In recent years, the Office of Compliance Inspections and Examinations (“OCIE”) of the Security and Exchange Commission (“Commission”) has increasingly scrutinized share class selection by registered advisors. A share class recommendation must comport with the requirements of Section 206 of the Investment Advisors Act of 1940 (“Advisers Act”) to act in the client’s best interest and to seek best execution for client transactions. Consistent with its 2016 examination priority to protect retail investors, OCIE launched its 2016 Share Class Initiative to examine registered advisors’ practices related to share class recommendations and compliance oversight of the process. Protecting retail investors continued to be a priority for OCIE in 2017 and share class selection appeared on its list of exam priorities for 2017 as well. Specifically, OCIE is concerned with conflicts of interest and other factors that may affect an advisor’s recommendation to invest, or remain invested, in particular mutual fund and 529 plan share classes. For example, OCIE seeks to identify conflicts of advisors who are also registered representatives of a broker-dealer which may influence recommendations in favor of share classes that have higher loads or distribution fees. During an exam on this topic, OCIE has focused on disclosures and compliance policies and procedures in addition to the fiduciary duty to act in the client’s best interest and to seek best execution.
This area has been the subject of two recent enforcement actions by the Commission, both in September 2017. In the first, the Commission issued a cease and desist order against registered investment advisor Envoy Advisory, Inc. (“Envoy”) on September 8. From January 2013 through March 2017, the Commission concluded that Envoy recommended to plans and IRA owners Class A mutual fund shares when less expensive share classes of the same mutual funds were available. During that time, Envoy’s affiliate received approximately $24,800 in 12b-1 fees. Envoy’s Form ADV did disclose the payment of 12b-1 fees, but failed to specify that such payments were received by its affiliate, instead saying they were paid to a “dealer”. The Commission found that Envoy failed to offer the least expensive mutual fund share class available and failed to properly disclose the practice. Envoy agreed to the disgorgement of the amounts improperly received.
On September 14, 2017, the Commission charged a subsidiary of SunTrust Banks with collecting more than $1.1 million in avoidable fees from clients for improperly recommending more expensive share classes of a variety of mutual funds when cheaper shares of the same funds were available. This practice affected more than 4,500 accounts. The Commission’s order states that SunTrust violated sections 206(2), 206(4) and 204 of the Adviser’s Act and Rule 206(4)-7. SunTrust agreed to pay a penalty in the amount of $1,148,071.01, disgorgement of the fees plus interest, and to be censured.
Takeaways
In light of its recent enforcement actions and the fact that exam priorities do not change substantially from year to year, we believe share class selection is likely to remain an enforcement focus for the Commission in 2018. We expect the Commission to release its 2018 exam priorities soon.
The Financial Industry Regulatory Authority (“FINRA”), has specifically identified share class selection as a priority in its recently released 2018 Annual Regulatory and Examination Priorities Letter (“Letter”). With respect to FINRA’s suitability requirement, the Letter states that “FINRA will review firms’ handling of products where FINRA has observed firms experiencing problems implementing effective controls, such as firms’ handling of…multi-share products as addressed in the Examination Findings Report…” The Examination Findings Report (“Report”) was issued in December 2017, and was the topic of our Alert, which can be read here. The Report stated that FINRA found that some firms failed to meet their suitability obligations with respect toindividual customers when recommending multi-share class products. For example,FINRA observed situations where firms recommended a higher-fee share class withouta reasonable basis to believe that the recommendation was suitable.
Therefore, member firms — dually-registered firms, in particular — should be mindful of their disclosures and that their compliance programs are designed to prevent and remediate violations of best interest, best execution and other rules. Because examination staff will likely review past and current Form ADV conflict disclosure language, it is imperative that such disclosures accurately reflect existing practices. Regular advisor training is also an effective preventative measure.
Please contact Stephen Wilkes if you have any questions.