Investment advisers may have noticed the SEC’s recent Share Class Selection Disclosure Initiative and thought they had nothing to learn from the 79 enforcement actions. The reality is that even investment advisers who are not affiliated with a broker-dealer can learn valuable lessons from these enforcement actions.

Lessons learned from Share Class Selection Disclosure Initiative

On March 11, 2019, the SEC announced that its Share Class Selection Disclosure Initiative had returned more than $125 million to investors. The initiative was launched in an effort to identify and quickly correct ongoing harm arising from the sale of certain mutual fund shares by investment advisers. The initiative offered an incentive to Registered Investment Advisers (“RIAs”) to self-report violations of the Investment Advisers Act of 1940, caused by undisclosed conflicts of interest. Among other violations discovered, certain firms made disclosures that were inconsistent with their actual practices. The initiative was also designed to ensure that RIAs reviewed and corrected their fee disclosures.

The initiative culminated in the settlement of 79 enforcement actions against advisers that directly or indirectly received inadequately-disclosed 12b-1 fees from investments selected for their clients. According to the SEC, the RIAs failed to adequately disclose conflicts of interest associated with the sale of higher-cost mutual fund share classes. These RIAs placed their clients in mutual fund share classes that charged 12b-1 fees, even though there were less expensive alternatives. The SEC found that 12b-1 fees were routinely paid:

• To investment advisers in their capacity as brokers;
• To their broker-dealer affiliates; or
• To their personnel who were also registered representatives.

These payments created a conflict of interest.

The SEC concluded that these RIAs violated Section 206(2) of the Investment Advisers Act. SEC-registered investment advisers also violated Section 207 of the Act by:

• Failing to disclose adequately that they received 12b-1 fees; and/or
• Failing to disclose adequately that they received additional compensation for investing clients’ money in share classes paying 12b-1 fees when a lower-cost share class was available.

The firms involved in these enforcement actions agreed to be censured and to disgorge the improperly-disclosed fees. They were also ordered to distribute those fees with prejudgment interest to affected advisory clients. In addition, each adviser agreed to review and correct all pertinent disclosure documents concerning mutual fund share class selection and 12b-1 fees. Furthermore, the firms agreed to evaluate whether current clients should be moved to an available lower-cost share class where appropriate. Pursuant to the terms of the initiative, the SEC did not impose penalties against the investment advisers.

Additional information regarding the initiative can be found here.

Fiduciary duty encompasses more than share class selection

Even when RIAs do not receive 12b-1 fees, firms must make certain they are not violating Sections 206(2) and Section 207 of the Act. RIAs must fully disclose their business model in Form ADV, including all fees and expenses charged to clients. Firms must thoroughly disclose their best execution practices, and they must strictly adhere to them. In addition, RIAs must make fair and full disclosure of any soft dollar arrangements. There have been enforcement actions against RIAs that miscalculated their fees, as well as where their charges were inconsistent with the firm’s Form ADV and/or advisory contracts.

RIAs should have policies and procedures detailing how fees are calculated. They must also implement thorough and complete policies and procedures regarding best execution and should compare broker-dealers to test for pricing and execution quality. Examiners will look to see if an RIA has evidence that the firm periodically and systematically evaluated recommended or required broker-dealers’ execution performance.

Best execution is not a one-and-done proposition. RIAs must monitor recommended or required broker-dealers on an ongoing basis. Without thorough and complete books and records, examiners cannot determine if an RIA has met its fiduciary duty of best execution.

Full disclosure applies to more than just best execution

RIAs must fully disclose all actual or perceived conflicts of interest. A question remains as to whether disclosure and informed consent are sufficient to satisfy a fiduciary’s duty to act in the best interest of the client.

When the SEC proposed its fiduciary rule for brokers in April, 2018, the Commission also outlined enhancements to investment adviser regulation. The SEC suggested that disclosure alone may not be sufficient unless it is clear and detailed. Disclosure that an adviser “may” have a conflict of interest is insufficient if the conflict actually exists. Disclosure by itself may not be enough if the facts and circumstances indicate that the client did not understand the nature and ramifications of the conflicts of interest. Where there are complex or extensive conflicts of interest, an adviser should eliminate them completely if the conflicts cannot be adequately mitigated. An RIA cannot disclose away its fiduciary obligation, and the client cannot waive the adviser’s fiduciary duty.

Take-away

The SEC is continuing to evaluate self-reporting documents from RIAs that were received prior to cut-off date of the initiative. It will also scrutinize RIAs that did not self-report share class violations.

The SEC’s initiative has implications for all RIAs, not just advisers who receive 12b-1 fees. Ultimately, the SEC’s goal is to improve the quality of RIAs’ disclosures and to prevent harm to retail investors who are unfairly exposed to any inappropriate fee or charge that erodes the value of their investments. Therefore, it is imperative that an RIA fully disclose all fees and expenses charged to the client.

Ara Jabrayan is the Managing Member of RIA Compliance Group, LLC, and on the Advisory Board for SmartRIA. His specialties include SEC and state RIA registrations, ongoing compliance assistance, mock exams, and the development of compliance programs. Follow him on LinkedIn, Facebook, or check out his Blog.