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SEC Announces Share Class Selection Disclosure Initiative

On February 12, 2018, the SEC Division of Enforcement announced the Share Class Selection Disclosure Initiative self-reporting initiative (the SCSD Initiative). The SCSD Initiative is in response to numerous enforcement actions filed against investment advisers for disclosure failures relating to advisers’ selection of mutual fund share classes that paid the adviser, or its related entities or individuals, a 12b-1 fee when a lower-cost share class of the same fund was available to clients.

Pursuant to Section 206(2) of the Investment Advisers Act of 1940 (the Advisers Act), advisers are prohibited from engaging in any acts or practices that operate as a fraud upon any client or prospective client. In addition, Section 206(2) imposes a fiduciary duty on investment advisers to act for their clients’ benefit and to make full disclosure of all material facts, including conflicts of interest. Furthermore, Section 207 of the Advisers Act makes it unlawful to willfully make any untrue statement of any material fact in a registration application or report filed with the SEC, or to willfully omit from such a registration application or report any material fact which should be included therein. Relying upon Sections 206 and 207 of the Advisers Act, the SEC recently pursued the numerous actions against investment advisers referenced above.

Who Should Consider Self-Reporting to the Division of Enforcement

The Enforcement Division describes a “Self-Reporting Adviser” as an adviser who received 12b-1 fees in connection with recommending, purchasing or holding 12b-1 paying share classes for its advisory clients when a lower-cost share class of the same fund was available to those clients, and failed to disclose “explicitly” in its brochure/brochure supplement(s) the conflict of interest associated with the receipt of such fees. The investment adviser received 12b-1 fees if:

  • It directly received the fees;
  • Its supervised persons received the fees; or
  • Its affiliated broker-dealer (or its registered representatives) received the fees.

So as to be sufficient, an adviser’s disclosure must clearly describe the conflicts of interest associated with making investment decisions in light of the receipt of 12b-1 fees, and selecting the more expensive 12b-1 fee paying share class when a lower-cost share class was available for the same fund. Additional information regarding adequacy of disclosures is provided in the various enforcement actions referenced in the announcement. In our third quarter 2017 Newsletter, DCS provides information regarding the administrative proceeding In the Matter of SunTrust Investment Services, Inc.,Investment Advisers Act Rel. No 4769 (September 14, 2017). Regarding the inadequacy of disclosures relating to 12b-1 fees retained by an adviser, the SunTrust Order provides the following:

STIS [SunTrust Investment Services] did not adequately inform its advisory clients of the conflicts of interest presented by its IARs’ share class selections and the receipt by STIS and the IARs of 12b-1 fees. STIS disclosed in its Form ADV Part 2A brochures for its investment advisory programs that STIS “may” receive 12b-1 fees as a result of investments in certain mutual funds and – for several STIS programs – that such fees presented a “conflict of interest.” However, STIS did not disclose in its Form ADV Part 2A brochures or otherwise that many mutual funds offered a variety of share classes, including some that did not charge 12b-1 fees and were, accordingly, less expensive for eligible investors. Moreover, STIS failed to disclose to affected clients that an IAR could purchase, hold, or recommend—and in certain instances did purchase, hold or recommend—mutual fund investments in share classes that paid 12b-1 fees to STIS, which STIS ultimately shared with its IARs as compensation, even though such clients also were eligible to invest in share classes of the same mutual funds that did not charge such fees and were less expensive.

When Must Investment Advisers Self-Report

To be eligible for the SCSD Initiative, an investment adviser must self report by notifying the Division of Enforcement by midnight EST on June 12, 2018. Notification can be made by email to SCSDInitiative@sec.gov or by mail to SCSD Initiative, U.S. Securities and Exchange Commission, Denver Regional Office, 1961 Stout Street, Suite 1700, Denver, Colorado 80294.

