On March 11, 2019, the SEC announced settlements with 79 investment advisers who self-reported violations of the Investment Advisers Act of 1940 (the “Advisers Act”) in connection with the Division of Enforcement’s Share Class Selection Disclosure Initiative (the “Share Class Initiative”). The advisers, collectively, agreed to return more than $125 million in fees and prejudgment interest to clients.
Form ADV requires investment advisers to make full and fair disclosure to their clients and prospective clients concerning their material conflicts of interest. Among other things, advisers are specifically required to disclose compensation and fees that they and their supervised persons receive, including from asset-based charges and service fees. The general instructions to Form ADV also remind advisers of their general obligation to fully disclose material facts relating to their advisory business.
The Share Class Initiative, which was announced in February 2018, encouraged investment advisers to self-report violations of the Advisers Act resulting from undisclosed conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available. The initiative enabled investment advisory firms to avoid civil money penalties if they timely self-reported the use of higher-cost share classes, agreed to compensate harmed clients, and undertook to review and correct their relevant disclosure and procedures.
According to the SEC, without adequately disclosing their conflicts of interest, the settling advisers placed their clients in mutual fund share classes that charged rule 12b-1 fees when lower-cost share classes of the same fund were available. The SEC said that the rule 12b-1 fees were “routinely paid to the investment advisers in their capacity as brokers, to their broker-dealer affiliates, or to their personnel who were also registered representatives, creating a conflict of interest with their clients, as the investment advisers stood to benefit from the clients’ paying higher fees.”
Without admitting or denying the findings, SEC-registered investment advisers that entered into settlements consented to cease-and-desist orders finding violations of Section 206(2) and Section 207 of the Advisers Act and agreed to distribute improperly disclosed fees and prejudgment interest to affected clients. The settling advisers also agreed to review and correct existing disclosure concerning mutual fund share class selection and 12b-1 fees and to evaluate whether existing clients should be moved to an available lower-cost share class (and, if so, to move them).
SEC Chairman Jay Clayton expressed his appreciation that so many investment advisers chose to participate in this initiative. This may be only a first wave of settlements, however, since the announcement suggests that the SEC staff continues to evaluate self-reports that were received from investment advisers prior to the Share Class Initiative cut-off date.