(Article from Registered Funds Alert, June 2018)
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The SEC recently has focused on what it perceives as disclosure violations related to how registered investment advisers select mutual fund share classes for their clients. In this Alert, we discuss a recent initiative by the SEC to encourage self-reporting of such violations and highlight ways the SEC could better incentivize self-reporting in the future.
Continuing a theme from 2017, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has stated that it will continue to focus on share class disclosure violations in its exam priorities for 2018. To that effect, the SEC Division of Enforcement (the “Enforcement Division”) launched a new initiative on February 12, 2018—the Share Class Selection Disclosure Initiative (“SCSD Initiative”). The SCSD Initiative provides a self-reporting outlet for firms that have failed to adequately disclose conflicts of interest related to the selection of mutual fund share classes that paid the adviser as a dually-registered broker-dealer, or its related entities or individuals, compensation when a lower-cost share class for the same fund was also available to the adviser’s clients. The SEC believes these violations are widespread and that the SCSD Initiative is a better allocation of agency resources than individualized enforcement actions. On May 1, 2018, the SEC published frequently asked questions (FAQs), providing additional information about the SCSD Initiative.
Further underscoring the SEC’s focus on this issue, the SEC announced settlements with three advisers—PNC Investments LLC, Securities America Advisors, Inc. and Geneos Wealth Management—for failing to disclose that they invested clients in share classes with Rule 12b-1 fees when cheaper shares of the same fund with lower Rule 12b-1 fees or no Rule 12b-1 fees were also available.[1] The SEC ordered each firm to pay a fine, along with disgorgement and interest.
Background
The SCSD Initiative is intended to be a reporting mechanism for advisers who have failed to make what the SEC views as necessary disclosures regarding Rule 12b-1 fees. The Advisers Act provides that advisers have a fiduciary duty to disclose to clients conflicts of interest which may lead an adviser, whether intentionally or not, to render investment advice that is not disinterested. The SEC asserted that advisers often recommend share classes with Rule 12b-1 fees over share classes of the same fund with lower fees in order to increase their revenue. Rule 12b-1 fees are paid by mutual funds to an adviser on an ongoing basis from the fund’s assets, thereby reducing a shareholder’s returns. As such, when a share class with no Rule 12b-1 fee or a lower Rule 12b-1 fee is available for the same fund, it is usually in a shareholder’s best interest to invest in the lower-cost share class. Advisers are required to disclose conflicts of interest, such as this, and receipt of Rule 12b-1 fees on Form ADV. The SEC believes this lack of disclosure is prevalent in the mutual fund industry.
Consequences of Self-Reporting
Advisers had until June 12, 2018 to self-report. If an adviser elects to self-report under the SCSD Initiative, the adviser must disclose both the conflict associated with making investment decisions in light of the receipt of 12b-1 fees and the conflict associated with selecting the more expensive Rule 12b-1 fee paying share class when a lower-cost share class was available for the same fund. In exchange for self-reporting, the Enforcement Division has stated that it will recommend favorable and standardized settlement terms. The standardized settlement terms involve:
- A cease and desist order 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, along with a censure;
- Disgorgement by the adviser of its ill-gotten gain, as reported on the self-reporting questionnaire and as discussed with the Staff, and prejudgment interest on such gain, which may be offset in the Staff’s discretion if it determines that the adviser reduced or offset its advisory fee by the amount of the Rule 12b-1 fees;
- A certification that the disgorgement is accurate and an order requiring the adviser to make an adviser-administered distribution to affected clients; and
- An acknowledgement that the adviser has taken certain steps to remedy the violation or an order of undertakings requiring that within 30 days of instituting the order, the adviser will take such steps.
The FAQs also highlighted two interesting features of the SEC’s approach to this issue. To provide advisers with certainty regarding the consequences of self-reporting, the SEC emphasized that “the severity and scope” of the conduct will not significantly change the terms that the SEC would seek to impose in connection with a settlement. Additionally, unlike the recent settlements noted above, any settlements recommended by the Enforcement Division under the SCSD Initiative will not involve civil penalties. However, under Section 203(e) of the Advisers Act, cease and desist orders require firms to agree to a “willful” violation of the Advisers Act.[2] To date, no settlements have been issued pursuant to the SCSD Initiative.
True Amnesty?
While the SCSD Initiative seemingly provides a rare safe opportunity for advisers who may have failed to disclose conflicts of interest regarding Rule 12b-1 fees, the extent of its protection is limited. Any other potential misconduct discovered throughout the course of an SCSD Initiative self-reporting investigation is not subject to the same leniency as a failure to disclose Rule 12b-1 fees, which the SEC reiterated in the FAQs. Further, the SCSD Initiative only applies to advisers. If individuals associated with the advisers have engaged in any violations of the securities laws, the SCSD Initiative will not cover these individuals.
An adviser who self-reports will inevitably face an SEC enforcement action, which may be disruptive to the adviser’s business and harmful to its reputation. The primary upside to self-reporting is that the Enforcement Division would not recommend a civil monetary penalty in connection with such an enforcement action. Fearing the peripheral consequences of an enforcement action and public sanctions, many advisers may, on balance, be deterred from self-reporting despite the standardized settlement terms.
Suggested Enhancements to a Self-Reporting Mechanism
The SEC could promote much greater levels of self-reporting if it lessened the potential collateral effects that an enforcement action may have on an adviser and its business. To encourage self-reporting, whether related to Rule 12b-1 fee disclosure or other issues, the SEC should consider taking an alternative approach with less severe consequences. In the past, the SEC has from time to time decided to take no enforcement action at all if a registrant self-reported. In a 2001 report investigation, the SEC emphasized that one of the factors it considered in not recommending an enforcement action was that the company self-reported its misconduct. Currently, the odds of an adviser avoiding an enforcement action are better if the adviser does not self-report. If the threat of an enforcement action was a less certain result of self-reporting, advisers may be more willing to initiate a dialogue with the SEC regarding potential violations.
Another potentially viable alternative to the current self-reporting regime may include solutions comparable to non-prosecution agreements or deferred prosecution agreements. Non-prosecution agreements are entered into in limited circumstances in which the SEC agrees not to pursue an enforcement action against an individual or company if they agree to cooperate fully and truthfully and comply with express undertakings, while deferred prosecution agreements also require that an individual or company comply with express prohibitions and undertakings during a specified period of time. While these agreements typically are entered into with respect to criminal conduct, the SEC should consider similar leniency under its self-reporting programs to better incentivize advisers to participate.
Conclusion
The SEC should be applauded for its creativity in launching the SCSD Initiative. It presents a rare opportunity for advisers to self-report violations of the securities laws with reasonable certainty as to the consequences that the SEC will impose. On the other hand, the consequences of self-reporting, and all of the attendant intangible harms to an adviser’s business and reputation, may outweigh the benefits of such certainty to advisers considering whether to self-report. The SEC should consider alternatives to sanctions in order for the SCSD Initiative, as well as similar future initiatives, to better encourage participation and remove the incentive for advisers to sweep minor violations under the rug.
[1] The FAQs provide examples of what it means for a lower-fee share class to be “available”, including when: a client could have purchased a lower-cost share class for the same fund because the client’s investment met the applicable investment minimum; according to a fund’s prospectus, the fund would waive the investment minimum for a lower-cost share class for the same fund for advisory clients and the adviser had no reasonable basis to believe the fund would not waive the investment minimum for a lower-cost share class for its clients; and the adviser purchased a lower-cost share class of the same fund for other similarly-situated clients.
[2] A finding of a willful violation does not require that an actor knows he or she is violating a federal security law.