Self-Report or Not: Consider What’s at Stake
The SEC’s recent share class initiative – in which the agency promises not to charge civil money penalties to advisers that voluntarily report that they placed clients in certain share classes when less expensive classes were available – has cast a spotlight on the question of whether self-reporting is a good idea.
Under the initiative, the SEC’s Division of Enforcement will not impose financial penalties against an advisory firm that by June 12 of this year voluntarily reports placing clients in certain share classes when less expensive share classes for the same investment were available (ACA Insight, 2/26/18). Advisers will still have to pay disgorgement and prejudgment interest, be censured and face the possibility of individual liability.
The Division also let advisers know that if they do not take advantage of the offer and are later found to have a share-class violation from a date prior to the offer’s expiration date, things may get tougher for them. Those found in this situation may face "greater penalties than those imposed in past cases involving similar disclosure failures," the Division said.
Some defense attorneys raised questions about not only this specific initiative, but about self-reporting in general.
"Self-reporting programs are not amnesty," said Mayer Brown partner Stephanie Monaco. In regard to the agency’s February 12 share class initiative, "It’s just ‘we’re going to go easy on you with the fines,’ but that doesn’t mean they won’t bring an enforcement action," she said.
Advisers should not be under any illusion that, once they self-report, "the next few years of your life won’t be a living hell as you settle this," Monaco said. "No good deed goes unpunished. After you self-report, an exam team will likely be on your doorstep to begin an examination as they look for other violations. After the exam and ultimate settlement of an action, the agony is not over and may last 10 years as assets leave once violations are disclosed. Typically, retirement accounts terminate when violations are disclosed, and there is also the risk of shareholder class actions/third-party lawsuits."
"For advisers, the issue has been that it is not really clear what the benefits of doing it really are," said Debevoise partner and former SEC Division of Enforcement Asset Management Unit co-chief Robert Kaplan, who addressed the topic as part of a panel at the Investment Adviser Association’s 2018 Compliance Conference in Washington, DC last month. "At this point, there is a huge amount of uncertainty and also a lack of transparency into the process." Among the risks that self-reporting entails are that examiners may come in and focus on related and/or unrelated problems and individuals, both of which may involve their own risk of civil money penalties.
"Since you never know what you get out (of self-reporting), it’s really risky to go in and buy yourself a problem," he said. "So, usually, it’s a risk handicap."
"Advisers have a duty to act with the utmost good faith and that encompasses an obligation to disclose all material information to a client," said Morgan Lewis partner Steve Korotash. "So, if knowledge that an adviser engaged in certain conduct would be important to a client, an adviser may have an obligation to disclose that information. Once a client knows about the conduct, there is obviously the possibility that others and even the SEC will learn about it."
By voluntarily reporting to the SEC in such circumstances, whether for a share class problem or for some other fiduciary violation, the agency will typically recognize your decision to come forward voluntarily and you will be in a better position to negotiate a deal for your advisory firm and have an opportunity to influence the message the public will hear, he said.
There may not be any need to self-report when the violation does not rise to the breach of a fiduciary duty, particularly when the monetary amount involved is small and your firm provided remediation, Korotash said. "In that case, self-reporting may not make sense."
The view from the Division
Division of Enforcement co-director Stephanie Avakian, who also spoke on the IAA panel, acknowledged the uncertainty that advisory firms may face in deciding whether to self-report, but suggested that "people should take the program at face value. It’s not intended to be some sort of program that gets into a bunch of firms to come in and then we are going to sift around in their closets and look for other problems."
She added, however, that "if someone has a host of other problems, we’ll look into it."
What the Division is trying to do with the share class initiative and other programs, Avakian said, is "give entities who truly cooperate tangible benefits, and communicate to the marketplace what those benefits are."
Making the decision
Advisory firms wrestling with the question of whether to self-report need to consider how likely it is that the government will find out about the conduct from another source, said King & Spalding partner Alec Koch. "If it is not likely to find out about it, remediate the problem and, if the government finds out later, you can say that you addressed the issue in a responsible way," he said. If the government is likely to find out about the violation, perhaps through a different source or through an examination, Koch suggested, that’s when the balance tips toward self-reporting.
"In my view, there is no one-size-fits-all answer," said Stradley Ronon partner Lawrence Stadulis. "It is always a fact-dependent analysis." For instance, he said, a technical violation of the Advisers Act may not necessitate self-reporting. "It’s more common when there are egregious violations done by a rogue employee."
The share class initiative
The share class initiative is for share-class selection violations in which advisers managing mutual funds pay more to encompass 12b-1 fees, according to the agency. Those fees are used on an ongoing basis by dually registered advisers / broker-dealers, or by advisory-firm-affiliated broker-dealers, to pay for shareholder services, distribution and marketing expenses.
The problem, from the SEC’s point of view, is not so much in the charging of the additional fee, but in the fund’s or the managing adviser’s failure to disclose the existence of less-expensive share classes, as well as their own possible conflict of interest if they receive a part of that fee themselves for their services.
Those who can take advantage of the initiative, according to the agency, are investment advisers that did not explicitly disclose in their Forms ADV, including in their brochures or in Part 2A, the conflicts of interest associated with the 12b-1 fees that the firm, its affiliates or its supervised persons received for investing clients in a fund’s 12b-1 fee-paying share class - when a lower-cost share class was available for the same fund.
The June 12 deadline may be flexible, in that the Division may be willing to grant extensions, Avakian said. If an adviser contacts the agency about self-reporting but says it needs more time, the Division may seek a way to accommodate that request, she said.
There is also the possibility that the Division may issue answers to frequently asked questions, Avakian said, if questions arrive that are specific enough to justify a set of FAQs.
If you decide to self-report
Consider taking the following steps if your firm, after careful consideration and discussion, decides to move forward on self-reporting to the SEC:
Confirm that there was a violation. "The main things that the Commission looks at are ‘how did this happen, why wasn’t it detected, and what did you do when you found out?’" said Korotash. With this in mind, check to see that your firm really did do something wrong and whether you have a viable defense that may negate the violation, he said. For instance, you may have already provided adequate disclosure through documents of which the regulator is not aware.
Remedial steps taken. "Be able to demonstrate that you put together a program to remedy the situation, and that you can show the steps that were taken, and that clients were paid back, if they were financially harmed," he said. "Anything to show that you’ve got your arms around the problem. If you are seen as cooperating, you can help shape the message, and deal with any reputational and credibility damage."
Consult your internal or external counsel. Your legal adviser needs to evaluate any defenses you have, as well as steps you plan to take.