On January 6, 2016, the staff (the “Staff”) of the SEC’s Division of Investment Management published guidance (the “Guidance”) containing the Staff’s views and recommendations relating to mutual fund distribution and sub-accounting fees. The Guidance is an outgrowth of the Staff’s observations from a three-year “distribution in guise” sweep exam of mutual fund complexes, investment advisers, broker-dealers and transfer agents (the “Sweep Exam”) conducted by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) and other offices and divisions of the SEC to identify whether firms were using fund assets to directly or indirectly finance any activities primarily intended to result in the sale of fund shares (“distribution-related activities”) outside of an approved Rule 12b-1 distribution plan (“12b-1 Plan”).
On February 21, 2013, OCIE announced in its list of annual examination priorities that it would begin to focus on payments for “distribution in guise” – i.e., payments purportedly made by a fund for the provision of shareholder services by intermediaries that are at least partially payments for distribution-related activities outside of the framework of a 12b-1 Plan. In conducting the Sweep Exam, the Staff asserted that advisers have inherent conflicts of interest in wanting funds to bear distribution costs to increase assets under management, which would likely increase adviser’s management fee and possibly reduce the revenue share payments the adviser would otherwise be required to pay to financial intermediaries for selling shares of the fund. As a result of the Sweep Exam, the SEC recently brought and settled an enforcement action against a fund’s adviser and affiliated distributor on the grounds that they had caused the fund to pay for certain distribution-related activities outside of a 12b-1 Plan. On January 6, 2016, the Staff issued the Guidance to provide its views on issues that may arise when mutual funds make payments to broker-dealers or other financial intermediaries that provide sub-accounting services for shareholders of the funds.
Rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”) prohibits a mutual fund from engaging, directly or indirectly, in distribution-related activities except pursuant to a 12b-1 Plan. The Guidance reiterates that this prohibition applies not only to payments that are clearly identified as intending to result in the sale of fund shares, but also to payments to financial intermediaries that are ostensibly made for some other purpose, but which, based on the facts and circumstances, are used in ways that finance distribution-related activities.
The Guidance recognizes that, with the proliferation of omnibus accounting, financial intermediaries are increasingly performing services for shareholders that were historically provided by funds and their transfer agents. Examples of such services include shareholder recordkeeping and communications, fund literature distribution, providing shareholder account statements and tax documents and transmitting proxies executed by shareholders. The arrangements with financial intermediaries to provides these services are frequently referred to as “sub-accounting” arrangements or shareholder servicing arrangements, and are often paid for with fund assets outside of a 12b-1 Plan.
In the Guidance, the Staff notes that mutual fund directors generally oversee the reasonableness of fees paid out of fund assets and the relationships between funds and their service providers. The Guidance emphasizes that fund directors bear substantial responsibility for determining whether fees paid by a mutual fund are used to pay for distribution-related activities, and that fund directors should focus on understanding the overall distribution process to inform their reasonable business judgments about whether sub-accounting and other fees paid by a mutual fund represent payments for distribution-related activities in whole or in part.
Principal Recommendations of the Staff
The Guidance provides the following recommendations with respect to mutual fund distribution and sub-accounting fees:
1) Regardless of whether a mutual fund has or is considering adopting a 12b-1 Plan, fund boards should have a process in place reasonably designed to assist them in evaluating whether a portion of fund-paid sub-accounting fees is being used to pay directly or indirectly for distribution-related activities.
2) Advisers and relevant service providers should provide any necessary information to assist boards in this evaluation process, including sufficient information for the board to evaluate whether and to what extent sub-accounting payments may reduce or otherwise affect advisers’ or their affiliates’ revenue sharing obligations, or the level of fees paid under a 12b-1 Plan.
3) Advisers and other relevant service providers should 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 should evaluate the appropriateness and character of those payments with heightened attention.
4) Consistent with the requirements of Rule 38a-1 under the 1940 Act, a fund should have written policies and procedures reasonably designed to prevent the fund from making payments in violation of Rule 12b-1.
