The Share Class Selection Disclosure Initiative Marches On

Sometimes it seems like all we talk about around here is the SEC’s Share Class Selection Disclosure Initiative. It’s an active enterprise! As a reminder, the Commission first described it this way in 2018:

The Commission may file enforcement actions alleging violations of these provisions against investment advisers that fail to disclose to their clients conflicts of interest, including those conflicts associated with the receipt of 12b-1 fees for investing client funds in, or recommending that clients invest in, a 12b-1 fee paying share class when a lower-cost share class was available to clients for the same fund.  A 12b-1 fee is a fee paid by a mutual fund on an ongoing basis from its assets for shareholder services, distribution, and marketing expenses.  Each share class of a fund represents an interest in the same portfolio of securities.  Therefore, when there is a lower-cost share class available that does not charge a 12b-1 fee (or charges a lower 12b-1 fee), 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.

Then the SEC brought 79 mutual fund advisers to heel with negligence-based charges and no penalties in March. Sometimes that’s all you get with these sorts of things.

But in August Commonwealth Financial said no more Mr. Nice Guy, held up what I presume was the SEC’s offer to settle on similar terms as the 79, and told the Commission to shove it. I’m pretty sure those were the exact terms they used. Some people, including the Financial Services Institute, said mean things about the Initiative, calling it “regulation without rules.” Would that be the end of the fun times, with settlements under the Initiative ground to a halt?

Well, was it over when the Germans bombed Pearl Harbor? Hell no! Nothing’s over until the SEC decides it is. So on September 30th, the Commission announced 16 more advisers that self-reported alleged violations of Section 206(2) of the Advisers Act under the Initiative. The administrative orders did not include reference to Section 207 this time, but did include censures and cease-and-desist injunctions, along with disgorgement and prejudgment interest.

One firm, Mid-Atlantic Financial Management Inc., did not self-report, but got dragged in by some other means. The Commission says that even without the self-report, it considered “other remedial acts promptly undertaken by MAFM and cooperation afforded the Commission staff.” Anyway, Mid-Atlantic had to pay over $1 million in disgorgement and prejudgment interest, along with a $300,000 civil penalty.

What is Going On

We don’t know exactly what’s going on, in the sense that the civil penalty for non-self-reporting Mid-Atlantic is not off the charts, coming in at about 30% of the disgorgement and prejudgment interest figure. At this point Mid-Atlantic and Commonwealth Financial are the only two mutual fund advisers we know of that have not self-reported to the SEC with potential 12b-1 fee share class violations. One is walking away with a relatively modest fine. The other appears to be fighting hard to give the SEC all it can handle in federal court. We’ll see how that works out.