On February 12, 2018, the U.S. Securities and Exchange Commission (SEC or Commission) issued a press release announcing the Share Class Selection Disclosure Initiative (SCSD Initiative) to encourage investment advisers to self-report certain violations of the Investment Advisers Act (Advisers Act) relating to selection of mutual fund share classes. Under the SCSD Initiative, the SEC Division of Enforcement will show relative leniency toward investment advisers who self-report violations relating to share class conflicts of interest from the receipt of Rule 12b-1 fees. For those self-reporting advisers, the Enforcement Division will recommend favorable settlement terms, including no civil money penalty, in any resulting enforcement action. The SCSD Initiative aligns with the Clayton Commission’s emphasis on retail investor protection and its desire to allocate the SEC’s resources efficiently. Stephanie Avakian, Co-Director of the Enforcement Division, commented on this theme in the initiative’s accompanying release by saying, “This focused initiative reflects our effort to allocate our resources in a way that effectively targets the continued failure by some advisers to disclose conflicts of interest around share class selection and, importantly, is intended to facilitate the prompt return of money to victimized investors.”1
What is the SEC Offering?
Section 206(2) of the Advisers Act prohibits advisers from engaging in fraudulent transactions, and the courts have interpreted it as imposing a duty to disclose conflicts of interest to clients.2 The SCSD Initiative aims to incentivize advisers to report failures to disclose conflicts of interest related to Rule 12b-1 fees3 by offering them “settlements that will require the adviser to disgorge its ill-gotten gains and pay those amounts to harmed clients, but not impose a civil monetary penalty.”4 Steven Peikin,
Co-Director of the Enforcement Division, emphasized that the favorable settlement terms offered by the initiative will not be available to advisers who fail to self-report and later find themselves in the Enforcement Division’s crosshairs, stating, “We strongly encourage advisers to take advantage of the favorable terms we are offering; these terms will not be available to advisers who do not self-report under this initiative, and we will continue to proactively seek to identify and pursue investment advisers that fail to make the necessary disclosures.”5
SEC Enforcement Activity Around Share Class Selection and Rule 12b-1 Fees
The SCSD Initiative follows several years of SEC enforcement actions charging investment advisers who failed to disclose financial conflicts of interest in connection with recommending that their clients invest in mutual fund classes imposing Rule 12b-1 fees. For instance, the Commission brought an enforcement action in 2013 against an investment adviser and its principal for breaching their fiduciary duties by causing pooled investment vehicles that they managed (the Funds) to buy “Class A shares of underlying mutual funds (Investment Funds) even when the Funds were eligible to own lower-cost ‘institutional’ shares of the very same Investment Funds. As a result, the Funds paid avoidable, and ongoing, 12b-1 fees.”6 More recently, the SEC fined a dually registered investment adviser and broker-dealer, Packerland Brokerage Services, for advising its clients to invest in mutual fund share classes that imposed a Rule 12b-1 fee and service fee but failing to disclose the availability of a lower-cost share class.7
The SCSD Initiative Is a Continuation of the SEC’s Cooperation Initiative
The SCSD initiative continues the SEC’s long line of cooperation initiatives—dating as far back as the SEC’s Seaboard 21(a) Report in 2001—designed to encourage self-reporting of securities law violations in exchange for reduced penalties.8 The SEC’s current Cooperation Program, launched in 2010, empowered the Enforcement Division to use previously unavailable cooperation tools to encourage individuals and companies to report violations. The new tools at the Enforcement Division’s disposal included cooperation agreements, deferred prosecution agreements and non-prosecution agreements.9 In 2014, the Enforcement Division announced the Municipalities Continuing Disclosure Cooperation Initiative (the MCDC Initiative), which offered standardized, favorable settlement terms to municipal issuers and underwriters who self-reported inaccurate statements made in connection with their continuing disclosure obligations.10 In announcing the MCDC Initiative, the then Enforcement Division Director warned that those who chose not to self-report could expect increased sanctions for their violations, a sentiment echoed by the SCSD Initiative’s announcement, which explained, “[a] settlement against an eligible adviser that fails to self-report under the SCSD Initiative may include greater penalties than those imposed in past cases involving similar disclosure failures.”11
