Advisers have a fiduciary obligation to recommend a share class that will provide their clients with the lowest overall expenses, based on anticipated transaction costs and holding periods. Moreover, if the Firm recommends mutual funds that carry 12b-1 fees when lower share class options exist, the Firm must make full and fair disclosure, including conflicts associated with making investment decisions in light of the receipt of 12b-1 fees; and selecting the more expensive 12b-1 fee paying share class when a lower-cost share class is available for the same fund. Share class selection is a regulatory priority. The SEC has indicated that examiners will conduct focused, risk-based examinations to assess whether investment advisers are meeting their obligations to

  1. Seek best execution;
  2. Disclose material conflicts of interest; and
  3. Maintain an effective compliance program.

Investment adviser should determine its approach for meeting these three obligations and train its personnel to comply with any policies, procedures, and guidelines governing share class selection.

Obligation to Seek Best Execution

When selecting or recommending a share class, an investment adviser has a fiduciary duty to act in the client’s best interest. The investment adviser must seek best execution for the client’s transaction. This best-execution obligation requires the investment adviser to seek to obtain the most favorable terms reasonably available under the circumstances.

For mutual funds and 529 plan investments, the most favorable terms are generally obtained by purchasing the lowest cost share class that the client is eligible to own. If selecting a share class other than the one with the lowest cost, the investment adviser should document its basis for concluding that the higher cost share class better serves the client’s interests (for example, the avoidance of transaction fees). A lack of documentation could cause a regulator to conclude that the investment adviser breached its duty to seek the most favorable terms available. 12b-1 fees and transaction fees should be considered in addition to any other fees charged associated with are commended mutual fund.

Obligation to Disclose Material Conflicts of Interest

As a fiduciary, an investment adviser has a duty to make full and fair disclosure of all material facts, including all material conflicts of interest that could affect the advisory relationship. In the Form ADV Part 2 brochure, an investment adviser must disclose whether it, its supervised persons, or an affiliate accepts compensation for the sale of securities, including asset-based sales charges, 12b-1 fees, or service fees from the sale of mutual funds. In addition, the investment adviser must explain the conflict of interest created by the receipt of such compensation and how it addresses the conflict, including its procedures for disclosing the conflict to clients. During examinations, regulators may focus on assessing the accuracy, adequacy, and effectiveness of the investment adviser’s disclosures regarding compensation for sales of mutual funds and the conflicts of interest associated with this practice.

Obligation to Establish an Effective Compliance Program

SEC-registered investment advisers must adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act and the rules thereunder. State-registered investment advisers have a similar obligation. Investment advisers should be prepared to have regulators scrutinize their practices for selecting share classes during examinations. Regulators will generally want to assess the adequacy and effectiveness of the investment adviser’s written policies, procedures, and guidelines governing share class selection.

For help developing and implementing policies and procedures for share class selection, please contact us. MasterCompliance provides expert consulting, outsourcing, and implementation tools in planning and budgeting your firm’s compliance responsibilities.