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Regulation and Compliance > Federal Regulation > SEC

SEC Continues Crackdown on Mutual Fund Share Classes

By Melanie Waddell

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The Securities and Exchange Commission continues its crackdown on firms’ use of more expensive Class A mutual fund shares as well as 12b-1 fees, levying recent actions against an RIA as well as SunTrust Bank’s investment services subsidiary.

On Sept. 8, the SEC issued a cease-and-desist order against Envoy Advisory Inc., and the firm agreed to pay disgorgement for failing to offer the lowest-fee mutual fund share classes available and failing to adequately disclose compensation paid to its affiliated broker-dealer.

The RIA recommended third-party mutual funds to 403(b) and IRA clients, who directed the investments.

According to the SEC, from January 2013 through March 2017, Envoy recommended, and plan participants and IRA holders held, Class A mutual fund shares when less expensive institutional share classes of the same mutual funds were available.

Unlike institutional shares, Class A shares may charge investors marketing and distribution or 12b-1 fees, typically 25 basis points per year. The 12b-1 fees (also commonly known as “trail” or “trailer” fees) are paid out of the assets of the fund.

In Envoy’s case, the 12b-1 fees paid by mutual funds held by plan participants and IRA holders went to Envoy’s affiliated broker-dealer, Envoy Securities LLC.

During the relevant period, Envoy Securities received at least $24,800 in 12b-1 fees in connection with investments in higher-fee share classes by plan participants and IRA holders.

Envoy’s Form ADV disclosures to plan sponsors during the relevant period disclosed that certain mutual funds “may” pay a “dealer” 12b-1 fees, but failed to disclose that the “dealer” receiving the 12b- 1 fees was Envoy’s affiliate, according to the SEC order.

The Envoy case is “slightly different from some of the prior enforcement proceedings in the area to the extent that it did not say that the advisor breached its duty of best execution,” Larry Stadulis, partner at Stradley Ronon Stevens & Young in Washington, told ThinkAdvisor on Thursday.

“However, like prior proceedings, the Envoy case also rests on a failure to properly disclose the practice and related arising conflicts, [which] amounted to a violation of the antifraud provisions of the securities laws. This particular case seems to hold there is a violation on failure to disclose conflicts and a compliance rule violation,” Stadulis said.

“Even though the SEC focused on inadequate disclosure, one gets the sense that they [the agency] will invariably find inadequate disclosure and thus an antifraud violation if you’re putting a client in a more expensive share class.”

On Thursday, the SEC charged the investment services subsidiary of SunTrust Banks with collecting more than $1.1 million in “avoidable fees” from clients by also improperly recommending more expensive share classes of various mutual funds.

SunTrust Investment Services agreed to pay a penalty of more than $1.1 million to settle the charges, and separately began refunding the overcharged fees plus interest to affected clients after the SEC started its investigation. 

SEC examiners cited the practice during a compliance review of the firm in mid-2015. More than 4,500 accounts were affected.

According to the SEC’s order, the Atlanta-based firm breached its fiduciary duty to act in clients’ best interests by recommending and purchasing costlier mutual fund share classes that charged 12b-1 fees. 

“Investors were not informed that they were eligible for less costly share class options that did not charge 12b-1 fees,” the SEC said. “The avoidable fees flowed back to SunTrust in the form of higher commissions from the funds.”

— Check out Morningstar: Industry’s Idea of Clean Shares May Not Be Clean Enough on ThinkAdvisor.

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