In light of the current debate over whether the Securities and Exchange Commission will deliver on a fiduciary duty rule for investment advisors and broker-dealers, one might expect to hear more clarifying statements from the SEC about a topic it has previously identified as a prime target for potential enforcement actions: fund share class selection and so-called “best execution” duties.
However, the SEC has been relatively mum on the topic since last February, when the co-chief of the SEC’s Asset Management Unit, Julie Riewe, caused a stir in investment advisor circles with a speech called “Conflicts, Conflicts Everywhere.”
In that speech, Riewe, who is leaving the SEC in February, identified priorities for 2015 “subject to possible enforcement action” against registered fund advisors involving conflicts of interest between advisors and fund investors.
One topic highlighted in Riewe’s speech related to “best execution” issues that the SEC contends arise when a fund advisor selects higher cost fund shares even though cheaper shares in the same funds are available. The SEC brought a settled case on this issue in 2013, In the Matter of Manarin Investment Counsel, alleging that over a 10-year period the fund advisor caused three fund clients to invest in “Class A” mutual fund shares when the funds were eligible to own lower-cost “institutional” shares in the same mutual funds.
As a result of owning “Class A” shares, the funds paid ongoing 12b-1 fees on the mutual fund holdings for distribution and shareholder services that the SEC contended could have been avoided had the advisor purchased institutional shares. The SEC charged the advisor with a breach of fiduciary duty and said that the fund’s registration statement disclosures were misleading because they said the advisor sought “best execution and net results” in effecting portfolio transactions.
The Manarin case raised some eyebrows by framing the issue as involving “best execution,” which traditionally referred to an advisor’s duty to select the appropriate broker-dealer for executing transactions based on execution performance rather than a duty to evaluate and select appropriate fund share classes.
To be sure, past “best execution” cases have involved paying “unnecessarily high commissions … while a lower cost alternative was available,” but the issue has arisen in the context of selecting between different brokers rather than different share classes. By highlighting Manarin as a priority issue for 2015, the AMU chief seemed to signal that the case was a harbinger rather than an anomaly.
But then the issue seemed to fade into the background as no related enforcement activity materialized during the next several months. Then on Dec. 18, the issue surged back into headlines with the SEC’s announcement of a $267 million settlement with two J. P. Morgan wealth management subsidiaries.
While the “best execution” share class issue was one among many alleged conflicts of interest, Riewe specifically pointed it out as though to re-emphasize the warning she had issued back in January: “In addition to proprietary product conflicts, [the advisor] breached its fiduciary duty to certain clients when it did not inform them that they were being invested in a more expensive share class of proprietary mutual funds.”
Notably absent from the SEC’s allegations in the J.P. Morgan subsidiary action was any reference to “best execution.”
Instead, the SEC simply noted the advisor’s failure to disclose the availability of less expensive share classes and the resulting breach of fiduciary duty resulting from that failure. Left unclear is whether the SEC takes the position that causing clients to purchase share classes with higher commissions is always a violation of the advisor’s duty of “best execution,” or whether an advisor may cure the issue with adequate disclosures.
While it might make good policy sense for the SEC to clarify this year the best execution issue through rulemaking — either the uniform fiduciary rule for brokers and advisors currently underway or some other rulemaking — the SEC probably will fail to address the issue in that way.
Rather, as with many issues that would benefit from clarification, the SEC will likely proceed by way of “rulemaking through enforcement.” That is, we will probably have to discern the SEC’s position on this share class “best execution” issue by interpreting the enforcement actions it brings rather than by interpreting rules that it makes.