Introduction. In an order (Order) dated September 21, 2015, the Securities and Exchange Commission (SEC) settled administrative proceedings against an investment adviser to a mutual fund and its affiliated distributor, charging that the adviser and distributor improperly used fund assets to pay for the marketing and distribution of fund shares. In the Order, the adviser and distributor agreed to pay nearly $40 million in combined disgorgement, prejudgment interest and civil monetary penalties, and the distributor agreed to retain an independent compliance consultant. The Order represents the first enforcement action brought under the SEC’s Distribution-in-Guise Initiative, a recent SEC initiative aimed at detecting and remediating the practice of unlawfully using fund assets to pay for distribution.
SEC Allegations. In the Order, the SEC alleged that:
- registered investment adviser First Eagle Investment Management, LLC (First Eagle) and its wholly-owned broker subsidiary, FEF Distributors, LLC (FEF), caused the First Eagle Funds (the Funds) to make improper payments of approximately $25 million out of the Funds’ assets to two financial intermediaries for distribution-related services over a period of nearly six years (from 2008 until 2014);
- the distribution payments were not made pursuant to a written plan under Rule 12b-1 (discussed below), and were not made out of First Eagle’s own assets (known as “revenue sharing”);
- the agreements (detailed below) with the two financial intermediaries were made to obtain the intermediaries’ distribution and marketing services, but First Eagle and FEF treated the agreements as though they were for sub-transfer agency (sub-TA) services and improperly used the Funds’ assets to pay the intermediaries for distribution and marketing;
- First Eagle inaccurately reported to the Funds’ board of trustees (the Board) that the distribution and marketing fees paid to the intermediaries were sub-TA fees; and
- the Funds’ prospectus disclosures also inaccurately stated that FEF or its affiliates were bearing distribution expenses not covered by the Funds’ Rule 12b-1 plan.
Rule 12b-1. Rule 12b-1 under the Investment Company Act of 1940 provides the only means for mutual funds to compensate brokers and other financial intermediaries out of fund assets for services those intermediaries provide to shareholders related to the distribution of fund shares. Rule 12b-1 requires, among other things, that such compensation be paid pursuant to a written plan that (i) is approved and renewed annually by the fund’s board and (ii) provides that it may not be amended to materially increase the amount spent for distribution without shareholder approval. Rule 12b-1 fees are reflected in a fund’s expense ratio and disclosed as a separate line item in the fee table near the front of the fund’s prospectus.
Provisions of Agreements with the Financial Intermediaries. According to the Order, the terms of the agreements with the two financial intermediaries in question expressly provided for distribution and marketing services. For example, one agreement was called a “Selected Dealer Agreement” and stated in its opening paragraph that the financial intermediary was invited to “become a selected dealer to distribute shares” of the Funds. Another agreement was called a “Correspondent Marketing Program Participation Agreement” under which the intermediary agreed to “market the Funds on [the intermediary’s] internal website” and “invite the Funds to participate in special marketing promotions and offerings to correspondent broker-dealers.” Moreover, the intermediaries received compensation under the agreements based on the amount of shares sold by the intermediary.
Adviser and Counsel Communications with the Funds’ Trustees. According to the Order, First Eagle periodically consulted with its outside counsel and reported to the Board regarding payments for distribution and sub-TA services. In those reports, the fees paid by the Funds under the agreements described above were inaccurately included as sub-TA fees. In 2008, First Eagle also engaged outside counsel to review its practices with regard to payments for sub-TA services and shared the results of that review (which indicated all fees paid to the two financial intermediaries, including those under the Selected Dealer Agreement and Correspondent Marketing Program Participation Agreement, were for sub-TA services) with the Board. Notably, the Order did not name any Board members, presumably because First Eagle misled the Board as to the payments being for sub-TA services and the trustees relied in good faith on the reports received from First Eagle and outside counsel.
Conclusion. While it appears to be a relatively straightforward case for the SEC to bring (given the plain terms of the agreements, it is hard to disagree with the SEC that the payments were for distribution, not sub-TA, services), the Order serves as a reminder to fund boards, advisers and distributors that they must continue to review and monitor the use of fund assets characterized to be for sub-TA services to make sure that the services do not include any distribution-related services.