Over the past year, the Securities and Exchange ("SEC") has announced multiple initiatives to focus on registered investment adviser ("RIA") mutual fund and 529 Plan share class selection. In relation to potential conflicts of interest or undisclosed compensation associated with share class selection, the SEC Office of Compliance Inspections and Examinations ("OCIE") staff has stated that it is focused on fiduciary duty and best execution, disclosure, and compliance policies and procedures. RIA firms should anticipate current and past investment recommendations related to mutual fund and 529 share classes to be probed during a regulatory examination.
Recent SEC Public Releases
Two recent SEC public releases indicate an increasing RIA branch office supervision focus:
- On July 13, 2016, the SEC OCIE staff issued a new registered investment adviser ("RIA") regulatory risk alert announcing an initiative "seeking to identify conflicts of interest tied to advisers’ compensation or financial incentives for recommending mutual fund and 529 Plan share classes that have substantial loads or distribution fees ('Share Class Initiative')." The risk alert notes that "examples of conflicts of interest related to share class recommendations include situations where the adviser is also a broker-dealer or affiliated with a broker-dealer that receives fees from sales of certain share classes, and situations where the adviser recommends that clients purchase more expensive share classes of funds for which an affiliate of the adviser receives more fees."
- On January 12, 2017, the SEC released its annual top exam priorities for the 2017 calendar year. For the first time, the SEC listed "Share Class Selection" as a regulatory focus area for the upcoming year. In particular, the staff states it "will identify and assess conflicts that certain investment advisory personnel may have, such as those who also are registered representatives of a broker-dealer, which may influence recommendations in favor of share classes that have higher loads or distribution fees."
SEC Examination Focus
The SEC OCIE notes in its risk alert that it focus on these three components related to mutual fund and 529 plan share class selection:
- Fiduciary Duty and Best Execution
SEC staff notes that "an investment adviser has a fiduciary duty under Section 206 of the Advisers Act that obligates it to act in the client’s best interest, and to seek best execution for client transactions." SEC-registered RIA firms should expect examination staff to review firms' investment practices to determine how mutual funds and 529 plan investments are recommended to clients. In addition, books and records will be reviewed "to identify share classes held and purchased in clients’ accounts and any compensation received by the adviser or any of its associated persons related to such investments."
SEC staff writes that "as a fiduciary, an investment adviser has a duty to make full and fair disclosure of all material facts, including all material conflicts of interest that could affect the advisory relationship." In regards to the Form ADV Part 2 brochure, RIA firms must disclose "whether the adviser or its supervised persons accepts compensation for the sale of securities or other investment products, including asset-based sales charges or service fees from the sale of mutual fund." Furthermore, an advisory firm "must also explain the conflict of interest such compensation creates and how the adviser addresses the conflict, including the adviser’s procedures for disclosing the conflict to its clients." During audits, the staff specifies that it will "focus on assessing the accuracy, adequacy, and effectiveness of the adviser’s disclosures regarding compensation for the sale of shares and the conflicts of interest created."
- Compliance Program
To address potential conflicts of interest, "advisers must adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder." During examinations, staff will look to "assess the adequacy and effectiveness of the adviser’s corresponding written policies and procedures."
RIA Compliance Share Class Selection Best Practices
Hybrid or dually-registered RIA firms that also act as a broker-dealer or have individual representatives affiliated with a broker-dealer (e.g. a traditional independent broker dealer ("IBD") relationship) need to very focused on mutual fund share class selection. Typically, compliance risk associated with mutual fund share class and 529 plan selection is more prominent for firms operating as a hybrid compared to a fee-only RIA firm. As RIA compliance consultants, we recommend RIA firms with this compliance risk consider taking the following actions:
- Review Form ADV Parts 1 and 2 to ensure that all material conflicts of interested related to share class selection are fully and prominently disclosed.
- Establish policies and procedures to ensure when making an investment recommendation to a given client that all available share classes are reviewed and the lowest cost share class is selected.
- Establish policies and procedures to confirm the clients' best interests are met during initial share class selection.
- Establish policies and procedures to regularly review existing client share classes to determine if a more cost effective share class is now available to a given client.
This RIA compliance focus area has been a subject of past regulatory enforcement action and is likely to remain an enforcement focus moving forward. As such, we recommend that the firm's Chief Compliance Officer ("CCO") and principal(s) take immediate steps to review the compliance program to ensure that this potential risk is being properly addressed. Firms may also want to explore an RIA compliance software platform to assist with supervision and review requirements.
RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.