United States: New SEC Enforcement Initiative Encourages Advisers To Self-Report Mutual Fund Share Class Violations

On February 12, 2018, the Division of Enforcement of the U.S. Securities and Exchange Commission ("SEC") announced a new initiative to encourage advisers to self-report share class violations.1 Share class violations occur when an adviser does not disclose that it receives trailer fees or other compensation (i.e., Rule 12b-1 fees) for purchasing a more expensive mutual fund share class for a client when a less expensive one is available and appropriate. Advisers are required to disclose these type of fees if they are received directly or indirectly (through affiliated broker-dealers or supervised persons) because receipt of such fees creates a conflict of interest. As discussed below, the Share Class Selection Disclosure Initiative (the "SCSD Initiative") incentivizes advisers to notify the SEC of such violations by offering "standardized, favorable settlement terms" to those advisers who self-report by June 12, 2018.2

This initiative addresses what the Division of Enforcement views to be "potential widespread violations" in the industry3 and comes on the heels of warnings from the SEC's Office of Compliance and Inspections ("OCIE")4 and several recent enforcement actions for alleged share class violations.5 This initiative also follows other initiatives by the Division of Enforcement to encourage registrants to self-report and remediate past violations, including the Municipalities Continuing Disclosure Cooperation Initiative (the "MCDC Initiative"). Consequently, these past enforcement actions and this previous initiative are instructive on how the Division of Enforcement will administer this new initiative and how advisers may avail themselves of it.

The SCSD Initiative

The Division of Enforcement explained in its announcement that, over the past several years, many advisers' disclosures regarding 12b-1 fees were not accurate. In particular, the Division of Enforcement noticed that many advisers disclose that they "may" receive 12b-1 fees and that those fees "may" create a conflict of interest. Yet the Division of Enforcement also noticed that many of those advisers did not disclose that a conflict of interest in fact existed where they had a choice between various share classes (some of which offered fees), chose the higher-cost share class for whatever reason, and as a result received undisclosed 12b-1 fees.6 Because the Division of Enforcement views such non-disclosure as a breach of fiduciary duty in violation of Section 206(2) of the Investment Advisers Act of 1940 (the "Advisers Act"), it instituted the SCSD Initiative "to identify and promptly remedy potential widespread violations of this nature."

Through this initiative, the Division of Enforcement encourages advisers that did not explicitly disclose 12b-1 conflicts of interest in their Form ADV to self-report these violations by midnight ET on June 12, 2018. Advisers that are currently being examined are eligible for this initiative, whereas advisers that are under investigation for such violations are not eligible. Individuals associated with advisers are also not necessarily eligible for this initiative.

Within 10 business days of the self-report, the adviser must submit a completed questionnaire to confirm eligibility by providing

  • Its identification and contact information and, if applicable, that of its affiliated broker-dealer;
  • Any information explaining the facts and circumstances relating to the previous non-disclosure (e.g., "any information regarding other disclosure documents the Self-Reporting Adviser believes contain an adequate disclosure of the conflict");
  • Information related to the 12b-1 fees received in excess of the lower cost share class from January 1, 2014, on; and
  • A statement that the adviser intends to consent to the settlement terms under the SCSD Initiative.7

For eligible advisers, the Division of Enforcement indicated it will recommend that the Commission accept settlements on the following terms:

  • Consent to a no admit, no deny administrative settlement under Sections 203(e) and 203(k) of the Advisers Act for alleged violations of Sections 206(2) and 207 of the Advisers Act;8
  • Pay disgorgement and prejudgment interest to harmed clients; and
  • Undertake certain remedial steps, including (i) review and correct disclosure documents and update compliance program, (ii) move existing clients to lower-cost share class as necessary, (iii) notify clients of the settlement, and (iv) certify compliance to the Commission.

While the Division of Enforcement indicated it will recommend that the Commission not impose a civil penalty, it noted that benefit applied only to self-reported conduct that meets the requirements of the initiative and made clear that "other potential misconduct [will be] subject to investigation and separate enforcement action, if appropriate." The Division of Enforcement also made no assurances for advisers that do not participate in the initiative, noting that those advisers will be subject to additional charges and greater civil penalties, as appropriate. The Division of Enforcement warned that it and OCIE "plan to continue to make mutual fund share class selection a priority, and plan to proactively seek to identify investment advisers that may have failed to make the necessary disclosures ..."

