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News October 2, 2017 Issue

12b-1 Fees: SEC Settles Share Class Charges with Two More Advisers

If you think the SEC only occasionally charges advisers for placing clients in expensive share classes when less expensive classes are available, recent events should change your mind. The agency reached settlements with two advisory firms involving share classes just last month, and those followed up on still other settlements and developments earlier this year and the year before.

Atlanta-based SunTrust Investment Services, a dually registered adviser and broker-dealer and a subsidiary of SunTrust Banks, on September 14 reached a settlement with the SEC that resulted in it paying more than $1.1 million. The settlement resolved charges that, between December 2011 and June 2015, SunTrust recommended to clients that they purchase Class A mutual fund shares when less expensive Class I shares were available. The practice was originally found during an examination of the firm, the agency said. More than 4,500 clients in more than 40 states were affected.

On September 8, Colorado-based Envoy Advisory, a firm with approximately 1,800 advisory clients and approximately $225 million in assets under management, settled charges with the agency that, from January 2013 through March 2017, it recommended to clients that they purchase more expensive share classes when less expensive ones were available. The firm paid more than $51,000 to settle the case.

Both settlements faulted the advisers over disclosures to clients, as well as for having what the SEC said were inadequate written compliance policies and procedures. Both settlements also credited the firms with taking remedial actions.

"The SEC is drilling down on conflicts of interests these days," said Bell Nunnally partner Robert Long. "Firms with affiliate relationships should pay particular attention to their ADV disclosures."

"Mutual fund share selection practices and related disclosure and procedures continue to be a focus of SEC adviser examinations," said Pepper Hamilton partner John Falco. "Advisers should make sure they have procedures in place to ensure that clients are placed in the lowest-cost share class that meets their needs in which they are eligible and disclose conflicts and payments by third parties in connection with their fund recommendations."

The settlements also tie into the July 2016 risk alert issued by the agency’s Office of Compliance Inspections and Examinations. That alert, "OCIE’s 2016 Share Class Initiative," let advisers know that examiners would focus on "conflicted investment recommendations" made to clients, including potential conflicts of interest tied to advisers’ compensation or financial incentives regarding share classes that may contain distribution fees.

The SEC has not been shy in following up on this risk alert. In May, the agency settled similar cases with two advisory firms, Chicago-based William Blair & Company, and Maryland-based Calvert Investment Management. The Calvert settlement cost that firm more than $22 million in disgorgement and penalties. The month before those two settlements, the SEC reached a settlement with well-known financial adviser Credit Suisse, and the month before that, with advisory firm, Alison.

The SunTrust settlement

SunTrust offered products to clients in its capacities as an adviser and as a broker-dealer, the agency said in its order instituting the settlement. From at least 2011, it offered its advisory clients the option of investing through various wrap-fee programs, known as its Asset Management Consulting (AMC) programs, under which both advisory, brokerage and custody services were covered. In all of these AMC programs, clients were eligible to invest in mutual funds that offered Class A shares, as well as the less expensive Class I shares.

As explained in the SEC’s order, while Class I shares were originally intended for institutional investors, "many mutual funds, over time, began making Class I shares available to non-institutional investors, including retail investors purchasing shares through wrap fee investment programs." These Class I shares have no upfront or deferred sales charges, and rarely have 12b-1 fees, which are used to pay for distribution services.

"As a result," the agency said, "an individual who invests in Class I shares of a mutual fund will pay lower fees over time – and keep more of his or her investment returns – than an individual who holds Class A shares of the same fund. Therefore, if an investor meets a mutual fund’s criteria for purchasing Class I shares, it is almost always in the investor’s best interest to select that share class over the same fund’s more expensive Class A shares."

Further, the SEC noted, Class A shares have increasingly become convertible to Class I shares, often on a tax-free basis and without any charge or fee to either the client or the adviser. What this meant in terms of the SunTrust case, is that during the period in question, SunTrust clients holding existing, or "legacy" Class A shares in certain mutual funds could have converted those shares to Class I shares at the request of SunTrust to the mutual fund and the carrying broker, the agency said.

SunTrust share class selection

SunTrust had an investment policy committee that was charged with proposing and adopting policies and procedures to ensure that the advisory firm’s products and services met all applicable regulatory requirements. The chief compliance officer was among those who sat on the IPC.

