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SEC not finished with scrutiny of self-reporting firms

Firms are facing additional scrutiny over mutual funds share-class selection, even after 79 companies have already settled with the SEC during the agency’s self-reporting initiative related to inadequate disclosure of 12b-1 fees.

The SEC has requested further information from at least two of the firms that had self-reported, this time regarding revenue sharing fees, according to two attorneys who represent firms before the SEC. The probe comes after the firms had voluntarily submitted information regarding their 12b-1 marketing and distribution fees.

It's not immediately clear how many firms may face additional scrutiny over share-class selection after self-reporting, according to Brian Rubin of Eversheds Sutherland. The other attorney asked not to be identified.

Firms were surprised to receive a follow-up letter from the SEC, Rubin says. “They assumed that the SEC’s initiative would be dealing with all areas of [mutual fund share class selection] which the SEC was concerned,” he says.

A spokeswoman at the SEC declined to comment on whether it was investigating any of the 79 firms that had settled. Financial Planning emailed 49 of the 79 broker-dealer RIA firms that agreed to share-class settlements. Of those, 38 did not respond, six declined to comment beyond noting their recent settlements and five declined to comment at all.

settlements SEC share class cases one title march 28 2019

Some firms that didn’t self-report are also under scrutiny related to 12b-1 fees and other forms of revenue sharing. At least two firms have received letters from the SEC requesting data on all revenue-sharing payments, including 12b-1 fees, according to redacted documents obtained by Financial Planning.

“The investigation is a non-public, fact-finding inquiry,” one letter from the SEC Division of Enforcement states. “The investigation does not mean that we have concluded that your firm or anyone else has violated the law.”

The SEC defines revenue-sharing payments as those “made by a clearing firm as a result of investments by Advisory Clients in certain mutual funds and/or money market funds,” according to the letters. The data inquiry also requests documentation of 12b-1 revenue the firm received as part of “ongoing annual marketing and distribution fees paid by a mutual fund per Rule 12b-1 of the Investment Company Act of 1940.”

One firm was given 15 days to produce documentation dating back to November 2013 on 12b-1 fees and revenue sharing payments the firm had collected; written policies, procedures and guidelines regarding share-class selection in client accounts; as well as internal communication of former SEC cases regarding mutual fund share class selection, according to a letter sent to a firm from the SEC’s Philadelphia regional office.

FINRA and the SEC have leveled more than 50 other enforcement cases involving share classes of mutual funds over the last five years. The SEC originally announced the self-reporting initiative regarding disclosures of 12b-1 fees in mutual fund share classes last February. The regulator unveiled the 79 settlements with BDs’ affiliated RIAs earlier this month.

“The real issue I see is that the SEC doesn’t like 12b-1 fees,” says Jaqueline Hummel, partner at Hardin Compliance Consulting. “But they have not eliminated them. They’ve been bringing forth certain actions against 12b-1 fees for years, but they haven’t gotten rid of the rule that allows firms to have them.”

In the self-reporting initiative, the SEC focused attention on whether firms were adequately disclosing conflicts of interest and recommending the lowest-priced share classes to retail clients. Some consumer advocates thought the SEC’s program did not hit the mark.

“It is an approach that leaves investors without meaningful protections when dealing with advisory firms, particularly dual registrants, who bring many of the broker-dealer conflicts into what was once a relatively pure advisory business model,” Barbara Roper, director of investor protection at the Consumer Federation of America, said in an email. “If this is what ‘fiduciary’ means to the SEC, it is as meaningless as their best interest standard, which also doesn’t require brokers to do what is best for their customers.”

Broker-dealers have accused the SEC of rulemaking by enforcement, according to a letter sent to the regulator by the American Securities Association, an advocacy group which represents Baird, LPL Financial, D.A. Davidson and other firms that voluntarily participated in the self-reporting initiative.

“In our view, this Initiative has turned into a mechanism for the Commission Staff to flex its muscles on the industry through the questionable act of regulation by enforcement,” the letter reads.

A spokeswoman at FSI says the IBD trade group is working with its members on this issue, but declined to comment further. SIFMA sent a letter to the SEC on behalf of its brokerage members that said the regulator was stretching the law by requiring investment advisors to make available every share class of a particular fund for clients, according to The Wall Street Journal. A spokesman at SIFMA did not respond to a request for the letter.

Firms have not had adequate direction on what the regulator’s disclosure expectations are around the fees, Hummel says. It was not clear to firms who participated in the self-reporting program what kind of disclosures were expected of them, she says.

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“The self-reporting initiative was somewhat unfair in that [the SEC] said that [a firm’s] disclosure wasn’t sufficient, but gave no guidance on what appropriate disclosure looked like,” she says. “You can’t impose a new obligation on people without providing some guidance on what was expected of them.”

A spokeswoman at the SEC declined to comment on what guidance firms received as part of the share-class selection investigations. The SEC provided an FAQ page on its website, months after announcing the 12b-1 fee disclosure program.

“The initiative leveraged the expertise of the agency in crafting an efficient approach to remedy a pervasive problem,” Steven Peikin, co-director of the SEC’s Division of Enforcement, said in a statement following the 79 settlements. He added that the SEC has made “tremendous headway” in returning money to retail investors and improving firm disclosures.

Ed Cofrancesco, CEO of International Assets Advisory, an IBD which was not involved in the self-reporting program, says that firms have had adequate time and guidance. Cofrancesco started hearing the SEC was focused on share-class selection a few years ago.

“They gave enough notice, if not official notice,” he says.

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