The SEC staff recently issued its examination priorities for 2013.1 One item of interest to retirement market participants is the staff 's intention to focus "on the wide variety of payments made by advisers and funds to distributors and intermediaries." According to the staff, such "payments go by many names and are purportedly made for a variety of services, most commonly revenue sharing, sub-TA, shareholder servicing, and conference support." The staff intends to assess whether the payments are being made in compliance with applicable law, including Rule 12b-1 under the Investment Company Act of 1940 (1940 Act). In other words, the staff will be looking for payments that ostensibly are for non-distribution services but instead are for distribution.
Rule 12b-1 provides the exclusive means by which a mutual fund may pay – directly or indirectly – for distribution of its shares. The rule requires a written plan adopted by the fund's board and approved by its shareholders. The fund must pay for distribution only pursuant to the 12b-1 plan, but it may pay for non-distribution services either pursuant to or outside of the 12b-1 plan. Issues arise if payments outside the plan could be viewed as being made indirectly for distribution.
The SEC staff previously considered similar issues in the context of payments made by a fund, its investment adviser and affiliates of the adviser to sponsors of "fund supermarkets."2 The staff noted that funds participate in supermarkets "to sell more of their shares and to increase assets under management" and concluded that whether payments to sponsors must be made pursuant to a 12b-1 plan depends on "the purpose of the payments and the party making the payment."
The staff took the position that, because of the objective of these arrangements, at least part of the fees paid to a sponsor had to be considered payments for distribution, i.e., "for services that are primarily intended to result in the sale of the fund's shares." The staff acknowledged that part of the fees could be for non-distribution services. It emphasized the responsibility of the fund's board to determine whether the fund was paying, directly or indirectly, for distribution or non-distribution services. In the case of non-distribution services, the staff said that the fund's board should consider the nature of the services, determine whether the fee paid by the fund for them is reasonable in relation to the value of the benefits received and the cost to the fund to obtain the services elsewhere and insure that the fund does not pay for services that duplicate services already being provided.
In considering fees paid by the fund's adviser and its affiliates, the staff referred to earlier SEC guidance regarding whether an advisory fee paid by a fund to its adviser might constitute an indirect payment for distribution by the fund.3 In the view of the SEC, it is impermissible for an advisory contract to serve as a conduit for the indirect payment of distribution expenses outside a 12b-1 plan. This situation could arise, for example, if the advisory fee included an allowance for distribution. The SEC, however, also takes the position that it is permissible for an adviser to use its own resources, including those arising from its legitimate profits under the advisory contract, to pay for distribution of the fund's shares. Legitimate profits are those an adviser derives from advisory fees which, for purposes of the 1940 Act, are "not excessive" in relation to the services rendered. If the fund's board is satisfied that an adviser's distribution payments are being made out of its own resources, it may conclude that the advisory contract is not a conduit for the indirect payment of distribution expenses.
The SEC staff 's current examination priority will focus not only on the purpose of various kinds of payments but also on board oversight of the payments and the adequacy of disclosures made to the board about the payments. This focus can be expected to lead to heightened attention by fund boards to payments for non-distribution services made by funds and by their advisers and affiliates. Those who provide and pay for those services should expect increased scrutiny of their arrangements, including the nature of the services being provided and associated costs and profits.
Footnotes
1 SEC, Office of Compliance Inspections and Examinations, "Examination Priorities for 2013" (Feb. 21, 2013) at 5.
2 Investment Co. Institute (pub. avail. Oct. 30, 1998).
3 1940 Act Release No. 16431 (Jun. 13, 1988).
John Blouch is of counsel to the firm's Investment Management Practice Group and serves as Chair of the Retirement Income Team. John's practice focuses on the federal securities laws and their application to participants in the financial services industry, such as insurance companies, banks, investment companies, investment advisers and broker-dealers, as well as to companies and individuals generally. John regularly advises insurance companies on a wide range of securities-related matters, including registered variable annuity and life insurance products, mutual funds, broker-dealer and investment advisory activities and the use of exempt group variable annuity contracts and mutual fund shares to fund qualified retirement plans. Over the years, John has advised dozens of insurance companies in connection with their variable insurance operations.
Bruce Dunne is of counsel to the firm's Investment Management Practice Group and a member of the Retirement Income Team. He focuses his practice on the registration, reporting, exemptive and other provisions of the federal securities laws, with emphasis on their application to investment companies, including retail and variable insurance products mutual funds, insurance company separate accounts and private investment funds, and to investment advisers.
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