SEC Announces Results of Share Class Selection Disclosure Initiative

People violate the securities laws sometimes. This happens more often than the SEC can even handle.

Prior SEC Disclosure Initiatives

Its then-Enforcement Director Stanley Sporkin realized this as long ago as 1974, when some digging spurred by the Watergate hearings revealed a LOT of public companies using slush funds to spend money on political campaigns and bribes of foreign government officials. Chairman Ray Garrett looked at all of them and said, “We can’t be suing every company.” So they came up with a volunteer program where companies were allowed to make disclosures about these payments and undertake to disclose them in their corporate filings. Sporkin remembers over 650 companies participating.

The SEC still does this sort of thing. In 2014 it looked across the landscape, didn’t love what it saw in the municipal issuer and underwriter space, and launched the Municipalities Continuing Disclosure Cooperation Initiative. Within the next two years, the SEC settled with 71 municipal issuers and 72 underwriters under non-scienter-based charges.

12b-1 Fees

In 2018, it saw similarly widespread problems with the disclosure of fees charged under Investment Company Act Rule 12b-1. What are those? Here’s what TheStreet said about them in 2003:

In the confusing alphanumeric soup of fees and share classes, probably no item is more misunderstood than the 12b-1 fee. The SEC adopted 12b-1 fees in 1980 as a way to let struggling funds use a small portion of their assets, on a short-term basis, to kick-start the marketing of the funds and counter redemptions, which in theory would lead to more assets, economies of scale and lower overall costs. . . .

By all counts, 12b-1 fees – originally meant as a short-term way for funds to pay for advertising and such – have become a substitute for a front-end sales load. “A large number of funds use 12b-1 fees in this way,” said Doug Scheidt, the associate director of the SEC’s Division of Investment Management. Indeed, 11,481 funds, or 66% of the 17,366 funds that Lipper tracks, assess a 12b-1 fee.

From a disclosure perspective, the issue for mutual fund investment advisers is that some mutual funds will have multiple share classes, some of which charge 12b-1 fees, and some of which don’t. So “when there is a lower-cost share class available that does not charge a 12b-1 fee (or charges a lower [one]), it is usually in the client’s best interest to invest in the lower-cost share class rather than the 12b-1 fee paying share class because the client’s returns would not be reduced by the 12b-1 fees.”

The Share Class Selection Disclosure Initiative

Over the past several years, the SEC has filed a number of actions where an investment adviser did not disclose lower-cost mutual fund share classes and instead recommended share classes that paid the adviser or its related entities or individuals 12b-1 fees. It suspected more were out there. So it launched the Share Class Selection Disclosure Initiative in 2018 to identify and address potential violations based in the lack of disclosure in this area.

The idea was the SEC’s Enforcement Division would recommend that the Commission accept favorable settlement terms for investment advisers that self-report possible violations relating to their failure to make necessary disclosures concerning mutual fund share class selection. Self reporters would settle to violations of Sections 206(2) and 207 of the Advisers Act, which can rest on findings of simple negligence.  

In March, the SEC “settled charges against 79 investment advisers who will return more than $125 million to clients, with a substantial majority of the funds going to retail investors.”

Each of the settling investment advisers consented to:

• cease-and-desist orders;

• censures;

• disgorgement of the 12b-1 fees at issue;

• distribute the money represented by those fees with prejudgment interest to affected clients; and 

• correct the relevant disclosure documents on mutual fund share class selection and 12b-1 fees and to move existing clients to an available lower-cost share class as necessary. 

These advisers avoided penalties.

What to do . . .

Going forward, mutual fund advisers should obviously be mindful of 12b-1 fees in Form ADV brochures and brochure supplements. If your funds have multiple share classes, be sure your clients are in the right ones, and that you’re clearly explaining to them the differences between them and the relative benefits of each. Maybe this goes without saying, but we’re saying it. But if you crossed your fingers and ignored this initiative, you had better pray to the god of skinny punks that you don’t get caught because you’re not going to escape without a penalty if you do.