The Division of Enforcement of the Securities and Exchange Commission (SEC) announced a new self-reporting initiative that “seeks to protect advisory clients from undisclosed conflicts of interest and return money to investors.”
Under the newly announced Share Class Selection Disclosure Initiative, dubbed the “SCSD Initiative,” the SEC’s enforcement agents “will agree not to recommend financial penalties against investment advisers who self-report violations of the federal securities laws relating to certain mutual fund share class selection issues and promptly return money to harmed clients.”
As the SEC explains, Section 206 of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisers to act in their clients’ best interests, including an “affirmative duty to disclose all conflicts of interest.” A conflict of interest, in this context, arises when an adviser receives compensation (either directly or indirectly through an affiliated broker/dealer) for selecting a more expensive mutual fund share class for a client when a less expensive share class for the same fund is available and appropriate. “That conflict of interest must be disclosed,” SEC confirms.
Under the SCSD Initiative, the enforcement division will recommend “standardized, favorable settlement terms to investment advisers that self-report that they failed to disclose conflicts of interest associated with the receipt of 12b-1 fees by the adviser, its affiliates, or its supervised persons for investing advisory clients in a 12b-1 fee paying share class when a lower-cost share class of the same mutual fund was available for the advisory clients.”
Advisers with undisclosed conflicts will not be getting off the hook entirely, SEC warns. For eligible advisers that participate in the SCSD Initiative, the enforcement division will recommend “settlements that will require the adviser to disgorge its ill-gotten gains and pay those amounts to harmed clients, but not impose a civil monetary penalty.” The enforcement division warns that it expects to recommend stronger sanctions in any future actions against investment advisers that engaged in the misconduct but failed to take advantage of this initiative.
This new initiative will play out against the SEC’s effort to find a way to collaborate with the Department of Labor (DOL) on that regulator’s own ongoing conflict of interest reforms. There are still different opinions in the retirement advisory community as to whether or not DOL and SEC will be able to find ways to truly collaborate and restore some sense of certainty about what the future holds for advisory professionals working under these regulators. The more optimistic analysts on this prospect point to the fact that leadership at both the DOL and SEC have signaled a willingness to work together to find complementary approaches to managing advisers’ conflicts of interest. Other, more pessimistic analysts on this point, see some systematic and political hurdles that could derail any true collaboration between DOL and SEC in the short term.
Either way, there is clearly a need for ongoing vigilance at both SEC and DOL. In the past several years, the SEC has charged nine firms with failing to disclose conflicts of interest of the type at issue here. These actions included significant penalties against the investment advisers, and collectively returned millions of dollars to clients. In addition, the SEC’s Office of Compliance Inspections and Examinations has repeatedly cautioned investment advisers and other market participants to examine their share class selection policies and procedures and disclosure practices.
“Proper disclosure of conflicts of interest is of utmost importance, and a necessity for any investment adviser to ensure that it is satisfying its obligations as a fiduciary to its clients,” says C. Dabney O’Riordan, co-chief of the Asset Management Unit in the SEC Division of Enforcement. “This initiative is designed to promote compliance with these obligations with respect to mutual fund share class selection, while at the same time quickly returning money to harmed clients.”
Eligibility for the SCSD Initiative is explained in a detailed announcement document. Investment advisers must notify the Division of Enforcement of their intent to self-report no later than June 12, 2018, by email to SCSDInitiative@sec.gov or by mail to SCSD Initiative, U.S. Securities and Exchange Commission, Denver Regional Office, 1961 Stout Street, Suite 1700, Denver, Colorado 80294.