On February 12, 2018, the Division of Enforcement of the US Securities and Exchange Commission (SEC) announced the Share Class Selection Disclosure Initiative (Initiative)1 to encourage SEC registered investment advisers (RIAs) to self-report certain violations relating to their failure to disclose conflicts of interests associated with the receipt of 12b-1 fees for investing client funds in, or recommending that clients invest in, a 12b-1 fee share class when a lower share class was available to clients for the same fund.
Under the Initiative, the SEC’s Enforcement Division would recommend favorable settlement terms with no civil penalty for any resulting enforcement action against an RIA that self-reported this share class violation and promptly returned money to harmed clients. To be eligible, an RIA must self-report by June 12, 2018.
The Initiative is squarely focused on comparatively more expensive share classes with 12b-1 fees selected for clients without adequate disclosures. Instances in which one share class is more expensive than another, but where neither share class pays a 12b-1 fee are not within scope and therefore not entitled to the protections provided by the Initiative.
In announcing this Initiative, the SEC hopes to clean up an area that has received intense regulatory scrutiny that began with the first enforcement action five years ago, and has continued over the past few years.2 An SEC Office of Compliance Inspections and Examinations (OCIE) Legal Alert, issued on July 13, 2016, provides some practical considerations as advisers sort through the implications of this Initiative with respect to their particular facts and circumstances.
To be eligible for the Initiative, an RIA must self-report any violation by notifying the SEC by June 12, 2018, and also must submit a “Questionnaire” within 10 business days of the self-reporting.3 The “Questionnaire” requests information on the reporting RIA; if applicable, its affiliated broker-dealer that received 12b-1 fees; any mutual funds that paid 12b-1 fees; time periods for the applicable violations; and any other information that may help the SEC determine the scope of the violations and disclosure failures.
RIAs subject to pending examination by the SEC’s OCIE related to potential share class violations may be eligible to participate in the Initiative, provided the adviser has not already been contacted by the SEC’s Enforcement Division prior to the Initiative. Any adviser that has already been contacted by the SEC’s Enforcement Division, prior to the Initiative, about its potential share class violations would be ineligible to participate in the Initiative. Based on information from the Staff, the Initiative’s reference to being contacted by Enforcement means that Enforcement is currently investigating the issue, not that the RIA has received a Wells notification.
3. Enforcement Actions Involving Rule 12b-1 Fees and Share Class Selection
The SEC has previously brought enforcement actions against firms and individuals for the conduct cited in the Initiative. These cases have assessed monetary penalties and generally ordered remediation. The “carrot” the SEC is offering for firms that self-report is that settlements related to the Initiative will not include a monetary penalty and will not include all of the charges cited against the firms previously. In addition, the Initiative warns that future cases may include greater penalties than those imposed in past cases.
If an RIA does not self-report through the Initiative, and the SEC learns about the firm’s relevant conduct and ends up bringing an enforcement action, it is likely that the firm will face an action similar to those previously brought, although likely with greater penalties and more findings of violations. The Initiative cited six enforcement actions. In fact, in the last five years, the SEC has brought 10 settled cases related to share class selection and the use of 12b-1 fees. All of those cases imposed civil monetary penalties against the firms, ranging from $80,000 to $125.5 million (certain cases alleged misconduct that went beyond share class selection). In most of those cases, the firms had already voluntarily provided a rebate, in whole or in part, to affected clients. In the actions, the SEC ordered disgorgement of the ill-gotten gains and/or a rebate to clients. The following are some significant differences among the cases:
- In six of the 10 actions, the SEC found that the firms failed to seek best execution for their clients by failing to place them in less expensive share classes that were available to clients.
- Takeaway: This is an important distinction because the Initiative states that if firms self-report, the settlements will not include this charge. It is possible that the SEC will bring that charge against firms that do not self-report. On the other hand, it is also possible that the SEC has rethought this issue and no longer believes that share class selection is a best execution issue. As discussed below, this issue is important because if the SEC continues to believe that best execution is implicated by share class selection, there is a question on whether a firm can ever have adequate disclosure regarding share class selection or share class cost.
- In three of the 10 actions, individuals were charged.
- Individual civil monetary penalties ranged from $20,000 to $100,000.
- One individual (the former president of a firm) was suspended for 12 months.
- Takeaway: While the Initiative states that the Division of Enforcement may recommend enforcement actions against individuals associated with firms that self-report, such actions seem unlikely because, based on the information that firms are required to provide to the Staff, firms will not likely provide information that incriminates an individual.
4. Availability of a Lower Share Class; Wrongful Profit; Inadequate Disclosure
The key component of violative conduct targeted by the Initiative is wrongfully profiting from the 12b-1 share class where a lower share class is available and the firm provided inadequate disclosure.
An adviser must first determine if it wrongly profited from selecting more expensive share classes for its clients where a lower share class was available. One question that arises is what constitutes a share class being “available.” Does it mean simply that the fund offered the share class or that the lower cost share class was within the scope of share classes for which the adviser made recommendations? Past discussions with the Staff regarding this issue suggest that for firms acting in a dual-capacity, the Staff will look to the selling agreement in place to determine the availability of a share class. However, the SEC’s position on this issue is by no means certain.
The RIA will also need to assess the adequacy of its disclosure regarding the conflict of interest presented by these 12b-1 fees on its Form ADV. The SEC explained in the Initiative that a sufficient disclosure 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.
