The Securities and Exchange Commission announced on March 11, 2019 that it had settled charges against 79 investment advisers in connection with its Share Class Selection Disclosure Initiative (SCSD Initiative).1 This initiative was an enforcement program offering standardized settlement terms for investment advisers that self-report circumstances in which they did not adequately disclose certain conflicts of interest relating to the sale of more expensive mutual fund share classes when lower-cost share classes of the same fund were available. According to the SEC, the self-reporting advisers, some of whom were dually registered as broker-dealers, did not adequately disclose either their receipt of 12b-1 fees2 or “additional compensation received for investing clients in a fund’s 12b-1 fee paying share class when a lower-cost share class was available for the same fund.” Per the terms of settlements under the SCSD Initiative, self-reporting advisers were found to have violated Section 206(2)3 and, except for advisers registered with a state and not the SEC, Section 2074 of the Investment Advisers Act of 1940.
Background
The SEC’s Division of Enforcement (Division) announced the SCSD Initiative in February 2018, citing a “significant” concern that advisers across the industry were not fully disclosing all material conflicts of interest relating to mutual fund share class selection practices in a manner consistent with their obligations as fiduciaries under the Advisers Act.
In announcing the SCSD Initiative, the Division asserted that Section 206(2) imposes an affirmative duty on advisers to disclose material conflicts of interest to their clients.5 The Division explained that such a conflict of interest may arise where an adviser invests client funds, or recommends that clients invest, in a 12b-1 fee-paying mutual fund share class when a lower-cost share class of the same fund is available. The Division added that, as among multiple share classes in the same fund (and thus the same portfolio of securities), “it is usually in the client's best interest to invest in the lower-cost share class.” According to the Division, whether an adviser receives compensation in the form of 12b-1 fees, directly or indirectly, amounts to a material fact that needs to be disclosed explicitly in the adviser’s Form ADV.6
The SEC had brought a number of enforcement actions involving this type of disclosure concern in the several years preceding the SCSD Initiative. Dating back to October 2013, these enforcement actions involved allegations of advisers either (i) not making disclosure regarding the conflicts of interest arising from their share class selection practices or (ii) making selective, inadequate disclosures that generally suggested a potential conflict of interest, without explicitly notifying clients of existing conflicts of interest. In addition to these cases, the SEC also articulated its view of an adviser’s disclosure obligations in this area through a 2016 OCIE Risk Alert.7 In the view of the Division, these developments placed the investment advisory industry on notice about the issues and principles raised by the SCSD Initiative.
Led by the Division’s Asset Management Unit, the SCSD Initiative sought to address the issue of undisclosed conflicts of interest on an industry-wide basis by offering to recommend standardized terms of settlement as an incentive for advisers to self-report. As part of the SCSD Initiative, the Division indicated that it would recommend that the SEC accept settlements in which the self-reporting adviser would be required to disgorge ill-gotten gains and pay prejudgment interest, but would face no civil monetary penalty. Additionally, the standardized terms of settlement would not require a self-reporting adviser to admit or deny the SEC’s findings, nor would they include charges of failure to seek best execution or violations of policies and procedures. However, the standardized terms of settlement would require the self-reporting adviser to make certain undertakings with respect to its share class selection practices and to review and correct its disclosure documents.
By contrast, the Division warned advisers that it would recommend more severe sanctions, including civil monetary penalties, in future enforcement actions against advisers that did not self-report when they were eligible to do so. The SCSD Initiative also offered no assurances with respect to individual liability. In the interest of helping advisers determine whether they were eligible to participate in this self-reporting initiative, the Division issued responses to certain frequently asked questions in May 2018, covering topics such as the scope of conduct to which the SCSD Initiative would apply and how to properly calculate disgorgement, as well as providing examples of circumstances in which a lower-cost share class would be deemed to have been available.8
Industry Commentary
On December 21, 2018, both the American Securities Association (ASA) and the Securities Industry and Financial Markets Association (SIFMA) submitted comment letters challenging the SCSD Initiative.9 The ASA’s letter to the SEC’s Commissioners10 and SIFMA’s letter to the Division11 each contended that the SEC had provided insufficient notice to advisers as to the scope of their disclosure obligations in the share class selection disclosure context, and that the standard set forth under the SCSD Initiative amounted to “regulation by enforcement.” According to the ASA and SIFMA, even though the SEC brought some related enforcement actions in this area in the several preceding years, and similarly articulated its position in the 2016 OCIE risk alert, the SEC’s underlying interpretation of an adviser’s disclosure obligations in the context of share class selection had not been subjected to the traditional administrative process. Thus, the ASA and SIFMA maintained, this left unaddressed significant operational questions as to how advisers should bring their practices into compliance. The letters discuss the logistical challenges advisers would face if the principles of the SCSD Initiative were broadly enforced with regard to mutual fund share class disclosure. These included: (i) considering investor eligibility for new mutual fund share classes as soon as they have been added to a fund’s prospectus (i.e., ongoing monitoring requirements, changes to existing eligibility criteria); (ii) negotiating selling agreements; (iii) disclosing share class selection practices in Form ADV (i.e., placement of disclosure); and (iv) disclosing share class selection where a third-party manager (rather than the current adviser) selected the share class.
Results
As part of the settled charges, the self-reporting advisers agreed, without admitting or denying the SEC’s findings, to return, in the aggregate, more than $125 million12 to their respective affected advisory clients and to undertake certain remedial actions concerning their relevant disclosure documents. The terms of the actual settlements were consistent with the framework of standardized settlement terms set forth in the SCSD Initiative.
In announcing these settlements, the SEC reiterated its view of advisers’ obligations to disclose conflicts of interest that arise in connection with advisers’ receipt of 12b-1 fees. SEC Chairman Jay Clayton emphasized that, “[r]egardless of the scope and duration of the investment advisory services, investment advisers are fiduciaries and, as such, their duties of care and loyalty require them to disclose their conflicts of interest, including financial incentives.” Division leadership also noted that most of the advisory clients affected by the alleged disclosure failures were retail investors, with Division Co-Director Stephanie Avakian explaining that “[a]n adviser’s failure to disclose these types of financial conflicts of interest harms retail investors by unfairly exposing them to fees that chip away at the value of their investments.”
Implications
The SEC Staff continues to evaluate self-reports received prior to the June 12, 2018 self-reporting deadline. Whether the standardized terms of settlement offered under the SCSD Initiative ultimately will be viewed as favorable will depend in large part upon how the SEC treats advisers that did not self-report.
It also is not clear if the SCSD Initiative will accelerate the trend toward the direct charging of service fees to clients rather than receiving indirect payments from funds in which those clients invest. Advisers may decide that even reasonable disclosures about conflicts of interest associated with their receipt of 12b-1 fees leave open the risk of enforcement action, and that the associated regulatory burdens (such as those outlined by the ASA and SIFMA) outweigh any potential benefits, and instead choose to charge service fees directly.
The program also may have an impact on the broader SEC enforcement program. After years of criticism that the benefits of self-reporting to the Division were illusory, the perceived success of the initiative may make it more likely the Division will consider offering standardized settlement terms for registrants that self-report in other circumstances.
