By Charles Black
Reality Check is an occasional blog post series we do where we analyze actual SEC enforcement actions or examination experiences and give you a summary of what to expect in the “real world.”
In 2019, the SEC closed its mutual funds share class selection disclosure initiative. This initiative allowed investment advisers to self-report to the SEC instances where they failed to disclose conflicts of interest and to implement reasonably designed policies and procedures relating to the selection of mutual fund share classes for clients. The SEC communicated that they would go easy on the advisers who self-reported vs. those who did not self-report.
Fast forward to today, and it’s clear the SEC still views this topic as a priority based on recent enforcement actions that have been released. At Joot, we’ve also witnessed first-hand the selection of mutual fund share classes come up as a topic in routine SEC exams.
In this post, I’m going to discuss two of the most recent enforcement actions including the findings. I’ll also provide some tips on how to update your compliance program to help prevent your firm from suffering the same fate.
- Each firm purchased, recommended, or held for advisory clients mutual fund share classes that charged fees pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“12b-1 fees”) instead of lower-cost share classes of the same funds which were available to the client;
- Each firm’s associated persons received 12b-1 fees in connection with these investments (in their capacities as registered representatives of a broker-dealer), but did not disclose this practice or the conflict of interest in its Form ADV or otherwise; and
- By causing certain advisory clients to invest in fund share classes that charged 12b-1 fees when share classes of the same funds that presented a more favorable value for these clients under the particular circumstances in place at the time the transactions were available to the clients, each firm breached its duty to seek best execution for those transactions.
The enforcement actions stated that both firms were eligible to self-report in the mutual funds share class selection disclosure initiative but did not do so. Each action discussed the disclosure, or lack thereof, that the SEC determined was inadequate. However, the SEC did not state definitively what disclosure would be sufficient in cases where clients were placed in mutual fund share classes when a cheaper class was available. The actions also cited best execution and other compliance deficiencies. Each firm was ordered to pay a fine and reimburse clients who were placed in higher cost share classes, as applicable.
Compliance Program Tips
When we read enforcement actions, we try to dissect and discern what steps or procedure updates need to be taken for investment advisers to prevent the action from happening to them. Here are some practical tips that will help you implement “reasonably designed” procedures for mutual fund share class selection.
Disclosure: Of course, you always need to make sure you have adequate disclosure for conflicts of interest. As previously noted, the SEC didn’t definitively state what disclosure would be sufficient in cases where clients were placed in mutual fund share classes when a cheaper class was available. If your firm has a similar situation in place you should seek counsel on what updates need to be made to your disclosure documents, or determine whether you can continue the same process and still meet your fiduciary duty as an investment adviser.
Best Execution and Procedures: It's clear through these and other similar enforcement actions that the SEC believes the concept of best execution applies to placing clients in the lowest cost share class. Here are some recommendations on how to amend your policies and procedures to address this.
- Compensation: The enforcement actions noted that associates of the firms received compensation in the form of 12b-1 fees from the higher cost share classes. However, even if associates are not receiving compensation, the SEC expects that clients will be placed in the lower cost share class. We know this first-hand based on recent SEC exams of some of our clients.
- Custodians: Most retail investment advisers utilize one, or maybe two, custodians for investing client money. When buying mutual funds, that means you are limited to what share classes the custodian can offer. This means your analysis of the lowest cost share class should apply to the custodian used, not every share class offered by the fund family. In most cases it would be too costly and inefficient to switch custodians or otherwise try to invest assets in a lower cost share class in separate accounts. However, you do need to compare the custodian to other custodians to help ensure that the custodian used is offering comparable services. This can be done by comparing trading costs for mutual funds and availability of lower cost share classes, such as Class I shares (Institutional shares).
- New Accounts: As your firm takes on a new client and reviews his/her portfolio, if you do decide to keep existing mutual fund investments, you need to determine at that time whether a lower cost share class is available at the custodian. If so, you will need to move the client to that lower cost share class, or otherwise document why you didn’t.
- Ticket Charges: Some custodians may include a ticket charge to buy/sell the lower cost share class while a more expensive share class may not have a ticket charge. The SEC in the enforcement actions states: “An investor who holds Class I shares of a mutual fund will usually pay lower total annual fund operating expenses over time – and thus will generally earn higher returns – than one who holds a share class of the same fund that charges 12b-1 fees. Therefore, if a mutual fund offers a Class I share, and an investor is eligible to own it, it is often, though not always, better for the investor to purchase or hold the Class I share.” This seems to verify that ticket charges should be part of the cost analysis, but in most cases, the SEC believes holding the lower cost share class over time will benefit the investor. Make sure you have a cost analysis in place to help determine if ticket charges are impactful to the investment.
- Review Process: A routine testing process - quarterly, for example - of all mutual fund purchases will help ensure the client was placed in the lowest cost share class. Also, as part of that testing process, you can reach out to the custodian to confirm if any new share classes were recently made available. This will help you determine if any existing clients can be switched to a lower cost share class.