SEC Launches Self-Reporting Initiative for Investment Advisers

February 14, 2018

In line with Chairman Jay Clayton’s oft-stated priority of protecting the long-term interests of Main Street investors, on Feb. 12, 2018, the Securities and Exchange Commission’s Division of Enforcement announced the launch of a new self-reporting initiative for investment advisers. This new initiative — the Share Class Selection Disclosure Initiative — aims to address undisclosed conflicts of interest associated with the receipt of 12b-1 fees by investment advisers, their affiliates or their supervised persons paid by advisory clients who were eligible to invest in a lower-cost share class of the same mutual fund.

The SEC’s position on investment advisers’ disclosure obligations regarding conflicts of interest as they pertain to mutual fund share classes are well-known. Indeed, the Office of Compliance Inspections and Examinations released a National Exam Program Risk Alert on the topic in July 2016, as well as identified mutual fund share class disclosures as one of its 2018 National Exam Program Examination Priorities. Additionally, the SEC has brought numerous enforcement actions against investment advisers for deficient disclosures concerning conflicts of interest arising from the receipt of 12b-1 fees. 

This focus is expected to continue: Enforcement has been clear that mutual fund share class selection practices will remain a priority, and enforcement actions outside of the self-reporting initiative will likely result in more serious charges.

Self-Reporting Initiative

The new self-reporting initiative is available to investment advisers, other than those already contacted by Enforcement on this issue, that did not explicitly disclose in their Forms ADV the conflict of interest associated with the 12b-1 fees the firm, its affiliates or its supervised persons received for investing advisory clients in a fund’s 12b-1 fee paying share class when a lower-cost share class was available for the same fund. To participate, an eligible investment adviser must self-report by June 12, 2018, and, within ten days of providing that notification, confirm its eligibility by submitting the SEC’s questionnaire. For any participating eligible investment adviser, Enforcement will recommend the following standardized settlement terms to the SEC:

  • On a neither-admit-nor-deny basis, entry of an order directing the respondent to cease and desist from committing or causing any violations and future violations of Sections 206(2) and 207 of the Investment Advisers Act of 1940 (IAA)
  • A censure
  • A respondent-administered distribution to affected clients of disgorgement of ill-gotten gains and prejudgment interest thereon
  • Remedial undertakings, including, to the extent necessary, correcting any relevant disclosures, moving clients to lower-cost share classes, updating relevant policies and procedures, and notification of the settlement terms to clients

Key Considerations

Importantly, eligible investment advisers that participate in the self-reporting initiative will not face the panoply of more draconian relief available to and obtained by the SEC in prior share class disclosure enforcement actions. Specifically, eligible investment advisers will not be required to pay a monetary penalty. Nor will there be any requirement to retain an independent compliance consultant and adopt and implement all of its recommendations. Investment advisers that elect not to participate in the self-reporting initiative and subsequently face an enforcement action for share class disclosure violations should anticipate financial penalties greater than those imposed in past actions involving similar conduct.

Similarly, the violations against participating eligible investment advisers will be limited to Sections 206(2) and 207 of the IAA. Generally, IAA Section 206(2), a non-scienter-based fraud statute, imposes a fiduciary duty on the investment adviser to disclose to its clients all conflicts of interest that may impact the investment adviser’s ability to render objective advice. IAA Section 207 makes it unlawful for any person willfully to make any untrue statement of, or omit to state any, material fact in Forms ADV.

Enforcement has indicated that it does not intend to recommend additional charges relating to the conduct at issue in the self-reporting initiative, even where the facts would support such charges. In this regard, previous share disclosure enforcement actions have also included findings that the investment adviser failed to seek best execution, in violation of IAA Section 206(4), and failed to adopt and implement policies and procedures reasonably designed to prevent violations as required by Rule 206(4)-7 thereunder. Thus, eligible investment advisers that do not avail themselves of the self-reporting initiative should, if supported by the facts, expect to face these additional charges in any share class disclosure enforcement action.

The self-reporting initiative is available only to investment advisers. Participation does not shield eligible investment advisers from investigation or separate enforcement actions for other misconduct. There is no similar program for individuals, and Enforcement has expressly provided no assurances that associated persons will be offered similar settlement terms for their involvement in the violations.

Next Steps

The deadline to self-report is four months away, but investment advisers would be well-served to act quickly to determine whether they will participate in the self-reporting initiative. In this regard, investment advisers should promptly review their Forms ADV and supplements to assess the sufficiency of their conflicts of interest disclosures associated with 12b-1 fees. To be sufficient, the disclosures must clearly describe the conflicts of interests associated with (1) making investment decisions in light of the receipt of the 12b-1 fees, and (2) selecting the more expensive 12b-1 fee paying share class when a lower-cost share class of the same fund was available to the same investor.

Investment advisers that identify deficient disclosures and intend to self-report should consider voluntarily undertaking the remedial measures that will otherwise be ordered under the self-reporting initiative.

Should you wish to discuss the self-reporting initiative, please contact any of the authors or any of McGuireWoods’ securities enforcement and regulatory attorneys.

McGuireWoods’ securities enforcement and regulatory attorneysattorneys will continue to monitor and report on important developments for broker-dealer and investment advisers. For further information, please contact the authors or any member of the McGuireWoods team.