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SEC Continues to Focus on RIA Share Class Selection and Disclosure

Posted by RIA in a Box

May 4, 2018 11:03:50 AM

SEC Share Class Disclosure Initiative for RIA firmsWith the US Securities and Exchange Commission ("SEC") increased scrutiny on share class selection and disclosure, registered investment adviser ("RIA") firms should approach this common regulatory issue with increased focus and clear understanding of the latest guidance and perspective. In particular, the SEC remains focused on how 12b-1 fees that are passed along to investors influence how the RIA selects investments, particularly when those fees end up compensate advisers and related persons.

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Overview of 12b-1 Fee Issues

By way of background, Rule 12b-1 under the Investment Company Act of 1940, which gave rise to “12b-1 fees” for mutual funds, was adopted in 1980 –a time when the mutual fund industry was far from the mainstay it is today and “when nurturing mutual fund growth was an SEC priority.”1 The initial premise behind the rule was that a mutual fund could pay 12b-1 fees out of fund assets to cover the added cost of distribution and shareholder service expenses. Over time, 12b-1 fees evolved from being a relatively direct offset of those specified expenses into a method of compensation2 for the financial institutions and that framework persists today.

The compensation to financial advisers and burden to investors has led the SEC to more closed examine the conflicts of interest that 12b-1 fees create, the fees that investors bear, and the associated disclosures. Specifically, the SEC has advised that placing a client in a higher-cost share class when lower-cost share classes were available to the client is a prototypical conflict of interest. While RIAs may not be expressly prohibited from using a more expensive share class, the broader duty to clients in assessing different investment possibilities extends to share class selection. This means that RIAs should likely weigh, e.g., comparable exchange-traded funds ("ETFs") against mutual funds, comparable mutual funds against one another, and also different share classes – including the tradeoff between sales loads, 12b-1 fees, and other expenses – for a given mutual fund. Moreover, firms must clearly disclose 12b-1 fees and the related conflicts of interest.

Share Class Selection Disclosure Initiative

As the SEC Office of Compliance Inspections and Examinations ("OCIE") continues to caution RIAs about the hazards of choosing more expensive share classes, the SEC Division of Enforcement ("DOE") recently announced its Share Class Selection Disclosure Initiative aimed at RIAs that may have violated federal securities laws relating to mutual fund share class recommendations and wish to self-report the violation to the DOE. The SEC’s definition of a Self-Reporting Adviser under the Initiative is below:

"Self-Reporting Adviser" is an adviser that received 12b-1 fees in connection with recommending, purchasing, or holding 12b-1 fee paying share classes for its advisory clients when a lower-cost share class of the same fund was available to those clients, and failed to disclose explicitly in its Form ADV the conflicts of interest associated with the receipt of such fees.

In exchange for self-reporting, the DOE will recommend that the SEC not impose a civil penalty. However, Self-Reporting Advisers would likely be subject to disgorgement of the 12b-1 fees received plus interest, a settlement, censure, and a cease-and-desist order. This means that the firm would likely have to disclose the SEC settlement on its Form ADV so any RIA considering self-reporting should confer with proper legal counsel. The deadline for self-reporting is 12:00 am EST on June 12, 2018.

Steps to Consider

RIAs that recommend or invest client assets in mutual funds with multiple share classes should review Form ADV to ensure that conflicts of interest regarding 12b-1 fees are fully disclosed, as well as how the firm mitigates that conflict (e.g., crediting any 12b-1 fees received against the RIA’s advisory fee, etc.3). While the receipt of 12b-1 fees by an RIA or its related persons is a textbook conflict of interest, the SEC considers the impact of fees on investors apart from the RIA compensation component, so firms should consider what policies and disclosure are appropriate even in situations where the RIA does not receive a portion of the 12b-1 fees.

  • Disclosures must address conflicts of interest arising from both4:
    • the influence of 12b-1 fee compensation on the RIA's mutual fund recommendations; and
    • the actual selection of share classes with higher 12b-1 fees when the mutual fund had available5 a lower-cost share class.
  • Looking beyond disclosure to practice, RIAs should strongly consider opting for the lower-cost share class (absent compelling other factors) as discussed in our earlier blog post on mutual fund share class selection. While it appears that the SEC has not definitely determined whether share class selection is necessarily an issue of best execution, RIAs must consider this obligation in evaluating share classs.
  • Moreover, state-registered RIAs should take a cue from the SEC since the duty to clients regarding share classes is not exclusive to federal regulations.
  • RIAs with personnel licensed as registered representatives should contact applicable broker-dealer(s) to determine how 12b-1 fees will be treated in light of the OCIE and DOE focus, as some independent broker-dealers ("IBDs") have disseminated their own guidance for dually registered individuals.

Share class selection is in the spotlight for the SEC; it should be in the spotlight for any RIA that is in apposition to choose between different share classes for its clients.

Download the SEC 2018 Top RIA Exam Priorities Checklist

[1] https://www.sec.gov/news/speech/2007/spch041207cc.htm

[2] https://www.sec.gov/news/speech/2007/spch041207cc.htm: “Very quickly, however, 12b-1 plans came to be used for other reasons. Most notably, instead of paying for distribution, they became a substitute for front-end loads. In this way, more substantial sales loads could be collected while the fund could still advertise itself to investors as "no load." The transformation of the 12b-1 fee from a distribution subsidy to a sales load in drag is now so nearly complete that the primary purpose to which the $11 billion in 12b-1 fees [in 2006] were put was to compensate brokers. Another way that 12b-1 fees have veered away from their conceptual basis as distribution subsidies has been using them to pay for administrative expenses in connection with existing fund shareholders. Even some funds which are closed to new investors continue to collect 12b-1 fees.”

[3] See FAQ #14 available at https://www.sec.gov/enforce/educationhelpguidesfaqs/share-class-selection-disclosure-initiative-faqs

[4] See FAQ #9 available at https://www.sec.gov/enforce/educationhelpguidesfaqs/share-class-selection-disclosure-initiative-faqs

[5] See FAQ #11 available at https://www.sec.gov/enforce/educationhelpguidesfaqs/share-class-selection-disclosure-initiative-faqs

Lexington Compliance and RIA in a Box LLC are not law firms, investment advisory firms, or CPA firms. Lexington Compliance and RIA in a Box LLC do not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

Topics: RIA Compliance, RIA Operations

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