Financial advisors taken by surprise by the Securities and Exchange Commission’s so-called Share Class Selection Disclosure Initiative (SCSD Initiative) should tune in to a single paragraph (and the associated Footnote 60) in the recently released interpretation accompanying Regulation Best Interest (Reg BI).
Early last year, the SEC enforcement division launched the SCSD Initiative, which called for financial advisors to self-report if they had put clients into higher cost mutual fund shares (charging 12b-1 fees) when lower-cost shares were available, and failed — in the SEC’s view — to adequately disclose the practice.
Recently, the SEC settled nearly 80 cases with financial advisors for alleged disclosure failures and forced the return of $125 million to investors.
Alarmingly, in neither announcing the Initiative nor the subsequent settlements did the SEC cite violations of any particular rule or regulation as support for its view of the sufficiency of the disclosure — a disclosure that had long been standard in the industry — but instead referred to previously pressured settlements that do not carry the weight of law.
In what appears to be a belated attempt to rectify that omission, Footnote 60 speaks to disclosures advisors need to make to investors about fees the advisors “may” or “will” charge. This distinction is fundamental in some of the cases brought by the SEC.
The language also appears to be an acknowledgement that the agency has “fallen down on the job,” as SEC Commissioner Hester Peirce described the breadth and scope of the initiative, saying, “An even more fundamental concern is less about our enforcement function than what the Initiative says about our regulatory function.”
The commissioner noted: “If we see a wide-scale departure from the fiduciary duty as we interpret it occurring over numerous years, we owe it to the firms we regulate and — more importantly — the investors whom we are charged with protecting to be very clear that there is a problem.”
By virtue of the large number of actions over these disclosure practices, clearly the SEC failed to provide the industry with ample notice of its expectations.
In 2010, the SEC failed to amend, via rulemaking, the rules concerning the level of disclosure necessary regarding share class fees and practices.
After giving up on efforts to enact these amendments, it instead took the easier, but highly problematic, practice of pursuing “regulation by enforcement.” The trouble is these and earlier enforcement cases were settled and likely under pressure. Settled enforcement cases are not law.
Some might argue that the SEC, through the new interpretation it provided as part of the Reg BI rule package, has now given clarity to the industry and investors. However, because of the nature of the settlements, advisors still do not have clarity about what disclosure formulation meets the SEC’s expectations.
Footnote 60 reveals an agency seeking to paper the record while continuing to investigate, and likely to bring actions concerning disclosures, that were made years before publishing this interpretation.
It’s time for the SEC to pause the SCSD Initiative and any expansions of it, and see it for what it really is: regulation without rules.
Paul Atkins is CEO of Patomak Global Partners LLC, a financial services consultancy. He was an SEC commissioner from 2002-2008.