(Article from Registered Funds Regulatory Update, April 2023)
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In a February 2, 2023 Staff Bulletin, the Staff of the Division of Investment Management reminded investment companies and their boards to consider the operation of fee waivers and expense reimbursement arrangements that result in different advisory fees being charged to different share classes of the same fund. The Staff noted that such differential advisory fee waivers could result in cross-subsidization between share classes in violation of Section 18 of the Investment Company Act and Rule 18f-3 thereunder. As a general matter, Rule 18f-3 provides a limited exemption from Section 18 to permit an open-end fund to issue multiple classes of voting stock as long as the fund’s board approves a written plan setting forth the separate arrangement and expense allocation of each class based on a finding that the plan is in the best interests of each class individually and of the fund as a whole. Many open-end funds and closed-end funds operate as multi-class funds in reliance on Rule 18f-3 or pursuant to exemptive relief requiring the fund to comply with Rule 18f-3, respectively.
In the Bulletin, the Staff reminded boards of their independent fiduciary obligations to each share class and stated that advisory fees should generally be the same percentage amount across share classes because shareholders receive the same advisory services regardless of the class they invested. Rule 18f-3 expressly allows expenses to be waived or reimbursed, though in Rule 18f-3’s Adopting Release, the SEC noted that waivers and reimbursements should not become “de facto modifications of the fees provided for in advisory or other contracts so as to provide a means for cross-subsidization between classes.” The Bulletin indicates these fee modifications are permitted on the limited premise that fund sponsors could have achieved the same result indirectly by waiving or reimbursing class expenses (as opposed to advisory fees). According to the Staff, differential advisory fee waivers that are long-term or permanent, without a clearly substantiated purpose, could present a means for cross-subsidization.
While acknowledging that a board’s determination regarding a differential advisory fee waiver will depend on the facts and circumstances, the Staff suggested that the fund’s investment adviser and counsel should help the board to document and consider all relevant factors before making its determination. Specifically, a board may wish to consider whether existing differential fee waivers risk cross-subsidization between classes, such waivers continue to be effective, and alternative fee arrangements would be appropriate. Further, the Staff recommended funds consider the extent to which these considerations and the board’s determination should be disclosed in the shareholder report as part of the discussion of the board’s approval of the fund’s investment advisory contract.
Differential Advisory Fee Waivers, Division of Investment Management Staff Bulletin: (Feb. 2, 2023), available at: https://www.sec.gov/investment/differential-advisory-fee-waivers.