SEC's 12b-1 Fee Crackdown Shows No Sign of Abating
by: RIch Blake
This past summer, the Securities and Exchange Commission (SEC) was in the middle of its continuing probe into share-class disclosure violations when the agency received some biting criticism – from an ex-SEC commissioner.
"Staffers are trying to enforce a standard that they only started articulating last year," Paul Atkins, now chief executive of Patomak Global Partners, said in a July interview with InvestmentNews.
Atkins served as a commissioner from 2002 to 2008.
"Why didn't the SEC do a rulemaking on this?,” Atkins said. “Why are they doing it through enforcement?"
The phrase "rulemaking by enforcement" was bandied about across the industry in late September, when the SEC announced it ordered a Pittsburgh-based registered investment adviser to pay a $300,000 civil monetary penalty for not telling clients that they were sold higher-fee share classes despite the availability of less expensive classes. The firm also had $1 million disgorged from it. The civil penalty was specifically imposed because this firm did not self-report these share-class sales activities under the SEC's Share Class Selection Disclosure Initiative (SCSD).
Begun in 2018, the SCSD Initiative, which seems to be a cross between an amnesty program and a staged intervention, cattle-prodded firms into coming clean about past share-class violations so as to avoid civil penalties. Sixteen RIA firms self-reported in the most recent phase. Earlier this year, 79 firms came clean and avoided fines, but had millions disgorged. The amount of assets disgorged from these self-reporting firms and returned to investors amounted to more than $130 million.
These actions "reaffirm the benefits to advisers and their clients for self-reporting as part of the [SCSD] initiative,” C. Dabney O’Riordan, Co-Chief of the SEC’s Asset Management Unit said in a public statement on Sept. 30. “They also demonstrate the Commission’s commitment to holding advisers accountable for selecting more expensive investments that eat away at their clients’ investment returns without proper disclosure.”
O'Riordan, through SEC spokesperson Judith Burns, declined to respond to the criticism surrounding rulemaking by enforcement. Publicly available information on the SEC’s website provides a window into the SEC's motivation.
"There is significant concern that many investment advisers have not been complying with their obligation under the Investment Advisers Act of 1940 to fully disclose all material conflicts of interest related to their mutual fund share-class selection practices, and that investor harm involving this lack of disclosure may be widespread," the SEC said in announcing its SCSD Initiative last year.
In other words, rules are rules.
Section 206(2) of the Advisers Act prohibits an investment adviser, directly or indirectly, from engaging "in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client," and imposes a fiduciary duty on investment advisers to act for their clients' benefit, including an affirmative duty of utmost good faith and full disclosure of all material facts.
Additionally, Section 206(2) requires an investment adviser to disclose to its clients all conflicts of interest that might incline an investment adviser, consciously or unconsciously, to render advice that is not disinterested. Then there is Section 207, which makes it "unlawful for any person ... willfully to omit to state in any such application or report any material fact which is required to be stated therein."
This crackdown has mainly targeted 12b-1 fee practices that were accepted 20 years ago. It happened around the same time that a bright spotlight was shined on some other common, not particularly controversial, practices: late trading and market timing.
Market timing, the rapid buying and selling of fund shares, was not illegal at the time it became political hay for then New York State Attorney General Eliot Spitzer, and later the SEC. Many big funds, however, stated that this kind of trading was prohibited but then went ahead and allowed some select parties to engage in it – sometimes for the wrong reasons, but sometimes owing to cost-benefit rationale. Either way, with headlines proclaiming abuse at the expense of the little guy, the practice became taboo. The total dilutive costs of undisclosed market timing arrangements were estimated to have reached into billions of dollars.
Late trading refers to “the practice of placing orders to buy or redeem mutual fund shares after the time as of which a mutual fund has calculated its net asset value, usually as of the close of trading, but receiving the price based on the prior NAV already determined as of that day,” according to the SEC.
Revenue sharing practices, including using 12b-1 fees – taken from shareholder assets – to compensate brokers who promoted funds, came under scrutiny around this same time.
Rule 12b-1 of the Investment Company Act of 1940 allowed for investor assets to be used for distribution costs, expanding the economies of scale. But while originally used for marketing costs, they ultimately turned into commissions for brokers.
The Pittsburgh adviser that failed to self-report a share-class selection disclosure violation was penalized in connection with the 12b-1 fees its affiliated broker received between 2013 and 2018. Recommending the share classes that charged 12b-1 fees instead of lower-cost share classes was a conflict. For not adequately disclosing this conflict and not coming clean about it to the SEC when given the chance, the firm was penalized, then singled out in a government news release and subsequent media articles.
We Should Have Seen This Coming
The SEC has not been cagey about having 12b-1 fee practices in its sights.
In April 2018, two months prior to the deadline for advisers to comply voluntarily with the SCSD, the SEC released three settlement orders with investment advisers because they placed clients in higher-cost mutual fund shares when lower-cost shares of the same funds were available.
The firms had to reimburse investors $12 million and pay penalties ranging from $250,000 to $900,000.
The agency was trying to show the industry what could happen to those who fail to take advantage of its offer, Jaqueline M. Hummel, partner and managing director or Hardin Compliance Consulting said in her blog post, "Why the SEC is Obsessed with Mutual Fund Share Class Selection and Disclosure (and why you should be too).”
"We should have seen this coming," Hummel said.
In the wake of the mutual fund scandals of the early 2000s, the SEC began targeting misconduct in the relationships between brokerage firms and mutual fund companies. In a number of high-profile cases, the SEC nailed firms for failure to disclose revenue-sharing and distribution payments made by mutual fund companies to brokerage firms in exchange for promoting fund shares, according to Hummel.
Regulators continued to clamp down on fund fees. FINRA brought share class cases in 2005. One year later, the SEC issued a landmark opinion in a matter involving a registered representative deemed to have committed fraud by negligently omitting to disclose material facts concerning the cost structure associated with different classes of multiple-class mutual funds. And in 2011, the SEC’s Asset Management Unit started its “mutual fund fee initiative” focused on excessive fees charged by advisors. Although not specifically related to the 12b-1 fee issue, the initiative did address the 15(c) process, which involves approval of fund fees charged by an adviser.
In a risk alert issued in July 2016, the SEC's Office of Compliance Inspections and Examinations announced its Share Class Initiative, putting advisers on notice that it would be conducting focused, risk-based examinations of high-risk areas, including disclosures of conflicts of interest and receipt of compensation from mutual fund companies, Hummel said.
Yet, speaking with InvestmentNews in July 2019, Atkins still insisted that the disclosure-standard goalposts had been moved, and that there remains "no real certainty as far as what is acceptable in the SEC's eyes."
The former SEC commissioner pointed to the number of firms involved in the initial settlement as warranting a total rethink of the crackdown.
"With that massive a scale of alleged non-compliance with whatever the purported standard was, why didn't the SEC do a rulemaking on this?" Atkins asked.
No one at the SEC has come out and said it, but the agency seems to be speaking loudly through its enforcement as far as what is considered unacceptable.
"The SEC has honed in on this issue," Hummel said. "And firms failing to take action are undoubtedly going to suffer."
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