In our October 2019 update, we discussed how the staff of the U.S. Securities and Exchange Commission (SEC) has remained sharply focused in recent years on the conflicts of interest related to investment advisers’ selection of mutual fund share classes for their clients, the types of fees charged to mutual fund shareholders, and the revenue sharing practices of mutual fund advisers and their affiliates. This trend has not decelerated, and indeed the scope of the SEC’s allegations has expanded, since last fall.

In January, the SEC’s Office of Compliance Inspections and Examinations (OCIE) in its 2020 National Examination Program Priorities highlighted enforcement actions discussed in our previous update and explicitly reasserted its intention to maintain focus on, among other things:

• Financial incentives that may influence investment advisers’ selection of mutual fund share classes for their clients, in particular the fees paid by certain fund share classes through a distribution plan adopted by the fund board pursuant to Rule 12b-1 under the Investment Company Act of 1940 (the 1940 Act) (Rule 12b-1 fees).
• Conflicts of interest associated with mutual fund fees and expenses and undisclosed, or inadequately disclosed, compensation arrangements.[1]
• Investment advisers’ compliance with their fiduciary duties and whether they provide advice in the best interests of their clients and eliminate, or at least mitigate through full and fair disclosure, all conflicts of interest which might incline the adviser to provide conflicted advice.

The publication of OCIE’s priorities was quickly followed by related enforcement actions. Several industry groups responded by criticizing the SEC’s enforcement actions in a petition requesting that the SEC initiate a rulemaking process to establish regulatory certainty regarding the continued use of fund share classes with Rule 12b-1 fees. 

As operational and market volatility issues arising from the COVID‑19 pandemic are rightly occupying much of the asset management industry’s bandwidth, this update serves as a reminder for investment advisers and mutual fund boards of the SEC’s continued enforcement around advisers’ share class selection and related practices. This enforcement continues to raise questions about the future of Rule 12b-1 fees and advisers’ revenue sharing and other compensation arrangements.

Background

As discussed in our previous update, the SEC’s adoption of Rule 12b-1 in 1980 was a compromise solution that permitted the use of mutual fund shareholder assets for fund distribution expenses. In the years following its adoption, Rule 12b-1 generated no small amount of controversy as the mutual fund industry and regulators debated the types of services that are, directly or indirectly, “primarily intended to result in the sale of fund shares.”

• Amendments were proposed to Rule 12b-1 in 1988 reflecting SEC concerns that industry practices (1) undermined the role of independent trustees in overseeing Rule 12b-1 plans, (2) did not adequately mitigate or disclose conflicts of interest associated with payment of Rule 12b‑1 plan fees to affiliated broker/dealers, and (3) did not provide sufficient disclosure about the nature of Rule 12b-1 fees and their impact on fund returns.[2]
• The SEC’s adoption of Rule 18f-3 under the 1940 Act in 1995 permitted differing fees and expenses for different fund share classes and led to the emergence of today’s familiar Class A, B, and C retail share classes and their differing expense ratios (with the now largely retired Class B shares typically carrying the highest Rule 12b-1 fees).[3]
• In 2016, the U.S. Department of Labor released a fiduciary rule proposal that moved the industry away from Rule 12b-1 fee share classes and towards lower cost “clean” shares, and OCIE gave notice of its Share Class Initiative sweep exam focused on advisers’ conflicts of interest disclosure and compliance with fiduciary duties around share class recommendations.[4]
• In 2018, the SEC’s Division of Enforcement Asset Management Unit announced its Share Class Selection Amnesty Initiative (the Amnesty Program) that was informed by OCIE’s Share Class Initiative and offered standardized, favorable settlement terms to eligible advisers that reported by June 2018 their “improper selection” of mutual fund share classes with Rule 12b-1 fees for clients when lower‑cost share classes were available to those clients. Shortly thereafter, the SEC began to institute the series of litigation and enforcement actions detailed in our October 2019 update.

Enforcement in 2020

The enforcement settlements in this arena announced by the SEC so far this year illustrate both the consistency and expansion—beyond the mere conflicted selection of Rule 12b-1 fee share classes—of the SEC’s enforcement claims.  

