The SEC’s Division of Investment Management recently released a Guidance Update entitled Mutual Fund Distribution and Sub-Accounting Fees. The update follows the Office of Compliance Inspections and Examination’s Distribution in Guise initiative and a settled action against a fund for allegedly improperly paying for distribution outside of a 12b-1 plan. The guidance notes that the potential for sub-accounting fees to be used for distribution arises “when the recipient of payments for services also finances distribution,” and such situations require “relevant input from the fund’s adviser and other relevant service providers and the informed judgment of the fund’s board.” The guidance uses the term “sub-accounting fees,” but notes that these fees may include subsub-transfer agent, administrative, sub-accounting, and other shareholder servicing fees.
The Division recognizes that “mutual fund boards are typically not involved in the day-today negotiation of agreements with intermediaries” and thus that “boards should be able to rely on the adviser and other relevant service providers to affirmatively provide information about the existence of any of these activities or arrangements, as well as summary data about expenses and activities related to distribution-related activities.” As a result, “the board’s role should focus on understanding the overall distribution process as a whole to inform its reasonable business judgment about whether sub-accounting and other mutual fund-paid fees represent payments for distribution, in whole or in part.” The staff also acknowledges that many fund groups have agreements with a large number of intermediaries and may have multiple agreements with the same intermediary. As a result, the guidance does not require directors to review each individual agreement; instead, boards could “have the adviser or relevant service providers furnish information in such a way that allows fund directors to understand the relevant conflicts and the general context within which the arrangements are made, as well as the specific details of atypical or particularly significant arrangements.”
The guidance recommends that boards have a process for evaluating payment of sub-accounting fees regardless of whether the fund has a 12b-1 in place because “in the absence of any such process, it is unclear how a board might make an informed judgment regarding the use of fund assets for distribution and the fund’s compliance with rule 12b-1(a).” The Division notes that the 1998 “supermarket letter” “may serve as a useful framework in establishing a process for a mutual fund board to evaluate whether a portion of fund-paid sub-accounting fees is or is not being used to pay directly or indirectly for distribution.” However, a board may also want to request additional information from the adviser and service providers, including:
- information about the specific services provided under the mutual fund’s sub-accounting agreements;
- the amounts being paid;
- if 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 the board evaluates the quality of services being delivered to beneficial owners (to the extent of its ability to do so).
Where a board establishes a “cap” on allowable sub-accounting fees based on what the fund would otherwise pay its transfer agent or an estimate of industry surveys or benchmarks, the guidance cautions that boards should “carefully evaluate” such benchmarks and consider economies of scale and differences in the “type and amount of services provided.” As a result of varying arrangements with intermediaries, different fee caps or payment rates may be appropriate, according to the guidance. The guidance also suggests that funds should have related compliance policies and procedures in place in order to satisfy rule 38a-1.
The adviser and relevant service providers should “provide sufficient information to inform the board of the overall distribution and servicing arrangements of the fund,” including “payment flows from relevant fund service providers,” and “information sufficient for them 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 rule 12b-1 plan.” Absent such information, “it would be difficult to make an informed judgment as to whether certain payments by the mutual fund are for distribution, despite ostensibly being characterized otherwise, and to assess conflicts of interest.”
To aid directors in the task of reviewing payments, the Division provides a list of six “indicia” for distribution-related payments. Where a fund does not have a 12b-1 plan, the fund’s board “may wish to inquire further regarding how fund distribution expenses, if they exist, are paid.” For those funds that do have 12b-1 plans, the staff flagged tiered payment structures (those in which intermediaries are first paid from 12b-1 fees, then sub-accounting fees, then from revenue sharing) for further review. Such structures “raise questions as to what services the mutual fund actually is 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.”
According to the guidance, boards also should keep an eye out for intermediaries that “condition providing certain 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.” The guidance also recommends that boards be cautious of situations in which the adviser and other service providers consider distribution benefits when considering sub-accounting fees, including when employees with primary responsibility for distribution are included in the sub-accounting fee determination.
The staff notes that agreements in which services are bundled and descriptions suffer from a lack of specificity as to the services provided raise distribution-related concerns. The guidance cautions that an approach considers whether the overall payment for bundled services is primarily for distribution-related services would be flawed because “if any specific identified activity or service in that bundle is distribution-related, any payments for such identified activities or services must be paid for through a 12b-1 plan, if paid from mutual fund assets.”
The guidance recommends that boards consider disparities across intermediaries and whether such disparities are due to competitive pressures or differences in the level of services provided, or are actually payments for distribution-related services. The staff specifically highlights situations in which “higher payments for the services are being paid to the mutual fund’s newest, largest, or fastest-growing distribution partners in light of the possibility that the fees may incorporate distribution payments as part of the higher payments.”
Lastly, the guidance suggests that boards “carefully consider” whether the sale of “information about the demographics of fund investors and other information about top sales partners and channels to obtain better understanding of them” is distribution-related.
The Division also notes that section 36(b) applies to payments to any affiliated person of the adviser and thus the staff believes that situations in which funds pay fees to affiliated entities that then in turn make distribution payments are subject to “the same analysis . . . as boards would use when they evaluate potential distribution aspects of compensation and payments to an adviser as part of the section 15(c) process.”