A Touch of Class: Mutual Fund Share Class Developments (Part 2)
As mutual funds began to increase the number of share classes they o ered, regulators began to scrutinize whether the fee structures commonly associated with different share classes presented a potential conflict of interest between an investor’s interests, on one hand, and an investment adviser’s or broker-dealer’s interest on the other. In a Notice to Members from 2005, the National Association of Securities Dealers (“NASD”), the predecessor agency to FINRA, alerted registered broker-dealers that transactions involving Class B and Class C shares, with their higher annual expenses than Class A shares, were “under increased scrutiny from all regulators.” FINRA also highlighted its focus on the application of sales charge waivers and breakpoints to certain mutual fund share classes in its 2015 and 2016 Regulatory and Examination Priorities Letters. In connection with these priorities, FINRA began a sweep examination of member firms’ mutual fund sales practices, which sought information from broker-dealers regarding their supervisory controls related to the application of sales charges and relevant waivers.
Additionally, OCIE published a risk alert in 2016 notifying investment advisers that OCIE was undertaking a “Share Class Initiative,” in which it “is seeking to identify conflicts of interests tied to advisers’ compensation or financial incentives for recommending mutual fund and 529 Plan share classes that have substantial sales charges or distribution fees.” In February 2018, the Division of Enforcement (the “Division”) announced that it was implementing a Share Class Selection Disclosure Initiative (the “Disclosure Initiative”), which is designed to encourage investment advisers to self-report conflicts of interest disclosure violations in connection with the sale of certain mutual fund share classes. The Disclosure Initiative states that it is intended to identify and remedy situations in which an investment adviser “failed to make required disclosures relating to its selection of mutual fund share classes that paid the adviser (as a dually registered broker-dealer) ... a fee pursuant to Rule 12b-1 of the [1940 Act] when a lower-cost share class for the same fund was available to clients” and violations of this nature. Under the Disclosure Initiative, for investment advisers that selfreport violations before June 12, 2018, the “Division will recommend settlements that will require the adviser to disgorge its ill-gotten gains and pay those amounts to harmed clients, but not impose a civil monetary penalty.” The Division stated that it will continue its focus on share class disclosure issues and may impose more onerous penalties on investment advisers that do not take advantage of the Disclosure Initiative and self-report.
As noted below, FINRA has taken a similar approach to imposing penalties on broker-dealers that self-report violations. Shortly following the SEC’s announcement of the Disclosure Initiative, FINRA staff announced plans to update guidance related to Rule 4530, the Extraordinary Cooperation Rule.