, 2018). Through Rule 4530, FINRA has granted “credit for extraordinary cooperation – with an emphasis on a respondent’s efforts on restitution and remediation – in a number of matters” and assessed “substantially reduced fines in recognition of their extraordinary cooperation.”
12) See Packerland, supra note 6 (adviser ordered to pay civil monetary penalty of $150,000; two portfolio managers ordered to each individually pay a civil monetary penalty of $80,000); Cadaret supra note 6 (adviser ordered to pay civil monetary penalty of $280,000); Pekin Singer supra note 6 (adviser ordered to pay civil monetary penalty of $150,000; two portfolio managers ordered to each individually pay a civil monetary penalty of $45,000); SunTrust, supra note 7 (adviser ordered to pay civil monetary penalty of $1,148,071.77); Envoy supra note 7 (adviser ordered to pay civil monetary penalty of $24,893); Manarin supra note 7 (adviser ordered to pay civil monetary penalty of $100,000).
13) OCIE announced a share class initiative similar to the SCSD Initiative in 2016. See OCIE’s 2016 Share Class Initiative (Jul. 13, 2016).
14) See also Chairman Jay Clayton, Governance and Transparency at the Commission and in Our Markets: Remarks at the PLI 49th Annual Institute on Securities Regulation (Nov. 8, 2017) (“I expect that our Enforcement Division will continue to be active in pursuing cases where hidden or inappropriate fees are at issue, but we also are exploring whether more can be done to clarify fee disclosures made to retail investors and, thereby, deter and reduce the opportunities for misbehavior.”).
15) Notification can be made 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.
16) A self-reporting adviser may receive an extension for submitting the questionnaire by submitting a request to SCSDInitiative@sec.gov at least two business days before the deadline to submit.
17) See Announcement (“The Division provides no assurance that individuals associated with these entities will be offered similar terms if they have engaged in violations of the federal securities laws.”).}