Tag: SCSD Initiative

The SEC’s SCSD Initiative Second Wave and the Applicability of the President’s Recent Executive Order

On September 30, 2019, the SEC ordered an additional 16 self-reporting investment advisory firms to pay nearly $10 million in disgorgement. Some have referred to this as the “second wave” of the SEC Division of Enforcement’s Share Class Selection Disclosure Initiative (“SCSD Initiative”). It’s unclear if there will be another “wave” of SCSD Initiative settlements. What is clear, though, is that the number of self-reporting firms charged by the SEC so far totals ninety-five. When the SCSD Initiative was first announced many anticipated that the tally of firms charged would number in the hundreds, but the number remains under 100.

While the number of self-reporting firms is still significant and indicates that this was an industry issue, it may also signal that many firms elected to take their chances and not self-report. Along those lines, the SEC also announced that same day a settlement against a firm that did not self-report. Many will recall that the Division of Enforcement touted in the SCSD Initiative announcement and in public statements thereafter that qualifying firms that did not self-report could face significant penalties, additional charges, and possible charges against individuals. Yet, the settlement released with this “second wave” had none of that. The civil penalty ordered against this firm was not a multiple of the disgorgement amount–but rather a fraction–approximately one-third. This ratio is in the general range of the penalty-to-disgorgement ratios that the SEC typically seeks in standard settlements that do not involve the issue of whether a qualifying firm failed to self-report. That said, the order did specifically advise that the SEC considered the cooperation and remedial acts promptly undertaken taken by the respondent.

Many have voiced the opinion that the SCSD Initiative was a prime example of “regulation by enforcement.” Interestingly, on October 9, 2019, the President issued an “Executive Order on Promoting the Rule of Law Through Transparency and Fairness in Civil Administrative Enforcement and Adjudication.” While Executive Orders do not technically apply to the SEC, or other independent regulatory agencies, in practice the head of an independent regulatory agency may determine to honor the spirit and/or letter of a presidential directive.

This Executive Order provides:

The rule of law requires transparency. Regulated parties must know in advance the rules by which the Federal Government will judge their actions.
* * *

No person should be subjected to a civil administrative enforcement action or adjudication absent prior public notice of both the enforcing agency’s jurisdiction over particular conduct and the legal standards applicable to that conduct.
* * *

Sec. 4. Fairness and Notice in Administrative Enforcement Actions and Adjudications. When an agency takes an administrative enforcement action, engages in adjudication, or otherwise makes a determination that has legal consequence for a person, it may apply only standards of conduct that have been publicly stated in a manner that would not cause unfair surprise. An agency must avoid unfair surprise not only when it imposes penalties but also whenever it adjudges past conduct to have violated the law.

While this may not technically apply to the SEC, the tone and language of this Executive Order is similar to the views expressed by SEC Commissioner Hester M. Peirce in her SECret Garden speech at SEC Speaks this past spring. With the SCSD Initiative hopefully fading into the past, perhaps the leadership at the SEC will scrutinize “regulation by enforcement” initiatives in the future more closely.

The SEC Files Another Litigated Disclosure Case – With More Violations

On August 29, 2019, the SEC filed a complaint against a registered investment adviser alleging failures to disclose four categories of conflicts of interest and seeking disgorgement of $10 million in undisclosed compensation. This litigated action was filed within a month of the SEC filing a litigated complaint against another firm alleging failing to disclose material conflicts of interest related to revenue sharing, despite that advisory firm having self-reported pursuant to the SEC’s Share Class Selection Disclosure Initiative (“SCSD Initiative”).

Based on these litigated actions (and despite the SCSD Initiative being over 18 months old), the SEC’s Division of Enforcement continues to focus its investigative and litigation resources on “Main Street” and to aggressively pursue registered investment advisory firms for disclosure violations involving actual or potential conflicts of interest.

In this most recent litigated action, not surprisingly, the SEC’s allegations with respect to share class selection conflicts and disclosure violations are consistent with the guidance released with the SCSD Initiative. This firm, however, did not fail to self-report its 12b-1 fee purported violative conduct. Rather, this alleged violative 12b-1 fee conduct was apparently uncovered during an examination by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”). The SEC also alleged disclosure violations related to revenue sharing, a longstanding priority for the SEC that has continued to expand since the SCSD Initiative.

