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Ken Joseph, Managing Director and Head of Disputes at Duff & Phelps, was featured in the Thomson Reuters Regulatory Intelligence article, “U.S. SEC prepares scores of cases of fund overcharges by firms.”
This article was written by Richard Satran, a financial journalist covering daily and emerging issues for Thomson Reuters Regulatory Intelligence.
U.S. SEC prepares scores of cases of fund overcharges by firms; individuals may be cited
The Securities and Exchange Commission is preparing to charge scores of firms for fiduciary violations in mutual fund share class violations, said industry sources. The cases are responses to an SEC self-reporting initiative that allowed firms to avoid penalties but left individuals liable to sanctions against advisers or managers for fraud or supervisory failures.
The agency contends that firms continue to pass on to consumers the cost of marketing funds in ways that could violate investment firms’ requirement to serve clients’ best interest or they fail to disclose conflicts of interest. The SEC launched its share class initiative in February saying there are “potential widespread violations.”
Conflicts all around: SEC Chief
A large number of violations among investment advisers could be a reputational stain for the sector, which has long been held to a higher fiduciary standard than broker dealers. It comes at a critical time in the $12 trillion retail market for which the SEC has proposed new conduct rules aimed at eliminating conflicts of interest in fees and compensation. The proposal also requires more robust disclosures on the standard of care offered by investment professionals.
“Both investment advisers and broker dealers have a number of conflicts of interest” that need to be disclosed to investors, said SEC Chairman Jay Clayton in a recent speech.
Through examinations and enforcement actions, the SEC has warned investment advisers to be more up-front and transparent about fees and conflicts of interest. The firms must provide "reasonable" disclosure to clients of any conflicts of interest. In the past, fund prospectuses have covered the requirement.
Being reasonable could help
The determination of what is reasonable disclosure, however, has been a source of controversy. The SEC has made it clear in past enforcement cases that it is not enough simply to say in fine print that firms “may” pass marketing fees along to customers. The agency has taken numerous enforcement actions based on insufficient disclosure in recent years.
“The fees are disclosed but a lot of times it’s not transparent, and it is murky to most people” said Morningstar Inc. analyst John Rekenthaler, a member of the investment research department of the fund research firm. Selecting fund classes is further complicated because the choice can depend on whether the investments are long-term or short-term, since paying fees upfront in load funds can save fees over time.
Cases could begin rolling out soon
The SEC is focusing on those marketing costs, known as 12b-1 fees, that became standard charges in the fund industry decades ago. The SEC for many years has allowed firms to pass on the cost of marketing mutual funds to individuals but not to institutions, where the distribution costs were lower. In recent years competition to cut fund fees has led to their elimination on many funds, but the fees still generate some $10 billion annually and are added to about half of all funds, according to industry estimates. The SEC has raised concerns, however, that many investment advisers are not offering the fee-free shares.
“Based on what I’ve heard there will initially be at least 50 to 100 cases in the next few months and possibly many more later,” said Brian Rubin, a former SEC enforcement counsel who heads the Washington office of Eversheds Sutherland U.S. LLP.
“They could come out in a tranches."
Muni sweeps provide model
The SEC has charged 10 firms amounts ranging from $80,000 to $125.5 million in mutual fund share-class related cases over the past five years, according to an Eversheds bulletin. Firms responded to the "carrot and stick" of the SEC initiative, said Rubin. "They could save money and time of a longer investigation, and they knew that if they did not self-report, the possible personal liability and penalties are likely to be much higher."
The SEC’s municipal securities initiative drew a large response, with more than 70 Wall Street firms voluntarily reporting violations. It was followed by a crackdown on disclosure lapses and market abuses in which larger sanctions were meted out in cases that were not part of the initiative.
Self-reports of more than 100 firms for share class violations “would not surprise me,” said Ken Joseph, Duff & Phelps LLC managing director of disputes and investigations and a former senior officer in SEC's Commission’s Office of Compliance Inspections and Examinations. The SEC was likely to cite individuals in some of the cases since the self-reporting does not protect individuals from being cited in cases of fraud, he added.
