SEC Cracking Down on Share Class Selection: High Standards and High Stakes

Last February the Securities and Exchange Commission ("SEC") announced their Share Class Selection Disclosure Initiative. This initiative is to prevent Investment Advisers from having their clients purchase shares with higher 12b-1 fees when cheaper ones are available. 12b-1 fees are paid by shareholders for the marketing, advertising, mailing of fund literature and prospectuses to clients, and paying the brokers.

Recently, the SEC settled with American Portfolio Advisers to pay $895,353 in disgorgement and prejudgment interest and a civil penalty of $250,000 due to inadequate client disclaimers regarding conflict of interests with 12b-1 fees.

In their Initiative Announcement, the SEC defined Investment Advisers receiving 12b-1 fees to mean (1) directly receiving fees, (2) a supervised person receiving fees, or (3) an affiliated broker dealer receiving fees. The SEC went on to state a proper disclosure does two things: it describes the conflict of interest in (1) making investment decisions in light of receipt of 12b-1 fees, and (2) selecting more expensive 12b-1 fee paying shares when lower cost shares are available for the same fund.

The initiative notes that disclosing that investment advisers “may” receive a 12b-1 fee and that there “may” be a conflict of interest was not enough. If the adviser is in fact receiving a 12b-1 fee they must say so and if the client is eligible for a lower cost share the adviser must inform them.

This duty stems from Section 206(2) of the Investment Advisers Act of 1940 ("Advisers Act"). Interpreted in SEC v. Capital Gains ResearchBureau, Inc., 375 U.S. 180, 194 (1963) to impose a financial duty on Investment Advisers to disclose to its clients all conflicts of interest which might incline an investment adviser consciously or unconsciously to render advice that is not disinterested.

These are high-standards and high-stakes for Registered Investment Advisers and for the Investment Advisers themselves. If you questions related to these standards or other SEC initiatives or regulatory standards, please call us at Cosgrove Law Group, LLC.