The Initiative is very much focused on inadequate disclosure in connection with the availability of a lower share class option. The SEC notes that other related issues such as best execution and broker-dealer registration may be put aside.4
5. Steps to Take
The SEC notes that an RIA should consider self-reporting under the Initiative if it failed to disclose the conflict of interest presented by its receipt of 12b-1 fees when lower-cost share classes were available to the client. If this conflict was not disclosed on the adviser’s Form ADV, and the RIA decides to self-report this inadequate disclosure pursuant to the Initiative, the adviser should calculate the amount of 12b-1 fees received when lower-cost share classes were available clients. The amount of these fees would typically be returned to the clients who were harmed by the decision to invest in a more expensive share class without adequate Form ADV disclosures.
As part of the Questionnaire, a reporting adviser must provide the list of the mutual funds that paid 12b-1 fees to the reporting adviser, the amount of year-end assets, and the total amount of fund-level 12b-1 fees charged. In addition, the reporting adviser must provide a breakdown of its total 12b-1 fees, including the 12b-1 fees it would have received from the lower-cost share class, the amount of 12b-1 fees received in excess of the lower-cost share class, and any 12b-1 fees that the reporting adviser intends to return to the harmed clients. The time period for the list of 12b-1 fees is from January 1, 2014, through the date that the misconduct stopped.
For RIAs participating in the Initiative, the SEC’s Enforcement Division will recommend that the SEC accept a standardized settlement that would require the disgorgement of the adviser’s ill-gotten gains and pay all of the disgorgement back to the harmed clients, but no civil monetary penalties would be assessed. In addition, the RIA will also agree to review and correct relevant disclosure documents, evaluate whether existing clients should be moved to a lower-cost share, evaluate the effectiveness of its policies and procedures, notify clients of the settlement terms in a clear and conspicuous manner, and provide the SEC Staff with a compliance certification regarding the applicable undertakings.
6. Collateral Consequences
Firms interested in taking advantage of the Initiative should proactively consider the potential collateral consequences arising from their participation in the program.
Dually registered firms may want to focus on the following issues:
- FINRA Rule 4530 Reporting Obligations – FINRA Rule 4530 requires broker-dealers to report to FINRA if the firm has concluded that the firm violated “any” securities law. This provision appears to apply to circumstances where the investment adviser side of a dually registered firm violates the Advisers Act. It is unclear how FINRA will handle Rule 4530 filings regarding the issues discussed in the Initiative. In the past, FINRA has brought cases against dually registered broker-dealers where the firm had inadequate procedures relating to advisory issues (although in those cases, the SEC did not bring an action against the adviser). In addition, because the SEC’s focus has been on RIA conduct, it is possible that FINRA will investigate the role that the broker-dealer played with regard to these issues.
- Statutory Disqualification – A firm could be statutorily disqualified if Initiative-related standardized settlements find that the firms “willfully” violated federal securities laws.5 Article III, Section 3(a) of FINRA's By-Laws states that a firm cannot continue to be a FINRA member if it is subject to a statutory disqualification. FINRA has established a process to allow firms to deal with this issue. Article III, Section 3(d) of the By-Laws allows a disqualified firm to file a Membership Continuance Application (Form MC-400A) to continue its membership. A firm will be permitted to continue business operations during the pendency of the Eligibility Proceeding.
- Net Capital Impact – Exchange Act Rule 15c3-1 requires broker-dealers to maintain a specific net capital at all times. When contemplating rebates to customers, firms may want to consider the impact on net capital. The failure to have adequate net capital can result in an enforcement action.
Regardless of dual registrant status, any participant in the Initiative also may want to consider the following:
- Civil Litigation/ Arbitration – Following regulatory enforcement actions, there is often follow-on civil litigation or arbitrations by allegedly injured parties. It is possible that following these share class selection settlements, investors will allege that the firms committed fraud through their actions and that the SEC-ordered remediation was insufficient.
- WKSI Waiver Issues – If a company settles with the SEC for a fraud charge, it may become an “ineligible issuer” and may not be able to qualify as a “well-known seasoned issuer” (WKSI). Under such circumstances, the company would have to apply to the SEC for a WKSI waiver. In general, a firm negotiates the WKSI waiver with the staff of the Division of Corporation Finance at the same time the firm negotiates the enforcement settlement with the Enforcement Division staff. In the past few years, there has been some public debate among Commissioners regarding how flexible the Commission should be when it considers these waivers.
The Initiative could be the sign of a “kinder and gentler” SEC, or at least an SEC that wants to see this issue wrapped up in as expeditious a manner as possible. The SEC could have continued down the road it was on and brought enforcement actions one at a time against multiple advisers for the same conduct after extensive investigations. The SEC may have viewed that as a waste of its investigative resources and as an expensive proposition for firms because investigations require firms to expend a lot of resources and usually pay for legal representation. The SEC is creating an incentive for firms to self-report and to settle by streamlining the investigative process and by deciding that firms do not need to pay a monetary penalty. The fact that the SEC will not be charging firms for best execution or broker-dealer violations in connection with these settlements indicates the SEC’s desire to focus on inadequate disclosure regarding the availability of a lower-cost share class. Furthermore, with respect to best execution, it may signal that the SEC has rethought whether best execution obligations apply to share class selection.