The staff of the U.S. Securities and Exchange Commission (SEC) Division of Investment Management (Staff) published a Guidance Update on January 6, 2016 related to mutual fund distribution and sub-accounting fees.1 In the Guidance Update, the Staff articulates its views regarding potential issues implicated by open-end investment companies registered under the Investment Company Act of 1940 (funds) paying fees to financial intermediaries for furnishing shareholder and recordkeeping services (sub-accounting fees) to omnibus and networked shareholder accounts.2
The Guidance Update provides several Staff recommendations with respect to the oversight responsibilities of a fund’s board of trustees (board) – as well as related information to be provided periodically to the board – in connection with its consideration of whether a portion of sub-accounting fees are for services primarily intended to result in the sale of fund shares (distribution or distribution-related activity). The Staff’s focus on these board oversight and reporting matters stems from the Investment Company Act’s prohibition, pursuant to Section 12(b) and Rule 12b-1 thereunder, against the use of a fund’s assets to pay distribution-related expenses other than in accordance with a plan of distribution meeting the requirements of Rule 12b-1 (a 12b-1 Plan).
In the Guidance Update, the Staff expresses its belief that 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. In light of the Staff’s concerns regarding the potential mischaracterization of fees as well as the potential for the inappropriate use of fund assets and the prohibition of Rule 12b-1, the Guidance Update sets forth the following recommendations, which are discussed in more detail below:
- Regardless of whether a fund has, or is considering adopting, a 12b-1 Plan, boards should have a process in place reasonably designed to evaluate whether a portion of sub-accounting fees is being used to pay directly or indirectly for distribution.
- As part of this process, advisers and other relevant service providers should furnish sufficient information to inform the board of the overall picture of intermediary distribution and servicing arrangements for the 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.
- 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.
In the Guidance Update, the Staff states that funds should develop and implement adequate policies and procedures for reviewing and identifying any payments that may be for distribution-related services that are not paid through a 12b-1 Plan, and even funds that have not adopted a 12b-1 Plan should have policies and procedures reasonably designed to prevent violations of Rule 12b-1.
In recent years, the SEC’s Office of Compliance Inspections and Examinations (OCIE) identified payment of sub-accounting fees as an examination priority. OCIE conducted sweep examinations of funds, investment advisers, broker-dealers and transfer agents, in which OCIE specifically reviewed the payments made by funds and investment advisers to intermediaries that distribute or promote fund shares.3 The Staff acknowledges that these so-called “distribution-in-guise” examinations brought into focus many of the issues discussed in the Guidance Update and highlighted the need to clarify and update its existing guidance. The Staff recognizes the increase in omnibus account and sub-accounting service arrangements in recent years, noting that intermediaries now perform many of the services for fund investors whose shares are held in an omnibus account, which were historically provided by transfer agents. As a result, funds (or their services providers) commonly enter in arrangements with intermediaries for the provision of these services and the payment of sub-accounting fees. The Guidance Update acknowledges that these arrangements often vary, with different levels of services and sources of payments (e.g., inside or outside of a Rule 12b-1 Plan or a fund’s investment adviser, distributor or transfer agent).
The payment of sub-accounting fees, particularly to intermediaries that distribute fund shares, may implicate Section 12(b) and Rule 12b-1, which together make it unlawful for a fund to directly or indirectly finance any activities that are primarily intended to result in the sale of fund shares outside of a 12b-1 Plan. Citing the 1980 adopting release for Rule 12b-1, the Guidance Update highlights that this prohibition “applies not only to payments that are clearly identified as distribution fees, but also to payments that are ostensibly made for some other purpose, but which, based on the facts and circumstances, are used in ways that finance distribution.”4
Board Process and Oversight
Staff Recommendations for Oversight and Reporting Framework
The Guidance Update notes that fund trustees have substantial oversight responsibilities, including the oversight of the reasonableness of fees paid out of fund assets and the relationships between funds and their service providers, approving various fund contracts and addressing potential conflicts of interests. In the context of financing distribution and compensating intermediaries for providing various services to fund shareholders, the SEC has taken the view that trustees bear substantial responsibility for determining whether fees paid by a fund are for distribution.5 The Staff believes that there is a potential for sub-accounting fees to be used to finance distribution, which is most likely to arise when the sub-accounting fees compensate intermediaries that are also involved in the distribution of fund shares. Although the SEC has acknowledged that there can be no precise definition of what types of expenditures constitute an indirect use of fund assets,6 it is the Staff’s view that the board’s responsibilities require relevant input from the fund’s adviser and other relevant service providers, as well as the informed judgment of the fund’s board.
