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
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:
- Directly received the fees;
- Supervised persons who received the fees; or
- 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.
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.