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 Speaks . . . and Cooperation is Key

SEC Speaks, the SEC’s annual conference in Washington, D.C., often provides valuable insight into developments at the agency, as well as pronouncements about policy evolution and enforcement priorities. At this year’s conference, “cooperation” emerged as one of the themes that the SEC has been prioritizing over the past year – and is committed to prioritizing in the future. Indeed, the co-directors of the SEC’s Division of Enforcement remarked that, “cooperation is as important now as it has ever been,” and that the “full range” of remedies are available to entities that provide meaningful cooperation to the SEC. Interestingly, the staff emphasized that the SEC is making a concerted effort to use its press releases and orders to highlight the importance, components, and benefits of cooperation – all in an effort to promote earlier, more meaningful, and more widespread cooperation.

Continue reading “The SEC Speaks . . . and Cooperation is Key”

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.     

Department of Justice Announces Important Revisions to the Yates Memo

Deputy Attorney General Rod Rosenstein recently announced significant changes to the Department of Justice’s corporate enforcement policy regarding individual accountability, previously announced in the 2015 Yates Memo. The revised policy no longer requires companies who are the target of DOJ investigations to identify all parties involved in potential misconduct before they can be eligible to receive any cooperation credit. This alert examines the updated policy, which should provide companies with greater flexibility in conducting investigations and negotiating dispositions with DOJ in both criminal and civil cases.

Read the full alert.

SEC Share Class Selection Disclosure Initiative to Encourage Self-Reporting

On February 12, 2018, the U.S. Securities and Exchange Commission (SEC) announced a “Share Class Selection Disclosure Initiative” (“SCSD Initiative”), led by the Asset Management Unit of the Division of Enforcement (“Enforcement”). To encourage self-reporting and participation in the SCSD Initiative, Enforcement advises in the release that it “will agree not to recommend financial penalties against investment advisers who self-report violations of the federal securities laws relating to certain mutual fund share class selection issues and promptly return money to harmed clients.” Enforcement also warns that it “expects to recommend stronger sanctions in any future actions against investment advisers that engaged in the misconduct but failed to take advantage of this initiative.”

The deadline for self-reporting is June 12, 2018. Firms contacted by Enforcement before the announcement regarding possible violations related to their failures to disclose the conflicts of interest associated with mutual fund share class selection are not eligible for the program. Firms that are subject to pending SEC examinations, but that have not been contacted by Enforcement, will be eligible. Importantly, Enforcement specifically offers no assurances with respect to the potential liability of involved individuals.

Below we summarize the SCSD Initiative, explore the direct and indirect messages being sent by the SEC, and provide practical strategic guidance for affected firms to consider.

Initial Strategies – What to Do

By way of background, the SEC has long been focused on Rule 12b-1 fees paid by a mutual fund on an ongoing basis for shareholder services, distribution, and marketing expenses. As with any fee, 12b-1 fees have the potential to reduce a client’s returns. In recent years, the SEC has brought several enforcement actions against investment advisers, finding that they failed to disclose conflicts associated with the receipt of 12b-1 fees for investing client funds in a 12b-1 fee-paying share class when a lower-cost share class was available for the same fund.

What firms should consider the SCSD Initiative? Investment advisers that did not explicitly disclose in applicable Forms ADV (i.e., brochure(s) and brochure supplements) the conflict of interest associated with the 12b-1 fees the firm, its affiliates, or its supervised persons received for investing advisory clients in a fund’s 12b-1 fee share class when a lower-cost share class was available for the same fund. Enforcement provides more specific guidance as follows:

A “Self-Reporting Adviser” is an adviser that received 12b-1 fees in connection with recommending, purchasing, or holding 12b-1 fee paying share classes for its advisory clients when a lower-cost share class of the same fund was available to those clients, and failed to disclose explicitly in its Form ADV the conflicts of interest associated with the receipt of such fees. The investment adviser “received” 12b-1 fees if (1) it directly received the fees, (2) its supervised persons received the fees, or (3) its affiliated broker-dealer (or its registered representatives) received the fees. To have been sufficient, the disclosures must have clearly described the conflicts of interest associated with (1) making investment decisions in light of the receipt of the 12b-1 fees, and (2) selecting the more expensive 12b-1 fee paying share class when a lower-cost share class was available for the same fund.

