Shearman & Sterling LLP | Government Regulatory Enforcement Blog | SEC Files Administrative Proceeding Against An Investment Services Firm For Improperly Recommending Higher-Fee Mutual Funds To Investment Clients<br >  
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  • SEC Files Administrative Proceeding Against An Investment Services Firm For Improperly Recommending Higher-Fee Mutual Funds To Investment Clients

    On September 14, 2017, the Securities and Exchange Commission (“SEC”) filed an administrative proceeding against SunTrust Investment Services, Inc. (“STIS”), the investment services subsidiary of SunTrust Banks.  STIS consented to the filing of the proceedings and settled the allegations, without admitting or denying them.  STIS agreed to pay a penalty totaling $1,148,071.77, as well as disgorgement plus interest.  In addition, the STIS agreed to be censured.

    The SEC’s action principally alleged that STIS collected more than $1.1 million in fees to which it was not entitled, by improperly recommending share classes of mutual funds that were more expensive than cheaper, alternative shares of the same funds that were available.  Specifically, the SEC alleged that STIS violated Sections 206(2), 206(4) and 207 of the Investment Advisers Act of 1940 and Rule 206(4)-7, and that STIS’s investment recommendations breached STIS’ fiduciary duty to act in its clients’ best interests.  In the Matter of SunTrust Investment Services, Inc., Admin. Proc. No. 3-18178 (September 17, 2017) (“Order”).

    The SEC alleged that between late December 2011 and late June 2015, STIS investment advisor representatives (“IARs”) purchased, recommended, or held “Investor class” or “Class A” mutual fund shares for advisory clients, when less-expensive “Institutional class” or “Class I” shares of the same mutual funds were available.  The recommended Class A shares carried ongoing marketing and distribution fees imposed pursuant to Section 12(b) of the Investment Company Act of 1940 and Rule 12b-1; known in shorthand as “12b-1 fees”.  These fees were paid by a mutual fund out of fund assets, and passed back to STIS by the fund’s distributor.  STIS then shared a portion of the 12b-1 fees with its IARs.  For Class A shares, the 12b-1 fees typically carried as much as 25 basis points per year for an advisory client.  The affected STIS clients held either discretionary or non-discretionary wrap fee investment accounts, which offered clients varying investment options, including numerous mutual funds with both Class A shares and lower-cost Class I shares.

    The SEC charged STIS with inadequately informing its advisory clients of the conflict of interest presented by its IARs’ share class selections and the receipt by STIS and the IARs of 12b-1 fees.  The fees, according to the Order, decreased the value of the advisory clients’ investments in the mutual funds, while increasing the compensation paid to STIS and its IARs.  While STIS disclosed in its Form ADV Part 2A brochures that STIS may receive 12b-1 fees as a result of investments in certain mutual funds and that such fees presented a “conflict of interest,” the SEC found that these disclosures were inadequate.   The SEC alleged that STIS should have disclosed that many mutual funds offered share classes that did not charge 12b-1 fees and were, accordingly, less expensive.  The SEC also noted that STIS failed to make a detailed disclosure that an IAR could purchase, hold, or recommend mutual fund investments in share classes that would allow them to share in the 12b-1 fees.  According to the SEC, STIS’s general disclosure was not enough.

    The settlement, with penalty and censure, is an indicator that the SEC interprets the Investor Act to require direct and clear conflict of interest disclosures from investment advisors.  In this case, the SEC viewed this obligation to go beyond merely informing investors that a conflict of interest could exist.  This is the fourth SEC enforcement action in the last eighteen months relating to the direction of client orders into more expensive fund share classes.  These recent trends indicate that the SEC will continue to look critically at investment advisor disclosures in this space, and we will continue to monitor enforcement actions in this area.  Industry participants should remain focused on processes and procedures for providing adequate disclosures of mutual fund class selection to clients.