Under Clayton’s SEC, Hefty Fines for Inadvertent Errors May Be Status Quo

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.