On Jan. 6, 2016, the staff of the SEC’s Division of Investment Management released long-awaited guidance on mutual fund payments to intermediaries for services to omnibus and networked shareholder accounts.   The guidance reflects the IM staff’s views on a range of payments to financial intermediaries for non- distribution-related services, including sub-transfer agent, administration, sub-accounting and other shareholder servicing fees (the staff call these, collectively, the “sub-accounting fees”). The guidance reaffirms that directors bear a substantial responsibility in approving these arrangements, expands the factors that boards should consider and identifies practices that should prompt greater board scrutiny.

The guidance reflects issues identified during the joint “distribution in guise” sweep examinations of funds, advisers, broker-dealers and transfer agents, conducted by the Office of Compliance Inspections and Examinations in collaboration with IM and other divisions of the SEC. In general, in connection with the increased use of omnibus accounts, financial intermediaries perform more of the services that were  historically provided by transfer agents, and these financial intermediaries have been compensated for these services through a variety of sub-accounting fees. Section 12(b) of the Investment Company Act of 1940, as amended, as implemented by Rule 12b-1 thereunder prohibits the use of mutual fund assets to pay for distribution except under an approved Rule 12b-1 plan, regardless of the label applied to the arrangement. In the guidance, IM advises that while there are permutations of appropriate fund practices, some components are essential:

  • A formal board process.
  • Specific compliance policies and procedures.
  • Regular full and comprehensible disclosure to the fund board about distribution and non-distribution intermediary arrangements.
  • Rigorous board review, especially when intermediaries also provide distribution-related activities.

Board approval

In the staff’s view, a fund’s board should have a process in place reasonably designed to assist the board in evaluating whether any portion of the sub-accounting fees paid by a fund is being used to pay directly or indirectly for distribution even when the payments may be “ostensibly for some other purpose.” This is particularly important where the payment is made to a party that also finances distribution (e.g., the fund’s distributor or an intermediary that distributes fund shares), because the facts and circumstances could reveal that through the arrangement, fund assets are being used to indirectly finance distribution.

According to the staff, the board’s process requires input from the fund’s adviser and other relevant service providers. For the first time, the staff acknowledged that some of the factors in the SEC’s 1998 “Fund Supermarkets” no-action letter, which was the most recognized guidance to date on approving distribution and sub- accounting arrangements, may not be relevant. The staff said that boards do not need to make findings with respect to factors identified in the 1998 letter if they are no longer relevant, and should request information about other issues, such as:

  • Information about the specific services provided under the sub-accounting agreements.
  • The amounts being paid.
  • Whether the adviser and other service providers are recommending any changes to the fee structure, or whether any of the services 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.

The board may also need to consider how it evaluates the quality of services being delivered to beneficial owners and request further information from the adviser or service provider (to the extent practically available).

The guidance does not specify how the board process should be structured, but the staff said that without a process, a board cannot make an informed judgment. The guidance also addressed a few practices observed during the sweep examinations, including:

  • Use of Caps: The staff warned that fees paid to transfer agents may differ from fees paid to intermediaries who provide sub-accounting services, so funds that use a maximum allowable sub- accounting fee cap based on the level of fees that would otherwise be paid to a transfer agent, or based on industry surveys or benchmarks, should carefully evaluate how the cap is established.
  • Fee Comparisons: Boards should carefully consider the services to be received when making fee rate comparisons, and also whether transfer agency fee rates reflect economies of scale. The staff also said that boards should consider whether complexes should have multiple payment rates or fee caps, which could apply to different intermediary arrangements and reflect variations in services provided.
  • Policies and Procedures: According to the staff, all funds should have policies and procedures designed to prevent violations of Rule 12b-1, by reviewing and identifying payments that could be made for distribution-related services, whether or not they have a Rule 12b-1 plan.

An overall picture

The staff said that the board process should include an “overall picture” of a fund’s distribution and servicing arrangements, including payment flows from the service providers, because this “informs” the board’s reasonable business judgment about whether payments are made — in whole or in part — for distribution and permits a board to identify and comprehend potential conflicts of interest. According to the guidance, the adviser has a fiduciary duty to either provide the board with complete information about payments to be made under a Rule 12b-1 plan (directly or indirectly for distribution or non-distribution services) or not recommend that payments be made under the plan.

