SEC Staff Issues Share Class Selection Disclosure Initiative FAQs
On May 1, 2018, the staff of the SEC’s Division of Enforcement (the Division) issued guidance in the form of frequently asked questions (FAQs) relating to the Division’s February 12, 2018 announcement (the Announcement) of an initiative “intended to identify and promptly remedy potential widespread violations” of federal securities laws relating to an investment adviser’s selection of mutual fund share classes for clients that pay a 12b-1 fee to the adviser or its affiliates notwithstanding the availability of a lower-cost share class of the same fund (the Initiative). As stated in the Announcement, the Division will recommend that the SEC accept “favorable settlement terms” for advisers that self-report such conduct in accordance with the Initiative. The following is a summary of the SEC staff’s guidance.
•The standardized settlement terms set forth in the Announcement will apply only to the conduct identified therein and only to eligible advisers that self-report such conduct in the manner set forth in the Announcement. Eligible advisers (referred to as Self-Reporting Advisers) are advisers that (1) received 12b-1 fees in connection with recommending, purchasing or holding for advisory clients mutual fund share classes that pay 12b-1 fees when a lower-cost share class of the same fund was available and (2) failed to disclose explicitly in their Forms ADV conflicts of interest associated with the receipt of such fees.
• The Initiative applies only to conflicts associated with 12b-1 fees and not to situations in which an adviser receives other fees in connection with recommending, purchasing or holding higher cost share classes.
• There is no minimum disgorgement amount required to self-report under the Initiative.
• The Division does not plan to recommend fundamentally different settlement terms with advisers based on “the severity and scope” of the conduct. Advisers should be prepared to enter into a settlement with the SEC under the standardized settlement terms described in the Announcement.
• Advisers must self-report to the Division in the manner set forth in the Announcement and not to another division of the SEC (e.g., Office of Compliance Inspections and Examinations (OCIE)).
• Advisers that have been or are being examined by OCIE in connection with matters covered by the Initiative but, as of February 12, 2018, had received communication from the Division “regarding possible violations related to their failures to disclose the conflicts of interest associated with mutual fund share class selection” are eligible to self-report regardless of the outcome of the OCIE exam.
• Advisers are still eligible to report under the Initiative if the Division communicated with the adviser on or after February 12, 2018. Advisers contacted by the Division before February 12, 2018 should contact the applicable staff attorney to ask whether the adviser may participate in the Initiative.
• The Initiative applies to conduct by investment advisers with respect to advisory clients regardless of the type of account in which the advisory client’s mutual fund shares are held and not when the investment advisor is acting in a capacity other than “recommending, purchasing, or holding 12b-1 fee paying share classes when a lower-cost share class of the same fund was available.”
• Advisers must disclose conflicts associated with both making investment decisions in consideration of 12b-1 fees to be received and selecting more expensive share classes that pay 12b-1 fees when a lower-cost share class is available. Advisers that failed to disclose either conflict or both conflicts are eligible to self-report under the Initiative.
• The Initiative applies to adviser conduct with respect to all types of funds, including adviser recommendations regarding money market funds.
• Determining whether a lower-cost share class is “available” depends on a fund-by-fund analysis. Following is a non-exhaustive list of examples the Division would likely conclude are lower-cost share classes “available” for the same fund:
– The client met the applicable investment minimum of a lower-cost share class for the same fund and could have purchased such shares.
– The prospectus contains or contained language stating that the investment minimum for a lower-cost share class would be waived for the same fund for advisory clients.
– The prospectus contains or contained language stating that the investment minimum for a lower-cost share class may be waived for the same fund for advisory clients, and the adviser had no “reasonable basis” to believe such waiver would not be made. The adviser must take steps to confirm its assumption that such waiver would not be made to establish a reasonable basis for this belief.
– The adviser purchased a lower-cost share class of the same fund for other clients who were similarly situated.
• The Division does not anticipate extending the June 12, 2018 deadline for self-reporting under the Initiative; however, an adviser must only notify the Division of its intent to participate in the Initiative by submitting, at a minimum, its name and contact information by the deadline. The adviser will then have ten business days (subject to extension) from the date of its notification to submit the questionnaire linked to the Announcement 1 and confirm its eligibility to participate in the Initiative.
• Under the Initiative’s standardized settlement terms, advisers will be required to disgorge “ill-gotten gain and prejudgment interest thereon.” Advisers are required to fill out the questionnaire linked to the Announcement and a related attachment 2 providing specific 12b-1 fee data. Advisers may also submit a supplemental narrative to provide the Division with additional details regarding the adviser’s disclosure failures and disgorgement intentions. Division staff would then expect to discuss with each adviser the appropriateness of the adviser’s disgorgement plans as submitted.
• Whether the Division will consider an adviser’s offset to its advisory fee by the amount of 12b-1 fees received in recommending the amount of disgorgement will depend on the facts and circumstances of a particular case. The Division presented two scenarios. In the first scenario, the adviser contends its management fee would have been less absent the receipt of 12b-1 fees; in this case, the Division would not expect to recommend any offset to the disgorgement. In the second scenario, the adviser’s annual management fees were reduced by the amount of 12b-1 fees received; in this case, the Division may recommend offset to the disgorgement.
• The requirements of each distribution by an adviser reporting under the Initiative will be identified in an order issued by the SEC. Typically, respondents will have 60 days from the entry of an order to notify the staff of how the adviser plans to calculate and perform its distribution. As soon as the staff has reviewed the proposal, the adviser will typically have 90 days to distribute funds.
• In recommending settlement terms to the SEC, the Division stated that it would consider “the potential for significant financial ramifications to the adviser and its clients if the adviser is required to satisfy the fullmonetary relief within a certain period.” An adviser should identify the details of any such ramifications in its narrative submitted with its questionnaire.
• Settlements recommended by the Division as a part of the Initiative will be pursuant to Section 203(e) of the Investment Advisers Act of 1940 (Advisers Act) and will require advisers to agree to a “willful” violation of the Advisers Act.
• Advisers should consult with counsel concerning any potential collateral consequences that may arise from self - reporting under the Initiative. The SEC has also set up a dedicated e-mail address (SCSDInitiave@sec.gov) to receive inquiries regarding the Initiative. The Division noted that the SEC staff cannot provide legal advice.
The FAQs are available at:https://www.sec.gov/enforce/educationhelpguidesfaqs/share-class-selectio...
1“Share Class Selection Disclosure Initiative Questionnaire for Self-Reporting Advisers,” available at: https://www.sec.gov/divisions/enforce/scsd-initiative-questionnaire.pdf
2 The Attachment to the Questionnaire is available at: https://www.sec.gov/divisions/enforce/scsd-initiative-questionnaire-atta...