• Conflicts and Consent. On February 13, 2020, the SEC released a settlement order with an affiliated investment adviser and broker-dealer on charges of insufficient disclosure regarding the conflicts of interest associated with recommendations of share classes with Rule 12b-1 fees to clients when lower-cost classes were available for which the clients were eligible. Settled outside of the SEC’s now-closed Amnesty Program that the firm declined to participate in, the SEC charged the firm with approximately $900,000 in fines and penalties. Of note, the language of the enforcement order echoes that of the SEC’s 2019 Interpretation Regarding Standard of Conduct for Investment Advisers, stating that where the firm received Rule 12b-1 fees “that it would not have collected had its advisory clients been invested in the available lower-cost share classes,” to meet its fiduciary obligation the firm “was required to provide its advisory clients with full and fair disclosure that is sufficiently specific so that they could understand the conflicts of interest concerning [the firm’s] advice about investing in different classes of mutual funds and could have an informed basis on which they could consent to or reject the conflicts.”
• Compliance Programs and Statutory Fraud. On April 17, 2020, the SEC announced settlements with three well-known asset management firms that self-reported recommending to clients, without sufficient conflicts of interest disclosure, mutual fund share classes with Rule 12b-1 fees when lower cost classes were available to clients. In all three instances, the SEC alleged violations of the anti-fraud provisions of Section 206(2) of the Investment Advisers Act of 1940 (the Advisers Act). One of the firms self-reported soon after the close of the SEC’s Amnesty Program and the other two self-reported during the Amnesty Program. Alleging violations of the compliance program requirements of Rule 206(4)-7 under the Advisers Act in addition to statutory anti-fraud violations, the SEC required the first firm to pay a civil penalty on top of disgorgement and prejudgment interest. The SEC required the second and third firms to pay disgorgement and prejudgment interest without any civil penalty.

  On May 29, 2020, the SEC settled an enforcement action with an investment adviser for breaches of fiduciary duty in connection with allegedly inadequate disclosure of the firm’s mutual fund share class selection practices. The SEC claimed that the firm held mutual fund share classes for its advisory clients that charged Rule 12b-1 fees instead of lower-cost share classes of the same funds that were available to the clients. Also, according to the SEC, the firm’s investment adviser representatives, as representatives of an affiliated broker-dealer, received Rule 12b-1 fees in connection with these investments, and the firm did not adequately disclose this conflict of interest in its Form ADV or otherwise. Again, the SEC found that based on the alleged facts, the firm had violated both the anti-fraud provisions of the Advisers Act and failed to adopt and implement suitable policies and procedures as required by the Advisers Act. Noting that the firm did not self-report to the SEC pursuant to the Share Class Selection Disclosure Initiative, the SEC imposed disgorgement, prejudgment interest, and a civil monetary penalty.

• Sales Loads and Securities Fraud. On April 24, 2020, an investment adviser, broker-dealer, and municipal advisor settled with the SEC for the firm’s alleged failure to disclose conflicts of interest related to share class selection practices that resulted in approximately 4,500 customer accounts being overcharged. According to the SEC, over a four-year period the firm recommended purchases of share classes with front-end or deferred sales loads in addition to ongoing Rule 12b-1 fees, despite the fact that many clients were eligible for either load-waived or no-load share classes. The SEC noted that the firm “did not have adequate systems and controls in place” to determine whether its retirement plans and charitable account customers were eligible for the no-load share classes. Significantly, the SEC claimed that the firm engaged in this practice without disclosing that the loads would result in greater compensation for the firm and negatively impact overall investor returns. Here, the SEC also charged the firm with violations Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, which prohibit materially misleading statements and omissions that operate a fraud or deceit in connections with securities offerings.
• Best Execution. On May 13, 2020, the SEC charged a registered investment adviser and its principals for breaching their fiduciary duty to investors as a result of the firm’s mutual fund share class selection practices. According to the SEC’s complaint, filed in the Eastern District of Pennsylvania, the adviser routinely invested its clients in mutual fund share classes with Rule 12b-1 fees when lower-cost mutual fund share classes were available, and continued to hold such investments in clients’ accounts even after they were eligible to convert to share classes without Rule 12b-1 fees. The Rule 12b-1 fees, the SEC said, were passed on to the adviser’s principals as additional compensation in their capacity as registered representatives of the affiliated broker-dealer that facilitated the transactions. This dynamic, according to the SEC, reduced investors’ returns and caused the adviser and its principals to breach their fiduciary duty to seek best execution for client transactions. Noting that the adviser could have disclosed to investors that best execution would not be sought for purchases of mutual funds with multiple available share classes, the SEC alleged that the firm’s conflicts of interest disclosures were insufficient because they failed to disclose (1) that the adviser’s principals routinely and continually received Rule 12b-1 fees, (3) the amount of the Rule 12b-1 fee revenue that the principals received, and (3) that the adviser’s share class selection practices would generally reduce investors’ overall return in comparison to share classes of the same mutual funds without Rule 12b-1 fees. In a familiar refrain, the SEC states in the complaint that “a reasonable advisory client would consider the omitted information as significant in order for clients to provide informed consent to the conflicts of interest…significantly altering the total mix of information made available.” The SEC also alleged that the adviser failed to adopt and implement written policies and procedures designed to ensure it was seeking best execution and providing full and fair disclosure of its conflicts of interest. The complaint seeks permanent injunctions, disgorgement of ill-gotten gains, prejudgment interest, and civil penalties.
• Wrap Programs. On July 28, 2020, the SEC settled an enforcement action with an investment adviser for, among other things, alleged fiduciary duty breaches in connection with disclosure of the firm’s mutual fund share class selection practices. Through its wrap program, the firm directly recommended to its clients portfolio models managed by third-party investment advisers. The SEC alleged that the firm recommended to its clients, and directed its primary third-party sub-adviser to steer clients towards, mutual funds offered through the adviser’s clearing broker’s no-transaction fee program, when lower cost funds and share classes were available to the clients. The overall arrangement allegedly benefitted the adviser because its agreement with the clearing broker resulted in the adviser (1) receiving revenue sharing and Rule 12b-1 fee payments, (2) not having to cover the execution costs, which it charged to clients as part of the management fee, of investments made through the clearing broker’s no-transaction fee program. The SEC alleged that the firm not only failed to fully and fairly disclose these conflicts and relationships to its clients, but disclosed them in a false and misleading manner. In addition, the SEC claimed that the firm failed to adopt and implement adequate policies and procedures as required by Rule 206(4)-7 under the Advisers Act and found that the firm had violated the anti-fraud provisions of the Advisers Act. Noting that the adviser did not self-report to the SEC pursuant to the Share Class Selection Disclosure Initiative, the SEC censured the firm and imposed disgorgement, prejudgment interest, and a civil monetary penalty totaling over $20 million.
• Benefits to Affiliates. On August 13, 2020, citing facts similar to those of previous share class selection enforcement actions, the SEC settled with an investment adviser that was alleged to have purchased, recommended, or held for advisory clients mutual fund share classes that charged Rule 12b-1 fees instead of lower-cost share classes of the same funds for which the clients were eligible. According to the SEC, without appropriate disclosure, the adviser’s affiliated broker-dealer received the Rule 12b-1 fees and the adviser purchased or recommended for advisory clients cash sweep money market funds for which the affiliated broker-dealer received revenue sharing payments from its clearing broker. The firm did not self-report to the SEC, and the SEC imposed disgorgement, prejudgment interest, and a civil monetary penalty.