Participating in the SCSD Initiative
The SEC has explained that advisers who “received 12b-1 fees in connection with recommending, purchasing, or holding 12b-1 fee paying share classes for [their] advisory clients when a lower-cost share class of the same fund was available to those clients, and failed to disclose explicitly in [their] Form ADV the conflicts of interest associated with such fees” are eligible to self-report pursuant to the SCSD Initiative.12 Advisers already contacted by the Enforcement Division regarding possible disclosure violations as of the date of the SCSD Initiative announcement, February 12, 2018, are not eligible to participate in the program. Advisers must notify the Enforcement Division by midnight EST on June 12, 2018, and—absent an extension—must submit an SCSD Questionnaire within 10 business days of this self-reporting. The SCSD Initiative’s Questionnaire seeks information regarding the legal names of the reporting entities; information as to affiliated broker-dealers that received Rule 12b-1 fees; information regarding mutual funds that paid the Rule 12b-1 fees; the time periods during which applicable Forms ADV may have failed to include necessary disclosures; and any facts that would assist the Enforcement Division’s staff in understanding the disclosure lapses. The SCSD Initiative is open only to eligible advisers; individuals who may have violated disclosure rules cannot expect similar benefits of self-reporting.
Standardized Settlement Terms
For eligible parties participating in the SCSD Initiative, the Enforcement Division will recommend that the Commission authorize an enforcement action against the self-reporting entity with the following standardized settlement terms:
- Charges: Administrative proceeding alleging violations of Sections 206(2) and 207 of the Advisers Act, which are non-intent-based provisions.
- Disgorgement: Settlements will include disgorgement of ill-gotten gains and prejudgment interest thereon.
- Civil Penalties: Civil monetary penalties will not be recommended.
- Remediation: Settlements will include either an acknowledgment that an adviser has already implemented or a commitment to implement, within 30 days of the order, the following undertakings:
- Review and correct relevant disclosure documents.
- Evaluate whether clients should be moved to lower-cost share classes, and move them if necessary.
- Notify clients of the settlement terms, in a clear and conspicuous manner.
- Provide the SEC staff a compliance certification regarding the applicable undertakings no later than 10 days after completion
1 Press Release, SEC, SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors (Feb. 12, 2018), available at: https://www.sec.gov/news/press-release/2018-15.
2 See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92 (1963).
3 12b-1 fees are distribution fees paid by mutual funds and that comply with the provisions of Rule 12b-1 of the Investment Company Act of 1940. See 17 C.F.R. 270.12b-1.
4 Press Release, SEC, SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors (Feb. 12, 2018), available at: https://www.sec.gov/news/press-release/2018-15.
5 Id.
6 In the Matter of Manarin Investment Counsel, Ltd., Rel. No. 34-70595 (Oct. 2, 2013).
7 In the Matter of Packerland Brokerage Services, Inc., Rel. No. 34-82383 (Dec. 21, 2017).
8 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Rel. No. 34-44969, 2001 SEC LEXIS 2210 (Oct. 23, 2001).
9 Press Release, SEC, SEC Announces Initiative to Encourage Individuals and Companies to Cooperate and Assist in Investigations (Jan. 13, 2010), available at: https://www.sec.gov/news/press/2010/2010-6.htm.
10 Press Release, SEC, SEC Launches Enforcement Cooperation Initiative for Municipal Issuers and Underwriters (Mar. 10, 2014), available at: https://www.sec.gov/news/press-release/2014-46.
11 Announcement, SEC, Share Class Selection Disclosure Initiative (Feb. 12, 2018), available at: https://www.sec.gov/enforce/announcement/scsd-initiative.
12 Id.
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