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SEC Crackdown on Share Class Selection Abuses

by Jacob Mohs

Last week, the SEC enforcement division announced that it would take aim at advisor failure to disclose conflicts of interest related to receiving 12b-1 fees when lower-cost mutual fund share classes are available to clients. This Share Class Selection Disclosure (SCSD) initiative reflects the Commission’s longstanding focus on conflicts of interest inherent in selecting mutual fund share classes. How long will it be until regulators leverage similar considerations in interval fund and non-traded REIT contexts?

From ThinkAdvisor’s interesting article on the SEC's initiative to crack down on share class shenanigans:

The division states that it will recommend “standardized, favorable settlement terms to advisors that self-report that they failed to disclose conflicts of interest associated with the receipt of 12b-1 fees by the advisor, its affiliates, or its supervised persons for investing advisory clients in a 12b-1 fee paying share class when a lower-cost share class of the same mutual fund was available for the advisory clients.”

For advisors that are eligible to participate in the SCSD Initiative, the Division states that it will recommend settlements that will require the advisor to disgorge its ill-gotten gains and pay those amounts to harmed clients, but not impose a civil monetary penalty.

However, the SEC warned that it will “recommend stronger sanctions in any future actions against investment advisors that engaged in the misconduct, but failed to take advantage of this initiative.”

The SCSD initiative pertains to 12b-1 fees for open-ended mutual funds. However, in practice most interval funds charge the equivalent of 12b-1 fees. Among other things, the standard interval fund exemptive relief application to offer multiple share classes will ask for relief to 

permit the Funds to impose asset-based distribution and shareholder services fees (in a manner analogous to Rule 12b-1 fees for an open-end investment company). [emphasis added—here we are quoting Blackstone / GSO Floating Rate Enhanced Income Fund’s application.]

It would be strange for the SEC to permit what it perceives to be abuses in the interval fund context, after cracking down on them for mutual funds, but I guess that it’s not impossible. 

Also, most REITs (although not all) are outside the ‘40 Act space, but the most recently launched non-traded REITs usually have multiple share classes, so it will be interesting to see if the SEC ever brings enforcement action (and creates a self-policing option) against advisors who use higher fee share classes inappropriately without proper disclosure and justification. It seems like this could be a problem for a dually-registered firm that puts broker clients into REITs that have low fee I shares for RIAs.    

And we may predict that such share class considerations for interval funds and REITs might not only eventually have the attention of the SEC, but also FINRA. Recall that back in the day, the predecessor to FINRA followed analogous logic to crack down hard (see pages 4-10 of the linked document) on firms that failed to take advantage of volume discounts for mutual funds.


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