SEC Share Class Selection Disclosure Initiative

The SEC announced its Share Class Selection Disclosure Initiative (“SCSD”) on Monday, February 12th. Under this initiative, investment advisers will have the opportunity to inform the SEC the failure to disclose required information regarding 12b-1 fees and the selection of mutual fund share classes. Advisors will have until June 12, 2018 to self-report these violations.

In return, the SEC will offer amnesty to advisors who self-report. There will be no monetary penalty assessed against the advisors, aside from compensating affected clients. With the advancement of data-driven initiatives, which allows enforcement to detect share-class issues faster than ever before, advisers can no longer hope to slip through the cracks, and must seriously consider self-reporting.

The SEC and FINRA have showed renewed interest in investment fees concerning mutual funds. Over the past couple of years, the SEC has frequently filed actions in which an investment adviser failed to make required disclosures concerning fees to retail customers when offering mutual fund share classes. Specifically, the SEC has expressed concern that investment advisers are not complying with the Investment Advisers Act of 1940 to fully disclose all material conflicts of interest related to their selection of mutual fund classes.

Section 206(2) of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisers to act for their clients’ benefit, including an affirmative duty of utmost good faith and full disclosure of all material facts. Section 207 makes it unlawful to make any untrue statement, or omit any information, pertaining to material fact in any registration application or report filed with the commission.

In a mutual fund there are different classes, with the most common ones being A, B and C. These classes represent a similar interest in the mutual funds portfolios and are differentiated by their fee/expense structures. These fee and expense structures can impact the return of an investment and are important for investors to understand when taking into account their investment time horizon.

Class A shares typically charge a front-end sales charge, which tends to be 3-5%, on the initial purchase of shares. In return, A shares have an asset-based sales charge that is lower than B or C shares. A shares are best utilized in portfolios of long-term investors due to their lower internal expenses and lack of 12b-1 fees.

Class B shares do not have a front-end sales charge, but instead contain a contingent deferred sales charge (CDSC), commonly referred to as a “back-load.” Purchasing B shares means the investor will pay a percentage of the dollar value of the shares as a fee when sold. The CDSC decreases over time and the B shares convert to A shares once the CDSC has been eliminated for 2 years. B shares also contain a 12b-1 fee, which increases the expenses of the fund.

Class C shares charge an ongoing fee, referred to as a “level-load,” for as long as the fund is held. In most cases, total cost will be the highest in C shares if you hold the investment for a long time.

Any investment advisor who believes that it did not explicitly disclose in applicable Form ADV (i.e., brochure(s) and brochure supplements) any conflicts associated with the purchase of such funds should seriously consider self-reporting.

Investment advisers that have already been contacted by the SEC regarding this issue are not eligible for the SCSD initiative. However, advisers that are subject to pending examinations by the Commission’s Office of Compliance Inspections and Examinations, but have not been contacted by the SEC on the class selection issue, are eligible for the SCSD initiative.

It is prudent for advisors to self-report if they have not disclosed the proper information concerning their mutual fund share selection.

If you are a registered investment advisor or broker seeking guidance on the issue of self-reporting, and/or have recently received a regulatory inquiry from FINRA or the SEC, contact the experienced securities regulatory attorneys at Lubiner, Schmidt & Palumbo for a free consultation.