SEC Settles with Investment Adviser for Over $100 Million for Misleading Investors About Tax Implications of Retirement Fund Changes

Who may be interested: Investment Advisers; Investment Companies; Boards of Directors; Compliance Staff

Quick Take: The SEC announced that an investment adviser (Adviser) agreed to pay over $100 million to settle charges that the firm made misleading statements about capital gains distributions and tax consequences for retail investors who held shares of the Adviser’s target date retirement funds.

According to the SEC’s order (Order), the Adviser sponsored a set of target date retirement funds aimed at both retail investors (Investor Funds) and institutional investors (Institutional Funds). These two sets of funds had a 5-basis point difference in total expense ratio. The Investor Funds’ prospectuses stated that the Investor Funds’ distributions could be taxable as either capital gains or ordinary income, and that capital gains distributions could vary between years because of the Investor Funds’ normal investment activities and cash flows.

In 2020, the Adviser evaluated the potential impacts of lowering the minimum investment amount for the Institutional Funds and reducing their expense ratios. This analysis, based on market activity from early 2020, included anticipating redemption activity and potential capital gain distributions due to sales to generate proceeds to pay redemptions. After considering additional options, including mergers, the Adviser requested that the Board approve a lower investment minimum and an expense ratio reduction. After the lower minimum investment was announced, shareholders from the Investor Funds redeemed at substantially higher than expected rates; as a result, the remaining shareholders received distributable capital gains at nearly five times greater than the anticipated rate.

According to the Order, the disclosures in the Investor Funds prospectuses warning of the potential for distributable capital gains were misleading, because they did not specifically warn of the risk of increased capital gains distributions due to redemptions by shareholders switching from the Investor Funds to the Institutional Funds to benefit from the lower expense ratios of the Institutional Funds, which should have been expected by the Adviser. The Order noted that, in order to meet fund redemptions, the Investor Funds had to sell underlying assets with gains due to rising financial markets, and that retail investors who held their shares in taxable accounts received historically larger capital gains distributions and also were deprived of potential compounding growth of their investments. The Order also found that the Adviser failed to adopt and implement written policies and procedures to address the accuracy of fund disclosures.

The Order found that the Adviser violated the Advisers Act and caused violations of the Securities Act and the Investment Company Act as a result of the conduct described above. As part of settlements of the SEC investigation and parallel state investigations, the Adviser agreed to a censure, a cease-and-desist order, $18.2 million in disgorgement and prejudgment interest (which will be deemed paid due to the states’ settlements totaling $92.91 million), and a $13.5 million civil penalty. In addition to this $106.31 million in ordered relief, the Adviser separately paid $42 million to settle investor class action claims and individual arbitrations.

The Order can be found here