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Trendspotter: SEC Cracks Down on Revenue Sharing, Including 12b-1 Fees

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The Trend

The Securities and Exchange Commission is zeroing in on revenue sharing arrangements like 12b-1 fees, payment for shelf space and cash sweep arrangements.

RIA exams will focus this year on whether advisors “are acting consistently with their fiduciary duty to clients, looking at both duties of care and loyalty, including best execution obligations, financial conflicts of interest and related impartiality of advice, and any attendant client disclosures,” according to the agency’s recently released 2022 exam priorities.

Another hot button for examiners: recommending or holding more expensive classes of investment products when lower cost classes are available (e.g., RIAs that recommend no-transaction-fee mutual fund share classes with 12b-1 fees in wrap fee accounts where the RIA may be responsible for paying transaction fees).

The SEC has continued to bring cases against advisors for 12b-1 fee violations since ending its Share Class Selection Disclosure Initiative in April 2020. Since ending the share class initiative, the SEC has levied what industry officials call, in some cases, follow-on actions to firms that had been under investigation during the initiative.

At least 11 actions related to 12b-1 fees have occurred since the initiative ended. Most recently, it fined the RIA City National Rochdale $30 million in March.

The Drivers

  • Conflicts of interest
  • Harm to investors as the advisor receives additional compensation for recommending a fund (or other investment product), versus a similar fund that has no revenue sharing (and often has lower fees).

The Buzz

Ron Rhoades, associate professor of finance at Western Kentucky University and director of its personal financial planning program:

“Broadly speaking, payments from investment product providers (asset managers and their affiliates) to broker-dealers are quite common, and they are undertaken in order to incentivize the sale of the products by the brokers,” Rhoades said. “Any payment from an investment product provider to the affiliated broker-dealer of an RIA firm creates a conflict of interest.”

Under an investment advisor’s fiduciary duties “(including the duty of best execution), conflicts of interest that harm a client should be avoided, at least where another avenue exists to secure for the clients greater benefits from the proposed transaction.”

Aside from commissions (front-end sales loads and contingent deferred sales charges, as they appear to investors), Rhoades said, revenue-sharing payments include:

  • 12b-1 fees, the vast majority of which are paid out by mutual funds to brokers who sell the funds. “12b-1 fees often vary in amount, by share class,” Rhoades said. “For dual registrants, receipt of 12b-1 fees can result in a breach of fiduciary obligations. It’s not just a matter of disclosure. It’s a breach of the fiduciary duty of an RIA to not obtain best execution for a client.”
  • Shelf space arrangements, at one time referred to as “pay-to-play.” In this practice, Rhoades said, “a fund’s investment adviser (manager) makes payments to a broker-dealer in exchange for some type of preferential marketing treatment.”
  • Cash sweep revenue sharing. The SEC brought an action in last August in First Heartland, a registered investment advisor. “[The RIA firm] had a conflict of interest when recommending certain money market funds to its clients: it had an incentive to recommend cash sweep products that resulted in FHC receiving revenue sharing as opposed to investments that did not,” Rhoades said.
  • Payment for order flow. “A very common practice — and one that should be banned, in my view,” Rhoades said. “It results in non-transparent compensation to brokers, including those affiliated with RIAs. At the end of last year, the SEC confirmed it would be exploring potential changes to the PFOF regime because of inherent conflicts of interest within the system. However, many in the compliance field believe that the SEC will not move to ban payment for order flow in 2022.”
  • Soft dollars. Higher commission rates are paid by certain mutual funds to selected broker-dealers, for trades occurring within the fund, Rhoades explained. “The higher commissions paid by the fund are borne by the fund shareholders, but are not reflected in the fund’s annual expense ratio.”

The SEC Division of Examinations issued a risk alert on Oct. 26 titled “Observations from Examinations in the Registered Investment Company Initiatives,” which summarized the observations of the staff coming out of a series of examinations from 2018 and 2019 that focused on mutual funds and exchange-traded funds.

“One deficiency noted by the SEC related to ‘sharing of soft-dollar commissions among clients to assess whether any client is disadvantaged,’” Rhoades said.

“In my view, if the SEC really wants to get serious about minimizing the conflicts of interest that are possessed by brokers under the poorly named ‘Regulation Best Interest,’ then the SEC should ban all revenue-sharing,” Rhoades said. “12b-1 fees make no sense.”

Jim Lundy, partner at Faegre Drinker in Chicago:

“There are three main areas of revenue sharing cases: [no transaction-fee] NTF revenue sharing, [transaction-fee] TF revenue sharing, and cash sweep revenue sharing. 12b-1 fee cases and other disclosure cases involve different types of financial conflicts and corresponding, alleged disclosure failures. Of those three that I just mentioned, the majority of the cases typically involve NTF revenue sharing.”

Also, “this is one of the only areas of financial conflicts disclosure theories for which the SEC can point to litigated precedent,” Lundy said.

Case in point: “A D.C. Circuit Court appellate opinion for a case commonly known as Robare. Cash sweep revenue sharing settlements, which have become more prevalent in the last year or so, do not have litigated precedent to support this newer theory. Rather, the first action appears to be the SCF Investment Advisors, Inc. settlement in August of 2020.”

Said Lundy: “Case law provides that SEC settlements are not precedent. Nevertheless, the SEC Enforcement Division treats its settlements like precedent, and has since used this settlement [against SCF Investment Advisors] to elicit more settlements for cash sweep money market sharing violations from firms.”

What will the future hold? “The revenue sharing crackdown started in the midst of the 12b-1 fee self-reporting initiative a few years ago now, but it was just not widely covered at that time, because it was a non-public initiative.”

Over the past year or so there have been “the settlements and litigated matters filed as a result of multi-year investigative efforts.

“Going forward, the SEC will always be focused on retail investor ‘main street’ issues, but this [revenue-sharing] crackdown was initiated under the prior SEC Chair Jay Clayton.”

While SEC Chairman Gary Gensler “will continue to support enforcement efforts such as this [one related to revenue sharing], as part of his ongoing agenda he will also be prioritizing other enforcement initiatives in other areas of the securities industry.”


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