Board Oversight of Intermediary Fees - The SEC s Recent Guidance

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1 Mutual Fund Directors Forum Policy Conference Breakout Session March 29, 2016 Board Oversight of Intermediary Fees - The SEC s Recent Guidance Lori L. Schneider Copyright 2016 by K&L Gates LLP. All rights reserved.

2 What is Distribution in Guise? Background: Under Rule 12b-1 of the Investment Company Act of 1940, payments by a fund for distribution services must be made pursuant to a Rule 12b-1 Plan. Specifically, Rule 12b-1 makes it unlawful to use fund assets to finance any activity which is primarily intended to result in the sale of [fund] shares unless such payments are made pursuant to a Rule 12b-1 Plan. Mutual funds typically make their shares available to investors through arrangements with intermediaries, generally broker-dealers, banks, insurance companies, and retirement plan administrators, which maintain omnibus accounts with the funds. Issues relating to payments made pursuant to Rule 12b-1 may arise because many intermediaries provide both distribution and non-distribution services. The term distribution in guise refers to the question of whether nondistribution-related fees (such as sub-transfer agent, administrative, subaccounting, and other shareholder servicing fees ( sub-accounting fees )) paid to intermediaries out of fund assets are actually for distribution-related activity. klgates.com 2

3 Key Points: IM Guidance Update, January 2016, Mutual Fund Distribution and Sub-Accounting Fees Board s Process: The SEC staff recommends that boards have a process in place reasonably designed to evaluate whether a portion of sub-accounting fees is being used to pay directly or indirectly for distribution. Board s Reasonable Business Judgment: The Guidance Update clarifies that the question of whether sub-accounting and other mutual fund-paid fees represent payments for distribution is a matter for the board s reasonable business judgment, and that boards may rely on the assistance of outside counsel, the fund s chief compliance officer, and personnel from the adviser or relevant service providers, as appropriate, to assist them in making these judgments. Emphasis on Adviser s Fiduciary Duty: The Guidance Update emphasizes that fund advisers have a conflict of interest in recommending the use of fund assets to pay for distribution; accordingly, the SEC staff states that advisers are required by their fiduciary duty either to refrain from recommending the payments or to provide complete information to the fund board. Compliance Policies and Procedures: The SEC staff recommends that funds establish, as part of their Rule 38a-1 compliance programs, adequate policies and procedures for reviewing and identifying any payments that may be made for distribution-related services are made pursuant to a Rule 12b-1 plan. klgates.com 3

4 The Board s Process Overall picture: As part of the evaluation process, the SEC staff recommends that advisers and other relevant service providers provide sufficient information for the board to understand the overall distribution and servicing arrangements, including how the level of sub-accounting fees may affect other payment flows that are intended for distribution (such as Rule 12b-1 fees and revenue sharing) Fund Supermarket Letter as Useful Framework: The Guidance Update refers to the factors and analysis described in the Supermarket Letter as a useful framework for establishing a board s process. The Supermarket Letter articulated the staff s positions that the board should determine whether the portion of the fee that the fund pays for non-distribution-related services is reasonable in relation to (a) the value of those services and the benefits received by the fund and its shareholders and (b) the payments that the fund would be required to make to another entity to perform the same services. klgates.com 4

5 The Board s Process (cont.) Additional Information: In the Guidance Update, the SEC staff notes that a board also may want to request from the adviser, service providers, and intermediaries, among other things: information about the specific services provided under the 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 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 (to the extent of its ability to do so). Use of Fee Caps: The SEC staff cautions that if boards use fee caps as part of their process, they should carefully evaluate any benchmark used in establishing a cap, and may wish to consider different fee caps depending on the varying kinds of services provided. klgates.com 5

6 The Adviser s Conflict of Interest and Fiduciary Duty The Guidance Update emphasizes the adviser s fiduciary duty to either eliminate conflicts of interest or mitigate them and provide full and fair disclosure of the conflict. The SEC staff notes that advisers and service providers are often involved in recommending that subaccounting fees be instituted or increased and may be subject to conflicts of interest to the extent that such payments reduce the payment obligations the advisers and other service providers would otherwise bear. The Guidance Update puts the burden on the adviser to provide sufficient information to inform the board of the overall distribution and servicing arrangements of the fund, including: payment flows from relevant fund service providers; information about sub-accounting payments and other intermediary payment flows; and the extent to which sub-accounting payments may reduce or otherwise affect advisers or their affiliates revenue sharing obligations or the level of fees paid under a Rule 12b-1 plan. The SEC staff raises the question of potential exposure for the adviser under Section 36(b) of the 1940 Act, noting that the section applies not just to payments to the adviser, but also to payments to any affiliated person of the adviser. In cases of mutual funds paying fees to affiliated entities that then make distribution payments, the staff believes that the same analysis applies as boards would use when they evaluate potential distribution aspects of compensation and payments to an adviser as part of the section 15(c) process. klgates.com 6