The SEC’s ongoing efforts on disclosure violations about share class selection and revenue sharing have been discussed widely in the financial press and by industry groups.

The latter two alleged disclosure theories, however, have not received similar attention, but provide information and insight into other legal theories that OCIE and Enforcement may now be prioritizing in their examination and enforcement programs. Specifically, the third group of alleged disclosure violations relate to the adviser’s receipt of administrative service fees. While Enforcement has brought cases using similar fee disclosure theories in the past, the number of cases focused on the disclosures and conflicts for these types of fees, as opposed to 12b-1 fees and revenue sharing, pales by comparison. Lastly, the SEC also alleged that the adviser failed to disclose compensation that it received in the form of non-transaction-based mark-ups on charges imposed by the clearing firm. The first time that we observed the SEC charge this type of undisclosed mark-up theory was just within this past year, in December 2018.

For both of these recent SEC actions, the advisers have apparently chosen to litigate and fight the SEC’s ever expanding efforts to regulate specific disclosure language, despite the D.C. Circuit’s ruling in Robare. The D.C. Circuit’s ruling, while troublesome for the SEC as it related to “willfulness” and that aspect of the opinion, supported and favored the SEC’s disclosure theory relating to the use of general disclosure terms such as “may” when, in fact, the adviser “was” receiving compensation. Interestingly though, the SEC chose to not file these two recent matters as administrative proceedings. Doing so would have allowed for the D.C. Circuit’s Robare opinion to serve as precedent. The SEC instead chose to file these as civil complaints in U.S. District Courts outside of the D.C. Circuit. Thus, potentially opening the door for the defendants to attempt to minimize that aspect of Robare by arguing that this opinion is not precedential in those appellate circuits, but only persuasive.

We will continue to follow these litigated matters and report back on any developments likely to impact the industry.

The First SEC Share Class Selection Disclosure Settlements: What We Learned & What’s Next?

Jim Lundy and Ben McCulloch authored an article entitled “The First SEC Share Class Selection Disclosure Settlements: What We Learned & What’s Next?” for the Investment Adviser Association’s IAA Newsletter Compliance Corner. In the article, Jim and Ben discuss the first wave of settlements under the SEC’s SCSD Initiative as well as lessons learned. They also explore the agency’s ongoing efforts regarding the remaining participants, consequences for firms who opted not to self-report, and the Division of Enforcement’s continued scrutiny of revenue sharing arrangements, disclosures, and conflicts.

Read the full article.*

*Originally published in the IAA Newsletter, April 2019.

SEC Releases SCSD Self-Reporting Initiative Settlements

On March 11, 2019, the SEC announced and released settlements against 79 self-reporting registered investment advisers (RIAs), touting $125 million being returned to investors. The actions stem from the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative). The SCSD Initiative incentivized RIAs to self-report violations resulting from undisclosed conflicts of interest, to promptly compensate investors, and to review and correct fee disclosures. Specifically regarding Rule 12b-1 fees, the SEC’s orders found that the RIAs failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.

SEC Chairman Jay Clayton commented: “I am pleased that so many investment advisers chose to participate in this initiative and, more importantly, that their clients will be reimbursed. This initiative will have immediate and lasting benefits for Main Street investors, including through improved disclosure. Also, I am once again proud of our Division of Enforcement for their vigorous and effective pursuit of matters that substantially benefit our long-term, retail investors.”

While the SEC and its Division of Enforcement may be pleased, the various industry reactions during the course of the SCSD Initiative included frustration–and at times reasonably so. Tempering that frustration, is that the SEC’s focus on RIA conflicts of interest and disclosures continues. First, there is an expectation that the SEC will announce more settlements in the future for additional SCSD Initiative participants and that this may involve a grouping of a “second wave” of settlements. Second, Enforcement’s Asset Management Unit has already opened investigations into RIAs who did not self-report. Lastly, these investigations included requests for documents and information regarding revenue sharing practices and disclosures.

In conclusion, it is expected that the SEC’s aggressive enforcement efforts regarding RIA conflicts of interest and disclosures to Main Street investors will continue and has already expanded to include revenue sharing.     

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