Thursday, April 30, 2020
A few securities industry groups hired Gibson Dunn to petition the SEC to abandon its share-class disclosure initiative. The petition argues that the initiative should have been rolled out as a rule proposal through the notice and comment process instead of simply being announced by the Commission.
The share-class disclosure initiative explained that the SEC had "filed numerous actions in which an investment adviser failed to [disclose] its selection of mutual fund share classes that paid the adviser . . . [12b-1 fee] when a lower-cost share class for the same fund was available to clients." The SEC asked advisers to plainly disclose when they put client assets in higher-fee share classes when lower-fee share classes were available.
Let's pause for a second here. All the SEC has asked for is disclosure. It has not asked firms to stop this practice. It just wants fiduciaries to disclose when they do it.
Many dually-registered investment advisers have operated this way for years, collecting enormous fees from investors who likely do not understand the conflict. Nicole Boyson has a fascinating paper on how large, dual-registered investment advisers routinely operate with staggering conflicts. We talked about an earlier draft of the paper in the Ipse Dixit Podcast here. She also spoke to the Wall Street Journal about the paper.
If you don't follow the space, this may seem a bit confusing. An example might help. Imagine you hire a decorator to advise you and recommend tasteful furnishings for your home or office. You pay the decorator $15,000 for the service. The decorator recommends some furniture without telling you that many of the exact same recommended items are available through the decorator's office at lower prices. The decorator is asking you to pay the higher prices because the furniture producer has a kickback deal where it pays the decorator more if the decorator can dupe you into overpaying. This is, in essence, the issue with the 12b-1 fee disclosures. Only it's actually worse because you would only pay the decorator's kickback once and you'd be paying the 12b-1 fee for as long as you hold a particular mutual fund.
The petition objects to the Commission's decision to require clear disclosures. In essence, it calls for the Commission to allow vaguer, more general disclosures to suffice or to go through a rulemaking process for every disclosure the Commission opts to enforce:
Although investment advisers have long disclosed that they receive 12b-1 fees and that receipt of those fees presents a conflict of interest, as per the Commission’s actual regulations, the Commission has recently claimed that investment advisers are (and were) also required to state specifically that some clients were placed in more expensive share classes where less expensive share classes were available. But, as discussed above, this type of broad disclosure has never been required by any of the Commission’s rules, or any litigated cases.
It's one thing for a person to say that "I may receive some 12b-1 fees if you buy particular funds." It's another thing for an adviser to disclose that "I recommend the higher-cost share classes to you even though lower cost ones in the same fund are readily available on my platform. I make more money this way and profit off this conflict of interest even though you already pay me a fee for investment advice. Under the law, that fee means I owe you a fiduciary duty to eliminate or disclose conflicts. I am not going to eliminate this conflict and have opted to disclose it to you instead. This is that disclosure."
From an investor protection standpoint, it's hard to see how investors benefit from hiding this information or making it less salient. If we expect the market to police disclosed conflicts, clarity will help investors make better choices. The Commission should stand its ground to require clear disclosure at a time when assets increasingly shift from brokerage channels to investment adviser channels. As this happens, the need for more enforcement and clarity in the space continues.