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Regulation and Compliance > Federal Regulation > SEC

Regulators Take Aim at Share Class Disclosure

By Melanie Waddell

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The new year is bringing renewed focus to mutual fund share class disclosure, and regulators’ continued crackdown on funds that include 12b-1 fees — with one compliance expert predicting such fees are on their way out.

In late January, the Financial Industry Regulatory Authority followed the Securities and Exchange Commission’s lead in putting a razor sharp focus on share class recommendations that include 12b-1 fees.

On Jan. 28, FINRA launched a program to allow broker-dealers to self-report share class disclosure violations related to 529 college savings plans, similar to the self-reporting program launched by the SEC last February.

The 529 Plan Share Class Initiative, as set out in Regulatory Notice 19-04, states that over the past several years, FINRA has found that some firms have failed to reasonably supervise brokers’ recommendations of multi-share class products.

As with mutual fund share class concerns, FINRA states that it has raised concerns specifically regarding firms’ supervision of share-class recommendations to customers of 529 savings plans.

Shares within 529 plans are commonly sold in different classes with differing fee structures, FINRA explains, with Class A shares typically imposing a front-end sales charge but lower annual fees compared with other classes. Class C shares typically impose no front-end sales charge but impose higher annual fees than Class A shares.

Susan Schroeder, head of FINRA’s enforcement division, stated in a video message that if firms self-report via the initiative, “a settlement under this initiative would be a supervisory settlement and would not trigger” a statutory disqualification.

To encourage voluntary reporting, FINRA will accept favorable settlement terms for firms that self-report these potential violations and provide FINRA with a detailed remediation plan.

To be eligible for the initiative, firms must self-report by providing written notification to FINRA Enforcement by noon on April 1. A firm that has timely self-reported must, by May 3, 2019, confirm its eligibility for the 529 Plan Share Class Initiative by submitting information for the period of January 2013 through June 2018.

Schroeder explained that FINRA is concerned about 529 plans because they “are incredibly important investment vehicles for a lot of Americans who are trying to save for the education of beneficiaries like their children.”

FINRA has learned through reviewing “some firms’ 529 plan sales that this can be a blind spot for some firms,” she continued.

Addressing the question of whether FINRA, through the crackdown, believes that C shares are “never suitable,” or are “always unsuitable” for younger beneficiaries, Schroeder said: “Absolutely not.”

FINRA “is not saying there is any ‘per se’ unsuitability about C shares,” Schroeder said. “In fact, with the recent revision of the tax laws, it’s even more complicated because you can use 529 plans under some circumstances for educational expenses before college. It really underscores the need to understand each investor’s particular circumstances and objectives to make sure the recommendation is suitable for that investor.”

The advent of FINRA’s disclosure initiative, however, does not signal the end of examiners’ focus on the share class issue, Schroeder stated. “The exam program will continue to look at 529 plans and share class recommendations.”

If firms fail to self-report such violations and FINRA examiners uncover them, the firms will face stiffer sanctions. Broker-dealers that sell 529 plans should consider participating in the program, she said.

Experts Weigh in After SEC Chairman Jay Clayton came aboard in mid-2017, the agency launched its Retail Strategy Task Force (RSTF) within the SEC’s Enforcement Division. In February 2018, the securities regulator announced its share class disclosure initiative and also allowed advisors to self-report violations. The deadline to participate in that initiative ended last June.

David Tittsworth, an attorney at Ropes & Gray in Washington, said the RSTF has “been focused on potential violations of the securities laws that harm retail consumers, such as a large number of 12b-1 cases that are expected to be announced soon.”

The Wall Street Journal reported in late January that more than 50 investment advisors are “under pressure” to settle SEC charges of selling higher-fee mutual funds over cheaper versions.

In fact, in late December, the SEC announced settled charges with American Portfolios Advisors — the RIA of broker-dealer American Portfolios Financial Services — as well as PPS Advisors and PPS CEO and Chief Investment Officer Lawrence Nicholas Passaretti for selecting mutual fund share classes inconsistent with their disclosures to clients.

The SEC is requiring the firms and the CEO to collectively pay more than $1.8 million, which will be returned to harmed investors.

Both firms were not eligible to self-report because the Division contacted them about the disclosure violations before the initiative was announced.

Todd Cipperman, head of Cipperman Compliance Services, sees the share class cases as signs of “the continued move away from the broker model.”

Ultimately, Cipperman continues, “the client-facing financial professional must receive compensation or [they] won’t work on behalf of the retail investor.”

The 12b-1 fee “cases suggest that the SEC wants up-front, transparent disclosure,” and “harken the end of 12b-1 fees and other revenue-sharing practices.”

This will lead advisors to “charge a higher up-front asset-based advisory fee and then scour the investing world for the lowest cost ETFs,” Cipperman opines, thus reducing “the number of retail investors with access to a financial advisor, thereby pushing them to direct purchases or to robo-advisors.”

Cipperman has advised advisor clients to “forego any type of revenue sharing, even if fully disclosed, because of the potential conflict of interest.”

As for self-reporting, “it’s complicated,” Cipperman states. “Every case depends on the facts and circumstances and whether your firm could successfully defend an enforcement action.”

Jim Lundy, a partner at Drinker Biddle & Reath’s Chicago office, said on the law firm’s recent Inside the Beltway webcast, that the SEC enforcement division’s priority for 2019 appears to have shifted from 12b-1 fee disclosures to revenue sharing.

Lundy explained that a couple of his clients “elected to not go through the [SEC] initiative, and as promised by the SEC, they have now received requests from the enforcement division to provide documents regarding their 12b-1 fee disclosures. However, these matters are not limited to 12b-1 fees. They include requests for information regarding their revenue sharing arrangements and their disclosure practices regarding those arrangements.”

Indeed, Eversheds Sutherland stated in a mid-December legal alert that the SEC’s enforcement division has launched new investigations into advisory firms that did not self-report violations under the agency’s Share Class Disclosure Initiative — with a new focus on revenue sharing.

It also stated that the SEC’s enforcement division sent request letters in early December to firms that didn’t self-report share-class violations, “but perhaps should have.”

Eversheds attorneys Brian Rubin and Cliff Kirsch said the letters sent to firms “largely mirrored the 12b-1 disclosure issues set forth in the Initiative, but expanded the SEC’s initial review,” in two key areas:

First, the SEC has expanded the relevant time period, going back to 2013. Second, the SEC’s request covers not just 12b-1 fees, but also revenue sharing.

Fred Reish, a partner and head of Drinker Biddle’s ERISA Financial Services Group, stated on the webcast that “reps of RIAs need to review their Form ADV disclosures and have somebody who’s familiar with the share class selection disclosure initiative, and who’s familiar with these enforcement investigations, look at it.”

The SEC, Reish said, has “taken a common practice … and they’re now saying it doesn’t work — a common disclosure does not work and if you’re [doing] it the old way, you’re in trouble.” The SEC also is saying, Reish continued, “‘Hey, we gave you a chance to come in under a self-disclosure initiative; you didn’t do that. Now we’re going to hit you with a baseball bat if we find you did it wrong.’”

Warned Reish: “Be very careful about this folks. It’s a big deal.”

Washington Bureau Chief Melanie Waddell can be reached at [email protected].

Melanie Waddell

@Think_MelanieW

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