SEC 12b-1 Fee Amnesty: Costly Ops Work

A, B, C. Those three simple letters of the English alphabet could cause plenty of administrative grief for compliance and middle office operations managers at US mutual fund management firms over the next few months.

That is, if they hope to take advantage of the Securities and Exchange Commission’s leniency program on overcharges to investors in annual 12b-1 fees.

A, B, C represent classes of mutual fund shares that investment advisers may have erroneously selected for clients’ investments. Investment advisers have just two months to figure out whether they misinformed investors and picked the wrong share class. If so, they will have to know by how much they overcharged investors. The SEC is giving advisers until June 12 to sign up to its Share Class Disclosure Initiative and avoid punitive fines.

Mutual fund share classes vary by type and amount of fees. Each class of shares has a different 12b-1 fee. Class A, Class B and Class C shares typically have 12b-1 fees. Investment advisers, who often manage mutual funds, can receive from mutual funds and pay to their affiliated broker-dealers 12b-1 fees for marketing and distributing a fund.

However, the fees charged to the fund as an operational expense must be disclosed to investors. So must any potential conflict of interest, says the SEC. The Investment Advisers Act of 1940 requires advisers to act in the best interests of their clients, including revealing conflicts of interest.

The SEC means business. As FinOps Report went to press, the agency said that three investment advisory firms PNC Investments, Securities America and Geneos Wealth Management had agreed to pay a total of nearly US$15 million for failing to disclose conflicts of interest and putting clients in higher cost mutual fund shares. Of the US$15 million, about US$2 million represents a civil penalty. PNC will pay the bulk: US$900,000.

The fines represent the latest salvo in the SEC’s efforts to curb investment advisers’ bad conduct through a big stick approach over the past few years. In December 2017, the SEC filed a complaint against investment advisor Westport Capital Markets and its chief compliance officer Christopher McClure for investing clients’ money in mutual fund shares with 12b1-fees when the same fund without such fees was available. Westport, according to the SEC, never told clients that it would benefit from collecting the fees in its dual role as a broker-dealer.

Although the SEC’s  new initiative has been coined “the amnesty program,” the SEC isn’t being too merciful. It is throwing investment advisers a very short carrot. Investment advisers must first confess to the SEC’s Division of Enforcement that they violated their fiduciary obligations in selecting higher-fee mutual fund classes. That means advisors didn’t tell investors they had a conflict of interest when recommending a higher-fee share class when a lower cost one was available.

Even if the SEC’s “leniency” offers the investment adviser a chance to avoid any punitive fines, avoiding reputational risk is not part of the deal. The advisor must still agree to a settlement with the SEC, disclose its wrongdoing in its Form ADV and face the possibility that its individual officers could be fined.

It could be worse. Investment advisers which don’t self-report their wrongdoing shouldn’t think they can get away with it. The agency is still proactively searching for fee overcharges by advisors. When it finds such breaches of fiduciary obligations it won’t hesitate to levy hefty penalties.

Some legal experts recommend that investment advisers think twice before they agree to accept the SEC’s leniency. “Advisers should assess their practices and disclosure, and with the assistance of legal counsel evaluate whether they resemble those found by the SEC’s prior enforcement actions to have violated the Advisors Act,” says Gwendolyn Williamson, a partner with the law firm of Perkins Coie in Washington DC. “Whether a lower cost share class was available and appropriate for a given investor is a very fact-specific question.”

If it confesses its wrongdoing to the SEC by the June 12 deadline, the firm has another ten days to calculate how much it overcharged investors by placing them in a class of shares with 12b-1 fees instead of an available and appropriate lower-cost class. The time period affected is from January 1, 2014, until the time the excess fees were no longer charged. The adviser must then reimburse the investors those excess fees plus interest.

Operational Effort

Will those ten days be enough time to crunch the numbers correctly? Maybe not, considering all the data involved.

“Calculating the fee overcharge will be cumbersome for investment advisers who must review all their shareholder records to determine who bought the shares of the mutual fund during the time period in question, the disclosures sent to each investor, how much those investors paid in 12b-1 fees, and how much they should have paid in 12b-1 fees,” explains Joanna Fields, a principal of Aplomb Strategies, a New York firm specializing in regulatory compliance. “Knowing how much they should have paid will be tricky, because the fund manager will need to track which lower fee share classes were available during the time in question.”

Typically, mutual fund Class A shares charge a front-end load taken off the initial investment while Class B shares have a back-end or contingent deferred sales charge. Class C shares typically have no-front end fees and allow the investor to avoid back-end fees after the shares are held for a specified period of time. Less popular Class B shares typically convert automatically into Class A shares over a period of time.

Advisers participating in the SEC’s leniency program must complete a questionnaire that requires information about the 12b-1 fee overcharges, including the erroneous share classes selected. “Just who must sign the document depends on the organizational structure of the investment adviser,” says Jay Baris, a partner with the law firm of Shearman & Sterling in New York.

Regardless of whether the chief compliance officer or another designated official steps up to the disclosure plate, the information must be accurate. Middle office fund accounting managers will have their work cut out for them. If at least one lower-fee share class was available, someone will have to decide whether that class was appropriate for each investor to whom the 12b-1 shares were sold during the period covered by the Share Class Disclosure Initiative.

Fields predicts heated debate among compliance managers and other staffers about how to calculate the correct overcharges — whether to base then on the share class with the lowest fees or ones with higher 12b-1 fees.

“Fund accountants, tax managers, compliance managers, and even portfolio managers will have to figure out the right answer and hope the SEC agrees,” she says. “The answer could depend on not only the fee involved, but the tax events of the share class, and investor suitability requirements.”

Compliance and operations managers at several US mutual fund complexes tell FinOps Report that mutual fund advisers who participate in the SEC’s leniency program might end up picking the share class with the lowest fee. “It’s the easiest way out if they are concerned about any disagreement with the SEC,” says one compliance manager.

The SEC does allow the adviser to use the narrative section of its questionnaire for the Share Class Disclosure Initiative to explain its decision-making process and other potentially mitigating facts. Yet some compliance managers are still worried.

“Writing any narrative could lend itself to more queries from the SEC and who wants that?” says the compliance manager at another mutual fund complex. His firm has hired an external compliance consultancy to help make the calculations and complete the narrative section of the questionnaire.

Even if the regulatory agency doesn’t find anything else amiss, it could still force the adviser to recalculate its reimbursement for investors. Ultimately, the adviser might be compelled to give investors more money than it initially projected.