Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News August 21, 2006 Issue

Fund CCOs Increasingly Involved in Distribution Issues

Distribution issues are consuming an increasing amount of fund CCOsí attention and energies.

Each of the past four major mutual fund scandals ó market-timing/late trading, breakpoints, revenue sharing, and B share sales ó have involved distribution issues. Currently, the information-sharing agreement requirements in ICA Rule 22c-2 are forcing CCOs to walk down their various distribution chains to identify intermediaries subject to the rule.

And clearly, distribution ó broadly defined as the process by which fund shares are sold ó presents a range of compliance risks. For example, the fund or its distributors could enter into unlawful (or at least questionable) agreements to bolster sales of the fundís shares. The fund may not be able to obtain the information it needs to identify and block potential market timers. Breakpoints may not be properly calculated. Investors may not be directed to suitable classes of the fundís shares.

A fund CCO will have varying levels of responsibility for these and other distribution-related issues, and many issues will fall squarely on the fundís distributor. However, under the fund compliance program rule, the fund CCO must assess the compliance program of the fundís service providers, including the fundís distributor. While a fund CCO may fulfill that oversight role through a combination of due diligence, testing, and certifications, to adequately perform such functions, the fund CCO should have "a full understanding of how the distribution system works," according to Susan Wyderko, executive director of the Mutual Fund Directors Forum.

Chip Miller, executive vice president of Access Data, a vendor used by many fund groups to analyze shareholder information and other distribution-related data, agreed that fund CCOs are increasingly being pulled into distribution issues. "Itís not that they didnít need to before," he said. Until recently, however, the focus was primarily on ensuring that distribution processes were properly disclosed in the fund prospectus. Now, however, fund CCOs are "much more involved in understanding the daily operational requirements" underlying fund distribution, he said. Miller reported that he is seeing more and more fund CCOs working together with their fund COO on operational issues. "They never had that before." In his view, the market timing scandal, the requirements of fund compliance rule, and now the information-sharing requirements of Rule 22c-2 have "created a whole other dimension for the responsibility of the CCO." In years past, he said, sales considerations drove the determination of the fundís distribution channels. Now, he said, to some extent, compliance considerations are driving that decision, as well.

In an era of multi-class funds, master-feeder funds, fund supermarkets, and brokers large and small, identifying your fundís distribution channels may be easier said than done. This has been most recently evidenced by fundsí struggle to identify their "sub-intermediaries" in preparation for compliance with Rule 22c-2. "Historically, mutual funds have not necessarily known very much about the parties further down the chain then the ones that they had direct relationships with," said Bingham McCutchen partner Hardy Callcott. "I know there are people spending time trying to understand these sub-distributor relationships."

If you need to get a quick handle on your fundsí distribution channels, a good place to start is your fundís prospectus. Read the section on how to purchase and redeem shares of your funds. If your fund offers more than one class of shares, pull your fundís 18f-3 plan and look that over.

Next, youíll want to review your fundís distribution agreement with its distributor. If you work at a fund group of any size, your distributor will most likely be affiliated with your firm. However, smaller fund companies may rely on a third-party distributor, such as SEI or BYSIS. Chances are, you will find that your distributor acts as a "wholesaler," in that it turns around and sells fund shares to other broker-dealers in a "selling group." Once again, there are agreements ("Selling Group Agreements") that govern that relationship. Itís worth reading a few of them to understand the relationship and obligations of the selling brokerage firms. To surface issues, lie various selling group agreements side-by-side and look for differences. Lastly, consider reviewing shareholder servicing agreements. (If you canít find the contracts you are looking for, ask your firmís legal department or the legal department of your fundís distributor.)

Once youíve read up, consider scheduling a sit-down meeting with the director of sales at your fundís distributor. The primary goal of such a meeting would not be to conduct due diligence (although, of course, you should be alert to any red flags that arise), but rather, to educate you as CCO and confirm your understanding of the way the fundsí distribution channels actually work.