The MCDC Initiative

The SCSD Initiative is similar to the MCDC Initiative that the Division of Enforcement announced in March 2014 to address the widespread disclosure deficiencies it perceived at the time in the municipal securities market.9 Pursuant to the MCDC Initiative, issuers and underwriters similarly were encouraged to self-report certain types of securities violations by completing and submitting a questionnaire by September 2014 to be eligible for "standardized favorable settlement terms" – specifically, a no-admission settled order for non-scienter violations where the issuer or underwriter agreed to update and strengthen its compliance program and to pay a limited civil penalty, if any.10 Also like the SCSD Initiative, the Division of Enforcement warned that the MCDC Initiative did not cover individuals, and issuers and underwriters "who do not self-report and instead decide to take their chances can expect to face increased sanctions for violations."11

Since then, the SEC has announced settled orders with more than 70 issuers and more than 70 underwriters that self-reported pursuant to the MCDC Initiative – all on the terms described in the announcement.12 As promised, the SEC also has announced harsher enforcement actions against issuers, underwriters, and associated individuals who did not self-report violations pursuant to the MCDC Initiative.

For example, in August 2017, the SEC announced enforcement actions against the municipal issuer Beaumont Financing Authority, its executive director Alan Kapanicas, its underwriter O'Connor & Company Securities Inc., and the underwriter's primary investment banker Anthony Wetherbee for alleged continuing disclosure violations that they did not self-report pursuant to the MCDC Initiative.13 According to settled orders against Beaumont Financing Authority, O'Connor & Company Securities, Inc., and Wetherbee and a settled federal complaint against Kapanicas, the respondents allegedly failed to disclose that they did not provide continuing disclosures to 24 separate offerings of municipal bonds totaling $260 million from 2003 to 2013. Instead of receiving the standard settlement terms, Beaumont Financing Authority was required to, among other things, retain an independent consultant to review and strengthen its compliance policies and procedures.14 Similarly, O'Connor & Company Securities Inc., was required to retain an independent consultant to review and strengthen its compliance policies and procedures and pay a civil penalty of $150,000, which appears to be 50 percent greater than it otherwise would have been required to pay under the MCDC Initiative.15 Wetherbee agreed to pay a civil penalty of $15,000 and serve a six-month suspension from the securities industry,16 whereas Kapanicas agreed to pay a civil penalty of $37,500 and be barred from participating in any future municipal bond offerings.17

Takeaways

The SCSD Initiative bears out our prediction that the Division of Enforcement would continue to emphasize disclosure of 12b-1 fees as an enforcement priority though 2018.18 Given this new initiative and comments by FINRA's Head of Enforcement Susan Schroeder that FINRA also will award credit to broker-dealers that self-report and reimburse undisclosed 12b-1 fees,19 investment advisers and broker-dealers that invest client money in mutual funds, among other things, should take the following steps.

  • First, registrants should review their formal disclosures to verify whether conflicts resulting from 12b-1 fees are clearly identified. When doing so, they should be mindful that the SEC has repeatedly emphasized that disclosures that "a conflict of interest may exist" are not clear when the conflict of interest in fact exists. To the extent appropriate, disclosures should be updated.
  • Second, registrants should identify whether they received any 12b-1 fees (either directly or through an affiliate or supervised person) since at least January 1, 2014, and if lower-cost share classes of the same mutual funds were available. If they received previously undisclosed 12b-1 fees that could have been avoided, registrants should reimburse them to their clients and move existing clients to the lower-cost share class promptly. Registrants also should carefully consider self-reporting pursuant to the SCSD Initiative (for advisers) or FINRA Rule 4530 (for broker-dealers) by factoring in (i) the benefits of the initiative's standardized settlement terms (or the potential cooperation credit provided by FINRA), (ii) the reputational and legal consequences of an enforcement action for 12b-1 related or other violations (either pursuant to or outside of the initiative), (iii) the potential of the SEC or FINRA uncovering the violations through an examination or a tip, and (iv) the additional sanctions that the SEC may impose outside of the initiative (including civil penalties that match the disgorgement amount, compliance consultants, and industry bars).
  • Third, registrants should review their compliance programs to identify ways in which they may be strengthened to protect against such undisclosed conflicts of interest, including, as appropriate, updating policies and procedures, training employees, and instituting automated alerts when 12b-1 share classes are selected.

Given the history of enforcement initiatives like the SCSD Initiative and the SEC's continued focus on 12b-1 fees, advisers and broker-dealers alike should at the very least take these steps to protect against any preventable fallout.

