Header graphic for print
The BD/IA Regulator Providing securities regulatory, enforcement and litigation trends for broker-dealers, investment advisers and investment funds

Enforcement Issues FAQs on the Share Class Selection Disclosure Initiative

Posted in Enforcement, Investment Adviser Regulation, SEC Enforcement

On May 1, the SEC’s Division of Enforcement issued a series of frequently asked questions (FAQs) related to its Share Class Selection Disclosure Initiative (“SCSD Initiative”). The SCSD Initiative, which was originally announced February 12, 2018, provides that the Enforcement Division will agree to recommend to the Commission standardized, favorable settlement terms for investment advisers who self-report possible securities law violations related to their failure to make certain disclosures concerning mutual fund share class selection.

Under the SCSD Initiative, the cut-off date for self-reporting is June 12, 2018.

Background

Over the last several years, the SEC filed several administrative actions against investment advisers that failed to adequately disclose to clients conflicts of interest arising from the receipt of 12b-1 fees for investing clients in, or recommending that clients invest in, a mutual fund share class that paid the adviser a 12b-1 fee when a lower cost share class was also available. The SEC took issue with the fact that such entities disclosed that they “may” receive 12b-1 fees and that such fees “may” create a conflict of interest. According to the SEC, such disclosure is not compliant with provisions of the Investment Advisers Act of 1940 that require disclosure of an adviser’s material conflicts of interest related to its mutual fund share class selection practices.

The FAQs

Among other things, the recent FAQs clarify that an adviser can rely on the SCSD Initiative only with respect to the specific self-reporting opportunity outlined in the original announcement. The Enforcement Division will not extend the SCSD Initiative settlement terms to other instances where an adviser failed to disclose conflicts of interest related to other fees received in connection with recommending, purchasing, or holding higher cost share classes. The Enforcement Division also confirmed that it does not plan to recommend fundamentally different settlement terms for advisers based on the relative “severity and scope” of an adviser’s conduct.

Importantly, the FAQs clarify that an adviser that has been or is being examined by the SEC’s Office of Compliance Examinations and Inspections (OCIE) cannot rely on its interactions with OCIE as self-reporting for purposes of the SCSD Initiative. The only way to ensure that the Enforcement Division will recommend favorable SCSD Initiative settlement terms is for the adviser to self-report as described in the initial announcement. The Division made it clear that “advisers that have been or are being examined by OCIE regarding the issues covered by the SCSD Initiative but, as of February 12, 2018, had not been contacted by the Division regarding possible violations related to their failures to disclose the conflicts of interest associated with mutual fund share class selection,” are eligible to participate in the SCSD Initiative, regardless of the outcome of the OCIE exam.

The FAQs also provide clarity regarding how the Division staff intends to determine the amount of disgorgement an adviser will be asked to make, how an adviser should determine if a lower fee share class was “available,” and that an adviser would be eligible to participate in the SCSD Initiative if it failed to disclose conflicts related to both (i) making an investment decision in light of the receipt of 12b-1 fees and (ii) selecting the more expensive class of shares. Importantly, any adviser entering into a settlement pursuant to the SCSD Initiative would be required to make certain specific undertakings, including an evaluation of whether existing clients should be moved to a lower cost share class, moving any such clients, and notifying its clients of the settlement terms.

Our Take

The FAQs clarify that the Division does not intend to extend the June 12, 2018 deadline to self-report and that advisers are encouraged to consult with experienced counsel to determine if participation in the SCSD Initiative would have any collateral consequences. Although it is unlikely that entering into a settled administrative action would be without any consequences, if an adviser does not do so, and is later determined to not have fully complied with its disclosure obligations regarding receipt of 12b-1 fees, it is likely that any collateral consequences of a resulting enforcement action would be more severe.