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Compliance December 19, 2018
After Grace Period, SEC Share Class Disclosure Investigations Begin
Attorneys warn the “other shoe has dropped” in the SEC’s special Share Class Disclosure Initiative—and RIAs that did not self-report potential 12b-1 fee disclosure violations are now being investigated.
Reported by John Manganaro
In February of this year, the U.S. Securities and Exchange Commission’s Division of Enforcement announced a special “Share Class Selection Disclosure Initiative,” under which registered investment advisers (RIAs) could self-report and correct previous failures to disclose the selection of mutual fund share classes that paid a Rule 12b-1 fee when a lower-cost share class for the same fund was available to clients.
In a new legal alert shared by Eversheds Sutherland, attorneys warn the “other shoe has dropped,” and SEC investigators are now following up with firms that didn’t self-report under the share class initiative by the June deadline. They say the SEC seems to be targeting firms that it thinks should likely have self-reported potential violations but did not.
As the Eversheds Sutherland attorneys point out, in announcing this initiative, SEC enforcement staff pledged that if RIAs accurately self-reported violations and promptly returned money to harmed clients, then it would recommend favorable settlement terms with no civil penalty for any resulting enforcement action against the self-reporting RIA. On the other hand, if RIAs didn’t self-report, then SEC enforcement staff would recommend “violations and remedies beyond those described in the initiative, including penalties that could be greater than those imposed in past cases involving similar disclosure failures.”
Eversheds Sutherland attorneys warn, beginning last week, SEC enforcement staff started sending request letters to firms that didn’t self-report “but perhaps should have.” The request letters largely mirror the 12b-1 disclosure issues set forth in the initiative, the attorneys say, but the letters expand on the SEC’s initial review with regard to two key areas.
“First, the SEC has expanded the relevant time period, going back to 2013,” the attorneys note. “Second, the SEC’s request covers not just 12b-1 fees, but also revenue sharing, including requesting all agreements concerning revenue sharing payments and data regarding each mutual fund that made revenue sharing payments due to the share class in which the advisory client assets were held.”
The attorneys warn that, assuming SEC enforcement believes a firm’s disclosures were inadequate, investigators may focus on the following additional issues: “Why the firm didn’t self-report; why the firm’s conduct resulted in inadequate disclosures; and any subsequent remedial efforts taken by the firm.” As described in the initiative announcement, SEC enforcement actions will likely allege fraudulent disclosures, breach of fiduciary duty and best execution failures.
“If firms have not received enforcement’s requests, they may, nonetheless, want to assess the issues being investigated,” the Eversheds Sutherland attorneys recommend.
The choice to forego self-disclosure
According to attorneys with the Wagner Law Group, some advisory practices may have had reason to forego this “carrot and stick” opportunity to self-report potential violations of fee disclosure and fiduciary standards. While the term “amnesty” used by SEC staff in describing the initiative conjured up an image of full forgiveness, the Wagner attorneys warn that any voluntary remediation program of this nature is not without its own risks.
“For one thing, it is not actually mandatory to self-report, although dual registered firms must consider their FINRA reporting obligations under FINRA Rule 4530(b),” the Wagner attorneys note. “Missteps in crafting a correction can increase a firm’s legal and reputational risk. Cease and desist orders carry their own consequences.”
The attorneys urge advisers to be cautious even as they do the right thing: “The goal of correcting past violations is to make injured parties whole, prevent recurrence and avoid increased scrutiny by regulatory authorities. Remedial efforts generally, and the decision whether to participate in the Share Class Disclosure Initiative, require a thoughtful, well-documented and careful review by the investment adviser.”
Because this initiative covers only eligible individual advisers, the attorneys warn, other individuals associated with the same firm do not actually have assurance that they will be offered similar terms for their role in any self-reported violations.