(Article from Registered Funds Alert, February 2016)
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Following a much publicized industry-wide “sweep exam” in early 2014 focused on mutual fund arrangements with financial intermediaries (as discussed in our prior Alert), the staff of the SEC’s Division of Investment Management (“Staff”) issued a guidance update in January 2016 addressing issues uncovered by the Staff during the sweep exam (“Guidance Update”). The Guidance Update updates and provides additional gloss on earlier Staff guidance in this area, promulgated primarily through the so-called “supermarket” letters from the late 1990s.[1]
At issue in the sweep exam, a subsequent enforcement action and the Guidance Update are mutual fund arrangements with financial intermediaries that allow fund shareholders to invest indirectly through an omnibus platform (instead of directly with the fund). “Direct” shareholders of a fund receive certain services from the fund’s transfer agent, such as account statements and tax documentation.
“Indirect” fund shareholders typically receive such services from their intermediary (“sub-TA services”). In addition to providing sub-TA services to indirect fund shareholders, many intermediaries also offer marketing/distribution support (such as “shelf space,” preferred lists or direct marketing of particular funds) for the funds on their platform.
While a fund is permitted to pay for sub-TA services, Section 12 and Rule 12b-1 under the 1940 Act prohibit a fund from “financing any activity which is primarily intended to result in the sale of shares” of the fund, other than through payments made pursuant to a 12b-1 plan (emphasis added). A Rule 12b-1 plan is a written plan, approved by a fund’s board of directors, stipulating that fund assets, up to a certain amount (typically up to 25 basis points for so-called Class A shares), may be used to pay for marketing or distribution of fund shares. To the extent that a financial intermediary charges fees for marketing/distribution that exceed a fund’s Rule 12b-1 plan, the fund’s adviser must pay the excess out of its legitimate advisory profits. In intermediary arrangements involving the bundling of sub-TA services and marketing/distribution services, a fund’s adviser is tasked, with board approval, with appropriately allocating payments among each category of services. If no part of the bundled fees is paid primarily to compensate the intermediary for marketing/distribution, then allocation typically is not required.
The Guidance Update places heavy emphasis on the duties of advisers to provide, and mutual fund boards to review, adequate information regarding payments made to financial intermediaries. The Staff positions stated in the Guidance Update raise questions of whether advisers and boards need to revisit existing practices with respect to the approval, renewal and oversight of Rule 12b-1 plans.
The Guidance Update states that mutual fund boards need to implement a process that is reasonably designed to evaluate whether a portion of any fees paid for sub-TA services is being used for marketing/distribution. In discussing that process, the Staff reiterated several factors outlined in the supermarket letters and also included certain additional factors beyond the existing guidance. The latter category includes, among other things:
- How sub-TA fee levels may impact other payment flows (such as 12b-1 fees and revenue sharing payments made by the adviser to intermediaries);
- Intermediaries’ use of fees received from a fund for sub-TA services;
- Specific sub-TA services provided to the fund by each intermediary;
- Whether any sub-TA services provided could have direct or indirect distribution benefits;
- Payments received by each intermediary for sub-TA services and other payment flows made to support marketing/distribution for the fund;
- The extent to which payments for sub-TA services may reduce or otherwise impact (i) the expense burden on the fund’s adviser (or its affiliates) and (ii) the level of fees paid under the fund’s Rule 12b-1 plan;
- Which employees of the adviser or intermediaries negotiate the fees to be paid for sub-TA services, whether the primary job of such employees is to distribute the fund and the process for approval of fees for sub-TA services; and
- A comparison of fees paid for sub-TA services among all intermediaries and, if applicable, a comparison of the sub-TA services provided.
Further, the Guidance Update discusses how intermediaries should provide sufficient information to fund boards to enable them to evaluate whether any fund assets are being used for marketing/distribution outside of a Rule 12b-1 plan. These references suggest that a board (and independent board counsel) may wish to consider sending information request letters directly to intermediaries, or request that advisers obtain this information in writing in order to support the board’s determinations on these issues.
The Guidance Update also states that many mutual funds do not appear to have policies and procedures that specifically address compliance with Section 12
and Rule 12b-1. The Staff notes that such policies and procedures should be in place regardless of whether a fund has adopted a Rule 12b-1 plan, as the prohibitions in the statute and the rule would still apply to the fund.
The Guidance Update is notable for several reasons. First, the guidance applies (as does existing guidance prior to the update) only to the purchasers of services, and not the providers (i.e., the financial intermediaries). Without a concomitant obligation on the part of financial intermediaries to provide information that is requested, funds and their boards may remain in the awkward position of having to make judgments with incomplete information. Second, the Staff seems to imply that open-end funds have an effective ban on use of fund assets to pay for distribution even incidentally, essentially reading the words emphasized above (“primarily intended” for distribution) out of the statute. One could imagine intermediary arrangements that are clearly not primarily intended to further distribution that may nonetheless have some distribution component. The Guidance Update does not seem to account for that possibility. Finally, the Staff criticizes a common allocation method in the industry—paying intermediaries out of Rule 12b-1 fees first, then sub-accounting (out of fund assets) and then revenue share—as rife with conflicts of interest. Many industry participants use the current allocation method, and it is well-settled that Rule 12b-1 fees may be used for purposes that are not solely related to distribution. The “tiered payment structure” called into question by the Staff is in most cases, in our experience, reasonable and defensible, since Rule 12b-1 plans and payments out of the adviser’s legitimate advisory profits both cover payments that could be said to be primarily intended to result in the sale of fund shares. Where a distribution plan has been adopted and disclosed, to suggest that a presumption that such plan will be used to actually make distribution payments is invalid is to call into question Rule 12b-1 plans altogether. While the SEC may choose to, and has indeed chosen to in several notable efforts in the past, cast doubt on the current distribution framework used in the industry, we would have thought that the appropriate method for doing so would be to revise its existing rule, instead of questioning well-settled practices in a guidance update not subject to notice and comment.
[1] See, e.g., Investment Company Institute, SEC No-Action Letter (Oct. 30, 1998).