Over the past several years, U.S. Securities and Exchange Commission (SEC) enforcement activity has eroded the stability of the once-standard lineup of share classes available to mutual fund investors.[1] Starting with investment advisers’ share class selection practices and turning to the related issues of revenue sharing arrangements and conflicts of interest disclosure, the SEC’s enforcement proceedings have at their core focused on advisers’ compliance with their fiduciary duties. They illustrate arrangements and practices that advisers should avoid and mutual fund trustees should be aware of in overseeing fund service providers and distribution-related issues. It is useful to keep in mind that these actions come only in the present moment of a decades-long regulatory debate across the federal government about the allocation of mutual fund distribution costs, protection of retirement and other retail shareholders, and investment adviser responsibilities, especially where affiliated broker-dealers are involved.

After providing a bit of background, this update summarizes SEC enforcement actions, including litigation, settlements and recent staff guidance (with FAQs) published over the past few months that illustrate the regulatory mousetrap that investment advisers and broker-dealers face today. These actions come after the SEC adopted its June 5, 2019, rulemaking package that included a new interpretation of advisers’ fiduciary duties under the Investment Advisers Act of 1940 (Advisers Act) and a new “best interest” standard for broker-dealers. The activities at issue in the cases from this fall predate the SEC’s June rulemaking package and the staff’s recent guidance, but in many instances the language used by SEC staff echoes that of the fiduciary interpretation established this summer.[2]

Background: Problems With Distribution and Shareholder Service Fees

Since the SEC adopted Rule 12b-1 under the Investment Company Act of 1940 (Rule 12b-1) in 1980 after lengthy back and forth among regulators about the appropriateness of mutual fund shareholder assets being used for sales loads and commissions,[3] SEC staff have keenly focused on the propriety of fund assets being used for distribution costs under Rule 12b-1 plans adopted by fund boards of trustees.

In 1998, the staff released the “fund supermarket” no-action letter that identified certain “services” mutual fund boards should consider to be “primarily intended to result in the sale of fund shares,” such that fund assets could be used, directly or indirectly, to cover the cost of those services only through 12b-1 fees paid under a board-approved plan. Concerns that fund assets were being used to cover shelf space and other distribution costs outside of Rule 12b-1 plans prompted calls for reform and the release of proposed Rule 12b-2 in 2010.[4] After the proposed rule died on the vine as the industry balked, in 2013, the SEC staff introduced its “distribution in guise” initiative and began actively searching for distribution-related payments made by funds to ostensibly cover the costs of shareholder services such as sub-transfer agency, sub-accounting and recordkeeping services. The staff’s guidance on distribution in guise was released in early 2016.

Pressure on the status quo “12b-1 fee” model—fund groups typically offered class A, B and C shares, and perhaps also a retirement class, carrying 12b-1 fees of varying amounts—increased in 2016 as lower-cost mutual fund shares (sans 12b-1 fees) began to proliferate due to market forces including the preference for lower cost, passively managed funds and the almost complete transition from direct-at-fund to omnibus sub-accounting in which beneficial fund shareholders invest through omnibus accounts offered by affiliated and third-party financial intermediaries.[5] The current model—where no-load or load-waived share classes without 12b-1 fees are ubiquitous and favored by regulators and retail and institutional investors alike—was also heavily influenced by the fund industry’s response to the once-looming compliance date of the now-defunct U.S. Department of Labor fiduciary rule.[6]

In July 2016, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert, “OCIE’s 2016 Share Class Initiative,” giving notice of a sweep exam focused on advisers’ conflicts disclosure and compliance with fiduciary duties around share class recommendations in “situations where the adviser is also a broker-dealer or affiliated with a broker-dealer that receives fees from sales of certain share classes, and situations where the adviser recommends that clients purchase more expensive share classes of funds for which an affiliate of the adviser receives more fees.” Then, in February 2018, the SEC’s Division of Enforcement launched a Share Class Selection Amnesty Initiative (the Amnesty Initiative) that offered standardized, favorable settlement terms (without civil penalties) to eligible advisers that self-reported improper selection of fund share classes with 12b-1 fees when lower-cost share classes were available to the clients by June of that year. Over a year later, on March 11, 2019, the SEC instituted actions against 79 investment advisers participating in the Amnesty Initiative, ordering payment of more than $125 million in disgorgement and interest to investors.

