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Enforcement News: Retail Investors to Receive More Than $125 Million Under the SEC’s Share Class Selection Disclosure Initiative

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  • Posted on: Mar 13 2019

On March 11, 2019, the Securities and Exchange Commission (“SEC” or “Commission”) announced (here) that it had settled charges against 79 investment advisers who agreed to return more than $125 million to their clients (the “Actions”). A a substantial majority of the funds to be returned are earmarked for retail investors.

The Actions arose from the SEC’s Share Class Selection Disclosure Initiative (“SCSDI” or the “Initiative”) (here), which the Division of Enforcement (the “Division”) created to address the harm caused by investment advisory firms that failed to disclose to clients that they had received 12b-1 fees for selling the funds.  Under the Initiative, investment advisers can avoid financial penalties by self-reporting violations of the Investment Advisers Act of 1940 (the “Advisors Act”) resulting from undisclosed conflicts of interest, compensating investors for the harm done as a result of the conflicts of interest, and reviewing and correcting their fee disclosures.

The orders issued by the SEC concerned advisers who directly or indirectly received 12b-1 fees for investments selected for their clients without adequate disclosure, including disclosures that were inconsistent with the advisers’ actual practices.

The SEC found that the investment advisers failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.  Specifically, the SEC found that the investment advisers placed their clients in mutual fund share classes that charged 12b-1 fees – which are recurring fees deducted from the fund’s assets – when lower-cost share classes of the same fund were available to their clients without adequately disclosing that the higher cost share class would be selected.  According to the SEC, the 12b-1 fees were routinely paid to the investment advisers in their capacity as brokers, to their broker-dealer affiliates, or to their personnel who were also registered representatives, creating a conflict of interest with their clients, as the investment advisers stood to benefit from the clients’ paying higher fees.

The SEC’s Crackdown on Share Class Selection-Related Violations of the Federal Securities Laws

Investment advisers owe a fiduciary duty to their clients. See, e.g., Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963). This means that an investment adviser has an obligation to act in the best interests of his/her clients and to provide investment advice in his/her clients’ best interests.

In this regard, investment advisers owe their clients a duty of undivided loyalty and utmost good faith. Thus, investment advisers should not engage in any activity that conflicts with the interests of their clients and should take all steps reasonably necessary to fulfill their fiduciary obligations.

Additionally, investment advisers must exercise reasonable care to avoid misleading clients and provide full and fair disclosure of all material facts to their clients and prospective clients. This means that investment advisers are required to disclose any and all material conflicts of interest, including conflicts arising from financial incentives, to clients and prospective clients.

Since at least 2013, the Commission has been cracking down on investment advisers who have failed to disclose conflicts of interest and failed to implement reasonably designed policies and procedures relating to mutual fund share classes in violation of the Advisers Act.  In those cases, the Commission generally required the investment advisers to pay disgorgement and penalties, and to distribute the funds to harmed clients.

In 2016, share class disclosures rose to the forefront. The Commission’s Office of Compliance Inspections and Examinations issued a Risk Alert (here) specifically addressing share class disclosure and cautioning investment advisers to examine their policies and procedures.  FINRA has also addressed share class selection issues with brokers, imposing censures and fines on brokers that failed to provide adequate disclosures (here).

The SCSDI

In February 2018, the Division announced the creation of the Initiative to address concerns that investment advisers were not adequately disclosing, or acting consistently with the disclosure regarding, conflicts of interest related to their mutual fund share class selection practices.  These disclosure failures caused harm to investors, particularly retail investors, including being deprived of the ability to make informed investment decisions when purchasing higher-cost share classes.  The Initiative enabled investment advisory firms to avoid financial penalties if they timely self-reported undisclosed conflicts of interest, agreed to compensate harmed clients, and undertook to review and correct their relevant disclosure documents.

SEC Comments About The Initiative

“The federal securities laws impose a fiduciary duty on investment advisers, which means they must act in their clients’ best interest,” said Stephanie Avakian, Co-Director of the SEC’s Division of Enforcement.  “An adviser’s failure to disclose these types of financial conflicts of interest harms retail investors by unfairly exposing them to fees that chip away at the value of their investments.”

“The initiative leveraged the expertise of the agency in crafting an efficient approach to remedy a pervasive problem,” said Steven Peikin, Co-Director of the SEC’s Division of Enforcement.  “Most of the advisory clients harmed by the disclosure practices were retail investors, and in just a year’s time, we made tremendous headway in putting money back into their hands while significantly improving the quality of firms’ disclosures.”

“Investment advisers play a vital and trusted role in our markets.  They offer a wide array of products and services to our retail investors, ranging from one-time advice on a model investment portfolio to comprehensive planning combined with continuous investment advice and other services.  Regardless of the scope and duration of the investment advisory services, investment advisers are fiduciaries and, as such, their duties of care and loyalty require them to disclose their conflicts of interest, including financial incentives,” said SEC Chairman Jay Clayton.  “I am pleased that so many investment advisers chose to participate in this initiative and, more importantly, that their clients will be reimbursed.  This initiative will have immediate and lasting benefits for Main Street investors, including through improved disclosure.  Also, I am once again proud of our Division of Enforcement for their vigorous and effective pursuit of matters that substantially benefit our long-term, retail investors.”

The Settlements

The SEC found that the settling investment advisers, other than the state-registered only advisers, violated the Advisers Act by: 1) failing to include adequate disclosure regarding the receipt of 12b-1 fees; and/or 2) failing to adequately disclose additional compensation received for investing clients in a fund’s 12b-1 fee paying share class when a lower-cost share class was available for the same fund.

Each of the settling investment advisers consented to the entry of the cease-and-desist orders without admitting or denying the findings in their respective orders.  The firms also agreed to a censure and to disgorge the improperly disclosed fees and distribute those monies with prejudgment interest to affected advisory clients.  Each adviser also agreed to review and correct all relevant disclosure documents concerning mutual fund share class selection and 12b-1 fees and to evaluate whether existing clients should be moved to an available lower-cost share class and move clients, as necessary.  Consistent with the terms of the Initiative, the Commission has agreed not to impose penalties against the investment advisers.

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