Conclusion

While the industry awaits more formal guidance from the SEC and its staff regarding the regulatory bounds of the revenue sharing arrangements, Rule 12b-1 fees, sales loads, and other compensation arrangements, the SEC’s enforcement staff has continued to implement its articulated priorities one enforcement proceeding at a time. With no signs of this pressure lifting, advisers and their affiliated broker-dealers should holistically review their firms’ financial arrangements around mutual funds, and advisers, broker-dealers, and funds should review their compliance programs and disclosures to ensure that conflicts of interest related to all practices are fully and fairly disclosed.  

Please contact experienced securities regulatory counsel with any questions about these developments and how they might apply to you or your business.

Endnotes

[1] In its 2020 examination priorities, OCIE encourages firms to “make investors whole when fees have been improperly calculated and charged” and explains that “fee and compensation-based conflicts of interest may take many forms, including revenue sharing arrangements between a registered firm and issuers, service providers, and others, and direct or indirect compensation to advisory personnel for executing client transactions. In addition, duty of care concerns may arise when an [investment adviser] does not aggregate certain accounts for purposes of calculating fee discounts in accordance with its disclosures. These potential breaches of fiduciary duty may adversely impact portfolio management costs, reduce investor returns, and inappropriately influence investment decision-making.” OCIE also notes that more than $70 million in such fees had been returned to investors during the SEC’s 2019 fiscal year and that OCIE would continue referring matters as appropriate to the SEC’s Division of Enforcement. See also Speech, Peter Driscoll, Director, OCIE, “How we protect retail investors” (Apr. 29, 2019).

[2] Gwendolyn A. Williamson, Classes and Conflicts: What’s Next for Fund Distribution Arrangements?, The Investment Lawyer, Vol. 27, No. 3 (Mar. 2020) available at https://www.perkinscoie.com/images/content/2/3/232370/Classes-and-Conflicts-What-s-Next-for-Fund-Distribution-Arrang.pdf.

[3] Id. See also, Gwendolyn A. Williamson, Will 12b-1 Fees Cave Under Pressure? and Related Questions in a Time of Change, The Investment Lawyer, Vol. 25, No. 9 (Sept. 2018) available at https://www.perkinscoie.com/images/content/2/3/236386/IL-0918-Williamson.pdf.

 [4] Id.

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