Distribution Fees: Don’t Disguise Them as Something Else
The SEC doesn’t like it when funds and advisers say they are paying for one kind of service when they actually are paying for another. Payments for sales of mutual fund shares are a case in point.
The Commission is suspicious that when mutual funds or advisers pay fund "supermarkets" for a variety of services, hidden among them are payments for distribution (sales). It’s not that paying a supermarket for distribution itself is improper. It’s whether those payments are made in accordance with Investment Company Act Rule 12b-1, commonly known as a "12b-1 Plan." The 1980 rule was adopted, in part, to address potential conflicts of interest between a fund and its adviser when a fund pays its own distribution costs.
Now the SEC is making it a priority, both in its exams and through the Division of Enforcement, to ensure the rule is being followed.
"We anticipate enforcement action from the Distribution in Guise Initiative," said SEC Division of Enforcement Asset Management Unit co-chief Julie Riewe earlier this year in a speech at a recent compliance conference, "where we are examining, among other things, conflicts presented by registered fund advisers using the fund’s assets to grow the fund and, consequently, the adviser’s own fee." The agency’s Office of Compliance Inspections and Examinations has also listed the use of such fees as an exam priority in recent years.
The issue comes down to who is paying the cost of distributing fund shares. "Is the adviser paying this out of its legitimate profits or from the fund?" asked ACA Compliance Group senior principal consultant Jason Rosenberg. The SEC is primarily concerned that advisers are directly or indirectly causing funds to pay for distribution of fund shares outside a 12b-1 plan using administrative fees such as sub-transfer agent fees. If the shares are being paid for by the fund, that means, in effect, that the costs are being paid by the fund’s investors, something the SEC doesn’t want.
In addition, "when a fund pays these expenses, the fund’s investment adviser is spared the cost of bearing the expenses itself, and the adviser benefits further if the fund’s expenditures result in an increase in the fund’s assets and a concomitant increase in advisory fees," the SEC staff said in an October 30, 1998 interpretive letter to the Investment Company Institute.
Rule 12b-1 seeks to address this problem by prohibiting mutual funds from using their own shares to finance, directly or indirectly, any activity primarily intended to result in sales of fund shares, Rosenberg said. The rule does allow funds to make such payments, however, if they do so under the strictures of a 12b-1 Plan.
A 12b-1 Plan requires, among other things, that fees paid are disclosed in fund prospectuses as a separate line item in their fee tables. Funds are also required to disclose certain information about the fees when describing their distribution arrangements in their prospectuses. The plan must be approved by both a fund’s shareholders and board of directors, including a majority of the independent directors.
The emergence of fund supermarkets – intermediaries set up by broker-dealers and other financial institutions that offer funds and advisers a wide variety of services – in the 1990s made the situation even more complex. Given the services supermarkets offer – sub-accounting, transaction processing and settlement, shareholder account set-up and maintenance, prospectus distribution, and more – it is relatively simple for distribution costs to be mischaracterized as something they are not. Adding to the confusion is that distribution costs may include expense for related sales services that some may not consider to be sales, such as marketing, educating advisers or sponsoring events.
"The SEC is concerned that boards are not being provided with enough information to make a critical determination as to whether an intermediary’s fee is in some way tied to distribution," said Willkie Farr attorney Justin Browder.
The main problem today – and perhaps the cause of adviser and fund confusion that is in turn fueling what may be a coming SEC crackdown – is that the 1998 letter is the only available guidance on these issues, Browder said. The use of fund supermarkets and other intermediaries is now "ubiquitous," he said, but law and regulation has not developed to address the complexities of the business arrangements.
Role of the board
The 1998 interpretive letter left it up to each fund’s board of directors to make the final determination as to which fees pertain to distribution. "The board is responsible for determining whether any portion of a fund supermarket fee paid (or to be paid) by the fund is for distribution, i.e., services primarily intended to result in the sale of fund shares," the letter states. "Whether or not any particular payment of a fund supermarket fee by a fund is for distribution services or non-distribution services is primarily a question of fact for the fund’s board of directors to determine."
"The SEC is concerned that boards are not being provided with enough information to make a critical determination as to whether an intermediary’s fee is in some way tied to distribution."
There are a number of conclusions boards may arrive at, each resulting in different action from the fund or adviser:
All fees are for distribution. If the board determines that the entire supermarket fee paid by the fund is for distribution-related services, they should all be paid pursuant to the 12b-1 Plan.
Some fees are for distribution. The board may determine that only a portion of the supermarket fee is for distribution, with the remainder being used for non-distribution services. In such a case, the portion being used for distribution must be paid pursuant to the 12b-1 Plan. However, the fund is not yet off the hook for those fees ostensibly paid for non-distribution services. The board will need to determine whether those fees are "reasonable" in relation to 1) the value of the services and the benefits received by the fund and its shareholders, and 2) the payments that the fund would have been required to make to another entity to perform the same services, the SEC staff said in its interpretive letter.
None of the fees are for distribution. This would mean that none of the fees would need to be paid pursuant to the 12b-1 Plan, but the SEC staff wants the board to be absolutely sure. The board "would need to satisfy itself that its determination was supported by all factors relevant to its characterization of the purpose of the services," it said in the letter, and then provided a list of such factors, including the nature of the services provided and whether the services provided distribution benefits. Perhaps just to make sure the board recognizes the questions the agency will place on such a determination, the letter states that "in future examinations, OCIE staff will closely scrutinize the analysis conducted by such a fund’s board of directors."
Fees are paid by the adviser. The SEC staff wants to ensure that advisory fees do not contain a built-in payment for distribution. "When an adviser finances the distribution of fund shares, the directors of the fund … must satisfy themselves either that the management fee is not a conduit for the indirect use of the fund’s assets for distribution, or that the fund has not complied with Rule 12b-1." If the adviser pays the supermarket fee from its own resources, it does not count as a violation. "It is appropriate to … view such expenditures as having been made from the adviser’s profits under the contract," the SEC staff said. The board, however, must ensure that such profits are not excessive. If they were, it would again raise questions as to whether they contained hidden distribution payments.
What to do now
Given the SEC’s increased attention under its Distribution in Guise initiative and the lack of any significant additional guidance since the 1998 interpretive letter, advisers and funds should consider the following steps:
Review all material intermediary agreements. "These relationships are complex and often have several agreements and amendments covering several years touching on several fee buckets," Rosenberg said. "Advisers must be able to identify the fees paid for each service and assess their appropriateness and reasonableness."
Remove sales leadership from fee negotiations. Sales executives have no business negotiating fees for non-distribution services with supermarkets. "The perceived conflict here is great. There is a huge risk in having such individuals discuss sub-transfer agent and administrative service fees as they are simultaneously attempting to improve access and distribution for the funds," Rosenberg said.
Make clear disclosures to boards and investors. "Advisers must disclose the substance and breadth of the services each fee encompasses to mutual fund boards during the annual 15c process," Rosenberg said. Browder said such disclosures must include the nature of the services provided, whether these services provide any distribution benefits, and what other intermediaries charge for similar services.
Implement appropriate policies and procedures for the adviser, funds, distributor and transfer agent to control this process. "There must be appropriate controls in place at each entity in the fund complex to monitor and mitigate these conflicts," Rosenberg said.