CFI Sourced for Expertise on FINRA’s 529 Plan Initiative

Slammed by Fines, Distributors Move to Fewer Share Classes, Simpler Sales Terms

Article published on March 25, 2019
By Jill Gregorie

Mounting regulatory pressure will push funds to slim down the number of share classes they make available, consultants say.

Earlier this month, the Securities and Exchange Commission announced settlements with 79 advisory arms of broker-dealers stemming from a February 2018 initiative in which the agency asked firms to self-report share class overcharges. In all, the companies will return $125 million to wronged investors, the SEC announced.

With the self-reporting initiative over, there is no sign that the regulator is letting up. “They’re actually now starting the process of sending targeted exam letters for a lot of RIAs who did not participate,” says John Ivan, a managing director at Palatine, Ill.-based Capital Forensics who focuses on wealth management, brokerage and advisory issues.

Finra has similarly slammed brokerages for improper sales of share classes, as well as failure to honor fund shares’ built-in fund breakpoints and fee waivers. In January, the self-regulatory organization launched its own self-reporting initiative for firms that recommended unsuitable share classes within 529 plans. Distributors have until April 30 to fess up.

But distributors face an alphabet soup of share classes that has brewed over the years and tracking the varying terms between them is a large task, Ivan says.

“As always, it’s a combination of everything: technology, training, improving processes and testing controls,” he says.

Fund manufacturers can play a role in keeping intermediaries on track, says Cari Hopfensperger, senior compliance consultant at Hardin Compliance Consulting.

For one thing, understanding in which platforms and programs a fund is used could allow fund shop reps to help distributors match the right share class to their specific programs, and then verify that their distribution partners are “consistently applying that strategy across distribution agreements,” she says.

Simpler terms and arrangements can help too, Hopfensperger says. For example, distributors may avoid distribution agreements for products containing the types of waivers and other share class features “that have helped contribute to today’s conflicts.”

Smaller firms, including those new to selling mutual funds, may need even more help, since they may inadvertently choose to sell a variety of products, creating a patchwork of placement decisions that can “open the door to conflicts,” Hopfensperger says.

This regulatory environment could also hasten the migration toward share classes that don’t have built-in 12b-1 marketing and distribution fees at all. Fund companies would then potentially pay distributors for the marketing and distribution support they provide out of pocket through revenue-sharing or other arrangements, says Gwendolyn Williamson, a partner at Perkins Coie.

“It’s hard to see the long-term viability of the structure we currently have in place,” she says. Recent attention to Fidelity’s “infrastructure fee” as another example of the types of fees fund companies may face and the consequences of using complex arrangements, she notes.

Already over the past year, distributor-specific sales provisions addressing various share class terms involving fund breakpoints, sales waivers and automatic conversion terms have cropped up in fund prospectuses. The terms, enshrined in fund legal documents, aim to help distributors. Those that move to uniform treatment of a common share class type — for example front-end load funds — can then apply the terms uniformly across fund families and their product lines, without worrying about some nuance in a particular product that would require the distributor to make an exception to their otherwise standardized processes.

But a disclosure-based approach to remediating share class issues may be unsustainable in the long run as well, Williamson says.

“In a short [-form] fund prospectus, sometimes the [distributor-specific] rules can be as long as the entire rest of the body” of the document, she says.

Many distributors are already becoming pickier about what they allow on their platforms, says Kamran Fotouhi, managing director at Capital Forensics and former Finra surveillance director.

“There is a rationalization of available fund families that assists not only the registered representatives in having a more refined suite of products available to clients, but helps firms with oversight and supervision,” he says.

Compliance teams at distributors, meanwhile, must be careful as they go about restoring investor losses, Capital Forensic’s Ivan says.

For example, if the firm decides to convert client investments to a lower-fee share class, they need to avoid recording the operation as a new sale or purchase, which could trigger tax issues, he says.

In addition, some RIAs may have a “chain of coordination” between their clearing firm and mutual fund platform, and will need to closely monitor whether tasks are being executed properly and routed, Ivan says.

Alternatively, if firms choose to provide rebates, they should routinely test whether those rebates are being applied correctly, especially if the process is automated, he says.

When updating disclosures, distributors should pay attention to terms that could trigger regulatory scrutiny, says John Lukanski, a Princeton, N.J.-based partner at Reed Smith. One example is if they convey that they “may” receive revenue-sharing payments, when they do, in fact, require such compensation, he says.

While verifying systems and reviewing all agreement terms may be time-consuming, it’s critical to preventing future missteps, Capital Forensic’s Ivan says.

“You can’t just rush to get it done, because what happens at a lot of firms is they go off to the next item, and forget to put the three or four extra pieces in place to make sure it doesn’t happen again.”