Evaluating and assessing these factors for purposes of determining whether to self-report pursuant to the SCSD Initiative will be resource-intensive and will likely involve analyzing complex legal, factual and reputational issues. Thus, firms should first consult with in-house or outside counsel. One of the benefits of involving counsel at the start – and throughout – is that it allows for the application of the attorney work product doctrine and attorney-client privilege. As a reminder, the majority of the cases interpreting these privileges have not extended them to compliance officers performing their duties as part of a firm’s compliance operations. Thus, involving in-house or outside counsel is necessary to claim privilege. The firm can ultimately decide to waive privilege if it elects to self-report. However, for the firms that conduct this evaluation and assessment and then elect not to self-report, preserving the attorney-client and attorney work product privileges will allow firms to protect their work from discovery by regulators or third parties.

With the oversight of counsel, the firm should consider developing and implementing a project plan, due to the anticipated resource-intensive nature of what will be required. The project plan should involve analyzing whether the firm failed to disclose conflicts of interest associated with the receipt of 12b-1 fees by the adviser, its affiliates, or its supervised persons for investing advisory clients in a 12b-1 fee-paying share class when a lower-cost share class of the same mutual fund was available for the advisory clients. More specifically, this involves conducting detailed analyses of each fund, fund class, the 12b-1 fees associated with the share classes, and all of the related disclosures.

Settlement Terms – What You Need to Know

Enforcement uses the description “favorable settlement terms” in its announcement, in order to entice participation. Firms, however, need to understand that self-reporting under the SCSD Initiative will undoubtedly result in a settled enforcement action, and that the terms will include the SEC’s typical terms, with the exception of a civil penalty. Firms should also consider the nature of the charges and their potential impacts, as discussed below.

Terms may include a cease-and-desist order and a censure, likely along with an SEC release touting the settlement as a successful result of the SCSD Initiative. Settlement terms will include full disgorgement by the investment adviser of its ill-gotten gains and prejudgment interest thereon. It is not clear from the announcement how Enforcement will calculate disgorgement, but it will likely be based on the 12b-1 fees received. The firm will also need to agree to a self-administered distribution to its affected clients, thereby assuming all of the internal or external costs associated with such a distribution. Lastly, the settlement will either include an acknowledgment that the adviser has voluntarily taken the following steps (if completed before the order is instituted), or order that within 30 days of instituting the order, the eligible adviser:

  • Review and correct as necessary the relevant disclosure documents.
  • Evaluate whether existing clients should be moved to a lower-cost share class and move clients as necessary.
  • Evaluate, update (if necessary), and review for the effectiveness of its implementation policies and procedures to ensure that they are reasonably designed to prevent violations in connection with the adviser’s disclosures regarding mutual fund share class selection.
  • Notify clients of the settlement terms in a clear and conspicuous fashion (this notification requirement applies to all affected clients).
  • Provide the Commission staff, no later than 10 days after completion, with a compliance certification regarding the applicable undertakings by the investment adviser.

The charges in the settlement order would be considered non-scienter and negligence-based, but the plain statutory language reads much harsher. The statutes under which a Self-Reporting Adviser will be settling for the violative conduct are Section 206(2) and Section 207 of the Investment Advisers Act of 1940 (“Advisers Act”). Section 206(2) prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client,” and imposes a fiduciary duty on investment advisers to act for their clients’ benefit, including an affirmative duty of utmost good faith and full disclosure of all material facts. Section 207 of the Advisers Act makes it “unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the Commission . . . or willfully to omit to state in any such application or report any material fact which is required to be stated therein.” Thus, based on the plain language of these statutes, these are by no means technical-type violations. Firms need to consider their exposure to reputational harm and other collateral damage. Moreover, a Self-Reporting Adviser will have to disclose the institution and resolution of the charges in its Form ADV, as well as in response to requests for proposals and certain other information requests.

