In financial advisory, client oversight is crucial for maintaining trust and ensuring compliance. Advisors have a fiduciary duty to uphold, and violations can direly impact your firm, resulting in reputational damages and enforcement actions.
One area that has received more stringent regulatory scrutiny in recent years is mutual fund share class selection and disclosure practices. Share class violations can jeopardize client interests and lead to severe consequences for financial advisors.
Tech-driven solutions have become indispensable tools for advisors seeking to safeguard against share class-related violations and ensure robust client oversight. Embracing these solutions will enable financial institutions to uphold their fiduciary responsibilities while providing optimal value to their clients.
Here, we explore the issue of mutual fund share class selection: What it is, why it matters (to you, your clients, and the SEC), and how you can build a tech-enabled compliance program that safeguards against share class selection-related risk.
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Why Does Mutual Fund Share Class Selection Matter?
Section 206(2) of the Investment Advisers Act of 1940 states that advisors must act in their client’s best interest. This fiduciary duty means advisors must put their clients ahead of themselves and work to provide unbiased guidance in good faith and with full disclosure of any pertinent information or potential conflicts of interest.
In recent years, the SEC has trained its attention on mutual fund share class selection as an area where significant violations of this fiduciary duty have occurred. During its regular examination process, the SEC began to notice recurring issues, specifically around the disclosure of share class selection.
Differentiating between mutual fund share classes can be confusing and overwhelming for retail investors, and the SEC found that some advisors were not clearly explaining the process or acting in the client’s best interest when discussing share class options.
Some advisors omitted details around 12b-1 fees, while others guided clients toward mutual funds with a wrap fee program that benefited their firm.
The SEC called out these issues in 2018, launching its Share Class Selection Disclosure (SCSD) initiative — providing advisors with a grace period in which they could self-report share class violations to the SEC. In turn, the Commission would not impose civil penalties on firms that came forward at that time.
How Compliance Technology Can Help Mitigate Securities Law Violations Risk
As technology becomes more sophisticated, regulators adopt increasingly advanced solutions to identify share class violations during examinations.
If your firm isn’t implementing its own technological solutions, you’re leaving yourself vulnerable to significant risk. You never want to be the last one to learn about compliance issues under your own roof.
Even if your firm is acting in good faith, your team could inadvertently be guiding clients toward less beneficial share class options. That's why technology that can review your clients' current holdings and compare them against available options helps maintain compliance.
Adopting compliance technology with monitoring capabilities is crucial to spotting issues with share class selection during regular internal audits. But it can do even more than that; compliance technology can help you at various stages of the process to address mutual fund share class risks and handle them appropriately if they do occur.
Prevention Is the Best Medicine: Establishing Strong Compliance Policies and Procedures
The best way to avoid securities law violations and the reputational and financial risks that come with them is to take steps to ensure they don’t occur.
Regarding mutual fund share class errors, establishing clear firm-wide policies and procedures around your expectations for advisors and disclosure notices for clients are vital steps.
First, you must educate your advisors about the rules around share class selection and how they are impacted by fiduciary duty. You should outline your firm’s expectations in your investment manual and make it easy for your team to access the information.
A compliance technology solution provides a centralized library to store all relevant policies and procedures. When you have one shared source of truth, your team always knows where to go to find the guidance they need.
Technology also allows you to ensure your advisors read and absorb the policies you create. Within a compliance technology tool, you can request that advisors attest to their review of specific materials. You may even use the tool for testing your team, asking them specific questions to assess whether or not they read and understood the materials.
Compliance technology can also help ensure that client disclosures are managed correctly. Your compliance library can house your Form ADV and any brochure supplements, which should include explicit language about the differences in share classes, how fees are charged, and your firm’s disclosure policy around conflicts of interest.
You can also create compliance checklists for your team to follow that ensure proper distribution of required client paperwork. If an advisor neglects to send the necessary forms or supplements to a client, your compliance team will receive an alert in the system so you can follow up.
Detection Is Vital: Ongoing Monitoring for Share Class Violations
You’ve laid the appropriate groundwork to protect against mutual fund share class violations, but we live in an imperfect world. Even if your entire firm is acting with the best intentions, things can go awry.
This is why controls and internal audits are essential to a healthy compliance program, and monitoring for share class violations should be a part of your processes.
In years past, monitoring for share class issues was a retroactive activity. Your team might pull data into a spreadsheet regularly and scan for violations. These reviews took time, and any problems they uncovered might be months old.
Today, compliance technology exists that allows for continuous monitoring. Fintech solutions can scan proactively for potentially less expensive share class availability and alert your team when it identifies alternatives.
When it comes to spotting any compliance violation, time is of the essence. Quickly finding issues helps you keep them from spiraling out of control and impacting a wider swath of your client base. It also empowers you to take swift and decisive action to remedy the issue.
If You See Something, Say (and Do) Something
If you do detect an issue with mutual fund share class selection at your firm, taking care to quickly address the situation and notify the appropriate parties is vital.
You’ll want to inform the regulators, your team, and any impacted clients. Then, it’s time to address the current problems and ensure they don’t happen again.
The SEC will likely provide additional guidance that’s specific to your firm, but at the most basic level, you should:
- Review your current disclosure documents, policies, and procedures. If you find any issues that contributed to this share class violation, now is the time to fix them.
- Inform your team of the issue, and educate them about what you will do collectively to ensure this does not happen again.
- Immediately move any impacted clients to the lower-cost share class.
- Notify clients of the issue and clearly communicate any settlement terms set by the SEC.
Violations of your fiduciary duty can have far-reaching negative impacts on your firm — from penalties and disgorgements to reputational damage. And with the SEC maintaining its focus on share class-related issues, you know this is an area where you should remain especially careful in minding your fiduciary responsibilities.
Investing in the right compliance technology solution can help you educate your team, manage appropriate client disclosures, and proactively monitor for any issues.
Flexible, scalable tech to build and maintain a solid compliance program.