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News May 7, 2018 Issue

SEC Issues Share Class Initiative FAQs Six Weeks Prior to First Deadline

Advisers wishing to take advantage of, or at least learn more about, the SEC’s Share Class Selection Distribution (SCSD) Initiative will doubtless find the agency’s May 1 set of 19 answers to frequently asked questions of interest – particularly since they face an initial reporting date of June 12. Those not planning to self-report under the program may also be interested, if only to learn what they won’t have to do.

The FAQs, issued by the agency’s Division of Enforcement, seeks to clarify and in some cases expand on just how the SCSD Initiative works. The initiative is part of the Division’s ongoing efforts to address share class violations, which occur when advisory firms fail to disclose that they placed clients in certain share classes when less expensive share classes for the same investments were available. Under SCSD, the Division will not impose civil money penalties against such advisers if they self-report. Advisers will still have to pay disgorgement and prejudgment interest, be censured and face the possibility of individual liability.

FAQ 12, for instance, makes clear that the June 12 deadline is only the date by which an adviser must notify the Division of its intent to self-report, not the date when further steps are due, such as submitting a completed questionnaire, which must occur within 10 business days from the notification date. The FAQ also makes clear that it may grant extensions to that date.

"It appears that many investment advisers are working diligently to evaluate whether they can take advantage of the initiative and we believe that providing these FAQs will help them make that determination," said C. Dabney O’Riordan, Co-Chief of the Division of Enforcement’s Asset Management Unit. "The initiative provides a framework to quickly and efficiently resolve these issues with self-reporting advisers and return money to their clients."

"Some people may continue to have skepticism about the initiative," said Mayer Brown partner Adam Kanter. A number of defense attorneys have urged caution in regard to self-reporting (ACA Insight, 4/2/18), noting that it opens advisers to other risks, among them that examiners may focus on related and/or unrelated problems and individuals – and that civil money penalties may apply in these cases. There is also the possibility of shareholder class actions and third-party lawsuits.

How useful are the FAQs? If an advisory firm already has internal or external attorneys working on self-reporting, they are not likely to find much that is new, said Stark & Stark attorney Max Schatzow. Advisers still considering whether to self-report under the initiative who have not yet consulted with counsel may find the staff’s elaboration on certain points helpful as they reach a decision, he said.

The FAQs

Following are some of the FAQs and the Division’s answers to them that are likely to be of most interest to advisory firms. Advisers are nonetheless urged to review all 19 FAQs and consult counsel before moving forward on self-reporting.

What does it mean to have a lower cost share class "available" for the same fund? (FAQ 11) "The availability of a lower-cost share class is fund specific," the agency staff said. It then provided the following "non-exhaustive" list of examples for when Division staff would likely conclude that a lower-cost share class was "available" for the same fund:

  • The client could have purchased a lower-cost share class for the same fund because the client’s investment met the applicable investment minimum.
  • There was or is language in the fund prospectus that says the fund will waive the investment minimum for a lower-cost share class for the same fund for advisory clients.
  • There was or is language in the fund prospectus that says the fund may waive the investment minimum for a lower-cost share class for the same fund for advisory clients, and the adviser had no reasonable basis to believe the fund would not waive the investment minimum for a lower-cost share class for its advisory clients. An assumption by the adviser that a fund would not waive the investment minimum for his or her clients without taking steps to confirm this assumption would not constitute a reasonable basis.
  • The investment adviser purchased a lower-cost share class of the same fund for other similarly-situated clients.

What the agency is suggesting, said Schatzow, is "that an adviser’s fiduciary duty extends to requesting a waiver of the investment share class minimums. This changes the baseline that the industry has operated under for many years." He also said that placing this obligation on advisers will increase the amount of disgorgement that a self-reporting adviser will have to pay as part of the initiative.

The examples, particularly the third bullet above, "put a lot of pressure on the adviser to have tried to take proactive steps to get the funds to waive or lower the investment minimum for a lower-cost share class," said Kanter. "Sometimes a lower-cost share might not have been readily available to the adviser."

Does the SCSD Initiative apply to higher-cost share classes purchased in brokerage accounts (FAQ 8)? "The SCSD Initiative applies to conduct by investment advisers . . . with respect to advisory clients, irrespective of the type of account in which an advisory client’s mutual fund investment is held," the agency staff said. "If the entity was not acting as an investment adviser in recommending, purchasing or holding 12b-1 fee paying share classes when a lower-cost share class of the same fund was available, then that portion of the entity’s business would not be eligible for the SCSD Initiative."

"This one seems directed toward dually registered advisory firms and broker-dealers," Kanter said. "The point the staff is making seems to be that the initiative’s application depends not only on the kind of financial firm you are, but on the activities of the firm with respect to impacted accounts."

Will the Division take into account that the adviser reduced or offset its advisory fee by the amount of the 12b-1 fees? (FAQ 14) "It depends on the facts and circumstances," the agency staff said, and then provided the two scenarios below to make its point. In each scenario, assume that the self-reporting adviser had an agreement with its client to charge an annual management fee of 1 percent of assets under management:

  • Scenario 1. "The self-reporting adviser contends that its management fee with the client would have been 1.25 percent absent the receipt of 12b-1 fees," the staff said. "The Division does not expect to recommend any offset to the disgorgement to the Commission in circumstances similar to this scenario."
  • Scenario 2. "The self-reporting adviser applied a portion of the 12b-1 fees it received to reduce the annual management fee so that the client was ultimately charged a management fee less than 1 percent," the staff said. "The Division may recommend an offset to the disgorgement to the Commission in circumstances like this.

The takeaway from this FAQ is that "it’s better to charge a higher base fee and then offset it than to initially apply a discount based on your expected revenue, because an offset is much more readily demonstrable," said Kanter.

Does an adviser have to disclose both conflicts – i.e., conflicts associated with (1) making investment decisions in light of the receipt of 12b-1 fees and (2) selecting the more expensive 12b-1 fee paying share class when a lower-cost share class was available for the same fund? (FAQ 9) The agency staff’s answer here is rather brief: "As reflected in the cases cited in the announcement, both of these disclosures are necessary. An adviser is eligible for the SCSD Initiative if it failed to disclose either or both of those conflicts."

This answer may be useful for self-reporting advisers that considered both of the conflicts listed in the question as one unified conflict, and were preparing to just list one conflict, when there are actually two, said Kanter. What the staff is telling advisers, he said, is that "if you haven’t covered both legs of the disclosure, then you haven’t done enough."