Alert February 19, 2008

California Attorney General and Fund Family’s Adviser and Distributor Agree to End Litigation Related to Revenue Sharing

The California Attorney General announced that it had reached an agreement to end litigation between the state and the distributor for a family of mutual funds and the affiliated adviser to the fund family over revenue sharing arrangements with broker‑dealers selling the funds’ shares (the distributor and adviser being collectively referred to as the “Sponsor”).  The Attorney General had filed suit against the Sponsor alleging that the failure to accurately disclose directed brokerage and revenue sharing arrangements with selling broker-dealers in the funds’ prospectuses violated antifraud provisions of the California Corporate Securities Law.  (In general terms, revenue sharing involves payments by a fund’s adviser and/or distributor to a broker‑dealer that sells the fund’s shares as compensation for the broker-dealer’s efforts on the fund’s behalf, while directed brokerage, now prohibited under the Investment Company Act of 1940, as amended, and FINRA rules, involves an adviser’s directing fund portfolio transactions to a selling broker-dealer for the same purpose.)  For its part, the Sponsor had filed suit against the Attorney General seeking (a) a declaratory judgment that the funds’ prospectus disclosures regarding directed brokerage and revenue sharing practices were accurate and not misleading under federal and state law and (b) an injunction enjoining the Attorney General from commencing or maintaining any enforcement action against the Sponsor on the grounds that any such action was preempted by the National Securities Market Improvement Act of 1996 (“NSMIA”). 

In 2007, the California Court of Appeal for the Second Appellate District, in a reversal of a trial court decision, held that NSMIA did not preempt the Attorney General’s suit (as discussed in the February 6, 2007 Alert).  Subsequently, the California Court of Appeal for the Third Appellate District expressed a similar view regarding NSMIA preemption when it reversed a trial court’s dismissal of an action brought by the Attorney General against a brokerage firm for failure to adequately disclose to investors and potential investors certain revenue sharing arrangements under which the brokerage firm received additional compensation for its sales efforts on behalf of certain preferred mutual fund families (as discussed in the September 18, 2007 Alert).

The terms of the Agreement of Discontinuance (the “Agreement”) between the Attorney General and the Sponsor include payment by the Sponsor of $2.5 million representing the costs and attorneys’ fees incurred by the Attorney General in the lawsuits and investigation.  The Attorney General’s press release announcing the Agreement cited positive changes in the mutual fund industry as a result of regulatory and enforcement action and noted that voluntary measures undertaken by the Sponsor in its sales practices and other areas affecting the fund family had resolved the state’s concerns.  The Agreement noted the following changes in the Sponsor’s sales practices:

  • eliminating the use of correspondent/clearing arrangements in recognition of mutual fund sales and discontinuing the practice of directed brokerage prior to the SEC’s adoption of a rule banning the practice
  • commencing efforts to enhance expense disclosures provided to retirement plan participants
  • committing to enhance fund prospectus disclosure regarding revenue sharing practices
  • developing and implementing a policy to guide and enhance the supervision and oversight of dealer relationship managers’ revenue-sharing activities
  • establishing a distribution oversight committee comprised of several of the fund family’s independent directors that meets at least annually to discuss relevant distribution-related issues affecting the fund industry and the fund family, and with participation from the distributor’s senior management, to review the distributor’s significant business initiatives and financial results

The Agreement also notes the Attorney General’s consideration of the Sponsor’s efforts and undertakings in the area of fund expenses, as follows:

  • the management, Rule 12b-1 and other fees charged to the fund family’s shareholders are in aggregate among the lowest in the industry
  • in 2005, the funds’ adviser began waiving 10 percent of its management fees, resulting in aggregate savings to fund shareholders to date of approximately $1 billion
  • the Sponsor will, at its own expense, proactively encourage the fund family’s shareholders to opt out of receiving paper disclosure documents in favor of receiving those documents electronically, at a potential savings of up to $20 million (the Agreement also provides that, to the extent disclosure documents are printed in the future, they will be printed on recycled paper using soy or other vegetable-based ink)

The Agreement cited the following measures undertaken by the Sponsor regarding director and shareholder education:

  • at its own expense and on a regular basis the Sponsor conducts seminars for the fund family’s independent directors that include sessions designed to assist them in carrying out their governance duties
  • the Sponsor has developed the fund family’s website at its own expense with current expenditures amounting to over $42 million per year
  • the Sponsor provides other services and information to shareholders, including: publishing shareholders’ newsletters ($10 million), underwriting wholesalers’ meetings with shareholders to educate them about basic investment concepts and how those concepts relate to the fund family ($20-30 million), and directly providing or assisting intermediaries in providing shareholder services ($40 million)