On January 6, 2016, the US Securities and Exchange Commission (“SEC”) published a Guidance Update (the “Guidance”) concerning payments made by mutual funds to financial intermediaries that provide shareholder and recordkeeping services for investors in such funds. The Guidance is a product of a three-year sweep exam conducted by the SEC that studied these payments, which are typically classified as sub-transfer agent, administrative, sub-accounting and other shareholder servicing fees (collectively, “sub-accounting fees”).
Background on the SEC Guidance Update
The use by broker-dealers and other intermediaries of omnibus accounts to hold shares of a mutual fund that are owned by a large number of beneficial owners has increased significantly in recent years.
These omnibus accounts reduce the record-keeping burden imposed on the mutual fund’s transfer agent because the financial intermediary performs many of the typical transfer agent services for the beneficial owners who hold their shares through the omnibus accounts. Mutual funds compensate these intermediaries for the services they render through sub-transfer agency or sub-accounting agreements.
A number of offices and divisions at the SEC have raised questions as to whether a portion of payments in respect of sub-accounting fees may have actually been used to pay for activities that are primarily intended to result in the sale of mutual fund shares and to pay for other distribution activities by the mutual fund.
Under Rule 12b-1 of the Investment Company Act (the “1940 Act”), fees paid by a mutual fund for distribution activities must only be paid pursuant to Rule 12b-1, which requires that such fees be paid pursuant to a plan (a “Rule 12b-1 plan”) that has been approved by the fund. Payments of sub-accounting fees that could be re-characterized as fees for distribution activities that are paid outside of a Rule 12b-1 plan would be improper under the 1940 Act.
SEC’s Division of Investment Management staff recommendations
Given the concerns noted above, the staff of the SEC’s Division of Investment Management (the “Staff”) made the following key recommendations in the Guidance:
- Regardless of whether a mutual fund has, or is considering adopting a Rule 12b-1 plan, mutual fund boards of directors should have a process in place that is reasonably designed to evaluate whether a portion of such fund’s sub-accounting fees are being used to pay directly or indirectly for distribution activities. Such process should include instituting explicit policies and procedures as part of the fund’s Rule 38a-1 compliance program.
- As part of this process, 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 activities.
- 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.
Indicia that sub-accounting fees may be used to pay for distribution activities
The Guidance identifies certain activities and arrangements that were observed during the recent sweep examinations that may raise concerns that a payment, though ostensibly not for distribution-related activities, may in fact be (or at least in part) a payment for such services:
- Distribution-related activity conditioned on the payment of sub-accounting fees. Some intermediaries conditioned distribution-related activity (for example, access to wholesalers, distribution through mutual fund supermarkets, or placement on preferred lists) on a fund’s payment or rate increase of sub-accounting fees.
- Lack of a 12b-1 plan. If a fund does not pay distribution expenses through a Rule 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. Some advisers have entered into agreements with intermediaries that provide for payments structured so that any payments are first made from Rule 12b-1 fees, then fund-paid sub-accounting fees, and finally any balance is paid by the adviser or an affiliate from revenue sharing. Such tiered structures raise questions as to what services the mutual fund is actually 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 has observed that in some cases intermediaries have not provided a clear list of services provided in exchange for sub-accounting fees, or payments for both sub-accounting and distribution have been bundled into a single contract. The Staff recommends that any sub-accounting and distribution services be clearly and separately identified and handled appropriately, particularly if bundled into a single arrangement.
- Distribution benefits taken into account. In some cases, the Staff 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.
- Large disparities in sub-accounting fees paid to intermediaries. Certain mutual funds pay, either directly or through the adviser or other relevant service providers, disparate sub-accounting payment rates to intermediaries that may be providing substantially the same set of services to the fund. 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 other relevant service providers, providing information about the demographics of fund investors and other information about top sales partners and channels to obtain better understanding of them.
Given the Guidance and the continued growth in the use of omnibus accounts held by financial intermediaries, mutual fund boards should revisit, and if necessary, update their processes for evaluating the payment of sub-accounting fees, especially fees paid to intermediaries that provide distribution-related services for such fund.