The Securities and Exchange Commission’s aggressive crackdown on disclosures surrounding payments by funds to financial advisers has some wondering if the agency is really trying to eliminate the practice.
The latest SEC salvo came last week when it ordered SCF Investment Advisors of Fresno, California, to pay $767,192 for allegedly selecting high-fee share classes of mutual fund and money market funds for clients without disclosing that less expensive classes of the same funds were available.
The firm took 12b-1 fees on mutual funds and revenue sharing on the money market funds. SCF did not admit nor deny the charges.
As was the situation with SCF and in the SEC’s recently concluded share-class selection initiative, the violations involve investment advisers also registered as brokers who select funds with 12b-1 fees for clients in advisory accounts and then send the 12b-1 revenue to a brokerage affiliate.
The SEC enforcement cases have not said it’s inappropriate for investment advisers to pay 12b-1 fees to brokers. The problem is that the advisers are violating their fiduciary duty by not telling their clients about the conflict of interest created by the 12b-1 fee revenue.
But Kit Addleman, a partner at Haynes and Boone, said the SEC is setting the disclosure bar so high on 12b-1 fees, there are limited instances in which receiving such payments would be okay.
“The SEC is essentially saying 12b-1 fees are a thing of the past,” said Addleman, former director of the SEC's Atlanta office. “There is no amount of disclosure that allows you to keep the fees.”
That sentiment was echoed last week by James Lundy, a partner at Faegre Drinker Biddle & Reath. “The SEC Enforcement Division has effectively outlawed [12b-1 fees],” Lundy said.
An SEC spokesperson declined to comment.
For more than two years, the SEC has been targeting firms that make inadequate disclosures relating to 12b-1 fee payments. Its share-class selection initiative returned about $139 million to harmed investors.
Since the conclusion of the program, the SEC has filed several more share-class cases, and there are likely more in the pipeline.
The Financial Services Institute, which represents independent broker-dealers and financial advisers, accuses the SEC of regulation by enforcement. It says the agency is penalizing firms for practices that had been routine and acceptable without giving them warning about the policy change.
“We want investors to be protected,” said Robin Traxler, FSI senior vice president of policy and deputy general counsel. But “we want an opportunity to understand what the SEC’s expectations are and have an opportunity to comment through a formal rulemaking process.”
It’s too early to tell how much pressure the SEC is putting on the receipt of 12b-1 fees as opposed to ensuring that they’re adequately disclosed.
A clue about the agency’s direction could be found in one aspect of the case against SCF Investment Advisors, said Barbara Roper, director of investor protection at the Consumer Federation of America.
In the share-class initiative cases, the SEC encouraged firms to self-report. By doing so they avoided civil penalties. SCF did not self-report. It was hit with a $200,000 fine but also was the subject of a wider case.
The SEC charged that by recommending funds with 12b-1 fees and revenue share, SCF violated best execution rules because those funds presented a less favorable value to investors that funds without the fees at the time of purchase.
“That gives [the SCF case] more substance,” Roper said. The SEC essentially told the firm “you recommended these [funds] when they weren’t the best available options for the investor.”
Roper will be watching whether best execution is part of future share-class cases.
“What I can’t tell is whether in a situation where there was robust disclosure that a best-execution violation would be enough to bring an enforcement action,” Roper said.
The SCF case involved the receipt of revenue sharing as well as 12b-1 fees, an expansion of the areas the SEC reviewed in the share-class initiative.
In a November speech, SEC Enforcement Director Stephanie Avakian mentioned revenue sharing as a concern. The agency also is pursuing litigation against Commonwealth Financial Network and Cetera Advisor Networks over alleged failure to disclose revenue sharing.
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