Key Notes:

  • Registered investment advisers have an affirmative duty to inform investors of the share classes with the lowest fees that those investors are eligible to own.
  • An adviser’s written compliance procedures and policies must address how an adviser selects mutual funds to offer its clients, with a robust explanation of the distinctions between those funds’ share classes.

The U.S. Securities and Exchange Commission (SEC) issued a cease-and-desist order (“Order”) to Envoy Advisory, Inc. (“Envoy”), a registered investment adviser that allegedly sold Class A mutual fund shares to advisory clients without disclosing that lower-fee institutional shares were available. The SEC also alleged that Envoy failed to adopt and implement written compliance procedures and policies governing the selection of mutual fund share classes.

Envoy’s clients are primarily organizations that sponsor Employee Retirement Income Security Act of 1974 Section 403(b) retirement plans for their employees, and individuals who hold individual retirement accounts with Envoy. Envoy recommended to these clients Class A shares of two funds that charged investors marketing and distribution fees pursuant to Section 12(b) of the Investment Company Act of 1940, as amended (“1940 Act”), and Rule 12b-1 thereunder (“12b-1 fees”). Envoy did not let its clients know that they also were eligible to own institutional shares of the same funds that carried lower fees, which resulted in the clients paying Envoy’s affiliated broker-dealer, Envoy Securities, LLC, 12b-1 fees that they otherwise could have avoided.

Cease-and-Desist Order

The SEC found that, by selling clients shares with 12b-1 fees that were paid to its affiliated broker-dealer, Envoy had a material conflict of interest that it did not disclose in either of its Forms ADV in violation of Section 206(2) of the 1940 Act. The Forms ADV also failed to disclose the availability of the institutional shares, or any information regarding share class distinctions. The SEC further found that Envoy’s compliance procedures and policies violated Sections 206(4) and 206(4)-7 of the 1940 Act because it did not have any written compliance procedures and policies addressing which share classes of mutual funds to offer its clients, nor were its compliance procedures and policies sufficient to identify its conflict of interest.

The Order directed Envoy to cease and desist from further violations of the 1940 Act and required that it disgorge the amount of avoidable 12b-1 fees plus pre-judgment interest. The Order further imposed a civil penalty on Envoy.

Steps to Avoid Violations

The SEC is vigilantly monitoring advisers to ensure that investors are purchasing the lowest-cost shares they are eligible to own. If an adviser’s client owns higher-fee shares, the adviser should verify that the client is aware of its other options. Advisers should review their compliance procedures and policies to ensure adequate discussion of how any share class distinctions, including 12b-1 fees, affect which mutual funds they offer, and that any conflicts of interest that arise from their offerings are properly disclosed.