Automated compliance systems are helpful, but they are not a cure-all. Like any tool, a compliance technology is only as good as the people using it. Bad inputs cause bad outputs. Also, firms can’t just “set it and forget it,” hoping that the system works.
In a recent FAQ, the staff of the SEC’s Division of Investment Management suggests that investment advisers consider rebating revenue sharing received from third parties against account-level fees. The FAQ purports to offer disclosure and mitigation guidance for advisers that receive payments or benefits from third parties for recommending certain classes of mutual funds. The staff requires extensive disclosure including the share classes available, differences in expenses and performance, limitations on the availability of share classes, conversion practices, how the adviser recommends different share classes, and the existence of incentives. The staff also encourages advisers to disclose “[w]hether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction” such as ERISA accounts.
We believe that, through these extensive disclosure requirements, the SEC staff is effectively outlawing revenue sharing unless the adviser rebates the compensation to clients. Disclosure alone may never be sufficient for an adviser to satisfy its fiduciary obligations. This standard would conform with how ERISA treats qualified accounts.
It is unclear whether this group of cases is the beginning, middle, or end of the Share Class Selection Disclosure Initiative. Regardless, firms are on notice that they must clean up their disclosures and reimburse investors if they have recommended higher expense share classes.
The SEC breaks new ground in this complaint by suggesting that the firm should have invested client assets in other funds (including funds sponsored by an affiliate of the clearing broker) that did not offer revenue sharing. Most prior revenue sharing cases have focused on the use of higher fee share classes of the same fund. This line of argument raises a concern that the SEC is implicitly advocating for the lowest cost fund regardless of investment mandate or performance. For example, would an adviser violate its fiduciary duty, absent revenue sharing, if it recommended a higher cost fund for reasons other than total expense ratio?
Once the SEC identifies possible wrongdoing, don’t compound the problem by further misleading clients during the remediation process. It is possible that this firm could have avoided the $400,000 in fines had it not lied to clients about its past practices.
We expect several enforcement actions this year based on the failure to offer the lowest mutual fund share class available. We recommend that advisers conduct an internal reviews of recommendation practices and take action to reimburse clients.
Three investment advisory firms will pay nearly $15 Million in fines and disgorgement for recommending more expensive mutual fund share classes that paid revenue sharing. The SEC faults the firms for failing to fully disclose that recommending higher-fee fund share classes in exchange for revenue sharing presented a conflict of interest. The SEC also alleges that recommending the higher-fee classes violated the firms’ best execution obligations. An SEC official “strongly encourage[s]” eligible firms to participate in the recently announced Share Class Disclosure Initiative amnesty program.
OUR TAKE: Given the number of cases in this area, it may be that, as a practical matter, an adviser can never include enough disclosure that would justify recommending anything other than the cheapest share class available. We recommend that compli-pros conduct an internal sweep of their firms’ mutual fund recommendation practices.
OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled. Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.
The SEC’s Enforcement Division is offering amnesty from civil penalties for firms that self-report failures to fully disclose conflicts of interest when recommending mutual fund share classes that pay 12b-1 fees. Under this new “Share Class Selection Disclosure Initiative,” self-reporting firms would disgorge the 12b-1 fees and reimburse clients as well as implement other compliance procedures to prevent future wrongdoing. The Share Class Initiative would apply to a registered adviser that failed to fully disclose the conflict of interest where it recommended mutual fund share classes that paid back 12b-1 fees to the firm or affiliates when lower fee share classes were available. The amnesty program would not apply to firms already involved in enforcement actions related to share classes but would be available if a firm is undergoing a pending OCIE examination. This amnesty program will not protect individuals associated with self-reported firms as the Enforcement Division will do a “case-by-case assessment of specific facts and circumstances, including evidence regarding the level of intent and other factors such as cooperation by the individual.”
OUR TAKE: Advisers should consult counsel to conduct a cost/benefit analysis of self-reporting, including the potential impact on senior executives.