For example, you could ask the director of sales about the size and activities of the distributorís external sales force (sometimes known as "external wholesalers"). This is the group that reaches out to brokers, financial planners, and other intermediaries in an effort to encourage them to recommend your fund over other funds. What markets is the sale force currently focusing on? How are they paid? Who supervises them? Who trains them?

On that score, Drinker Biddle partner Diana McCarthy cautioned that distributors that quickly ramp up their sales forces may face compliance issues down the line. "I think itís always a concern when you are bringing in lots and lots of new people to make sure that those people understand what the ground rules are. Sales people are sales people," she said. "You find in the mutual fund industry that itís very common that a lot of the people who are brought in donít necessarily have any experience in selling mutual funds."

The director of sales also should be able to provide you with information about the relative percentages of your fundsí shares that are sold via various channels. For example, you may learn that X percent of your shares are sold through a fund supermarket, X percent are sold through financial planners, and X percent are sold through national brokerage firms.

Having a baseline understanding of your fundsí distribution channels will equip you to better address compliance issues as they come down the pike. And clearly, the biggest distribution issue right now is implementation of the information-sharing provisions of the SECís redemption fee rule, Rule 22c-2.

There are two issues, explained Callcott. First, funds must determine whether sub-intermediaries will be able to implement a redemption fee (assuming one is imposed by the fund). Secondly, the fund must confirm that the sub-intermediaries are able to provide information about any shareholder that has been identified in engaging in suspicious trading.

Callcott noted that the two functions are not necessarily linked. Even if trading "doesnít trigger a redemption fee," he said, "you may still decide you want to block that particular trader."

As part of the process of implementing the 22c-2 agreements, said Callcott, funds need to decide "how often should they be requesting the information" and what to do with the information once they get it.

He pointed out the special problems with respect to chains of intermediaries. "Youíve got the contractual relationship with the broker-dealer," he explained, "but the broker-dealer has investment advisers and pension funds that are trading through it. Funds, he said, need to determine whether their intermediaries in turn have intermediaries that they are doing business with, and if so, "how are they going to reach down" to get information from those intermediaries if, at the mutual fund level, suspicious trading is detected.

How can a fund CCO assure that a sub-intermediary will be able to provide the requisite information? "I think typically what they want is a certification that the intermediary is going to be able to provide information about trading by any of its intermediaries, and a certification that they are going to be able to either impose redemption fees themselves or cause their sub-intermediaries to impose the redemption fees," he said. What is being requested, he added, "is more of a certification of the ability to comply" than it is "to provide all the information today in writing about all the sub-intermediaries." However, he added, "it does vary a little bit from organization to organization."

How often should funds request the shareholder information? "I think typically it depends what kinds of fund you have and how vulnerable it is to market timing," Callcott said. "A lot of funds are thinking of getting regular downloads."

Should the fund get it every week? Every month? Once a quarter? Should it even be on a regular basis, or should it be sought on an occasional basis, whenever testing is being conducted? "That answer is going to vary from fund to fund," said Callcott. "If youíve got a short-term bond fund, youíre not very vulnerable to market timing." However, if the fund in question is an emerging markets international fund, "youíre going want to get much more information and get it much more frequently."

McCarthy reported that some funds are learning that platforms on which their share are distributed simply are not able to provide the requisite information because they do not keep historical transaction data. "There are a lot of these retirement and other types of platforms that donít have the systems capability right now to actually track when somebody actually purchases and sells shares in the same fund," she said. Some intermediaries have asked whether they can simply put a "trade block" on the shares in the omnibus account, "which would basically not permit the clients on that particular platform to trade in a particular fund" within a specific number of days, per the fundís short-term trading policy. "People are talking about putting up these trade blocks so they wouldnít actually have to keep track of purchases and sales."

Lastly, McCarthy sounded a note of caution that should be heeded by intermediaries not able to provide the shareholder information required under Rule 22c-2: "If somebody canít implement the rule," she said, "it will force people to change who they deal with."