The new year is bringing renewed focus to mutual fund share class disclosure, and regulators' continued crackdown on funds that include 12b-1 fees — with one compliance expert predicting such fees are on their way out.
In late January, the Financial Industry Regulatory Authority followed the Securities and Exchange Commission's lead in putting a razor sharp focus on share class recommendations that include 12b-1 fees.
On Jan. 28, FINRA launched a program to allow broker-dealers to self-report share class disclosure violations related to 529 college savings plans, similar to the self-reporting program launched by the SEC last February.
The 529 Plan Share Class Initiative, as set out in Regulatory Notice 19-04, states that over the past several years, FINRA has found that some firms have failed to reasonably supervise brokers' recommendations of multi-share class products.
As with mutual fund share class concerns, FINRA states that it has raised concerns specifically regarding firms' supervision of share-class recommendations to customers of 529 savings plans.
Shares within 529 plans are commonly sold in different classes with differing fee structures, FINRA explains, with Class A shares typically imposing a front-end sales charge but lower annual fees compared with other classes. Class C shares typically impose no front-end sales charge but impose higher annual fees than Class A shares.
Susan Schroeder, head of FINRA's enforcement division, stated in a video message that if firms self-report via the initiative, "a settlement under this initiative would be a supervisory settlement and would not trigger" a statutory disqualification.
To encourage voluntary reporting, FINRA will accept favorable settlement terms for firms that self-report these potential violations and provide FINRA with a detailed remediation plan.
To be eligible for the initiative, firms must self-report by providing written notification to FINRA Enforcement by noon on April 1. A firm that has timely self-reported must, by May 3, 2019, confirm its eligibility for the 529 Plan Share Class Initiative by submitting information for the period of January 2013 through June 2018.
Schroeder explained that FINRA is concerned about 529 plans because they "are incredibly important investment vehicles for a lot of Americans who are trying to save for the education of beneficiaries like their children."
FINRA has learned through reviewing "some firms' 529 plan sales that this can be a blind spot for some firms," she continued.
Addressing the question of whether FINRA, through the crackdown, believes that C shares are "never suitable," or are "always unsuitable" for younger beneficiaries, Schroeder said: "Absolutely not."
FINRA "is not saying there is any 'per se' unsuitability about C shares," Schroeder said. "In fact, with the recent revision of the tax laws, it's even more complicated because you can use 529 plans under some circumstances for educational expenses before college. It really underscores the need to understand each investor's particular circumstances and objectives to make sure the recommendation is suitable for that investor."
The advent of FINRA's disclosure initiative, however, does not signal the end of examiners' focus on the share class issue, Schroeder stated. "The exam program will continue to look at 529 plans and share class recommendations."
If firms fail to self-report such violations and FINRA examiners uncover them, the firms will face stiffer sanctions. Broker-dealers that sell 529 plans should consider participating in the program, she said.
Experts Weigh in After SEC Chairman Jay Clayton came aboard in mid-2017, the agency launched its Retail Strategy Task Force (RSTF) within the SEC's Enforcement Division. In February 2018, the securities regulator announced its share class disclosure initiative and also allowed advisors to self-report violations. The deadline to participate in that initiative ended last June.
David Tittsworth, an attorney at Ropes & Gray in Washington, said the RSTF has "been focused on potential violations of the securities laws that harm retail consumers, such as a large number of 12b-1 cases that are expected to be announced soon."
The Wall Street Journal reported in late January that more than 50 investment advisors are "under pressure" to settle SEC charges of selling higher-fee mutual funds over cheaper versions.
In fact, in late December, the SEC announced settled charges with American Portfolios Advisors — the RIA of broker-dealer American Portfolios Financial Services — as well as PPS Advisors and PPS CEO and Chief Investment Officer Lawrence Nicholas Passaretti for selecting mutual fund share classes inconsistent with their disclosures to clients.