Finally, for those Self-Reporting Advisers participating in the SCSD Initiative, Enforcement will likely expect them to disclose information and produce evidence with respect to employees who were involved with the sale of 12b-1 class shares to clients, as well as those involved in the Self-Reporting Adviser’s disclosure of conflicts of interest. Accordingly, as advisers navigate their way through the process of determining whether it is in their best interest to participate in the SCSD Initiative, they should also be sensitive to the possibility that certain employees may need separate representation due to potential conflicts of interest that may arise.


The decision to self-report and participate in the SCSD Initiative deserves serious consideration, but there is no one-size-fits-all approach. As discussed, the decision-making process will be resource-intensive and involve complex and high-stakes legal, factual and reputational decisions, so firms should work closely with counsel. That said, here are five key takeaways for firms to consider:

  • Engage with in-house or outside counsel at the start for the attorney-work product doctrine and attorney-client privilege to apply, subject to waiver by the firm if the determination is made to self-report.
  • A project plan should be developed and implemented under the oversight of in-house or outside counsel to evaluate and assess whether the firm’s practices and disclosures warrant consideration of self-reporting pursuant to the SCSD Initiative.
  • Firms need to understand that, while avoiding a civil penalty, the settlement terms will include a cease-and-desist order and a censure; disgorgement, prejudgment interest, and the accompanying internal or external distribution costs; and the detailed undertakings discussed above.
  • Firms also should recognize that settling to charges under Section 206(2) and Section 207 of the Advisers Act present reputational risks that need to be weighed, and collateral consequences that need to be considered.
  • Lastly, firms that determine that they qualify as Self-Reporting Advisers should heed the SEC’s warnings and self-report, or they will potentially expose themselves to the SEC pursuing significant monetary penalties and possible additional charges and remedies.

SEC Affirms Commitment to FCPA Enforcement Actions

Andrew J. Ceresney, Director of the Division of Enforcement, reaffirmed the SEC’s focus on FCPA enforcement actions at the International Conference on the Foreign Corrupt Practices Act. Mr. Ceresney’s speech focused on companies’ need to self-report violations.

Mr. Ceresney stated that the SEC uses “a carrot and stick approach to encouraging cooperation,” where self-reporting companies can receive reduced charges and deferred prosecution and non-prosecution agreements, while companies that do no self-report do not receive any reduction in penalties. Mr. Ceresney warned that “companies are gambling if they fail to self-report FCPA misconduct.”

Mr. Ceresney gave examples of how this policy has benefited companies recently. Mr. Ceresney highlighted the SEC’s decision not to bring charges against the Harris Corporation after it self-reported violations and mentioned to examples where the SEC entered into non-prosecution agreements as a result of self-reporting.

Mr. Cerseney stated that the SEC’s “actions have sent a clear message to the defense bar and the C-Suite that there are significant benefits to self-reporting [to] and cooperation with the SEC” and that he expects “the Division of Enforcement will continue in the future to reinforce this message and reward companies that self-report and cooperate.”

Mr. Cerseney also spoke about recent cases that highlight “the Enforcement’s Division’s renewed emphasis on individual liability in FCPA cases[,]” noting that seven actions in the past year involved individuals. Mr. Cerseney stated that “pursuing individual accountability is a critical part of deterrence and . . . the Division of Enforcement will continue to do everything we can to hold individuals accountable.”

Mr. Cerseney’s remarks demonstrate that the Division of Enforcement does not expect to change its recent focus on FCPA violations and individual liability as it transitions to the new administration.

