The Securities and Exchange Commission (“SEC”) recently announced a temporary program for investment advisers who may have inadequately disclosed potential conflicts of interest related to their selection or recommendation of mutual fund share classes. Participation in the program, however, is not without its drawbacks.
On February 2, 2018, the Division of Enforcement of the Securities and Exchange Commission (the “Division”) released an Announcement that launches the Division’s Share Class Selection Disclosure Initiative (“Initiative”). The Initiative continues the SEC’s focus on investment advisers who receive compensation or financial incentives in connection with the selection or recommendation of mutual fund share classes.
As described in the Announcement, the SEC has identified numerous arrangements in which an investment adviser, its affiliated broker-dealer, or its supervised persons received compensation pursuant to Rule 12b-1 of the Investment Company Act of 1940 (“12b-1 fees”) from a higher-cost mutual fund the adviser recommended or selected when a lower-cost share class of the same fund was available, without explicitly disclosing such conflicts of interest to clients in its Form ADV.
Sections 206(2) and 207 of the Investment Advisers Act of 1940 (the “Advisers Act”) require that investment advisers provide advice to their clients in a manner that is consistent with their fiduciary obligations, not engage in “any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client…,” and not make any untrue statement of material fact or willfully omit any material fact in any registration application or report filed with the SEC. Thus, the Advisers Act requires investment advisers to clearly disclose any material facts, including conflicts of interest, to their clients.
The Division explains in the Announcement that many investment advisers violate Sections 206(2) and 207 by failing to provide sufficiently clear disclosures concerning mutual fund share class selection. Advisers often disclose that they, their affiliates, or supervised persons may receive 12b-1 fees from the sale of mutual fund shares, and that such compensation may create a conflict of interest. However, the Division considers this form of disclosure to be insufficient.
In the Division’s view, investment advisers must affirmatively disclose that they have a conflict of interest when selecting or recommending mutual fund share classes that pay 12b-1 fees if there are share classes of the same fund available to their clients that do not. The Announcement states that investment advisers must clearly describe the conflicts of interest associated with (1) making investment decisions in light of the receipt of 12b-1 fees, and (2) selecting the more expensive 12b-1 fee paying share class when a lower-cost share class is available for the same fund.
As the Announcement indicates, however, the more equivocal “may create” disclosure language is common. Thus, the Division is providing investment advisers with an opportunity to self-report this type of past disclosure failure, if certain conditions are met.
Only “Self-Reporting Advisers” may take advantage of the Initiative. The Announcement defines a “Self-Reporting Adviser” as an adviser that (i) received 12b-1 fees in connection with recommending, purchasing, or holding 12b-1 paying share classes for its advisory clients when a lower-cost share class of the same fund was available to those clients, and (ii) failed to disclose explicitly in its Form ADV the conflicts of interest associated with the receipt of such fees. An investment adviser is deemed to have “received” 12b-1 fees if it directly received the fees, its supervised persons received the fees, or its affiliated broker-dealer (or its registered representatives) received the fees. Investment advisers that have already been contacted by the Division for possible violations as of the February 12, 2018, Announcement date, however, are not eligible to self-report under the Initiative.
Investment advisers that want to self-report under the Initiative must notify the Division (by e-mail or regular mail) no later than 12:00am EST on June 12, 2018. After notifying the Division, investment advisers have ten business days to submit a completed Questionnaire (part 1 and part 2) that provides the following information:
- Identification and contact information for the investment adviser and the investment adviser’s affiliated broker-dealer, if applicable;
- Information to assist the SEC staff in understanding why the investment adviser did not disclose the applicable conflicts of interest in its Form ADV, and identification of any other disclosure documents that, in the opinion of the investment adviser, contain adequate conflicts disclosure;
- Information related to the 12b-1 fees received in excess of the lower-cost share class for the period from January 1, 2014, through the date the disclosure failure was corrected; and
- A statement that the investment adviser intends to consent to the Initiative’s settlement terms.
In exchange for self-reporting under the Initiative, the Division will recommend that the SEC accept favorable settlement terms for the investment adviser with respect to its disclosure failures. Under these terms:
- The investment adviser must consent to the institution of an administrative and cease-and-desist proceeding in which the adviser neither admits nor denies the SEC’s findings.
- The settlement will include an order to cease and desist from committing or causing any violations (and future violations) of Sections 206(2) and 207 of the Advisers Act, and a censure.
- The investment adviser must disgorge its “ill-gotten gains,” plus prejudgment interest, and must distribute the excess 12b-1 fees and interest to affected clients.
- Within 30 days of the settlement the investment adviser must:
- Review and correct (as necessary) the relevant disclosure documents;
- Evaluate whether existing clients should be moved to a lower-cost share class, and move clients, as necessary;
- Evaluate and update (as needed) policies and procedures to ensure that they are reasonably designed and effectively implemented to prevent disclosure failures in connection with mutual fund share class selections and recommendations;
- Notify clients of the settlement terms in a clear and conspicuous manner; and
- Certify to the SEC staff that the applicable steps have been taken no later than 10 days after completion of those steps.
- The Division will recommend that the SEC not impose civil penalties.
Consequences of Not Self-Reporting
If an investment adviser is found by the Division to have disclosure failures that the adviser could have self-reported under the Initiative, but failed to do so, the Division will likely impose greater penalties than those applied in past cases. Thus, investment advisers who qualify should consider taking advantage of the Initiative while it is available.