Carrot and stock of enforcement
“The Share Class Initiative was an opportunity offered by the Commission to affected investment advisers to perform the analysis to determine whether clients should have been placed in a lower-cost share class in the same fund, take corrective action, clarify disclosures, fix compliance oversight weaknesses, reimburse clients, and self-report to the Commission--all on a voluntary basis,” said Ken Joseph, Global Leader of Duff & Phelps, LLC’s Disputes practice and a former senior officer in the SEC's Office of Compliance Inspections and Examinations.
“Advisers that elect to timely self-report and take the other corrective steps, are eligible for settlements that include non-scienter based anti-fraud charges and non-monetary penalties, although those advisers will be required to reimburse clients with interest for the differential in share costs.” “By contrast, advisers who have failed to perform the analysis to determine whether they purchased the appropriate lower-cost shares for their clients, or who otherwise failed self-report knowing the appropriate lower-cost shares were not purchased for clients, do so at their peril. Given the Commission’s stated view on an adviser’s fiduciary duty obligations to its clients, it is unlikely that the Commission will look favorably upon advisers who forego an opportunity to correct a problem where client harm allegedly occurred.”
The self-reporting initiative is aimed at the investment adviser firm, which can avoid monetary penalties, settle to non-fraud charges, and pay disgorgement and interest to clients who are harmed. However, individuals are explicitly not covered by the initiative, and in cases where fraud is detected and supported by the evidence there is potential for actions to be taken against individual advisers, chief compliance officers and other “gatekeepers.
"Individuals should have concerns," said Joseph. "The Commission explicitly provided ‘no assurances to individuals’ and it may elect to seek harsher remedies than what is made available to the firms that participate in the initiative, including the imposition of monetary penalties, scienter-based fraud charges, and industry bars.” The Commission these days in particular would tend to include individual respondents, especially in cases involving retail clients."
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"Individuals should have concerns," said Joseph. "The commission these days in particular would tend to include individual respondents, and especially in cases involving retail clients."
The primary goal of the share class initiative has been to uncover cases where firms have failed to offer clients “best execution” by putting investors in the least expensive fund class. But the SEC has also targeted undisclosed “material conflicts of interest” that it said “may be widespread.” This includes the use of “soft dollar” services.
Soft dollars also feathering nest
“A lot of things are being offered — educational material, compliance tools, software," said Jaqueline Hummel, a partner at Hardin Consulting Services LLC. "The SEC has gone way beyond looking at just cash. They are looking now at soft dollar payments that included the kind of services that were pretty routine. People took them without thinking much about it. But you have to be transparent and those things have to be reported. And the SEC has a lot more data and ways to find out.”
The enforcement cases are likely to be settled over the next month or two, the industry sources said. The cases could add up to tens of millions of dollars being repaid to consumers based on prior, similar cases of fund over charges. The SEC declined comment on the ongoing cases.
"Willful" violations in some cases
The self-reported cases are likely to include many smaller fines, since the SEC set no minimum amount on the self-reports, which had a deadline of June 12. The settlements are based on a simple formula and there will be no adjustments based on the circumstances of the violations, so closing the cases could be swift. Some are likely to come by the end of the fiscal year September 30 and others by the end of the calendar year.
One industry compliance professional who asked not to be named, said that not all firms were reporting under the program, since the violation would automatically go onto their form ADV as a “willful” violation, even though the terms of the initiative do not require firms to admit or deny findings.
Risky business of self-reporting
“Some people are saying 'Forget that. It goes right up on my form ADV.' And now with the new disclosure requirements (of proposed form CRS, for Customer Relationship Summary) it will be displayed prominently in firms' marketing material. With the SEC doing so few examinations, some IAs are taking the risk and not reporting,” the compliance professional said.
“Self reporting is always risky. You have to decide you are going to get into trouble anyway and that it’s better to make a clean breast of it. But this is not going away. It is going to be a part of compliance programs going forward. You will have to be prepared to show how you made your share-class determination, what kind of disclosures you need to make and what is the process. The SEC is going to continue to look at it.”
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