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.

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 exams 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 are also asking about potential conflicts of interest involved in such conversions as well as the disclosures firms make 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 has scrutinized these issues over the past year, but they have 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 involves the role of 12b-1 fees, said Chuck Martin, chief operating officer at Vigilant, a compliance consultancy.

Mutual funds use 12b-1 fees to cover marketing costs, but ETFs do not.

It remains a gray 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. 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 may 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 exam 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 require agency exemptive relief, so the SEC is probably going to be looking at whether firms comply with the conditions of their exemptive relief, di Florio said.

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

Volatility-linked and single-stock ETFs are 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 are likely asking about the potential risks associated with the products and whether they are appropriate for investors, given their investment objectives and risk profiles, di Florio said.

The SEC will also be seeking to verify compliance with standards of conduct for investment advisors and broker-dealers in recommending complex products, or those with unconventional strategies, including variable annuities, proprietary products and non-traded real estate investment trusts, he said.

The SEC will also prioritize examining "private funds managed side-by-side with [business development companies]," according to its exam priorities. Co-investment funds are registered closed-end funds like BDCs that invest alongside private equity funds and other private funds in limited ways with fee and liquidity restrictions. A 2020 SEC rule made it easier for such arrangements to form.

Whenever there is growth in the markets, as private markets have experienced, SEC examiners investigate to ensure compliance with the securities laws, di Florio said.

Firms should question whether their co-investments act as a way for retail investors to access otherwise prohibited investment categories like venture capital and private equity, he said.

"If your private equity strategy is the same as the BDC strategy, then you're effectively exposing that to the public," he added.

"I think [the SEC staff] think a lot about conflicts of interest and making sure advisors are addressing conflicts of interest and disclosing them," said Jessica Reece, a partner at Ropes & Gray.

Firms with co-investment structures need to determine whether conflicts can be managed through disclosure or whether they need to be outright eliminated, she said.

As in other areas of the capital markets, the SEC is focused on process as well as outcome, Reece noted. "Advisors need to be so thoughtful about what their processes are because it's not just the outcome that matters," she added. "Two advisors, two boards, can come to two different conclusions on a very different set of facts and both might not necessarily be wrong, but what matters is process."

Overall, the SEC under Chair Gary Gensler is focused on retail investor access to "the proliferation of new investment products that just look different than even in the recent past," Reece said.

SEC Targets 12b-1 Fees in Fund-to-ETF Conversions

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