The Staff recommends that fund boards have a process in place reasonably designed to assist them in evaluating whether a portion of fund-paid sub-accounting fees, if paid to intermediaries that distribute fund shares, is being used to pay directly or indirectly for distribution. The Staff states that this recommendation is applicable regardless of whether a fund has, or is considering adopting, a 12b-1 Plan. In addition, the Staff recommends that advisers and relevant service providers furnish, or arrange for the provision, to boards any necessary information to assist boards in this evaluation process in order to address conflicts of interest in the establishment or subsequent increase or decrease of sub-accounting fees.
As noted by the Staff, many boards already have established processes intended to assist them in making a determination as to whether sub-accounting fees are being used to pay for the distribution of fund shares. Although these processes may take a variety of forms, the Staff referred to the factors and analysis described in the 1998 “Fund Supermarkets” no-action letter.7 The Staff considers these factors and analysis as potentially useful in developing a framework for a board to evaluate the character of sub-accounting fees (i.e., whether or not the fees are directly or indirectly being used to finance distribution). In addition, the Staff notes that boards might consider requesting information regarding, among other things:
- 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).
The Staff also recommends that advisers and relevant service providers affirmatively provide information to the board regarding whether the activities or arrangements described below in the section entitled “Indicia that a Payment May be Used to Pay for Distribution” occur. If such activities or arrangements occur, the Staff recommends that “the board closely scrutinize the appropriateness and distribution character of such payments as part of its evaluation.” However, the Staff notes that none of these situations alone necessarily demonstrates that a payment made from fund assets outside of a 12b-1 Plan is for a distribution-related activity.
In addition, the Staff recommends that boards have a process in place that is reasonably designed to provide them with enough information that they can make an informed judgment as to whether sub-accounting fees are being used to pay directly or indirectly for distribution. Although the Staff recognizes that there are a number of reasonable approaches that boards may take in establishing such a process, the Staff states that 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.
Sub-Accounting Fee Caps
The Staff notes that some boards have established fee caps for sub-accounting fees, which are often based on fees that a fund would otherwise pay its transfer agent for the sub-accounting services performed by the intermediary or on industry surveys or benchmarks. However, the Staff cautions that fees paid to transfer agents may differ from the fees the fund might pay for the same services obtained elsewhere, suggesting that a board may wish to take such information into account during its fee cap evaluation process. The Staff recommends that, if a board imposes sub-accounting fee caps, the board should carefully evaluate any benchmark used in establishing the cap, and may wish to consider whether any benchmarking rates reflect relevant economies of scale and involve comparable type and amount of services. In this regard, the Staff notes that boards may wish to consider different payment rates or fee caps to intermediaries depending on the types of services provided to the fund.
Providing Boards an Overall Picture of Distribution and Servicing Arrangements
As noted in the Guidance Update, Rule 12b-1 requires that a board request, and certain parties furnish, any information reasonably necessary to make an informed determination of whether to implement or continue a 12b-1 Plan.8 With respect to this determination, the Staff recommends that the adviser and other relevant service providers furnish sufficient information to inform the board of the overall distribution and servicing arrangements of the fund, including payment flows from relevant fund service providers that would be relevant to this facts and circumstances analysis. In addition, the Staff recommends that boards be provided information sufficient for trustees to evaluate whether and to what extent sub-accounting fees may reduce or otherwise affect advisers’ or their affiliates’ revenue sharing obligations, or the level of fees paid under a 12b-1 Plan. In the Staff’s view, this information is likely to be relevant to a board’s determination as to the distribution character of sub-accounting fees and may be relevant to its evaluation of whether to implement or continue a 12b-1 Plan.
Indicia that a Payment May be Used to Pay for Distribution
In the Guidance Update, the Staff explains that certain activities or arrangements observed during the “distribution-in-guise” examinations may raise concerns that sub-accounting fees (or a portion of such fees) are financing distribution, particularly when the fees flow to intermediaries that distribute fund shares. Although none of the following situations may, by itself, demonstrate that a payment made from fund assets outside of a 12b-1 Plan is for a distribution-related activity, the Staff provides the following examples that, in its view, raise questions as to whether sub-accounting fees may be for distribution:
- Distribution-related activity is conditioned on the payment of sub-accounting fees.
- Financing of distribution in the absence of a 12b-1 Plan.
- Intermediary arrangements that provide for a number of services (which may include distribution-related activities) are paid for via tiered payment structures (i.e., payments often are first made from Rule 12b-1 fees, then sub-accounting fees, and finally any balance is paid by the adviser or an affiliate from revenue sharing).
- Lack of specificity of services or bundling of services into a single contract.9
- Distribution and sales benefits 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 for substantially the same set of services.
- Sale of data regarding the demographics of fund investors and other sales-related information to funds, advisers and service providers.
