In quick succession in early May, the SEC imposed heavy fines in two cases against mutual fund advisors, faulting them for using fund assets to pay 12b-1 distribution fees to intermediaries outside of a plan approved by the fund’s board or shareholders.
While the SEC has occasionally brought similar cases in the past, the new cases — coming as they did on the eve of SEC Chairman Jay Clayton’s confirmation and on the watch of fellow Republican Commissioner Michael Piwowar — may provide valuable insights into the new SEC’s direction on broader issues facing fund advisors.
Emphasis on Negligent Violations?
In the first case, against a Chicago-based investment advisor, the SEC alleged that the advisor used fund assets to pay out-of-plan expenses, but the SEC was sure to make clear that the payments were accidental and not intentional.
The SEC characterized the payments as “erroneous” and said that the advisor “inadvertently misclassified the fees” during a transition from a manual oversight system to an increasingly automated system. Further, the SEC conceded that the payments resulted from “negligent conduct,” and the “impact on the affected funds was less than one penny per share.”
Similarly, in the second case, against a Maryland-based advisor, the SEC alleged that the advisor “negligently” and “improperly caused” the funds to pay 12b-1 fees to intermediaries.
While the funds had 12b-1 plans permitting some types and amounts of payments to the intermediaries, the advisor negligently caused the funds to pay for other services not permitted under the plans in amounts beyond an annual cap in the plans. The SEC did not allege that the advisor intentionally caused the funds to make the payments.
Whether the SEC should devote its scarce enforcement resources to pursuing investment advisors for negligent violations — particularly if it means that the SEC is not using those same resources to pursue advisors for intentional violations—is an issue that every Commission grapples with.
Several years ago, former Commissioner Paul Atkins made forceful legal and public policy arguments questioning the wisdom and deterrent effect of punishing advisors for negligent violations:
… from a purely practical perspective, I dispute the regulatory approach underlying the contention that ‘by taking sufficient care to avoid negligent conduct, advisors will be more likely to avoid reckless deception.’ By an extension of that same logic, a strict liability standard would evoke even more care by advisors. Even if the SEC is authorized … arbitrarily selecting a higher standard of care ‘just to be on the safe side’ has the potential of misdirecting enforcement and inspection resources and chilling well-intentioned advisors from serving their investors.
With these two cases, the new SEC may be signaling a rejection of Atkins’ view.
Benefits of Cooperation and Remediation?
Another issue each Commission must wrestle with is how much and in what way to reward investment advisors and others for identifying, self-reporting and remediating potential violations.
The SEC has long held out potential leniency as an incentive for firms to voluntarily cooperate with regulators, but the level of reward varies from case to case and from Commission to Commission.
The two 12b-1 fee cases call into question just how lenient the current SEC is willing to be.
In the Maryland advisor case, the SEC went out of its way to applaud the advisor’s voluntary efforts, imposing a “reduced penalty” in light of the advisor’s “self-reporting of the improper fee payments, significant cooperation, and prompt remediation.” According to the SEC, “upon discovery of some of the improper fees,” the advisor “initiated an in-depth review of intermediary agreements and promptly self-reported their findings” and “provided significant cooperation with the Commission’s investigation.”
Finally, after discovering the improper fee payments, the advisor “promptly implemented enhanced policies and procedures regarding payments for distribution and sub-TA services, and informed the staff that they intend to reimburse affected shareholder accounts.”
What penalty did the SEC impose in light of such high level of cooperation (and unintentional violations)? $1 million.
It could have been worse. In the case against the Chicago-based firm, the SEC similarly credited the advisor with “remedial acts promptly undertaken” including “an independent internal review of its intermediary arrangements” that resulted in a discovery of the “erroneous” payments. The SEC went on to observe that “after identifying the payment errors,” the advisor “promptly notified the board, reimbursed the funds with interest, and supplemented its practices of providing oversight of payments to financial intermediaries.”
The SEC rewarded the advisor for its efforts with a civil penalty in the amount of $4.5 million.
The Commission approved these settlements prior to Clayton taking the reins, so a different approach may still materialize. However, advisors of all types should be prepared for an SEC willing to devote enforcement and examination resources to combating negligent and inadvertent errors and willing to reward cooperation and self-remediation with “leniency” in the form of multimillion-dollar penalties.