In our January 18, 2018 Law Alert on share class selection, we expressed our opinion that share class selection is likely to remain an enforcement focus for the Security and Exchange Commission (the “Commission”) in 2018. This was confirmed by the Commission’s February 7th announcement of its 2018 exam priorities wherein it affirmed its intent to protect retail investors, which includes share class selection and the disclosure and calculation of fees, expenses and other charges. Under Section 206 of the Investment Advisers Act of 1940 (“Advisers Act”), share class recommendations must be in the client’s best interest, best execution must be sought, and all material facts (including conflicts of interest) must be fully disclosed. The complexity of investment products with different share classes (and underlying costs and revenue sharing arrangements ) makes this extremely challenging.
Yesterday, the Commission announced its Share Class Selection Disclosure Initiative (the “SCSD Initiative”). Investment advisors have until June 12, 2018 to self-report to the Division of Enforcement (“Division”) any conflict of interest situations in which clients were placed in more expensive share classes of mutual funds and advisors received 12b-1 fees, without proper disclosure, when lower-cost shares of the same funds were available. In its announcement, the Commission cited “potential widespread violations of this nature.” The Division will recommend that the Commission accept a settlement and will not recommend penalties against the advisor if client funds (plus interest) are promptly returned. Investment advisors that have already been contacted by the Division as of February 12, 2018 about possible violations of share class selection are not eligible to take part in the SCSD Initiative. However, those subject to pending examinations by the Office of Compliance Inspections and Examinations (“OCIE”) related to this issue, but who have not been contacted by the Division, are eligible to participate.
To take part in the SCSD Initiative, advisors should self-report by notifying the Division by 12:00 am EST on June 12, 2018. Advisors must then complete a questionnaire confirming eligibility under the program within 10 business days of notification. The settlement will include the following terms depending upon the advisor’s eligibility: (i) the firm’s consent to an administrative and cease-and-desist proceeding for violations of Section 206(2) and 207 of the Advisers Act, where the advisor neither admits nor denies the Commission’s findings; (ii) an order to cease and desist from committing or causing any violations and future violations of Section 206(2) and 207, and a censure; (iii) disgorgement of the “ill-gotten gain” and prejudgment interest, along with a certification as to the accuracy of the questionnaire, and agreement to an order requiring the firm to make a respondent-administered distribution to affected clients; (iv) either an acknowledgement that the advisor has taken certain prescribed steps, or an order requiring the advisor to complete such steps within 30 days, which includes correcting disclosure documents, evaluating whether clients should be moved to lower-cost share class, etc.; and (v) a recommendation by the Division that the Commission not impose a penalty on the advisor. Because the SCSD Initiative covers only eligible individual advisors, other individuals associated with the same firm have no assurance that they will be offered similar terms for violations.
The Commission states that eligible advisors who choose not to participate in the SCSD Initiative may face stiffer consequences than those provided under the initiative. It cautions that OCIE and Division staff “plan to continue to make mutual fund share class selection practices a priority, and plan to proactively seek to identify investment advisors that may have failed to make the necessary disclosures related to mutual fund share class selection.”
Takeaways
Amnesty under the SCSD Initiative (or any voluntary remediation, for that matter) is not without risk. For one thing, it is not required to self-report, although dual registered firms must consider their FINRA reporting obligations under FINRA Rule 4530(b). Missteps in crafting the correction can increase a firm’s legal and reputational risk. Cease and desist orders carry their own consequences. The goal of correcting past violations is to make injured parties whole, prevent recurrence and avoid increased scrutiny by regulatory authorities. Remedial efforts generally, and the decision whether to participate in the SCSD Initiative, require a thoughtful, well-documented and careful review by the investment advisor.
Please contact Stephen Wilkes if you have any questions.