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The SEC’s examination priorities also pointed to nontransparent, and single-stock ETFs © Reuters

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The Securities and Exchange Commission is investigating whether 12b-1 fees are being appropriately handled during the process of converting mutual funds to ETFs, compliance consultants say.

Certain mutual fund share classes charge 12b-1 fees, which cover marketing, distribution and shareholder costs. But it is exceedingly rare for ETFs to carry such fees. And companies that convert mutual fund share classes with 12b-1 fees into ETFs could open themselves up to SEC scrutiny, the consultants say.

Conversions from mutual funds to ETFs are an examination priority for the SEC this year, according to the agenda it published last week. But the areas of inquiry that are outlined in the document were formulated from examinations conducted over the past year, said Carlo di Florio, global advisory leader at ACA Group.

“They’re coming in specifically and asking about the conversions,” he said. “They’re saying, ‘Describe for us the governance process that you have for the conversion. Describe for us why you’re doing it, the decision-making process, the disclosure around it.”

Agency examiners were also asking about potential conflicts of interest involved in such conversions as well as the disclosures firms made to investors about them, and all related documentation, he said.

“If you’re converting, you want to make sure that the governance, the conflicts and the disclosure are in good shape so that investors understand what’s going on with that conversion and understand the money and how it flows in that conversion and what the benefit is to them as well as potential conflicts of interest,” he said.

The SEC had scrutinised these issues over the past year, but they had come into “sharper focus” recently, di Florio added. The SEC has not focused on any specific types of funds that are converting.

Part of that scrutiny involved the role of 12b-1 fees, said Chuck Martin, chief operating officer at Vigilant, a compliance consultancy.

It remains a grey area whether 12b-1 fees collected from mutual funds could be used to promote them as converted ETFs, said Andrew Davalla, a partner at Thompson Hine. As ETFs did not generally charge 12b-1 fees, eliminating 12b-1 fees before the switch occurs, and not at the moment of the change, would save the fund shareholders money, he added.

The SEC might also just be seeking to better understand the relatively new practice of conversion, Martin said.

“We’ve started to see a lot more conversions,” said Vadim Avdeychik, a partner at Clifford Chance. “They’re looking at what’s going on in the industry and responding.”

The SEC’s examination priorities also pointed to a number of relatively new ETF models that will receive SEC scrutiny, such as nontransparent ETFs and single-stock ETFs.

Nontransparent ETFs required agency exemptive relief, so the SEC was probably going to be looking at whether firms comply with the conditions of that relief, di Florio said.

Loan-focused funds raised resiliency and systemic risk questions in a high-interest-rate environment for the SEC examiners, di Florio said.

Volatility-linked and single-stock ETFs were complex and risky, raising disclosure and other issues, he added. On other industry and product innovations, such as cryptocurrency, business development corporations and environmental, social and governance investing, the SEC will be looking for similar issues around complexity, risk and disclosures.

SEC examiners were likely to ask about the potential risks associated with brokers and advisers recommending the products and whether they were appropriate for investors, given their investment objectives and risk profiles, di Florio said.

Overall, the SEC under chair Gary Gensler was focused on retail investor access to “the proliferation of new investment products that just look different than even in the recent past”, said Jessica Reece, a partner at Ropes & Gray.

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