SEC Levies Disgorgement and Civil Penalties for Violations of the Consumer Protection Rule and the Dodd-Frank Whistleblower Protection Rule

On June 23, 2016, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. (collectively, “Merrill Lynch”) agreed to pay $415 million and admit wrongdoing to settle charges of rules based violations, including Exchange Act Rule 15c3-3, the Consumer Protection Rule (the “Consumer Protection Rule”) and Exchange Act Rule 21F-17 (“Rule 21F-17”), which prohibits any action impeding an individual from communicating directly with Commission staff about possible securities laws violations. See Release No. 78141.

Exchange Act Rule 15c3-3, known as the Consumer Protection Rule, was enacted to “protect broker-dealer customers in the event a broker dealer becomes insolvent” by eliminating the “use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities a trading and underwriting through the separation of customer related activities from other broker-dealer operations.” To safeguard assets, the Consumer Protection Rule requires broker-dealers to “maintain a reserve of funds and/or certain qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers” and to “promptly obtain and thereafter maintain physical possession or control over customers’ fully paid and excess margin securities . . . . in one of several locations . . . held free of liens or any other interest that could be exercised by a third-party to secure an obligation of the broker-dealer.” The Consumer Protection Rule also imposes a self-reporting requirement where, in the event that a broker-dealer fails to maintain sufficient reserves, it must immediately notify the Commission and FINRA.

Signaling that the SEC may suspect that other broker-dealers may have also violated the Consumer Protection Rule, Michael J. Osnato, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, announced in a press release: “Simultaneous with today’s action, SEC staff will begin a coordinated effort across divisions to find potential violations by other firms through a targeted sweep and by encouraging firms to self-report any potential violations of the Customer Protection Rule.” Press Release No. 2016-128. In light of the significant civil penalty imposed by the SEC against Merrill Lynch, broker-dealers should take a hard look at their own compliance with the Consumer Protection Rule and seriously consider self-reporting if they find violations as required by the Consumer Protection Rule itself.

Rule 21F-17 was enacted to “evince[] a Congressional purpose to facilitate the disclosure of information to the Commission relating to possible securities law violations and to preserve the confidentiality of those who do so.” “Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934,” Release No. 34-64545, at p. 198 (Aug. 12, 2011). The SEC acknowledged that it did not discover any instance where a Merrill Lynch employee was prevented from directly communicating with the Commission regarding potential securities law violations, certain Merrill Lynch policies, procedures, and agreements with employees included language that the SEC claimed did not permit an individual to voluntarily disclose confidential information. The Order further states that Merrill Lynch promptly took “substantial remedial acts” to address any Rule 21F-17 violations, including revising its severance agreements. Notably, this is the second time the Commission has held proceedings for Rule 21F-17 violations without any evidence that any employee had been prevented from disclosing confidential information to the government. See In the Matter of KBR, Inc., Release No. 74619. Given that the Consumer Protection Rule violation seems unrelated to the Rule 21F-17 violation, it seems likely we will see the staff asking about language included in employment agreements, severance agreements and other employment policies during investigations even in the absence of specific whistleblower concerns.

While Merrill Lynch admitted to wrongdoing, the settlement involves rules based violations as opposed to fraud based violations. Merrill Lynch did not admit to any fraudulent conduct. Notably, some of the largest “admit” settlements have been grounded in rules based violations. See Press Release No. 2013-187 (JPMorgan Chase admits to wrongdoing and pays $200 million and $920 million worldwide to settle SEC charges); see also Press Release No. 2014-17 (Scotttrade admits to wrongdoing and pays $2.5 million to settle SEC charges). The Commission also announced on June 23rd, a litigated administrative proceeding against William Tirrell, Merrill Lynch’s former Head of Regulatory Reporting, related to the Consumer Protection Rule violations. See Release No. 78142. The proceeding will be scheduled for a public hearing before an administrative law judge.

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