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SEC Charges Two More Firms With Share Class Disclosure Violations

The settlements are the latest in a string of SEC enforcement actions for similar conduct, which one lawyer says is now 'low-hanging fruit' for the regulator.

Berthel Fisher & Company Financial Services, an Iowa-based dually registered broker/dealer and investment advisor with nearly $800 million in regulatory assets under management, settled charges with the Securities and Exchange Commission over claims it failed to disclose conflicts concerning recommendations of certain mutual fund share classes that included 12b-1 fees.

The offer of settlement, which was filed on Sept. 16, is the latest in a string of SEC enforcement actions for similar conduct. Only several days earlier, Chicago-based Rothschild Investment Corporation, an RIA and broker/dealer with about $1.6 billion in AUM, settled with the commission for 12b-1 disclosure violations. Rothschild also failed to self-report those violations in the commission’s 2018 Share Class Selection Disclosure Initiative, though it was eligible to do so.

Kurt Wolfe, an attorney in the SEC Enforcement Practice at the law firm Quinn Emanuel Urquhart & Sullivan, said the enforcement issue was “low-hanging fruit” for the commission’s Enforcement Division. SEC staff have become well versed in the nuances of how such actions manifest in firms after working on the Disclosure Initiative, in which firms were able to inform the SEC of previous disclosure lapses in return for leniency on penalties.

“So by now, I think they have a ‘you know it when you see it’ kind of reaction. If the exam staff is looking at whatever they’re doing, they may say ‘what’s this firm doing when there are products with multiple classes?” Wolfe said. “It becomes a pretty repeatable thing for them to identify and charge.”

Mutual funds often offer different kinds of share classes with similar objectives and attributes, but may differ in fee structures for a variety of reasons. This potentially leads to situations where advisors may recommend a particular share class with elevated 12b-1 fees that would lower returns for the investor but boost profits for the advisor or broker selling the fund.

Starting in January 2014, investment advisory representatives at Berthel Fisher received 12b-1 fees from mutual fund share classes it recommended or purchased for clients, even when more affordable share classes from the same mutual funds were available, according to the SEC’s order. The firm also failed to disclose the inherent conflicts on its Form ADV or elsewhere. By April 2018, the firm began crediting the 12b-1 fees raised from recommending certain purchases to advisory client accounts on a going-forward basis.

The SEC also knocked the firm for failing to disclose revenue-sharing payments from its cleaning brokers based on the amount of client assets that had been invested in certain cash sweep accounts.

“The payments BFCFS received created an incentive for BFCFS to recommend its advisory clients buy or hold share classes that paid 12b-1 fees over other share classes of the same mutual funds that did not pay 12b-1 fees when rendering investment advice to BFCFS’s advisory clients,” the order read.

The context in which the commission and the industry view 12b-1 fees has also changed over time, according to Bill Singer, a securities attorney and the author of the blog. To Singer, this shift has contributed to the boost in enforcement actions, in addition to the commission’s increased familiarity with 12b-1 fees in the aftermath of the self-reporting initiative. 

Singer argued 12b-1 fees initially worked as a way for mutual funds to encourage b/ds to market their product to consumers. He said 12b-1 fees had become more important to brokerage firms as a continued source of revenue from mutual funds, and that times had changed since 12b-1 had been seen as a kind of “legitimate” marketing fee.

“12b-1 hasn’t changed, but the way we look at it has,” Singer said. “It’s gone from something we thought was helping customers to get them due diligence, (and) now it’s being seen as a payoff, a bribe to push something even when you know it’s not the best option.”

The SEC has cracked down on other firms for similar lapses in recent months. In August, J.W. Cole Advisors, a Florida-based RIA with about $3.93 billion in AUM, was fined $1.6 million for such lapses, while Northwest Advisors, a defunct Pennsylvania-based RIA, agreed to pay more than $900,000 to affected investors based on similar allegations.

Also in August, Dallas-based ISC Advisors, a hybrid b/d and RIA with more than $1 billion in assets, settled with the SEC for recommending more expensive share classes, while the Colorado dual registrant Cascade Investment Group agreed to a cease and desist, a censure and a civil penalty of $125,000 for allegedly making similar violations.

In June, Centaurus Financial, a California-based firm with $2.7 billion in AUM, agreed to pay $1.2 million for allegedly failing to disclose share class conflicts, while that same month Crown Capital Securities, another California firm with about $1.17 billion in managed assets, settled with the regulator on similar claims. Though the majority of these actions end in settlements between the SEC and firms, the Tennessee-based firm CapWealth Advisors has disputed SEC allegations concerning share class recommendations, with a jury trial set for no later than June of next year.

Even if these kinds of cases are increasingly commonplace, firms still benefit from avoiding lengthy investigations, as the process and resulting penalty can be expensive. Even with the conclusion of the SEC’s Disclosure Initiative, Wolfe said there were some remedial steps a firm could take if it had 12b-1 lapses in its background, including pursuing its own internal actions and scrutiny. Proactively disclosing to the SEC could also still lead to favorable treatment, with Wolfe noting that in some cases the penalties included in settlement actions were not excessively high; he speculated that in these instances firms may have approached the commission, not vice versa.

While such cases can take some time to develop depending on the size of the firm, Wolfe expected the SEC would continue to pursue them, believing that commission staff would not come to the conclusion that they’d pursued these cases to the fullest extent. 

“The SEC was pretty clear; ‘if you don’t come in and talk to us, we know there are others in the space, and we’re going to come find you,’” he said. “And they have been.”

In the case of the most recent actions, while BFCFS did not admit nor deny the findings, it agreed to a cease and desist and a censure, as well as paying disgorgement and prejudgment interest totaling more than $150,000, as well as a civil penalty of $235,000. Likewise, Rothschild Investment did not admit nor deny the findings, but it also agreed to a cease and desist and censure. Additionally, Rothschild will pay disgorgement and prejudgment interest totaling more than $1.9 million, as well as a $400,000 civil penalty, according to the order.

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