Regulators have showed renewed interest in investment fees in recent years. Specifically, the U.S. Securities and Exchange Commission (SEC) has heightened focus on advisers not complying with the Investment Advisers Act of 1940, when fully disclosing all material conflicts of interest related to their selection of mutual fund classes for clients.
The SEC announced its fee disclosure initiative in 2018, when it gave advisers a four-month grace period to self-report violations regarding 12b-1 fees and the selection of mutual fund share classes without risk of being assessed a monetary penalty aside from compensating affected clients. The initiative indicated that SEC staff expected to recommend stronger sanctions in any future actions against investment advisers that it alleges has engaged in the misconduct but failed to take advantage of the initiative.
The advancement of data-driven initiatives has emboldened regulators to detect share-class issues faster than ever before and prompted advisers to review the language and adequacy of their policies and procedures.
A 2022 Exam Priority
Earlier this year, the SEC announced plans to target RIAs’ use of 12b-1 fees in wrap accounts where the RIA may be responsible for paying transaction fees. In April, the SEC charged an Illinois-based advisory firm with investing certain clients’ assets in higher-cost mutual fund share classes — as part of a wrap fee arrangement — that included 12b-1 fees.
According to the SEC’s order, the firm invested certain clients’ assets in higher-cost mutual fund share classes than were otherwise available while failing to disclose the conflicts of interest associated with those investment recommendations. Although the firm and its IARs did not receive any of these 12b-1 fees, by investing clients in no- transaction-fee share classes, the firm and its IARs avoided paying transaction fees on client trades of these mutual funds.
Section 206(2) of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisers to act for their clients’ benefit, including an affirmative duty of utmost good faith and full disclosure of all material facts in any registration application or report filed with the commission.
The SEC said the firm’s conduct violated 206(2) because it breached its duty of care, including its duty to seek best execution. It caused advisory clients who had already opened a wrap account to invest in fund share classes that charged 12b-1 fees when share classes of the same funds were available that presented a more favorable value for clients. The SEC also cited the firm’s failure to undertake an analysis to determine whether the particular mutual fund share classes it recommended were in the clients’ best interests.
Three Rules to the RIA Investment Manual
A significant takeaway is the firm’s inability to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act in connection with its mutual fund selection practices in its wrap program and its disclosure of its associated conflicts of interest.
It all comes down to the importance for advisers to have robust written policies and procedures in place as a preventative measure. Policies and procedures are a RIA’s investment manual, and there are three rules every RIA’s compliance program should follow:
- Have adequate policies and procedures to prevent violations from occurring.
- Have adequate policies and procedures to detect violations that have already occurred.
- Have adequate policies and procedures to correct said violations.
Assessing the Adequacy of Disclosure
Fee disclosure will remain a matter of interest for the SEC. Firms should disclose any conflict of interest with specificity and in plain English to provide clients with the information necessary to support their investment decisions.
The SEC’s ongoing scrutiny regarding recommendations of mutual funds by RIAs makes it imperative your firm determines whether it wrongly profited from selecting more expensive share classes for its clients where a lower-cost share class was available.
The RIA will also need to assess the adequacy of its disclosure regarding the conflict of interest presented by these 12b-1 fees on its Form ADV.
Core Compliance specializes in reviewing a firm’s policies and procedures to mitigate disclosure risk and handle the unique regulatory compliance challenges advisers face today. Contact us at 619.278.0020 to schedule a consultation.
 SEC wraps up share-class initiative by settling with Merrill, two others – InvestmentNews
 2022 Examination Priorities Report (sec.gov)
 Highpoint Advisor Group, LLC (sec.gov)