Self-Reporting to SEC of 12b-1 Conflicts of Interest Not Without Risk

This week the U.S. Securities and Exchange Commission (SEC) revealed its new temporary policy of offering “amnesty” to advisers who self-report and correct violations of conflict of interest rules pertaining to the collection of 12b-1 fees.

Under the new program, advisers have until June 12, 2018, to self-report to the SEC’s Division of Enforcement “any conflict of interest situations in which clients were placed in more expensive share classes of mutual funds and advisers received 12b-1 fees, without proper disclosure, when lower-cost shares of the same funds were available.”

In its announcement, the SEC cited “potential widespread violations of this nature,” and so naturally the advisory industry is taking head.

As laid out in preliminary commentary shared by the Wagner Law Group, the SEC enforcement agents will recommend that the commission “accept a settlement and not recommend penalties against the adviser if client funds (plus interest) are promptly returned.” Investment advisers that have already been contacted by the Division as of February 12, 2018, about possible violations of share class selection are not eligible to take part in the initiative. “However, those subject to pending examinations by the Office of Compliance Inspections and Examinations related to this issue, but who have not been contacted by the division, are eligible to participate,” the Wagner attorneys note.

While the term “amnesty” conjures up an image of full forgiveness, the Wagner attorneys warn that amnesty under this new self-reporting initiative, “or any future voluntary remediation, for that matter,” is not without risk.

“For one thing, it is not required to self-report, although dual registered firms must consider their FINRA reporting obligations under FINRA Rule 4530(b),” the attorneys note. “Missteps in crafting the correction can increase a firm’s legal and reputational risk. Cease and desist orders carry their own consequences.”

The attorneys urge advisers to be cautious even as they do the right thing: “The goal of correcting past violations is to make injured parties whole, prevent recurrence and avoid increased scrutiny by regulatory authorities. Remedial efforts generally, and the decision whether to participate in the SCSD Initiative, require a thoughtful, well-documented and careful review by the investment adviser.”

The Wagner attorneys offer some additional helpful context, as follows: “To take part in the initiative, advisers should self-report by notifying the Division by 12:00 am EST on June 12, 2018. Advisers must then complete a questionnaire confirming eligibility under the program within 10 business days of notification. The settlement will include the following terms depending upon the adviser’s eligibility: (i) the firm’s consent to an administrative and cease-and-desist proceeding for violations of Section 206(2) and 207 of the Advisers Act, where the adviser neither admits nor denies the Commission’s findings; (ii) an order to cease and desist from committing or causing any violations and future violations of Section 206(2) and 207, and a censure; (iii) disgorgement of the ‘ill-gotten gain’ and prejudgment interest, along with a certification as to the accuracy of the questionnaire, and agreement to an order requiring the firm to make a respondent-administered distribution to affected clients; (iv) either an acknowledgement that the adviser has taken certain prescribed steps, or an order requiring the adviser to complete such steps within 30 days, which includes correcting disclosure documents, evaluating whether clients should be moved to lower-cost share class, etc.; and (v) a recommendation by the Division that the Commission not impose a penalty on the adviser.”

Because the initiative covers only eligible individual advisers, the attorneys warn, other individuals associated with the same firm have no assurance that they will be offered similar terms for violations.