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News January 11, 2016 Issue

Distribution Fees: New Mutual Fund Guidance Clarifies Board and Adviser Roles

It’s the job of a mutual fund’s board of directors to police how shares are sold, and it’s the job of the fund’s adviser to provide the board with sufficient information to make that determination.

That is the essence of the guidance update, "Mutual Fund Distribution and Sub-Accounting Fees," issued January 6 by the SEC’s Division of Investment Management. In it, the SEC staff provides its first guidance on the subject of distribution in guise – fees for fund share sales disguised to look like fees for sub-accounting services – since it issued a 1988 interpretive letter.

What the 15-page guidance spells out in some detail boils down to confirming the responsibility of a fund’s board of directors (or trustees) to ensure that payments for sub-accounting services, such as those to transfer agents, are not used, directly or indirectly, to subsidize sales, also known as distribution, and that it is the responsibility of the adviser to provide the information a board needs.

"The staff recommends that boards have a process in place to evaluate such payments, and that as part of that process, advisers and other service providers provide sufficient information for the board to understand the overall picture of the distribution and non-distribution intermediary arrangements of the mutual fund," the guidance states.

"Overall, this is probably a good thing," said Morgan Lewis partner John McGuire, "good in that it is good to know what the SEC is expecting." But he also noted that this is just one more responsibility "dumped" on fund boards.

But is it enough? While ACA Compliance Group senior principal consultant Jason Rosenberg said he found the guidance to be "fair," he found "one huge problem" with it: The guidance leaves out the broker-dealers that constitute the bulk of the intermediaries. "The broker-dealers will push back and not give the needed information to the advisers, which means the advisers won’t have it to give to the boards," he said. "They are not in the habit of divulging it and won’t do it." Guidance from the Division of Trading and Markets would help, but such guidance has not yet appeared.

The concern behind the guidance

Here’s what the new guidance comes down to: The Division of Investment Management wants to make sure that when mutual funds or advisers pay for distribution, they are doing so in accordance with Investment Company Act Rule 12b-1, commonly known as a 12b-1 plan. The rule, adopted in 1980, was designed to address potential conflicts of interest between a fund and its adviser when a fund pays its own distribution costs.

When a fund pays fees for distribution, that means, in effect, that investors are paying those fees. The SEC doesn’t want investors paying for them, unless through a 12b-1 plan. Otherwise, it is the adviser’s job to pay them.

"Mutual fund fees have a direct impact on investor returns," the guidance says. As an example, it notes that "because investors may evaluate funds based on the specific levels of 12b-1, management and other fees, potential mischaracterization of fees may lead them to invest in funds that they would otherwise not have selected."

The guidance is the latest effort by the SEC under its distribution in guise initiative, which the Division of Enforcement’s Asset Management Unit co-chief Julie Riewe described in a February 2015 speech. The SEC’s Office of Compliance Inspections and Examinations has listed the problem as an exam priority in recent years, and recently concluded a sweep exam of mutual funds and other entities that addressed this issue. The SEC made its first settlement with an adviser involving distribution in guise in September, with the adviser paying $40 million to settle agency charges that it used fund dollars to pay two financial intermediaries for distribution-related services (ACA Insight, 9/28/15).

Specific recommendations

The SEC staff recommends that:

  • Mutual fund boards of directors should have "a process in place reasonably designed to evaluate whether a portion of sub-accounting fees is being used to pay directly or indirectly for distribution;"
  • Advisers and other relevant service providers should "provide sufficient information to inform the board of the overall picture of intermediary distribution and servicing arrangements for the mutual fund, including how the level of sub-accounting fees may affect other payment flows (such as 12b-1 fees and revenue sharing) that are intended for distribution;" and
  • Advisers and other relevant service providers "inform boards if certain activities or arrangements that are potentially distribution-related exist in connection with the payment of sub-accounting fees, and, if they do, boards evaluate the appropriateness and character of those payments with heightened attention."

Red flags

The SEC staff suggested that advisers and others "scrutinize the appropriateness and distribution character" of payments to intermediaries when certain conditions are found, although it added that these conditions by themselves may not necessarily mean there is a problem. Here’s the staff’s red flag list, along with some staff comments on each item:

  • Distribution-related activity conditioned on the payment of sub-accounting fees. "Such conditions may indicate that a portion of the fees paid is for distribution-related services that otherwise would be reduced or eliminated unless the mutual fund or its adviser or relevant service providers agree to the increased fee … ."
  • Lack of a 12b-1 plan. "If a fund does not pay distribution expenses through a 12b-1 plan, sales loads, or otherwise, boards may wish to inquire further regarding how fund distribution expenses, if they exist, are paid."
  • Tiered payment structures. These are arrangements in which certain services are paid before others. Such structures "raise questions as to what services the mutual fund actually is paying for, and whether the use of fund-paid fees reduces or subsidizes any fees that the adviser and other relevant service providers might otherwise be responsible for, which would be a conflict of interest."
  • Lack of specificity or bundling of services. The staff, through its examinations, observed that in some cases, intermediaries did not provide a clear list of services in exchange for sub-accounting fees, or that payments for sub-accounting and distribution were bundled into one contract. "Such lack of specificity of services provided … raises the question as to whether sub-accounting payments are at least in part for distribution."
  • Distribution benefits taken into account. The staff in some cases observed that "distribution and sales benefits were taken into account by the adviser and other relevant service providers when recommending, instituting, or raising sub-accounting fees. …When such employees negotiate sub-accounting fees, it heightens the risk that distribution benefits or services are in part driving the arrangement."
  • Large disparities in sub-accounting fees paid to intermediaries. "While this may be a result of competitive pressures, depending on the facts and circumstances, such disparities in payments for the same services may also indicate that they are payments for distribution-related activities."
  • Sales data. Intermediaries may offer to sell additional "strategic sales data" to mutual funds, their adviser or others. "The staff recommends that boards carefully consider the extent to which any payments for such sales data are distribution-related, and thus should be paid pursuant to a 12b-1 plan or from adviser or relevant service provider revenue sharing."