Fall 2019: Enforcement Regarding 12b-1 Fees, Revenue Sharing and Disclosure

On September 30, 2019, the SEC announced that it had entered into enforcement settlements with 17 additional advisers arising under the Amnesty Initiative and ordered them to repay nearly $10 million in disgorgement to investors. The SEC also charged two advisers that did not self-report and penalized each with a $300,000 civil penalty in addition to disgorgement and interest. A representative example of these enforcement orders underscores the intensity of the pressure on the 12b-1 fee framework: in alleging that the adviser violated its fiduciary duties, the SEC simply points to evidence that the adviser “purchased, recommended, or held for advisory clients mutual fund share classes that charged 12b-1 fees instead of lower-cost share classes of the same funds for which the clients were eligible” and “failed to disclose in its Form ADV or otherwise the conflicts of interest related to (a) its receipt of 12b-1 fees, and/or (b) its selection of mutual fund share classes that pay such fees.”

Another group of recently announced enforcement actions and settlements concerns the adequacy of advisers’ disclosure regarding the conflicts of interest that the SEC has asserted are typically associated with investment advisers’ recommendation of mutual fund share classes with 12b-1 fees and advisers’ revenue sharing arrangements with affiliated and third-party intermediaries. Importantly, the SEC has also asserted that, without disclosure enabling investors to give informed consent to the conflict, an adviser’s selection of a more expensive share class (with 12b-1 fees) for a client when an less expensive class is available violates its fiduciary duty to seek best execution for client trades.

• On August 1, 2019, the SEC charged a dual-registered investment adviser and broker-dealer with failing to disclose material conflicts regarding revenue sharing received for investing clients in certain share classes of certain mutual funds. The adviser allegedly had a revenue-sharing agreement with an unaffiliated broker through which, when the adviser purchased or sold certain “no-transaction-fee” fund shares for its clients, the client did not pay upfront transaction fees but did pay ongoing 12b-1 fees to the unaffiliated broker-dealer, who would then share a portion of those payments with the defendant.
  
  According to the SEC’s complaint, this revenue-sharing arrangement created a number of differing financial incentives for the adviser when recommending mutual funds to its advisory clients, including that some fund share classes were less expensive than those that generated revenue sharing payments for the adviser. In addition, the SEC asserted that the adviser had a disincentive to recommend certain mutual funds available to its advisory clients that were not covered by a revenue sharing arrangement. The SEC alleged that the adviser breached its fiduciary duty under Section 206 of the Advisers Act by failing to disclose these differing financial incentives. More appropriate disclosure would make clear that even “no-transaction-fee” share classes could generate ongoing revenue sharing payments to the adviser and that less expensive share classes were sometimes available.
  
  The adviser’s response to the SEC’s complaint, filed on September 30, 2019, perhaps gives voice to the negative response that some had to the language of the SEC’s suit, arguing that while the SEC’s assertion that the adviser “had an obligation to make specific disclosures as to particular aspects of its revenue sharing” is premised on violations of applicable law, the SEC has not formally addressed revenue sharing disclosure and that to attempt to “retroactively impose uncabined duties” through litigation, among other things, violates the due process that advisers should be afforded. The court’s ultimate resolution of these issues will be instructive, but will not establish binding precedent for or against the SEC’s position on revenue sharing, absent years of potential appeals and further litigation.