Summary of Guidance
Board Process to Oversee Sub-Accounting Fees
The Guidance notes that many fund boards have already established processes for determining what, if any, portion of a fee is for distribution-related activities based on the 1998 letter issued by the Staff regarding mutual fund supermarket fees (the “1998 Letter”). In the 1998 Letter, the Staff expressed the view that if a mutual fund pays a fee for participating in an intermediary-sponsored fund platform, then the fund’s board is responsible for determining what, if any, portion of the fee is for distribution-related services and what portion of the fee is for non-distribution-related services. The Guidance recognizes that the same types of factors and analysis described in the 1998 Letter may be useful, but it notes that some of these factors may not be relevant to sub-accounting fees. The Guidance further notes that boards may also want to request additional information from the advisers or intermediaries, including:
- information about the specific services provided under the mutual fund’s sub-accounting agreements;
- information about the amounts being paid;
- whether the adviser and other service providers are recommending any changes to the fee structure or if any of the services provided have materially changed;
- whether any of the services could have direct or indirect distribution benefits;
- how the adviser and other service providers ensure that the fees are reasonable; and
- how to evaluate (while not specifically stated in the Guidance, presumably in the view of the adviser) the quality of services being delivered to beneficial owners (to the extent of the board’s ability to do so).
Sub-Accounting Fee Caps
The Guidance notes that some boards have implemented sub-accounting fee caps on the total amount of allowable sub-accounting fees to be paid by a fund. In this context, the Guidance notes that boards should carefully evaluate any benchmarks they use to establish such fee caps (e.g., per-account fees paid to a fund’s primary transfer agent), whether the benchmark takes into account relevant economies of scale, and the comparability of the type and amount of services provided in the context of the benchmark versus the context of a financial intermediary providing the sub-accounting services. The Guidance also notes that boards may want to consider the appropriateness of different payment rates or fee caps based on types of services provided to the fund by different intermediaries.
Indicia that a Payment May be Used to Pay for Distribution-Related Activities
The Guidance lists activities that could be indicators that payments to intermediaries are being used, at least in part, to pay for distribution-related activities, and notes that advisers and relevant service providers should affirmatively provide mutual fund boards with information as to whether any of these activities occur. The Guidance notes that a board should closely scrutinize the appropriateness and distribution character of such payments as part of its evaluation. The activities listed were as follows:
- Distribution-related activities that are conditioned on the payment of sub-accounting fees;
- Financing of distribution-related activities by a fund that lacks a 12b-1 Plan;
- Tiered payment structures and whether fund-paid fees reduce or subsidize any fees that the adviser and other relevant service providers might otherwise be responsible for;
- Lack of specificity or bundling of services, which precludes the board’s ability to determine whether specific fees are primarily for distribution-related activities or for sub-accounting services;
- The adviser taking distribution and sales benefits into account when recommending, instituting, or raising sub-accounting fees;
- Large disparities in sub-accounting fees paid to different financial intermediaries, particularly when higher fees are being paid to the mutual fund’s newest, largest, or fastest-growing distribution partners; and
- Fees paid for “sales data” and whether the purchase of such data is related to distribution.
Compliance Policies and Procedures
The Guidance notes that OCIE found that many mutual funds did not have explicit policies and procedures as part of their rule 38a-1 compliance programs designed to prevent violations of Section 12(b) and Rule 12b-1. The Guidance emphasizes that, regardless of whether a mutual fund has adopted a 12b-1 Plan, the fund should have policies and procedures reasonably designed to ensure that payments for distribution-related activities are not being made in violation of Section 12(b) or Rule 12b-1.
 See Letter from Douglas Scheidt, Associate Director and Chief Counsel, Division of Investment Management, Securities and Exchange Commission, to Craig S. Tyle, General Counsel, Investment Company Institute (Oct. 30, 1998), at 10 (“1998 Letter”).