The Staff made clear that boards should be able to rely on the adviser and other relevant service providers to furnish relevant information and summarize data about distribution-related activities and corresponding expenses, as well as receive and rely on the assistance of outside counsel and a fund’s chief compliance officer.10 For example, the Staff recommends that advisers and relevant service providers furnish information to boards generally about the personnel responsible for negotiating sub-accounting fees, as well as the process for, and considerations taken into account in, approving such fees, with the intention of informing the board’s fee approval evaluation process. As intermediaries may offer to sell additional “strategic sales data” to funds, their advisers or other relevant service providers, the Staff recommends that boards carefully consider the extent to which any payments for such sales data are distribution-related, and thus should be paid pursuant to a 12b-1 Plan or revenue sharing arrangement with an adviser or relevant service provider.
When funds pay fees to affiliates of the adviser, which in turn make payments for distribution out of their own resources, the Staff believes that boards should apply the same analysis that they would use when evaluating potential distribution aspects of compensation and payments to an adviser as part of the contract review process consistent with Section 15(c) of the Investment Company Act.11 The Staff notes that this evaluation should be made by the board in its reasonable business judgment based on the facts and circumstances and the information provided by the adviser and other relevant service providers.
To address the risk that a portion of sub-accounting and other fees paid from a fund’s assets may, directly or indirectly, finance distribution-related activities in violation of Section 12(b) of the Investment Company Act and Rule 12b-1 thereunder, the Staff articulates a number of recommendations in the Guidance Update. Although the Staff notes that the considerations set forth in the Guidance Update are not dispositive as to the value or appropriateness of fees paid to intermediaries or their proper characterization, boards and advisers should consider incorporating the Staff’s recommendations into their evaluation and reporting processes, to the extent applicable.
1) IM Guidance Update No. 2016-01, Mutual Fund Distribution and Sub-Accounting Fees (Jan. 6, 2016). This OnPoint summarizes the Guidance Update, and in some instances tracks the Guidance Update without the use of quotation marks.
2) For purposes of the Guidance Update, sub-accounting fees generally refer to sub-transfer agent, administrative, sub-accounting and other shareholder servicing fees. The Guidance Update identifies the following services, among others, as specific examples of these shareholder and recordkeeping services: communicating with customers about their fund holdings; maintaining their financial records; processing changes in customer accounts and trade orders; recordkeeping for customers; answering customer inquiries regarding account status and the procedures for the purchase and redemption of fund shares; providing account balances and providing account statements, tax documents, and confirmations of transactions in a customer’s account; transmitting proxy statements, annual reports and other communications from a fund; and receiving, tabulating and transmitting proxies executed by customers.
3) In September 2015, the SEC settled an enforcement action resulting from one of these OCIE examinations. Investment Company Act Rel. No. 31832 (Sept. 21, 2015) (stating that fund assets were used to pay for distribution and marketing services outside of a 12b-1 Plan and that the respondents therefore did not bear the additional distribution and marketing expenses not covered by the 12b-1 Plan, as had been disclosed).
4) Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Rel. No. 11414 (Oct. 28, 1980) [45 FR 73898 (Nov. 7, 1980)].
7) 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). The Guidance Update states that the Fund Supermarkets letter articulated the Staff’s view that if a board determines that a portion of a fee paid by a fund is for distribution-related activities and a portion is for non-distribution-related activities, the board should determine whether the portion of the fee that the fund pays for non-distribution-related activities is reasonable in relation to (a) the value of those services and the benefits received and (b) the payments that the fund would be required to make to another entity to perform the same services. In connection with this determination, the Fund Supermarkets letter provides that the board should consider (1) the nature of the services provided; (2) whether the services provide any distribution-related benefits; (3) whether the services provide non-distribution-related benefits and are typically provided by fund service providers; (4) the costs that the fund could reasonably be expected to incur for comparable services if provided by another party, relative to the total amount of the fee; and (5) the characterization of the services by the intermediary.
8) The Staff also notes that advisers have a fiduciary duty to either eliminate relevant conflicts of interest, or to mitigate and disclose the conflict. The Staff believes that this fiduciary duty requires advisers to either to refrain from recommending the payment of mutual fund assets for distribution or to provide complete information to the mutual fund directors so that they can evaluate the conflict, and determine whether the payment should be made pursuant to a 12b-1 Plan.
9) 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. In addition, the Staff articulates its view that it is inconsistent with the requirements of Rule 12b-1 for a board to evaluate whether the overall payment for for a bundled set of services or activities is a payment that is primarily for distribution-related services, because the use of fund assets to pay for any activity that is primarily intended to result in the sale of fund shares must be paid inside a 12b-1 Plan (i.e., any specified distribution-related activity must be paid under a 12b-1 Plan, if paid from fund assets).
10) Given the number and variation of fund intermediary arrangements, the Staff suggests that boards may wish to request that relevant information be provided in a clear and concise manner and that information be furnished in such a way that allows trustees to understand the relevant conflicts and the general context of the arrangements, with specific details as appropriate.
11) The Staff notes that such payments would also be subject to Section 36(b) of the Investment Company Act, which applies not only to payments made to a fund’s adviser, but also to payments made to any affiliated person of the adviser.