7 Specific Arrangements of Concern The SEC staff cites certain activities and arrangements observed during the sweep exams that it believes raise questions as to whether funds are paying for distribution outside of a Rule 12b-1 Plan, especially when the fees are paid to an intermediary that distributes fund shares. The SEC staff recommends that advisers and relevant service providers provide a fund s board with information as to whether these specific activities or arrangements occur and states that boards should be able to rely on the adviser and other service providers to affirmatively provide such information. If such activities do occur, the staff recommends that the board scrutinize the appropriateness and distribution character of such payments. klgates.com 7

8 Specific Arrangements of Concern (cont.) Activities or arrangements identified in the Guidance Update as potentially reflecting indicia that a payment may be used to pay for distribution : Distribution-related activity that is conditioned on a fund s payment or rate increase of sub-accounting fees; The absence of a Rule 12b-1 Plan for a particular fund or share class; Tiered payment structures involving a combination of fees paid out of fund assets and revenue sharing paid by the adviser; Lack of specificity or bundling of services into a single arrangement without a clear list of services provided in exchange for sub-accounting fees; Distribution and sales benefits being taken into account by the adviser and other relevant service providers when instituting or raising sub-accounting fees; Large disparities in sub-accounting fees paid to intermediaries that may be providing substantially the same set of services to the fund; and Intermediaries offering sales data about the demographics of fund investors and other information about top sales partners and channels. klgates.com 8

9 Rule 38a-1 Compliance Policies and Procedures The SEC staff notes that, as it discovered during the sweep exams, many funds do not have as part of their Rule 38a-1 compliance programs policies and procedures to prevent violations of Section 12(b) and Rule 12b-1. The SEC staff recommends that, where a fund has a Rule 12b-1 Plan, the fund should establish, as part of its Rule 38a-1 compliance program, adequate policies and procedures for reviewing and identifying any payments that may be made for distribution-related services that are not paid pursuant to the plan. The staff notes that funds that have not adopted a Rule 12b-1 Plan should also have policies and procedures in place that are reasonably designed to ensure that the funds are not making distribution payments in the absence of such a plan. The reference to Rule 38a-1 in the Guidance Update suggests that the SEC could charge a fund or its directors with violating Rule 38a-1 if the fund did not have compliance policies and procedures sufficient to make the determinations of compliance with Rule 12b-1 that the staff asserts are necessary. klgates.com 9

10 Practical Considerations Boards may request that information be provided in a clear and concise manner, with summaries or overview documents being included to assist them in their review as appropriate. Boards should obtain an overall picture of the arrangements and typical services and fees. SEC staff recommends in the Guidance Update that advisers and relevant service providers furnish boards with general information about who at the firm is negotiating the fees, the process for their approval, and the considerations taken into account. Boards may want to consider atypical or particularly significant arrangements and ask why one intermediary s fees are higher than another s or what enables one intermediary to provide seemingly similar services than another for lower fees. SEC staff acknowledges in the Guidance Update that these disparities may be the result of competitive pressures, depending on the facts and circumstances, but cautions that disparities in payments for the same services may indicate that they are payments for distribution-related activities. klgates.com 10

11 Practical Considerations (cont.) Consider having the compliance policies and procedures detail, among other things: the board s process for reviewing intermediary arrangements; and the type of information the adviser will provide, including the specific arrangements identified by the SEC staff in the Guidance Update as evidencing indicia that a payment may be used to pay for distribution. Practical challenges include: the difficulty of obtaining complete information from intermediaries regarding the type and quality of their services; and the lack of clear benchmarks against which to assess the reasonableness of any fees paid out of fund assets for non-distribution services, given the potentially wide range in the nature and quality of services from one intermediary to another. klgates.com 11

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