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News September 28, 2015 Issue

First Distribution-in-Guise Settlement Leaves Adviser $40 Million Poorer

The SEC has been saying that it would crack down on advisers it believed were using fund dollars to pay for distribution services. Now it has made good on that promise, with a mutual fund adviser and its affiliated distributor agreeing to pay nearly $40 million to settle the charges.

Adviser First Eagle Investment Management and FEF Distributors, while neither admitting nor denying guilt, on September 21 settled charges with the SEC that they used money from funds to make payments to two financial intermediaries for distribution-related services, according to the administrative order instituting the settlement. "The distribution payments were not paid pursuant to a written, approved Rule 12b-1 plan, and were not paid by First Eagle out of its own resources," the agency said.

The Commission sees the use of fund money to pay for distribution services as a conflict of interest, as the adviser is spared the expense of paying for distribution services, but would benefit if the distributions result in an increase in the fund’s assets and a resulting increase in advisory fees.

"This case may have a broad impact on the industry," said Morgan Lewis partner John McGuire, noting that it followed a sweep exam into similar cases that the SEC conducted.

Investment Company Act Rule 12b-1 was created in 1980 to address this problem. It allows advisers to use fund expenses to pay for distributions, but only if a 12b-1 plan is adopted. Such a plan requires, among other things, that the fees paid for distribution are disclosed in fund prospectuses as a separate line item in their fee tables, that funds disclose certain information about the fees when describing their distribution arrangements in their prospectuses, and that the plan be approved by both a fund’s shareholders and board of directors, including a majority of the independent directors.

"First Eagle and FEF inappropriately used money belonging to the shareholders of the fund to pay for services clearly intended to market the funds and distribute their shares," said SEC Division of Enforcement director Andrew Ceresney. "Unless part of a 12b-1 plan, the firm should bear those costs, not the shareholders."

"Mutual fund advisers have a fiduciary duty to manage the conflict of interest associated with fund distribution, namely whether to use their own assets or to recommend to their fund’s board to use the fund’s assets to distribute shares," said Enforcement Division Asset Management Unit co-chief Julie Riewe.

Not all that new?

One might question, however, whether this settlement does, in fact, break new ground. "When the SEC first launched the Distribution-in-Guise initiative in 2013, one concern from mutual fund advisers was that the Enforcement Division would engage in so-called ‘rulemaking by enforcement’ in which enforcement actions would be used in the place of rulemaking to set forth SEC expectations," said Zaccaro Morgan partner Nicolas Morgan. "For example, would the SEC second guess judgment calls about prices paid for bundles of services provided by brokerages to fund firms, perhaps alleging that some portion of the bundle was ‘overpriced’ in order to mask improper payments for distribution?" However, he said, "In this first action, the SEC did not venture into such potentially gray areas."

Instead, Morgan suggested, "the SEC’s allegations were consistent with its long history of alleging that adviser representations to investors differ from actual practice. Specifically, the fund distributor’s agreements with brokers called for the payment of distribution and marketing services by the funds outside of a Rule 12b-1 plan – despite the fact that the funds’ prospectuses stated to investors that the distributor would bear such distribution expenses. An enforcement action based on such a divergence between representation to investors and actual practice does not break new ground."

Stern Tannenbaum partner Aegis Frumento noted that the case "illustrates once again that in the Advisers Act arena, disclosure really is the name of the game. The harm here is not at all that mutual fund assets were used to pay distribution expenses, but that those payments were not approved in the funds 12b-1 plans or disclosed in the funds’ prospectus. If you consider that the disclosures actually said that fund assets would not
[emphasis Frumento] be used to pay distribution expenses, then it's no surprise that contrary conduct would lead to a violation."

How it worked

FEF, a wholly owned broker-dealer subsidiary of First Eagle, served as the funds’ principal underwriter and distributor. The funds themselves were set up as a trust and registered with the SEC as an open-end diversified investment company, the administrative order said. From January 2008 through March 2014, when the improper activity was alleged to have occurred, up to seven funds were in the trust.

Financial intermediaries are often used to provide distribution and shareholder services to mutual funds. The SEC said that FEF had arrangements with two intermediaries, which it identified as Intermediary One and Intermediary Two.

Under an agreement it had with Intermediary One, FEF allowed the intermediary to distribute shares of the funds, the SEC said, and specifically listed marketing as among the contractual services that would be provided. Under the agreement, the funds would pay a one-time fee of $50,000, 25 basis points of total new gross sales of any shares of any class sold by Intermediary One, and 10 basis points of the value of fund shares sold by Intermediary One that are held for more than one year. These fees were in addition to any 12b-1 plan fees paid to the intermediary by the funds, the SEC said.

"First Eagle and FEF caused the funds to pay total fees of approximately $24.6 million to Intermediary One …," the agency said. "The services to be provided … were generally marketing and distribution, not sub-TA services," which the agency said were covered by a separate agreement with Intermediary One.

As for Intermediary Two, FEF entered into a marketing agreement with it in 2007, although the SEC said that the funds had already been paying Intermediary Two for "substantially the same services" since 2005. The specific services that the agency said were required by Intermediary Two under the agreement included providing email distribution lists of correspondent broker-dealers that had requested sales and marketing concepts from Intermediary Two, marketing the funds on its internal web site, and inviting the funds to participate in special marketing promotions and offerings.

Intermediary Two charged an annual fee of 5 basis points of the net asset value of outstanding shares of the funds it sold, the SEC said, totaling $290,000 for the period from January 2008 through March, 2014.

Violations and penalties

The SEC charged First Eagle with willfully violating Section 206(2) of the Advisers Act, which prohibits fraud, and Section 34(b) of the Investment Company Act, for making an untrue statement of material fact in a registration document. First Eagle and FEF together were charged with having caused the funds to violate Section 12(b) of the Investment Company Act and its Rule 12b-1, for financing the sale of shares outside a 12b-1 plan.

As part of the settlement, First Eagle agreed to pay disgorgement of more than $24.9 million and interest of approximately $2.3 million. First Eagle and FEF together agreed to pay a fine of $12.5 million. The attorney representing the two respondents chose not to comment when contacted.