• In a separate suit filed on August 29, 2019, the SEC alleged that an adviser breached its fiduciary duty to clients when it, without any disclosure regarding the associated conflicts of interest: (1) selected and held for advisory clients mutual fund share classes with 12b-1 fees when lower-cost, share classes of the same fund were available; (2) funneled clients towards certain funds with respect to which it would receive revenue sharing from a broker-dealer, despite the availability of other funds; (3) collected service fees shared by the broker-dealer, which incentivized the adviser to funnel clients towards funds that paid these fees to the broker-dealer; and (4) directed the broker-dealer to mark up certain non-transaction-fees charged to the adviser’s clients by up to 300%, which were then paid from the broker-dealer back to the adviser.
• On September 19, 2019, the SEC settled with an adviser that allegedly failed to disclose multiple conflicts related to mutual fund share class selection and the receipt of revenue-sharing payments. As stated in the SEC’s order, the adviser violated its fiduciary duties by failing (1) to disclose the inherent conflict in recommending mutual fund share classes with 12b-1 fees where the adviser and/or its affiliates receive an asset-based portion of the fee from the clearing broker and lower-cost share classes of the same funds without 12b-1 fees were available to the clients and (2) seek best execution for clients by selecting the 12b-1 fee share class for clients.
• Once again, on September 27, 2019, the SEC settled with two advisers that were alleged to have consistently selected for clients higher-cost, retail share classes with 12b-1 fees when lower-cost institutional share classes of the same funds were available to those clients. The clients’ payment of 12b-1 fees, according to the SEC, permitted one of the advisers to receive revenue sharing payments from its clearing broker and permitted the other adviser to avoid paying transaction fees to the broker. The SEC again found that, without appropriate disclosure, the adviser’s selection of the 12b-1 shares classes and avoidance of the transaction fees violated its fiduciary duty to seek best execution for clients.

October 2019: SEC Staff Guidance and FAQs on 12b-1 Fees/Share Class Selection, Revenue Sharing and Disclosure

On October 18, 2019, the staff of the SEC’s Division of Investment Management released a set of FAQs and commentary touching directly upon the potential financial conflict and disclosure issues discussed above that advisers may face. While carrying the standard disclaimer that the FAQs represent the views of the staff of the Division of Investment Management only, the informal guidance and FAQs largely mirror the Rule 12b-1, share class selection, revenue sharing and disclosure issues, including the issues triggering the wave of enforcement in fall 2019, brought forward by OCIE, the Division of Enforcement and SEC discussed above. The FAQs and commentary further suggest that the SEC and its staff view the framework established by the above-referenced enforcement as a restatement of current law rather than a new set of obligations.

Conclusion

The SEC’s attention to 12b-1 fees over the past 40-plus years and its more recent initiatives, enforcement activities and FAQs suggest that the SEC will continue to closely scrutinize advisers’ share class selection and recommendation practices at least for the foreseeable future. This persistent eye of the regulator, combined with the other market forces, gives advisers a strong incentive to avoid 12b-1 share classes and revenue sharing arrangements altogether. But what will drive profitability? The relative ease by which the SEC staff can identify share class related conflicts of interest and assert fiduciary duty violations, coupled with advisers’ and funds’ struggle to survive in a disrupted and evolving industry, makes this a compliance issue of primary importance to advisers and mutual fund boards.

Endnotes

[1] The following three settlement orders from late December 2018 regarding allegations that without adequate disclosure, and inconsistent with the obligation to seek best execution under Section 206 of the Advisers Act, advisers placed clients in mutual fund share classes with 12b-1 fees when less expensive share classes of the same funds were available, are illustrative of the cases settled with the SEC at that time: Inv. Adv. Act Rel. No. 5083; Inv. Adv. Act Rel. No. 5084; Inv. Adv. Act Rel. No. 5090.

[2] SEC Chairman Jay Clayton has defended the fiduciary rulemaking, emphasizing that the fiduciary interpretation for investment advisers is consistent with the U.S. Supreme Court’s decision in SEC v. Capital Gains and merely reaffirms the existing fiduciary standard under the Advisers Act.

[3] It was at an SEC hearing in 1976 that it was suggested that increased sales of mutual fund shares could benefit shareholders, making it appropriate for fund shareholders to bear distribution costs at least under certain circumstances.

[4] The articulated purpose of the reform was to “protect individual investors from paying disproportionate amounts of sales charges in certain share classes, promote investor understanding of fees, eliminate outdated requirements, provide a more appropriate role for fund directors, and allow greater competition among funds and intermediaries in setting sales loads and distribution fees generally.” It would have generally required any fund with annual 12b-1 fees greater than 0.25% to rework its expense ratio.

[5] Industry data shows that at the end of 2018, approximately 77% of actively-managed mutual fund shareholders were invested in share classes without 12b-1 fees, up almost 10% from 2014.

[6] More recently, firms have been reevaluating 12b-1 fees on certain share classes—typically class A shares—in response to the Share Class Initiative, with one firm announcing reductions or full cuts to 12b-1 fees on over $8 billion in bond fund assets in class A and “service” share classes in early October 2019.

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