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Regulation and Compliance > Federal Regulation > SEC

SEC Presses Ahead in 12b-1 Fee Crackdown

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The Securities and Exchange Commission’s crackdown on 12b-1 fees has now hit nearly 100 advisors and sparked a renewed battle over so-called “regulation by enforcement.” While 12b-1 fees, which are marketing or distribution fees charged by mutual funds, have been in the SEC crosshairs for years, the agency’s Share Class Selection Disclosure Initiative (SCSDI) launched last February is aimed at ensuring advisors provide adequate disclosure and consent about such fees.

Since the initiative’s launch, the Financial Services Institute and former SEC Commissioner Paul Atkins have called foul, stating the program is unfair, and that it should be halted until the agency develops a formal rule to address the 12b-1 fee issue. At least one broker-dealer also is fighting the SEC’s charges.

Todd Cipperman, head of Cipperman Compliance Services, told me in early October that the SEC has brought 95 cases, which he said is “significant,” under the initiative and recovered $135 million. However, he adds: “That’s less than $1.5 million returned per case. The aggregate, while great for investors, may be less than many in the industry expected especially given the regulatory attention devoted to this issue.”

In announcing the initiative, the SEC said at the time that it had filed “numerous actions” for advisors failing to make required disclosures relating to the selection of mutual fund share classes that paid the advisor (as a dually ­registered broker-dealer) or its related entities or individuals a fee pursuant to Rule 12b-1 of the Investment Company Act of 1940 when a lower-cost share class for the same fund was available to clients.

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. Then in February 2018, the securities regulator announced its share class selection disclosure initiative and also allowed advisors to self-report ­violations. The deadline to participate in that initiative ended last June.

Steven Peikin, co-director of the SEC’s Enforcement Division, said ­during the annual SEC Speaks conference last February, just after the ­initiative was launched, that investment ­advisors putting their clients into higher fee share classes when lower cost ones are available “is a widespread problem.”

A year later, in early March 2019, the SEC announced that as a result of the share-class initiative, 79 investment advisors would return $125 million to clients as part of settled actions for directly or indirectly receiving 12b-1 fees for investments selected for clients without adequate disclosure, including disclosures that were inconsistent with the advisors’ actual practices.

FSI has called the SEC initiative the “kind of drive-by regulating without rules [that] harms independent financial services firms and American investors.”

Independent financial firms and advisors, FSI continued, “have a reasonable expectation the SEC will establish clear rules of the road before engaging in enforcement.”

The SEC enforcement division should “stay further enforcement actions” under the initiative, FSI has argued, and not expand it further, “until appropriate rules addressing the Commission’s concerns have been adopted.”

Crackdown Continues

The SEC continued its crackdown in late September, announcing settled charges against 17 additional investment advisors for disclosure failures regarding their mutual fund share-class selection practices, bringing the total amount ordered to more than $135 million.

The firms include 16 advisors that self-reported as part of the Division of Enforcement’s share class initiative and one advisor that did not self-report and was ordered to pay a $300,000 civil penalty.

The actions “demonstrate the Commission’s commitment to holding advisers accountable for selecting more expensive investments that eat away at their clients’ investment returns without proper disclosure,” said C. Dabney O’Riordan, co-chief of the Asset Management Unit.

The SEC’s orders found that the 16 self-reporting firms violated Section 206(2) of the Investment Advisers Act of 1940, and ordered that they are censured, that they cease and desist from future violations, that they pay disgorgement and prejudgment interest totaling nearly $10 million and that they comply with certain undertakings, including returning the money to investors.

A separate action was also filed in late September against Founders Financial for failing to adequately disclose the conflicts of interest related to its receipt of 12b-1 fees and its selection of mutual fund share classes that pay such fees.

Founders also was charged with breaching its duty to seek best execution for its clients by investing them in mutual fund share classes with 12b-1 fees rather than available lower-cost share classes of the same funds. Founders benefited from “over $1.24 million in 12b-1 fees for advising clients to invest in or hold such mutual fund share classes,” the SEC said.

‘Call to Action’

FSI launched in early September an online “Call to Action” encouraging interested parties to contact Congress, stating: “It’s time for the SEC to return to required rulemaking to impose new regulations, rather than regulating without rules.”

Chris Paulitz, SVP, Membership & Marketing for FSI, told me in early October that FSI’s “efforts to constructively work with the SEC on this urgent matter continue. Our member firms are following the rules and being penalized for doing so. Rulemaking by enforcement is wrong, it hurts both businesses and investors, and we’ll continue our work until it comes to an end.”

Former SEC Chairman Harvey Pitt argues, however, that, while he’s not a fan of regulation by enforcement, the securities regulator has long employed the practice and through the share-class initiative is trying to get a handle on a widespread industry problem.

“The Commission has had a long history of tackling industry-wide issues by collective enforcement actions, so the current [SCSDI] effort is not new,” Pitt said. “The advantage of what the Commission has done here includes not singling out individual firms, which perhaps creates competitive dislocations, but rather treating an industry segment as a collective whole, and addressing an industry-wide problem.”

Further, Pitt said, “utilizing this type of global approach enables the Commission to tackle a broad issue in specific factual contexts. That makes the enforcement settlement process employed here a very effective tool to describe what it is the Commission finds problematic, and deal with the entire industry in one fell swoop.”

New Focus on Revenue Sharing

Last December, the SEC’s enforcement division launched new investigations into advisory firms that did not self-report violations under the agency’s SCSDI — with a new focus on revenue sharing.

David Bellaire, FSI’s general counsel, said that with the initiative’s new focus on revenue sharing, “the SEC is compounding their mistake by extending the logic to other streams of revenue in phase two. It’s time for the SEC to call a timeout on regulating without rules. We are asking them to play the game fairly by proposing a rule and enforcing it prospectively.”

In early August, Commonwealth Financial Network came under the SEC’s sword over revenue sharing.

The SEC charged Commonwealth with breaching its fiduciary duty by failing to disclose that it received over $100 million in a revenue sharing arrangement related to client investments in certain share classes of “no transaction fee” and “transaction fee” mutual funds.

The allegation came about six months after the independent broker-dealer joined the 78 other firms in paying the combined $125 million over 12b-1 fees.

Commonwealth filed a reply brief on Sept. 30 denying the SEC’s allegations.

The Massachusetts independent broker-dealer said in a statement that while the enforcement action proposed by the SEC is a pending legal matter, “Commonwealth Financial Network vehemently denies the allegations and believes they are categorically without merit. We are confident we have operated both appropriately and justly and will vigorously defend our actions in this matter.”

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


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