The Securities and Exchange Commission (“SEC”) recently published guidance on the characterization of mutual fund fees, specifically 12b-1 distribution fees and sub-accounting fees, as part of their ongoing Distribution-in-Guise Initiative. Pursuant to Rule 12b-1 under the Investment Company Act of 1940, payments made by mutual funds (“funds”), to financial intermediaries from fund assets for the distribution of fund shares must be paid pursuant to a Rule 12b-1 plan that has been approved and adopted by the fund’s shareholders and Board of Directors (“Board”). In recent years the SEC has noticed that there are various fees being paid to intermediaries, in addition to distribution fees, that are being characterized as non-distribution-related fees and are not being paid pursuant to a Rule 12b-1 plan. Those fees include sub-transfer agent fees, administrative sub-accounting fees, and other shareholder servicing fees (collectively “sub-accounting fees”).
While these sub-accounting fees may in some cases be valid non-distribution-related fees, if they directly or indirectly compensate at all for any distribution-related activities, they are improperly labeled. Because of the importance of this issue given that fund fees directly impact investor returns and inherently involve conflicts of interest, the SEC has published guidance to assist funds in ensuring that distribution-related fees are being properly labeled and disclosed in a Rule 12b-1 plan as required. This potential problem was brought to the SEC’s attention after a recent sweep examination of various market participants including mutual funds, investment advisers, transfer agents, and broker-dealers.
In order to avoid mischaracterization of fees, the SEC suggests that a fund’s Board should have a reasonably designed process in place to assess whether any portion of these sub-accounting fees are paying directly or indirectly for distribution-related activities. To facilitate this determination, advisers and other fund service providers should provide all relevant information to the Board regarding the distribution and servicing agreements the fund has in place with its various intermediaries. The Board should carefully evaluate the appropriateness and character of each sub-accounting fee based on the facts and circumstances of each case to ensure it is properly labeled as a non-distribution-related fee.
The SEC emphasized that the Board bears substantial responsibility for making this determination using its informed judgment. It noted that the framework established in its 1998 Letter regarding the participation of mutual funds in “fund supermarkets” can be applied and used by Board here as a useful tool in evaluating whether any portion of a sub-accounting fee is being used to pay for distribution. Generally, the 1998 Letter stated that if a certain fee contains a distribution-related portion and a non-distribution related portion, the Board should evaluate whether the non-distribution-related portion is reasonable in relation to: 1) the value of services and benefits received; and 2) payments fund would make to another entity for the same services. Other relevant information Boards should consider include information about specific services provided by sub-accounting arrangements, amounts being paid, any changes to the fee structure, direct or indirect distribution benefits, the method by which adviser and service provider ensure that fees are reasonable, and the method by which the quality of services is evaluated.
The SEC also emphasized that providing the Board with adequate information is a part of an investment adviser’s fiduciary duty to eliminate any potential conflicts of interest or to fully and fairly disclose any potential conflicts of interest and work to mitigate them. In furtherance of this duty, advisers must provide complete information to the Board to allow them to make a fully informed judgement regarding the fee and whether it is distribution-related. The SEC has found that certain activities or arrangements can indicate that a fee is distribution-related despite being labeled as non-distribution-related. These indicia include: 1) conditioning distribution-related service on the payment of a sub-accounting fee; 2) lack of any 12b-1 plan; 3) tiered payment structures that include distribution-related activities; 4) lack of specificity of services provided or bundling of services; 5) sub-accounting fees which take into account distribution benefits; 6) disparities between sub-accounting fees paid to different intermediaries for the same services; and 7) purchase of strategic sales data from intermediaries.
In order to ensure compliance with Rule 12b-1(a) and the SEC’s guidance, funds should make sure they have a clearly delineated procedure in place outlining how they determine whether sub-accounting fees are being used to pay for any distribution-related activities. This written procedure should detail how it ensures the Board receives all the information it needs from fund advisers in order to make an informed determination. The SEC cautions that even funds that have not adopted rule 12b-1 plans should have these policies and procedures in place to ensure that fees are not being improperly characterized in violation of rule 12b-1.
Parker MacIntyre provides legal and compliance services to investment advisers, broker dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Visit our website for more information.