The Securities and Exchanges Commission, SEC, has released guidance describing the steps that fund complexes and their boards can take to ensure that their funds are not paying for distribution from fund assets outside of a rule 12b-1 plan through the mischaracterization of distribution-related payments as sub-transfer agent, sub-accounting or other shareholder service fees.

The guidance comes in the wake of an SEC sweep examination and enforcement action focused on this issue and emphasizes that fund boards should have in place policies and procedures reasonably designed to assist them in determining whether fund-paid sub-accounting fees are being used, directly or indirectly, to pay for distribution. These policies, according to the staff, should be explicit and incorporated into the fund’s rule 38a-1 compliance policies and procedures.

The guidance provides that these policies and procedures should include a robust process for ensuring that the board has received from the adviser and other relevant service providers all the information it needs to determine that the fund isn’t paying for distribution through sub-accounting or other service fees. “In the absence of any such process,” the SEC staff notes, “it is unclear how a board might make an informed judgment regarding the use of fund assets for distribution and the fund’s compliance with rule 12b-1(a).”  The guidance recommends that boards scrutinize in particular any arrangement in which an intermediary receives sub-accounting fees and is also providing distribution services to ensure that all payments are appropriately characterized.  The staff goes on to provide a list of information that the board should request to help it make this determination:

• Information about the specific services provided under the mutual fund’s sub-accounting agreements;

• The amounts being paid;

• If the adviser and other service providers are recommending any changes to the fee structure or if any of the services provided 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; and

• How the board evaluates the quality of services being delivered to beneficial owners.

Additionally, the guidance notes the conflict of interest inherent in an adviser’s recommendation that a fund pay for distribution out of its own assets and provides that an adviser’s fiduciary duty requires that the adviser either refrain from making that recommendation or provide the board with sufficient information to evaluate that conflict of interest and determine whether the payment should be made pursuant to a 12b-1 plan.

To assist the board in making this determination, the guidance recommends that the adviser and relevant service providers furnish the board with information as to how the funds are paying for distribution and whether and to what extent sub-accounting payments may reduce or otherwise affect the revenue sharing obligations of the adviser and its affiliates.  The staff also notes that some funds have established caps for sub-accounting fees but cautions that boards should carefully evaluate any benchmark used to establish a cap.  In particular, notes the guidance, transfer agency fees may or may not be relevant benchmarks because the services and economies of scale may not be comparable.  The guidance also urges boards to consider different rates or caps for intermediaries depending on the services provided to a fund.

Finally, the guidance lists various red flags that might indicate that a non-12b-1 payment may be providing compensation for distribution-related activity:

• The provision of distribution-related services is conditioned on a fund’s payment for sub-accounting or other service fees.

• The fund does not have a 12b-1 plan.  In such case, the board should inquire as to how distribution expenses, if they exist, are paid.

• The fund pays for services through a tiered payment structure under which various services are paid for first from a 12b-1 plan and then from other sources.

• A sub-accounting agreement does not provide a clear list of the services to be provided, or sub-accounting and distribution services have been bundled into a single agreement.

• The adviser and other relevant service providers take distribution and sales benefits into account when recommending, instituting or raising sub-accounting fees.

• There are large disparities in various intermediaries’ sub-accounting fees.

• Intermediaries offer to sell additional sales data, such as information about fund investor demographics or top sales partners and channels, to the fund or its adviser.

The guidance emphasizes that fund service providers have an “affirmative duty” to provide information relevant to the above red flags so that the board can appropriately scrutinize the non-12b-1 payments.

The guidance highlights the significant risk posed by the inadvertent or purposeful use of fund assets to pay for distribution outside of a rule 12b-1 plan and the SEC’s continued focus in this area.  Under the guidance, the onus is on fund boards to determine that funds aren’t impermissibly paying for distribution out of fund assets, though they may rely on information received from the adviser and other service providers and the assistance of counsel, the fund’s chief compliance officer, and personnel of the adviser and other service providers.

Practice Tips

• The guidance does not, in our view, materially change the fund board’s basic responsibilities from the SEC’s 1998 Supermarket Letter.  It does, however, appear to place more responsibility on the adviser and service providers to provide relevant information to the board, including disclosure regarding conflicts of interest, so that it can perform its evaluation of fees without a corresponding obligation being placed on intermediaries to provide some of this information.  

• Nevertheless, advisers and service providers to funds that make these sub-accounting payments should examine the information they are requesting of intermediaries and providing to boards to ensure it is as robust, complete and accurate as possible.  

• Chief compliance officers may consider reviewing compliance policies and procedures to ensure that they explicitly cover the risks of inappropriate distribution payments to intermediaries from fund assets.