By:  Samuel Pangas, Compliance Associate

 January 25, 2016

As a result of recent sweep examinations, the SEC Division of Investment Management has released guidance relating to the mischaracterization of mutual fund distribution fees as sub-accounting fees.

In the past, transfer agents were required to provide recordkeeping and other services to investors in mutual funds. Because of the increased use of omnibus accounts in recent years, transfer agents commonly do not have access to investor information. As a result, broker-dealers and other financial intermediaries are now providing these services under sub-accounting arrangements.

Rule 12b-1 of the Investment Company Act of 1940 prohibits mutual funds from financing mutual fund sales activities unless it does so pursuant to a 12b-1 plan. To determine whether payments should be characterized as distribution fees, the SEC uses a facts and circumstances approach.

Because mutual funds boards of directors are responsible for overseeing the reasonableness of fees paid out of fund assets and the relationship between funds and their service providers, the SEC recommends that boards have a process in place reasonably designed to evaluate whether sub-accounting fees are being used to pay directly or indirectly for distribution. To assist the board, investment advisers and other service providers need to provide the board with sufficient information about the fund’s distribution and servicing arrangement, including how the level of sub-accounting fees may affect other payments that are intended for distribution. While investment advisers are not statutorily required to provide such information, the SEC asserts that they are so required by their fiduciary duty.

The SEC recognizes that there are a number of reasonable approaches that a board may take in evaluating sub-accounting fees, and does not recommend any one approach. Rather, the staff simply recommends that a board develop a process reasonably designed to provide enough information for them to make an informed judgment as to whether sub-accounting fees are being used directly or indirectly for distribution. A board’s role should focus on understanding the overall distribution process. A board may rely on investment advisers and other service providers to provide accurate information; and on outside counsel, its chief compliance officer, and service provider personnel to help guide its determination.

The SEC pointed to its 1998 letter establishing a framework for determining what portion of a fee paid to participate on an intermediary-sponsored fund platform, or “supermarket,” is for distribution or for other services. The staff suggested that, when evaluating sub-accounting fees, a board start with the framework established in the 1998 letter, but to additionally evaluate the following information:

• The specific services provided under the mutual fund’s sub-accounting agreements
• The amounts being paid
• Whether 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
• The process used by the adviser and other service providers ensure that the fees are reasonable, and
• The quality of services being delivered to beneficial owners.

The staff cautioned against using caps to limit the amount of sub-accounting fees paid, because economies of scale and other factors may affect the price that different service providers charge. If a board has resolved to use caps, it should carefully determine the fee cap based on the types of services being provided.

During its sweep examinations, SEC staff noted that certain arrangements commonly led to the mischaracterization of distribution fees. Mutual fund boards should request information regarding the following activities and arrangements, since they may indicate that fund fees are being used for distribution:

• Distribution-related activity conditioned on the payment of sub-accounting fees
• Lack of a 12b-1 plan
• Tiered payment structures, and whether the use of fund-paid fees reduces any fees the adviser or other service provider might otherwise have to pay
• Lack of specificity in service descriptions or bundling of services
• Distribution benefits taken into account by the adviser or other service providers when setting fees
• Large disparities in sub-accounting fees paid to intermediaries
• Service providers offering sales data to funds along with sub-accounting services

Regardless of how a fund labels its expenses, the SEC will look to facts and circumstances to determine whether fees are distribution-related. Therefore, a board must first understand the fund’s distribution process and servicing arrangements before it can determine whether fees for sub-accounting services are actually distribution-related. All distribution-related expenses should be characterized as such and paid pursuant to a 12b-1 plan.