Share class violations result in returns to investors

Do you own mutual funds? You may be getting a check in the mail if you bought them through a certain type of financial adviser, one who is both a registered representative of a brokerage firm (for example, Wells Fargo, acting as a broker-dealer) and an investment advisory representative of a registered investment adviser (for example, Wells Fargo, acting as a registered investment adviser).

This is a result of an initiative that the U.S. Securities and Exchange Commission’s Division of Enforcement announced in February 2018 (“Share Class Selection Disclosure Initiative”).

The SEC offered firms a chance to voluntarily agree to self-report violations of the law that had to do with disclosure obligations and the receipt of compensation related to mutual fund sales.

These firms received 12b-1 fees for investments selected for their clients without adequate disclosure of “conflicts of interest” related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.

For example, you can have a fund that offers two share classes. One class has operating expenses of, say, 1.5 percent, the bulk of which is a 12b-1 fee of 1 percent. (A 12b-1 fee typically pays for distribution costs, including an ongoing payment to the financial adviser.) A lowercost share class may have operating expenses of, say, ½ of 1 percent, with no 12b-1 fee.

Financial advisers working for these firms placed their customers in higher-cost share classes when lower-cost share classes of the same fund were available, without adequately disclosing that the higher-cost share class would be selected.

The 12b-1 fees “were routinely paid to the investment advisers in their capacity as brokers, to their broker-dealer affiliates, or to their personnel who were also registered representatives, creating a conflict of interest with their clients, as the investment advisers stood to benefit from the clients’ paying higher fees.”

In March 2019, the SEC reported that $125 million was being returned to investors by 79 firms. In September 2019, an additional 16 firms were returning about $10 million.

To see if your firm is one of them, read “SEC Share Class Initiative Returning More Than $125 Million to Investors” at https://www.sec.gov/news/ press-release/2019-28 and “SEC Orders an Additional 16 Self-Reporting Advisory Firms to Pay Nearly $10 Million to Investors” at https://www.sec.gov/news/ press-release/2019-200.

The SEC also reported on a firm that did not self-report. Mid Atlantic, whose affiliate received 12b-1 fees, failed to fully disclose the conflicts arising from its selection of more expensive mutual fund share classes for clients when lowercost share classes were available. Among other things, the SEC ordered Mid Atlantic to pay over $1 million in disgorgement and prejudgment interest. Unlike the firms that selfreported, Mid Atlantic was also fined $300,000.

The firms involved agreed to review and correct disclosure documents relating to mutual fund share class selection and 12b-1 fees. They also agreed to evaluate whether to move existing customers to lower-cost share classes.

Mutual fund investors do need to understand the differences in share classes, which is information found in the fund’s prospectus. But they should also be able to rely on a financial adviser acting in the investor’s best interest.

Conflicts of interest are

sometimes hard to ferret out. It’s a little easier if your financial adviser works for a standalone investment adviser (not dually registered and not affiliated with a broker-dealer) that does not receive 12b-1 fees — or compensation from anyone other than the client. Normally, that compensation is a fee based on assets managed.

It’s not a bad idea to have a conversation with your financial adviser about how he or she is paid. It’s even more important to put that into context by asking about the type of firm he or she works for. The choices are stand-alone broker-dealer; dually registered brokerdealer; stand-alone investment adviser; brokerdealer affiliated with an investment adviser.