It’s like a breaking news chyron on any cable channel, and designed (successfully) for maximum attention: “Investment Management Law Alert—Regulatory Focus on Share Class Selection in 2018.”
The e-blast from The Wagner Law Group hit inboxes in January, and confirmed what 401(k) advisors, sponsors and product manufacturers have long-known; share class confusion is an increasing concern—and focus—of regulators.
While it might seem like an evergreen and ongoing issue for the investment industry as a whole (beginning with a B-share beatdown over a decade ago), a new wrinkle in the form of the fiduciary rule is adding a frenzied air.
In recent years, the alert noted, the SEC’s Office of Compliance Inspections and Examinations (OCIE) has increasingly scrutinized share class selection by registered advisors.
“A share class recommendation must comport with the requirements of Section 206 of the Investment Advisors Act of 1940 to act in the client’s best interest and to seek best execution for client transactions,” it read in typical legalese. “Consistent with its 2016 examination priority to protect retail investors, OCIE launched its 2016 Share Class Initiative to examine registered advisors’ practices related to share class recommendations and compliance oversight of the process.”
Consumer protection continued to be a priority for OCIE in 2017 and share class selection appeared on its list of exam priorities for 2018 as well. It’s specifically concerned about conflicts of interest with advisor recommendations regarding share classes that have higher loads or distribution fees.
“I think it’s a direct result of the fiduciary rule,” Wagner bluntly translated when asked about the focus, and why it’s happening now. “I’m not saying people weren’t talking about different shares; B shares were beaten up for a while and then A and C shares. I think all of that was the beginning musical score to the crescendo we’re now seeing.”
Not surprisingly, the specter of the Voldemort-style villain (for some), tort lawyer Jerry Schlichter, is raised any time fees and fiduciary are mentioned together.
“I think you’re seeing more lawsuits dealing with this very issue; the appropriateness of share classes,” Wagner adds.
And, as the aforementioned fiduciary rule (officially the Conflict of Interest Rule) has shown us over and over and over again, sea changes within the investment industry, especially large institutional changes, take time.
It’s all a lot to digest, made more so with the advent of so-called fiduciary shares, better known as “T shares” and “clean shares.”
First, definitions are in order:
Clean shares (officially Z shares) are stripped of front-end loads and 12b-1 fees, which are generally used to pay for a fund’s distribution costs.
“Clean shares are exactly that, they’re clean and have no front-end load, deferred sales charge, or other asset-based fee for sales or distribution,” Wagner explains. “It’s, ‘What does it cost to maintain the fund or investment option?’, and that’s it. And then the broker-dealer, RIA, recordkeeper or whomever is going to distribute them, adds in their charge directly for services rendered.”
More specifically, it’s an investment option whereby there are no additional administrative expenses embedded in the expense ratio.
“Therefore, it’s very useful, for example, in an open architecture type of an arrangement. Recordkeeping fees can be layered on by whatever financial institution, custodial fees could be layered on, sub-transfer agency fees can be layered on, distribution and marketing fees can be layered on, things like that. So basically, the expense is determined ultimately by the financial institution.”
The directive is that it will not be as much about mutual fund companies setting the share price as it is the financial institution, be it a broker-dealer, wirehouse or someone else.
“Now that’s to be distinguished from something like a T share. T shares, from what I can tell, are almost like level fees. T stands for transactional and is meant to coordinate with the DOL rule by imposing uniform sales charges across all fund categories—an attempt to mitigate any conflict of interest.”
Her hesitation is warranted, and what exactly terms like “T” and “clean” officially mean is still being determined, with Morningstar’s Aron Szapiro pointing to competing regulatory definitions, as well as disagreement over whether sub-transfer agency fees, or sub-TA fees, and other kinds of revenue sharing are included.
As with most that’s happened regarding the fiduciary rule, it’ll most likely be left to the courts to make sense of it all (and why we’re speaking with a lawyer like Wagner), however, she emphasizes that recent SEC reviews have approved clean and T shares concepts. Clean Shares were discussed favorably by the SEC in a No-Action Letter on January 11, 2017, and T Shares were the subject of SEC IM Guidance Update 2016-06.
“T shares might be about a mutual fund family with every fund in a lineup or arena about the same cost. For example, I’ve heard a number 2.5 percent or 250 basis points. You’re paying 250 basis points for, say, an international fund, equity fund or smallcap fund or what have you. The reason that something like T shares is interesting is because of the fiduciary rule. Where we think the fiduciary rule is going when everything is finally, finally, finally done is with a prohibition in certain circumstances of differential compensation.”
So, a T share is not a clean share, she reiterates. And in an effort to avoid running afoul of regulatory scolds, some product manufacturers and money managers are actually seeking out the opinions of their distribution networks, for example broker-dealers and wirehouses, to determine “what might be appropriate and what might be reasonable. So, I think there’s a lot of interaction amongst the various players.”
When all is said and done, she notes, the thinking behind T and clean shares has existed for some time, but not widely discussed.
“These very concepts have come to the forefront as a direct result of the fiduciary rule. We would not be even discussing clean shares versus T shares but for the COI rule. You must be careful if you are advising IRA clients or pension plan clients or profit-sharing clients on the different share classes. Not all are created equally and if they’re going to be different expense ratios you have to understand for what you are paying.”
For advisors in the current litigious environment, her conclusion is something of which to pay special heed.
“I’m not saying that one is more reasonable than another, I’m really not. What I’m saying is that you need to know 1) what they are, 2) that you have a choice and 3) what you are willing to pay for and decide that it is reasonable. I think that is the issue. Knowledge and prudent decision making is very much power when it comes to differentiating and determining the appropriateness of a share class.”
Since 1996, The Wagner Law Group has provided a practical approach and sophisticated legal solutions while offering the personalized attention of a boutique law firm. Our practice areas include: ERISA Law, Investment Management Law, Employment Law, Labor and Human Resources, Employee Benefits, Welfare Benefits, Privacy & Security, Corporate Law, Tax, Estate Planning and Administration, Real Estate and Litigation. Marcia Wagner can be reached at [email protected].