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SEC “Distribution in Guise” Sweep

SEC “Distribution in Guise” Sweep

There has been a lot of news recently about the SEC sweeps where they are looking at fund companies that may be paying out distribution fees but disguising them as servicing fees. With all that the SEC has on their plate, you may be asking yourself, “why is this so important to them”? Well, the SEC has a long history of either trying to do away with or at least trying to modify their own Rule 12b-1. This is the rule that allows a fund to pay out distribution fees from fund assets. A little background first on a fund’s ability to pay out distribution fees. Distribution fees can be paid out of a fund only if the fund has adopted a plan (12b-1 plan) authorizing their payment. What is interesting here is that the SEC does not cap how much of a fund’s assets get paid out as distribution fees. There is a cap, but it is not imposed by the SEC, it is imposed by the Financial Industry Regulatory Authority or FINRA. Since only broker/dealers can receive 12b-1 fees, FINRA regulates how much they can receive in 12b-1 fees. FINRA allows 25 basis points to be paid out for marketing and service fees and provides a cap of 75 bps to be paid to brokers to compensate them for selling the funds. This in effect creates a 1% cap on 12b-1 fees. If the fund is a no-load fund, then FINRA only allows the 25 bps marketing and servicing fee to be paid out.

It is interesting to note that some funds have adopted “defensive” rule 12b-1 plans. These plans do not impose distribution fees on the fund, but are designed to ensure that a fund does not violate rule 12b-1 if other expenditures are later determined to have been intended to result in the sale of fund shares.

Now back to the SEC and their take on 12b-1 fees. They seem to be Ok with the 25 bps marketing and service fee, but they are not real keen on the 75 bps distribution fee paid to brokers. Before passing rule 12b-1 in 1980, a fund was not allowed to pay any distribution fees from fund assets. Rule 12b-1 allowed the funds independent directors to approve a written plan of distribution to pay fees for sales activities intended to result in the sale of shares. In 1988, the SEC proposed amendments to tighten the requirements under which a fund could pay a 12b-1 fee, but the proposals were not adopted by the SEC.[1]Then in 2010, they actually voted to get rid of 12b-1 fees as they currently exist.[2] The SEC viewed the 75 bps fee allowed to be paid to brokers as ongoing sales charges levied on all shareholders in the fund. The SEC’s position was that at some point, these on-going (trailer) commissions should be capped and not just run on forever. It got put on the back burner as the industry focus shifted to money market reform, but don’t think SEC reform of 12b-1 fees will just go away. We have not seen the last of a 12b-1 reform initiative from the SEC.

So the SEC has to date not been able to put a cap on 12b-1 fees, but they are still very much focused on them. The focus now is more on making sure the payments being made to distribution firms are being properly classified and disclosed to shareholders. Many of the large distributors of mutual funds, such as the wire houses, now charge a platform fee. They really don’t care how the fee is broken down, just as long as they get their fee. At this point in time, the SEC is not so concerned with the amount of distribution fees being paid as it is with the fund properly accounting for them. Since the fund itself is limited in how much it can pay for distribution, the SEC wants to make sure the fund is paying out only what it is allowed to and any additional distribution fees are being paid by the advisor or underwriter to the fund.

What has really complicated the issue of properly paying and allocating 12b-1 fees has been the move to omnibus accounts. In the pre-omnibus world when accounts were held direct on the fund company’s transfer agent system, the brokers were mainly involved in the selling of the funds, not the servicing of them. With omnibus accounts, these firms are now both selling the funds as well as servicing the shareholders. Brokerage firms are putting more and more pressure on fund companies to pay them for distributing their funds as well as for servicing the fund shareholders. So this is really getting to the heart of the matter concerning the SEC’s sweep around “distribution in guise”. How much are the fund companies paying for the distribution aspects of the relationship and how much are they paying for services performed for the shareholders being serviced by the brokerage firm? As stated earlier, this is very important to the SEC. Are funds being pressured to pay more to be on a firm’s platform in order to get the distribution of their funds? It is becoming more and more important for funds to fully understand the various services being performed by their distribution partners on behalf of a fund’s shareholders and what is the value of those services being performed. How are fund companies breaking out platform fees between distribution and servicing? That is what the SEC wants to know.

[1] https://www.ftc.gov/sites/default/files/documents/advocacy_documents/ftc-staff-comment-sec-concerning-proposed-regulations-governing-payment-asset-based-sales-loads/v880053.pdf

[2] https://www.sec.gov/news/press/2010/2010-126.htm


Burton Keller

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