On July 13, 2016, the SEC’s Office of Compliance Inspection and Examinations (OCIE) issued a Risk Alert announcing the launch of a share class initiative (the Initiative) to examine whether registered advisers and their associated persons are receiving undisclosed compensation or other financial incentives when recommending certain share classes to clients. As part of its focus on retail investor protection (one of OCIE’s 2016 examination priorities), OCIE seeks to identify conflicts of interest concerning advisers’ compensation or financial incentives for recommending mutual fund and 529 Plan share classes that have “substantial loads or distribution fees.”
In the Risk Alert, OCIE identifies the following situations as examples of a conflict of interest related to share class recommendations: (1) where the adviser is dually registered as a broker-dealer (or is affiliated with a broker-dealer) that receives fees from the sale of certain share classes; and (2) where the adviser recommends that clients purchase more expensive share classes of funds for which an affiliate of the adviser receives greater fees.
In seeking to identify such conflicts of interest, the Risk Alert indicates that the SEC staff will focus on adviser practices relating to share class recommendations and compliance oversight of the process, including the following “high risk areas”:
- Fiduciary Duty and Best Execution. In view of an adviser’s fiduciary duty to act in the client’s best interest, including to seek best execution for client transactions (which, according to the staff, may be defined as an obligation “to seek the most favorable terms reasonably available under the circumstances”), OCIE examiners are expected to review advisers’ investment practices associated with share class recommendations, as well as advisers’ books and records, in order to identify share classes held and purchased in client accounts and any related compensation received by the adviser or any of its associated persons.
- Disclosures. Noting an adviser’s duty to make full and fair disclosure of all material facts, OCIE staff will likely review an adviser’s practices surrounding its selection of mutual fund and 529 Plan investments in its clients’ accounts with “a focus on assessing the accuracy, adequacy, and effectiveness of the adviser’s disclosures regarding compensation for the sale of shares and the conflicts of interest created.”
- Compliance Program. Examiners will likely review the adviser’s practices surrounding its selection of mutual fund and 529 Plan share class investments in clients’ accounts and assess the adequacy and effectiveness of the adviser’s corresponding written policies and procedures (which must be reasonably designed to prevent violations of the Advisers Act and the rules thereunder).
The Risk Alert cautions that examiners may select additional topics based on other risks identified during the course of the examination.
The Risk Alert concludes by encouraging investment advisers to reflect upon their own practices, policies and procedures in these areas and to make improvements in their compliance programs as necessary.