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SEC's 12b-1 Crackdown to Go From Trickle to Deluge

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The SEC‘s long-awaited strikes against investment advisors for failing to place investors in less expensive Class I shares threaten to go from a trickle to a deluge with the recent enforcement action against three affiliates of AIG–Royal Alliance Associates, SagePoint Financial and FSC Securities Corp.

The SEC appears determined to stop what it views as breaches of fiduciary duty and disclosure failure relating to conflicts of interests arising from the practice of placing investors in more expensive share classes, thereby generating more revenue for the firms. 

The three AIG affiliates—which agreed to pay $9.5 million to the SEC–placed clients in share classes that charged fees for marketing and distribution even though the clients were eligible to buy shares in an institutional share class, or Class I, that did not charge such 12b-1 fees. The SEC claimed that the choice of a more expensive share class allowed the affiliates to improperly collect an additional $2 million in fees from investors—fees that the advisors received in their capacity as broker-dealers and shared with their registered representatives.

The SEC also charged the firms with a failure to disclose in their Forms ADV, client service agreements, and other account documentation the fact that the firms had a conflict of interest with respect to selecting fund share classes created by the financial incentive to put clients in higher fee share classes over lower-fee share classes of the same fund.

The firms resolved the action by agreeing to pay a penalty of $7.5 million and disgorgement of $2 million and by retaining an independent compliance consultant.

The AIG action comes on the heels of the settlement announced this past December in which J.P. Morgan Securities and JPMorgan Chase Bank paid $267 million and admitted wrongdoing which also related to a failure to disclose conflicts of interest in connection with the practice of investing clients in more expensive share classes of the firms’ proprietary funds. 

As a result of the violations, the firms obtained $127.5 million in fees that they were forced to disgorge. In addition, the firms agreed to pay a matching penalty of $127.5 million, plus nearly $12 million in prejudgment interest on the disgorgement amount. 

The JP Morgan and AIG matters both reinforce comments made in February 2015 by the then-co-chief of the SEC’s Asset Management Unit, Julie Riewe, regarding the agency’s “overarching concerns” over conflicts of interests in all investment vehicles. Those comments were addressed specifically to the conduct the SEC has charged here, failure to disclose conflicts of interests, which in Riewe’s words, “is at the heart of advisers’ fiduciary relationship with clients,” and share class selection.

These two cases and the SEC’s public comments should leave no doubt that the SEC is focused on identifying investment advisors who it believes are making investment decisions designed to generate more fees, and therefore are not in the best interests of investors. Accordingly, we can expect to see more share class selection cases in the coming months.

One byproduct of the SEC’s push in this area will be the elimination of a source of compensation for the individual representatives employed by the broker-dealer arm of the fund groups. While the SEC did not specify how much of the $2 million in fees in the AIG affiliate case or the $127.5 million in fees in the JP Morgan case went to individual brokers at the firms, industry surveys suggest that as much as two-thirds of mutual fund 12b-1 fees go to compensate brokers.  One piece of that revenue stream to brokers will presumably be coming to an end.

Registered reps may be impacted more directly if the SEC finalizes its uniform fiduciary rule for brokers and advisors:  the SEC might name individual brokers as defendants. In the AIG and JP Morgan cases, the SEC charged advisors with breaches of fiduciary duty but said nothing about the brokers who presumably selected the share classes and who received a portion of the resulting fees. The SEC’s approach would surely change in the face of a broker fiduciary duty rule.

Zaccaro Morgan LLP partner Sam Puathasnanon contributed to this article.


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