Footnotes

[1] SEC Release, SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors, SEC Rel. No. 2018-15 (Feb. 12, 2018), https://www.sec.gov/news/press-release/2018-15.

[2] Id.

[3] SEC Announcement, Share Class Selection Disclosure Initiative (Feb. 12, 2018) ("SCSD Initiative Announcement"), https://www.sec.gov/enforce/announcement/scsd-initiative.

[4] SEC National Exam Program Risk Alert, OCIE's 2016 Share Class Initiative (July 13, 2016), https://www.sec.gov/ocie/announcement/ocie-risk-alert-2016-share-class-initiative.pdf.

[5] See, e.g., In re Packerland Brokerage Services, Inc. and Atlas Capital Management Corp., SEC Settled Order, Admin. Proc. File No. 3-18319 (Dec. 21, 2017) (no admission settlement imposing disgorgement and prejudgment interest of more than $455,000 and civil penalty of $80,000 where adviser revised compliance program and informed clients of the settlement), https://www.sec.gov/litigation/admin/2017/34-82383.pdf; In re Suntrust Investment Services, Inc., SEC Settled Order, Admin. Proc. File No. 3-18178 (Sept. 14, 2017) (no admission settlement imposing disgorgement and prejudgment interest of more than $40,000 and civil penalty of nearly $1.15 million where adviser implemented certain remedial measures, including crediting fees back to clients, converting shares to lower-cost classes, and instituting automated alerts for rebated 12b-1 fees), https://www.sec.gov/litigation/admin/2017/34-81611.pdf; In re Cadaret, Grant & Co., Inc., SEC Settled Order, Admin. Proc. File No. 3-18087 (Aug. 1, 2017) (no admission settlement imposing disgorgement and prejudgment interest of nearly $2.8 million and civil penalty of $280,000 where adviser was credited for undetailed cooperation and remediation), https://www.sec.gov/litigation/admin/2017/34-81274.pdf.

[6] SCSD Announcement.

[7] Share Class Selection Disclosure Initiative Questionnaire for Self-Reporting Advisers (Feb. 12, 2018), https://www.sec.gov/divisions/enforce/scsd-initiative-questionnaire.pdf.

[8] The Division of Enforcement indicated in the announcement that it will not recommend registration violations under Section 15(a) of the Securities Exchange Act of 1934 for advisers who received 12b-1 fees directly but were not registered as broker-dealers.

[9] SEC Release, SEC Launches Enforcement Cooperation Initiative for Municipal Issuers and Underwriters, Rel. No. 2014-46 (Mar. 10, 2014) ("MCDC Initiative Release"), https://www.sec.gov/news/press-release/2014-46.

[10] SEC Announcement, Municipalities Continuing Disclosure Cooperation Initiative (Mar. 10, 2014), https://www.sec.gov/divisions/enforce/municipalities-continuing-disclosure-cooperation-initiative.shtml.

[11] MCDC Initiative Release.

[12] SEC Release, SEC Charges 71 Municipal Issuers In Muni Bond Disclosure Initiative, Rel. No. 2016-166 (Aug. 24, 2016), https://www.sec.gov/news/pressrelease/2016-166.html.

[13] SEC Release, Muni Bond Issuer and Underwriter Charged With Disclosure Failures, Rel. No. 2017-148 (Aug. 23, 2017), https://www.sec.gov/news/press-release/2017-148.

[14] In re Beaumont Financing Authority, SEC Settled Order, Admin. Proc. File No. 3-18132 (Aug. 23, 2017) ("Beaumont Release"), https://www.sec.gov/news/press-release/2017-148.

[15] In re O'Connor & Company Securities, Inc. and Anthony Michael Wetherbee, SEC Settled Order, Admin. Proc. File No. 3-18131 (Aug. 23, 2017), https://www.sec.gov/litigation/admin/2017/33-10405.pdf.

[16] Id.

[17] Beaumont Release.

[18] Charlie Marlow, BakerHostetler Briefing Provides Regulatory Update: Developments in SEC Enforcement and Hot Topics in Taxation Affecting Private Funds (Part Two of Two), The Hedge Fund Law Report (Jan. 25, 2018), https://www.hflawreport.com/article/3659.

[19] Tracey Longo, In Wake Of SEC Action, Finra To Update Rule On 12b-1 Fee Conflicts, Financial Advisor (Feb. 13, 2018), https://www.fa-mag.com/news/finra-to-go-easy-on-cooperative-b-ds-if-they-refund-12b-1-fees-37157.html.

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