United States: SEC Issues Long-Awaited Distribution And Sub-Accounting Guidance

 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.