A recent Ignites article highlighted the imminent enforcement from the SEC on “distribution in guise”. This is a complex topic our clients are faced with. Our current clients are using the insight from our analytics suite coupled with the automated expense allocation execution our Fee Management platform to solve this complex issue. We prepared this overview of the issue to provide insight for our clients on how these issues can be tackled regardless of technical platform and compliance with distribution rules can be obtained in the current complex fee marketplace.
Issue at point in SEC sweeps:
Inflated Sub-TA and or Service Fees that are actually ‘Enhanced Revenue Share’ fees or “payments for distribution in guise” paid by the Fund and not the Fund Management Company.
Analysis of the issue:
Distribution firms like Broker Dealers, Retirement Record Keepers and Bank Trusts in an Omnibus arrangement with the Fund provide Sub-TA, product support and compliance services to the Fund and charge the Fund for these services via fees usually labeled “Sub-TA” or more generically “Service” fees. Fees for sub-accounting and other core shareholder services traditionally provided by the Fund’s Transfer Agent are appropriate expenses for the Fund to bear regardless of who provides them to the shareholder. Several industry insiders have stated that these fees provided by the distribution company have steadily increased, which increase the revenue for the distributor although the distribution firms cost of sub accounting should have fallen on a per account basis as they have gained scale, operational efficiency and reduced their expenses with software and operations service providers.
What we believe the SEC sees as a violation of expense allocation:
Certain Service Fees have increased to a point whereby there is little doubt that there is actually a portion that is more properly identified as an “Enhanced Revenue Share” masquerading as a Service or sub-TA fee. If this is the view held by the SEC then the overage above a reasonable expense for each service needs to be paid by the Fund Management Company not the Fund. It is not an issue for a Fund Management Company to pay ‘Enhanced Revenue Share’ fees to increase a Fund’s distribution; it is just not an expense that can be charged to the Funds and thereby flow through to the shareholders through decreased performance by increased expenses. The 12b-1 is the only payment that is allowed to be paid by the fund for distribution of its Funds.
Where the issue exists:
The issue primarily lies in Omnibus relationships whereby the intermediary is providing Sub-TA and other services and receiving fees for those services. The sub-transfer agent service is provided by most large Broker Dealers, most Retirement Plan Record Keepers and many Bank Trust Companies that are now trading in Omnibus accounts. Further obfuscating the fees is that they are often charged in basis points not $/account and often combined into single “Platform Fees”.
Analysis to be performed on Services provided:
The Services provided by each distributor on behalf of the Fund must be documented and their cost analyzed. Distributors should be paid by the Fund for the services rendered.
The operational process of allocation of internal payment for the Service Fees to a distributor needs to address the ‘Max Rate’ of Sub-TA and other shareholder services provided by that distributor.
- Our analysis shows that the Sub-TA rates are charged back on both per account and AUM basis on the Broker Dealer platforms but more homogenously AUM based on the Retirement and Bank Trust platforms. A move across all distribution channels to single AUM based “Platform Fees” is also prevalent.
- The primary asset attributes used to differentiate levels of cost for each service provided are what platform the assets were sold on (Retail, Retirement, High Net Worth, Institutional) Institutional vs. Retail share classes and Asset Type (Equity, Fixed, Money Market).
- The Investment Company Institute provides a great deal of insight and data on servicing fees in their bi-Annual Fund Servicing report that can be used to establish benchmarks. Outside consulting firms can also provide data and assistance in working through determining a baseline for the fees with Fund Boards.
- A fund should also look at what their own Transfer Agency and service costs are for direct held accounts. Combining this data with outside data from the ICI and consultants, they can establish a Max Service Fee for each type of service performed in each channel. Close attention should be paid in any instance whereby the Fund is paying more for a service through a sub-TA platform than the service costs in their direct channel service provider. The recent Ignites article also recommends separation of roles regarding the negotiation of distribution fees and Service Fees. This insures that interests of service for shareholders are separated from interests in platform availability and dealer market share.
Allocation of Expense Methodology:
Once a baseline “Max Service” expense for each service provided has been established the value should be used in a payment funding methodology whereby the Fund’s general ledger is charged for the baseline amount and the overage is charged to the distribution firm’s general ledger.
- Ex: Max Sub-TA rate has been determined to be $13.50 / account. Omnibus distribution firm ABC bills the Fund a Sub-TA fee of $17.00 / account; The subsequent expense to the funds ledger account should be $13.50 and the overage of $3.50 expense should be allocated to the Fund Management Company’s ledger account.
- If the distribution firm charges basis points on AUM, for instance 13bp for Sub_TA then the operations group must leverage the transparency data to determine the number of accounts, convert the basis points charge to per account, and then do the above math.
A final observation we make on this recent action was the enforcement taken when the last guidance provided on this topic was the 2008 Schwab Service Guidance Letter from the SEC. It appears the SEC has moved toward enforcement action with less warning than we have seen in previous areas of their focus whereby they would provide a clear heads up through guidance, observe then apply enforcement if necessary.
In conclusion enhanced revenue sharing is prevalent in large distribution platforms. A program should be in place to determine the going rate for each of the services by platform, asset type and investment type. A “Max Rate” should be applied to all distributor fee negotiations independently by a team focused on servicing in Omnibus relationships. Each fee received from a distributor providing services beyond 12b1 distribution should be decomposed and the allocation of overages should clearly apply all fees above the going rate to the Fund’s distribution firm.
Whitfield Athey is CEO of Delta Data Software. His role at Delta Data is focused on growth of the product base, satisfaction of clients and scalability of the organization.