As early as 2011, according to the SEC, members of the IPC were aware that:

  • Class I shares were gradually becoming more available for SunTrust clients to invest in;
  • Some of SunTrust’s investment advisory representatives "were nonetheless continuing to purchase for, or recommend to, their advisory clients certain Class A shares even though those clients were eligible to invest in the less expensive Class I shares of the same funds;" and
  • Many SunTrust advisory clients continued to hold in their advisory accounts Class A shares carrying 12b-1 fees that were eligible for conversion to Class I shares on a tax-free basis and without charge.

What it all came down to

Here’s what the SEC charged: "Despite knowing that [SunTrust] advisory clients with non-qualified accounts were continuing to incur 12b-1 fees that could be avoided, the IPC did not at that point adopt policies and procedures that prohibited [SunTrust investment advisory representatives] from recommending Class A shares to, or purchasing Class A shares for, advisory clients with non-qualified accounts, or investing or holding such clients in Class A shares, when less expensive Class I shares of the same mutual funds were available." Nor, the agency said, did the IPC adopt policies and procedures to convert the legacy Class A shares already held by advisory clients with non-qualified accounts to less expensive Class I shares.

"In fact, it was not until early June 2012 that the IPC adopted policies and procedures to halt the recommending or purchasing of Class A shares for advisory clients with newly opened non-qualified accounts when less expensive Class I shares were available," the agency said. It was not until a year after that that the IPC adopted policies and procedures to begin the conversion of Class A shares to Class I shares.

"From December 27, 2011 through June 30, 2015, [SunTrust] and its investment advisory representatives received at least $1,148,072 in avoidable 12b-1 fees that would not have been collected had [SunTrust] placed its advisory clients with non-qualified accounts in lower-cost share classes, or converted legacy clients . . . Class I shares," the SEC said.

"SunTrust made self-serving investment recommendations to the detriment of everyday investors who rely on mutual funds to secure their financial futures," said SEC Atlanta Office associate regional director Aaron Lipson. "The story has a happy ending for customers with the extra fees back in their accounts, and an obvious lesson for investment advisory representatives that you must always recommend the best deal for your clients, not yourselves."

"The firm addressed the matter on a prospective basis with remedial actions starting in the summer of 2015," said the attorney representing SunTrust. "Although the firm believes that its disclosures were in accordance with industry standards, the firm cooperated fully with the SEC and it is pleased to have settled this matter."

SunTrust was charged with willfully violating Section 206(2) and (4) of the Advisers Act, both of which prohibit fraud, as well as Section 207, which prohibits making untrue statements of material fact. The SEC credited the firm with taking a number of remedial steps, including, as of July 1, 2015, crediting any newly incurred 12b-1 fees back to clients, and the firm working to convert existing investments in Class A shares to Class I shares.

The Envoy settlement

While there are similarities between the SunTrust case and the Envoy case, there are also differences, among them no mention in the Envoy settlement of wrap-fee programs or of converting Class A shares to Class I shares.

"Envoy’s disclosures did not adequately inform its advisory clients of the conflict of interest presented by its recommendations to purchase Class A mutual fund shares," the agency said, particularly that "Envoy’s affiliated broker-dealer, Envoy Securities, received approximately $24,893 in 12b-1 fees that it would not have collected had plan participants and IRA holders been invested in lower-cost shares for which they were eligible."

"Envoy’s Form ADV disclosures to plan sponsors during the relevant period disclosed that certain mutual funds ‘may’ pay a ‘dealer’ 12b-1 fees, but failed to disclose that the ‘dealer’ receiving the 12b-1 fees was Envoy’s affiliate," the SEC said. Envoy’s disclosures to IRA holders during the same period made no mention of 12b-1 fees at all, nor of the conflict of interest, it said, while the firm’s investor handbook, provided to IRA holders during the relevant period, said that Envoy or the account custodian "may" receive 12b-1 fees.

"Envoy’s general disclosures regarding the potential receipt of 12b-1 fees were inadequate to put advisory clients on notice that its affiliated broker-dealer, Envoy Securities, would, and did receive additional compensation by Envoy recommending investments in more expensive share classes of a mutual fund," the agency said.

As part of the settlement, Envoy was charged with having willfully violated Advisers Act Sections 206(2), which prohibits fraud; Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule. The agency credited Envoy with taking certain remedial acts, among them stopping recommendations, as of October 2016, of investments in share classes that pay 12b-1 fees; and engaging a compliance consultant. An attorney representing Envoy did not respond to an email or voice mail seeking comment.