The staff said that the adviser and any relevant service providers should furnish the boards with information about sub-accounting arrangements and payment flows made in support of a fund’s distribution and servicing activities, including sufficient information for the board to evaluate the extent to which the sub-accounting arrangement reduces or otherwise affects the adviser’s revenue-sharing obligations or the level of fees paid under a Rule 12b-1 plan. This information would be relevant to a board’s determinations as to whether a Rule 12b-1 plan should be implemented or continued. Boards should receive this information in a way that permits them to identify conflicts and understand the general context of the distribution process, including variations in service providers, services and payment rates. Although the staff said that boards can rely on summary information, in certain areas boards should receive specific details, including with respect to “atypical or particularly significant” intermediary arrangements.

Indicia of distribution — “Red Flags”

The guidance lists features that might suggest a particular payment is at least in part for distribution, in which case the adviser and the relevant service providers should provide more information to the board, and the board should especially scrutinize the appropriateness and characterization of the payments:

  • Distribution-Related Activity Conditioned on the Payment of Sub-accounting Fees: When access to wholesalers, distribution through mutual fund supermarkets or placement on a preferred list is offered based on the rate of payment, it suggests that a portion of the fee may be for distribution.
  • Lack of a 12b-1 Plan: When distribution expenses are not paid through a Rule 12b-1 plan (e.g., the adviser or fund distributor subsidizes fund distribution expenses and/or the funds have no Rule 12b-1 plan) and the fund imposes no sales loads, boards should ask how fund distribution expenses, if they exist, are paid.
  • Tiered Payment Structures: Tiered payment structures, including formal or informal “waterfall” arrangements (under which payments for multiple services are made first from Rule 12b-1 fees, then from fund-paid sub-accounting fees and finally from revenue sharing), raise issues about what services are being received for the fund-paid fees, and could create a conflict of interest if the payment structure reduces the amount the adviser or other service provider would otherwise pay.
  • Lack of Specificity or Bundling of Services: There should be a clear list of services provided by an intermediary in exchange for sub-accounting fees, and payments for both sub-accounting and distribution should not be “bundled” under a single contract.
  • Distribution Benefits Taken Into Account: When personnel responsible for distributing fund shares are involved in negotiating sub-accounting arrangements, including recommending, instituting or increasing sub-accounting fees, “it heightens the risk that distribution benefits or services are in part driving the arrangement.” The staff suggested that advisers and service providers should give fund boards detailed information about who is negotiating the fees, the process for negotiation and approval, and relevant internal considerations.
  • Large Disparities in Sub-accounting Fees Paid to Intermediaries: When funds pay disparate sub- accounting rates to intermediaries that are providing substantially the same services, it may indicate that these are distribution-related payments, especially if the higher amounts are paid to a fund’s “newest, largest, or fastest-growing distribution partners.”
  • Sales Data: When an intermediary offers to sell “strategic sales data” reflecting information about demographics of investors or the sales process including sales channels, boards should carefully consider whether these services are distribution-related.

The staff was careful to point out that directors are not expected to be involved in the day-to-day administration of a fund’s distribution arrangements, and that they can rely on the adviser and other service providers to “affirmatively” provide information about servicing arrangements, including summary data about expenses and activities related to distribution.

The staff also noted that Section 36(b), which prohibits the payment of excessive compensation, could be  implicated when an affiliate of a fund’s adviser receives a fee and also makes payments in support of distribution. The staff said that in this scenario, boards should apply the same analysis they use in approving compensation and payments to an adviser under Section 15(c) to consider the distribution-related aspects of the arrangement, which requires a fact-specific determination based on information provided by the adviser and other service providers.

The guidance is Mutual Fund Distribution and Sub-Accounting Fees, IM Guidance Update 2016-01 (January 2016), which is available at https://www.sec.gov/investment/im-guidance-2016-01.pdf.