By Joseph S. Simms

The SEC’s focus on mutual fund share classes charging 12b-1 fees is nothing new.  In particular, the SEC has for years taken the position that in the absence of adequate disclosures, it is a conflict of interest in violation of the federal securities laws for an advisor to recommend mutual fund share classes that pay the advisor or its affiliated entities or individuals 12b-1 fees when lower cost share classes are available.  Over the years, the SEC has pursued numerous enforcement actions against firms for alleged conflicts of interest resulting from disclosures the SEC determined to be inadequate—more than 15 in just the last 5 years according the Division of Enforcement’s 2018 Annual Report. 

In an effort to address its concerns in this area more globally, rather than on a case-by-case basis, the SEC announced its Share Class Selection Disclosure Initiative in February 2018. Pursuant to the Initiative, the SEC invited its registrants to self-report the receipt of such fees in the absence of adequate disclosures as violations of Sections 206 and 207 of the Investment Advisers Act of 1940. In exchange for such self-reporting, the Division of Enforcement agreed that responding firms, among other things, would be subject to certain findings and ordered to reimburse their clients for the 12b-1 fees and interest thereon, but that the Division would not pursue fines or other monetary sanctions in addition to the payment of the 12b-1 fees and interest. According to the Division’s Annual Report, “scores” of registrant firms self-reported, and are now working with SEC staff to finalize the terms of those agreements.    

In the meantime, starting in the summer of 2018, the SEC sought and obtained data from clearing firms around the country to ascertain whether—and to what extent—firms that did not self-report nonetheless received 12b-1 fees (and other revenue-sharing payments that noticeably were not included in the self-reporting initiative) without adequate conflict-of-interest disclosures in purported violation of the Advisers Act. Armed with that information, in November and December 2018, the SEC’s Enforcement Division Staff began sending out requests for documents and information to numerous firms around the country that the Staff suspects may have acted in violation of the Advisers Act over the past 5+ years as outlined above. While those inquiries are still in their early stages (having been delayed somewhat by the partial government shutdown), it is important for firms to gather and be prepared to produce all documents and information to aid in their defense (regardless of whether actually responsive to a particular SEC request). Such information includes, of course, an analysis of the mutual fund families involved to determine whether lower cost share classes were even available, and whether and to what extent 12b-1 fees were rebated, refunded or credited back to clients. In addition, firms should compile and provide documentation showing the nature and extent of any and all disclosures made by the firms, how such disclosures were amended or revised over the period of time identified by the SEC, and whether outside compliance consultants or legal counsel were utilized in the preparation of the disclosures and the determination of their adequacy under the law, standards and practices in effect at the time.  

While it remains to be seen what the Staff will do with the information it obtains, it bears noting that in instances where the SEC determines that a violation occurred, it will likely seek settlements that include fines and penalties beyond disgorgement of the 12b-1 fees and payment of interest as was offered to firms that self-reported. Absent such agreements, the Division will likely be pursuing enforcement actions against firms it determines have acted in violation of the conflict-of-interest rules. Consequently, it is important for any firm receiving such an inquiry from the Division of Enforcement to engage experienced counsel to assist in the process and respond promptly, thoughtfully and carefully.

Joseph S. Simms is a Shareholder in the Cleveland, Ohio office of Reminger Co., LPA, where he practices in the firm’s Financial Services Professional Liability and Securities Litigation Groups.  His primary focus is complex securities litigation and arbitration, financial institution litigation, regulatory investigations and inquiries, and broker-dealer liability defense, in which he represents brokers, broker-dealers, investment advisors, banks, and insurance companies in claims involving allegations of professional misconduct.

This has been prepared for informational purposes only. It does not contain legal advice or legal opinion and should not be relied upon for individual situations. Nothing herein creates an attorney-client relationship between the Reader and Reminger. The information in this document is subject to change and the Reader should not rely on the statements in this document without first consulting legal counsel.

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