On February 12, 2018, the U.S. Securities and Exchange Commission announced an initiative to address undisclosed conflicts of interest by investment advisers in the context of mutual fund share classes. Dubbed the Share Class Selection Disclosure (“SCSD”) Initiative, the program encourages investment advisers to self-report potential violations by June 12, 2018, in exchange for favorable settlement terms.
The Potential Violations
An investment adviser often has several share classes to choose from when investing in a mutual fund for a client. One share class may charge a 12b-1 fee at a certain rate, while another may charge the fee at a lower rate, and still another may not charge a 12b-1 fee at all. Where an investment adviser financially benefits from its selection of a 12b-1 fee-paying share class despite the availability of a lower-cost share class, it must sufficiently disclose the associated conflict of interest. Failure to do so may constitute a violation of Sections 206(2) and 207 of the Investment Advisers Act of 1940 (“the Act”). Further, the selection of the higher-cost share class may constitute a breach of the investment adviser’s fiduciary duty to seek best execution. Finally, the aforementioned conduct may be indicative of the investment adviser’s failure to adopt and implement adequate compliance policies and procedures, in violation of Section 206(4) of the Act and Rule 206(4)-7 thereunder.
An investment adviser is eligible to participate in the SCSD Initiative if:
- Since January 1, 2014, the investment adviser recommended, purchased or held a 12b-1 fee-paying share class for a client despite the availability of a lower-cost share class for the same mutual fund;
- The investment adviser, its supervised persons, its affiliated broker-dealer, or registered representatives of its affiliated broker-dealer received the 12b-1 fees; and
- The associated conflict of interest was either not disclosed or insufficiently disclosed on the investment adviser’s Form ADV.
The Benefits of Self-Reporting
The SCSD Initiative offers numerous benefits to eligible investment advisers, including:
- the avoidance of civil penalties (e., fines) in connection with any resulting settlement;
- availability of settlement terms wherein the investment adviser neither admits nor denies the Commission’s findings;
- violations covered in the settlement will be limited to those involving lack of disclosure; the Enforcement Division will not recommend related charges, such as failing to seek best execution or having an inadequate compliance program; and
- to the extent that the investment adviser directly received 12b-1 fees without being dually-registered as a broker-dealer, the Enforcement Division will not recommend charging the investment adviser with failing to register under Section 15(a) of the Securities Exchange Act of 1934.
To receive these benefits, participating investment advisers will be required to perform certain remedial undertakings, such as correcting relevant disclosure documents, moving clients to lower-cost share classes where appropriate and updating policies and procedures as necessary to prevent future violations of the Act. Eligible investment advisers who choose not to participate in the SCSD Initiative and subsequently become the subject of enforcement action will not only face the potential for additional charges and civil penalties, but should expect that the Enforcement Division will recommend penalties greater than those imposed in past cases for similar violations.
How to Participate
Eligible investment advisers must notify the Commission of their intention to participate in the SCSD Initiative by 12:00 a.m. Eastern Time on June 12, 2018. Notification can be accomplished by sending an email to SCSDInitiative@sec.gov or snail mail to:
U.S. Securities and Exchange Commission
Denver Regional Office
1961 Stout Street, Suite 1700
Denver, Colorado 80294
Within ten business days of such notification, participants must submit a completed questionnaire providing information about the reporting investment adviser, its affiliated broker-dealer and the underlying mutual funds, including the difference between the fees charged by the selected share classes and those of the lowest-cost share classes then available. Note that when interacting with regulators, it is imperative to adhere to sound procedures and best practices.
 Named after Rule 12b-1 of the Investment Company Act of 1940, these are ongoing fees charged to the investor and paid from fund assets to cover expenses related to shareholder services, distribution and marketing. They are typically paid to the distributing broker-dealer.
 To the extent the Commission determines an investment adviser received improper benefits/gains in the sale of a mutual fund (related to 12b-1 fees or otherwise), the investment adviser will remain subject to an order that it distribute those benefits/gains to affected customers, with interest.
John Han focuses his practice on regulatory advice, counseling and defense for broker-dealers and investment advisers. Immediately prior to joining the firm, John served as in-house counsel at LPL Financial, a registered investment adviser and one of the largest broker-dealers in the country. Prior to that, he spent a decade as an enforcement attorney at the Financial Industry Regulatory Authority. John began his career as a criminal prosecutor at the New York County District Attorney’s Office.
*Licensed in New York. Practicing in North Carolina pursuant to Rule 5.5(e) of the North Carolina Rules of Professional Conduct.