On February 20, 2018 DCS distributed a Special Alert regarding the SEC Division of Enforcement’s February 12, 2018 announcement of the Share Class Selection Disclosure Initiative (“SCSD”). Please see our February 20th Special Alert. Following is a SCSD update since that initial announcement of the initiative by the Division of Enforcement.

On April 6, 2018 the SEC announced settled administrative proceedings against three investment advisers relating to, among other things, the advisers failing to disclose conflicts of interest and violating their duty to seek best execution by investing advisory clients in higher-cost mutual fund shares when lower-cost shares of the same funds were available. The three advisers are: PNC Investments, LLC; Securities America Advisors, Inc.; and Geneos Wealth Management, Inc.

The PNC Investments Administrative Proceeding Order describes the following conduct by PNC Investments:

• PNC Investments invested advisory clients in mutual fund share classes with 12b-1 fees instead of available lower-cost share classes of the same funds without 12b-1 fees. PNC Investments received a financial benefit from such actions which created a conflict of interest that PNC Investments failed to adequately disclose to clients through its Form ADV Part 2A or otherwise.
• PNC Investments breached its duty to seek best execution for its clients by investing them in mutual fund share classes with 12b-1 fees rather than lower-cost share classes.
• PNC Investments received marketing support payments from three mutual fund complexes. The mutual fund complexes paid these support payments only when PNC Investments invested its advisory clients in mutual fund share classes that charged 12b-1 fees. PNC Investments never disclosed this conflict of interest to clients through its Form ADV Part 2A or otherwise.
• PNC Investments improperly charged over $105,000 in advisory fees to client accounts whose investment adviser representative had departed the firm and for which PNC Investments failed to assign a new investment adviser representative within thirty days.

The Securities America Advisors, Inc. (“SAA”) Administrative Proceeding Order describes the following conduct by SAA:

• SAA invested advisory clients in mutual fund share classes with 12b-1 fees instead of available lower-cost share classes of the same funds without 12b-1 fees. SAA’s broker/dealer affiliate received 12b-1 fees based on these investments, which were paid to the affiliate broker/dealer’s registered representatives who also acted as investment adviser representatives for SAA. Such actions created a conflict of interest that SAA failed to adequately disclose to clients through its Form ADV Part 2A or otherwise.
• By investing advisory client assets in mutual fund share classes with 12b-1 fees rather than available lower cost share classes, SAA acted in a manner inconsistent with its duty to seek best execution for its clients.

The Geneos Wealth Management, Inc. (“GWM”) Administrative Proceeding Order describes the following conduct by GWM:

• GWM invested advisory clients in mutual fund share classes with 12b-1 fees instead of available lower-cost share classes of the same funds without 12b-1 fees. GWM is also a registered broker/dealer and in its capacity as a broker/dealer GWM received 12b-1 fees based on these investments. Such actions created a conflict of interest that GWM failed to adequately disclose to clients through its Form ADV Part 2A or otherwise.
• By investing advisory client assets in mutual fund share classes with 12b-1 fees rather than available lower cost share classes, SAA acted in a manner inconsistent with its duty to seek best execution for its clients.
• GWM was party to revenue sharing agreements with two third-party broker/dealers. Pursuant to these agreements, the third-party broker/dealers agreed to share with GWM certain revenues that the third-party broker/dealers received from the mutual funds in the third-party broker/dealer’s no-transaction-fee mutual fund program (“NTF Programs”). Payments received under the NTF Programs created a conflict of interest for GWM in that they provided a financial incentive for GWM to favor mutual funds in the NTF Programs over other investments. GWM failed to disclose this compensation to its clients.
• In March, 2017 GWM filed an update to its program brochure that included disclosure that GWM will select share classes that assess 12b-1 fees most of the time, even if a less expensive share class is available. Despite this material change, GWM states in its March 2017 brochure that it had not made any material changes to its business or the contents of its brochure.

Each of the advisers was subject to, among other things, disgorgement, interest and civil monetary penalties. PNC Investments consented to $6,407,770 in disgorgement and prejudgment interest along with a $900,000 penalty. SAA consented to $5,053,448 in disgorgement and prejudgment interest along with a $775,000 penalty. GWM consented to $1,558,121 in disgorgement and prejudgment interest and a $250,000 penalty.

On May 1, 2018 the SEC Division of Enforcement issued frequently asked questions (“FAQs”) on the SCSD Initiative. While most of the FAQs deal with technical aspects of the SCSD Initiative, e.g. eligibility for the SCSD Initiative, whether the self-reporting deadline will be extended, etc., certain of the FAQs provide insight into the activity that is found to be problematic or otherwise provides additional clarifying statements. FAQ 9 provides the following: “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?” Citing previous administrative actions, the Division of Enforcement provided that 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.

Furthermore, FAQ 11 provides the following: “What does it mean to have a lower cost share class “available” for the same fund?” The Division of Enforcement answer provides that the availability of a lower-cost share class is fund specific. Thereafter, the Division of Enforcement provides a non-exhaustive list of examples where the Division of Enforcement 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.

FAQ 14 provides the following: “Will the Division take into account that the adviser reduced or offset its advisory fee by the amount of the 12b-1 fees?” The Division responded that this is facts and circumstances dependent. To illustrate the Division references two different scenarios, with each assuming that the self-reporting adviser’s agreement with the client is to charge an annual management fee of 1% of assets under management. If the self-reporting adviser contends that without the 12b-1 fees its management fee would have been 1.25%, the Division will not recommend any offset to the disgorgement to the Commission. In an instance where a self-reporting adviser applied a portion of the 12b-1 fees it received to reduce the annual management fee so that the client was charged a management fee of less than 1%, the Division may recommend an offset to the disgorgement to the Commission.

Ultimately the FAQs are crafted for and applicable to self-reporting advisers under the SCSD Initiative. However, the above referenced FAQs may be of assistance to advisers in addressing future conduct relating to share class selection.

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Resources

• PNC Investments Litigation
• Securities America Advisors Litigation
• Geneos Wealth Management Litigation
• SEC Share Class Initiative FAQs