What Must Investment Advisers Self-Report

Within 10 business days from the date of its notification, an adviser must confirm its eligibility for the SCSD Initiative by submitting a completed questionnaire. Following is a summary of the information included in the questionnaire:

  • Identification and contact information;
  • To the extent applicable, identification and contact information for the affiliate broker-dealer;
  • Identification of the periods during which brochure(s) and brochure supplement(s) failed to include the necessary disclosures and copies of such forms;
  • The following information regarding each mutual fund that paid 12b-1 fees for investing or holding client assets (submitted in a provided Excel format):
    • Fund name;
    • Ticker symbol;
    • CUSIP;
    • Amount of year-end assets held by the adviser’s clients;
    • Total amount of 12b-1 fees incurred by the adviser’s clients (by each share class);
    • Amount of 12b-1 fees (if any) if the adviser’s clients assets had been invested in the lowest cost share class available;
    • Amount of 12b-1 fees in excess of the lowest cost share class;
    • Total 12b-1 fees received by the adviser, its supervised persons, an affiliated broker-dealer and/or the affiliated broker-dealer’s registered representatives; and
    • 12b-1 fees that the adviser plans to disgorge.
  • Any other facts that the adviser determines would be relevant to the Division of Enforcement’s understanding of the circumstances.

The Standardized Terms of Settlement

If an adviser meets the terms of eligibility for the SCSD Initiative and the Division of Enforcement decides to recommend enforcement action against the adviser, the following are the settlement terms to be recommended by the Division of Enforcement.

Types of Proceedings and Nature of Charges

The proceeding will be an administrative cease-and-desist proceeding under Sections 203(e) and 203(k) of the Advisers Act for violations of Sections 206(2) and 207 of the Advisers Act based on the adviser’s failure to disclose the conflict of interest. In an approved settlement, the adviser will neither admit nor deny the findings of the SEC.

Cease-and-Desist Order and Censure

The settlement will include an order to cease-and-desist from committing violations of Sections 206(2) and 207 of the Advisers Act, and a censure.

Disgorgement and Prejudgment Interest

The settlement will include disgorgement of the inappropriately received 12b-1 fees and prejudgment interest on such amounts. For eligible advisers, the Division of Enforcement will not recommend the imposition of a penalty.

Undertakings

Approved advisers will be required to acknowledge taking the following steps within 30 days of an approved settlement order:

  • Review and as necessary correct the disclosure documents;

  • Evaluate whether existing clients should be moved to a lower cost share class and move clients as necessary;

  • Evaluate, update if necessary and review for effectiveness the implementation of policies and procedures designed to prevent violations of the Advisers Act related to disclosures regarding mutual fund class share selection;

  • Notify all affected clients of the settlement terms; and

  • Provide to the SEC, no later than 10 days after completion, a compliance certification regarding the undertakings.

Individual Liability

The SCSD Initiative covers only advisers. The Division of Enforcement is providing no assurances as part of the program that individuals will be offered similar terms if they engaged in violations of federal securities laws. The Division of Enforcement may seek enforcement actions against such individuals and remedies beyond those provided for in the SCSD Initiative.

Entities That Do Not Take Advantage of the SCSD Initiative

For advisers that would have been eligible for the SCSD Initiative but did not participate, the Division of Enforcement expects in any proposed enforcement action to recommend additional charges and the imposition of penalties. The Division of Enforcement and the Office of Compliance Inspections and Examinations plan to continue to make mutual fund share class selection practices a priority.

© 2018 Dinsmore & Shohl LLP. All rights reserved.

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About this Author

Kevin Woodard, Dinsmore Law Firm, Finance and Investment Attorney
Attorney

With over 20 years experience providing services to investment managers, broker-dealers, mutual funds/private funds and bank wealth management divisions, Kevin has experience as in-house and outside legal compliance counsel at banks and investment organizations.

Before joining our DCS, he served as chief compliance officer and chief legal officer for various investment advisers, broker-dealers, private fund advisers, municipal advisers, mutual funds and bank trust/wealth management divisions. He was also the compliance solutions managing...

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