On March 11, 2019, the Securities and Exchange Commission announced that it had settled charges with 79 investment advisers who agreed to return more than $125 million to their clients, with a substantial majority of the funds going to retail investors. The SEC entered into the settlements after the advisers self-reported violations of the Investment Advisers Act under the SEC’s Share Class Selection Disclosure Initiative (“SCSDI”).
In recent years, the SEC has increased its enforcement activities in the area of mutual fund share selection. Beginning in 2016, the SEC has brought numerous enforcement actions against advisers who received undisclosed payments of 12b-1 fees as a result of recommending the purchase of higher-cost mutual fund shares to their clients. See, e.g., In re PPS Advisors, Inc., Investment Advisers Act Rel. No. 5084 (December 20, 2018).
On February 12, 2018, the SEC announced the SCSDI, which allowed advisers who self-reported violations of federal securities laws relating to mutual fund share class selection, and who had promptly returned money to harmed clients, to avoid civil penalties. Likewise, in guidance from the Office of Compliance Inspections and Examinations (“OCIE”), the SEC stated that an adviser who advises his clients to invest in a mutual fund share class that is more expensive than other available others “when the adviser is receiving compensation that creates a potential conflict of interest and that may reduce the client’s return” may violate its fiduciary duty and the antifraud provisions of the Adviser’s Act, particularly when the adviser has not provided a full and fair disclosure of the conflict and obtained the client’s informed consent. See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Rel. No. IA-4889 (April 18, 2018) (“Proposed Interpretation”), p. 12.
In an announcement dated May 1, 2018, the SEC clarified that the SCSDI does not apply to adviser share class recommendations “where one share class is higher-cost than another share class but neither share class pays a 12b-1 fee or where the adviser has no financial conflict of interest.”
While the SEC has long held the view that an adviser owes its clients a duty of “best execution,” the SEC’s earliest interpretation of that duty focused on the quantitative and qualitative factors that bear on an adviser’s selection of broker-dealers to execute securities transactions. See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Rel. No. 23170 (April 28, 1986) (“1986 Interpretive Release”), at n.58. Beginning in 2016, the SEC included a best execution violation in some settled mutual fund share class selection cases, see, e.g., In Re Everhart Financial Group, Inc. Investment Advisers Act Rel. No. 4314 (January 14, 2016), ¶ 16 (citing the 1986 Interpretive Release), but has not done so in all such cases. See, e.g., In re Envoy Advisory, Inc., Investment Advisers Act Rel. No. 4764 (Sept. 8, 2017).
The SEC has not provided clear guidance as to what is meant by the duty to provide “best execution” in the mutual fund share class area. The SEC has never stated that the purchase of a higher cost class of mutual fund when a lower-cost alternative is available is always a violation of section 206(2) of the Advisers Act. Instead, the SEC’s stepped-up enforcement activity focuses primarily on advisers who failed to disclose the conflict of interest created by their receipt of 12b-1 fees. Conversely, numerous SEC publications indicate that best execution depends on the facts and circumstances. The 1986 Interpretive Release, while not specific to mutual fund share selection, states “The Commission wishes to remind money managers that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.” Id., at nn.58-59. Likewise, in another OCIE publication, titled Compliance Issues Related to Best Execution by Investment Advisers (“OCIE Compliance Issues), the SEC stated that the adviser must execute transactions for clients in such a manner that the client’s total costs in each transaction are “the most favorable under the circumstances.” Id., p. 1 (emhasis added). The adviser’s conduct must be analyzed, not in hindsight, but “under the particular circumstances occurring at the time of the transaction.” Proposed Interpretation, pp. 13-14.
In the area of mutual fund share class selection, the SEC stated in the Proposed Interpretation that the purchase of the least expensive investment product might not satisfy the adviser’s fiduciary duty:
Furthermore, an adviser would not satisfy its fiduciary duty to provide advice that is in the client’s best interest by simply advising its client to invest in the least expensive or least remunerative investment product or strategy without any further analysis of other factors in the context of the portfolio that the adviser manages for the client and the client’s investment profile.
Proposed Interpretation, p. 12. An adviser must have a “reasonable belief” that the investment advice is in the best interest of a client after the adviser has conducted a “reasonable investigation” into the investment. Id., at pp. 12-13. In the adviser’s analysis, the customer’s time horizon is important. For customers with short time horizons, a lower-cost fund share class “may be more costly relative to other mutual fund share classes.” See Regulation Best Interest (Proposed Rule), p. 311.
Thus, it would not be consistent with SEC guidance to require that investment advisers recommend only the lowest-cost mutual funds, without considering whether a different share class may be appropriate under the circumstances. There are valid reasons why an adviser may determine that it is reasonable for a client to invest in a higher-fee share class, even when a lower-cost fund class is available. These include, for example, the imposition of transaction fees on one class but not another, the size of the transaction, the investor’s time horizon, and operational considerations. The adviser’s conduct must be analyzed at the time of the transaction, not in hindsight.
© Andrew Whiteman 2019
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