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The Motivations behind the SEC “Distribution in Guise” Sweeps

The Motivations behind the SEC “Distribution in Guise” Sweeps

The biggest and most vexing news concerning mutual funds this year involves a three letter acronym: SEC, followed by a three letter word: why? The SEC has been conducting deep drill down sweeps into the practice of fund companies paying out distribution fees disguised as service fees. The question floating around the industry is: why has this become important to the SEC now? Well, to understand the present involves looking at the past, and that requires a review of the SEC’s Rule 12b-1

The SEC has a long history of either trying to do away with or at least modify their own Rule 12b-1. This rule allows a fund to pay out distribution fees from fund assets. Let’s start with a little background 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 12b-1 plan authorizing their payment. What’s interesting is that the SEC does not cap how much of a fund’s assets get paid out as distribution fees, although there is a cap. The cap is imposed by the Financial Industry Regulatory Authority or FINRA, not the SEC.

Only broker/dealers can receive 12b-1 fees, consequently FINRA regulates through 12b-1, how much they can receive in these 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.

The SEC seems is OK with the 25 bps marketing and service fee, but is uncomfortable with 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 fund’s 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 to be paid to brokers allowable 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. This action was placed on the back burner as the industry focus shifted to money market reform. However to assume to SEC reform of 12b-1 fees will just go away is a mistake; we have not seen the last of a 12b-1 reform initiative from them.

To date the SEC has not been able to put a cap on 12b-1 fees, but they are still very much on the docket. The focus now is on making sure the payments being made to distribution firms are properly classified and disclosed to shareholders. Many of the large distributors of mutual funds, such as the wire houses, now charge a platform fee. These players really don’t care how the fee is broken down, as long as they receive their fees. At this point in time, the SEC is as 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; any additional distribution fees are being paid by the advisor or underwriter to the fund.

Confusions and complications. What has really muddied the waters with this issue is the proper payment and allocation of 12b-1 fees moving 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. And this this is really gets to the heart of the matter concerning the SEC’s sweep around “distribution in guise.”

The big question, and the one that will continue to drive the SEC, concerns how much the fund companies are 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. This is critical to the SEC. More areas driving current and future inquiries include:

Are funds being pressured to pay more to be on a firm’s platform in order to get the distribution of their funds?

What is the actual value to a fund of what is the actual value of the services being performed by their distribution partners on behalf of a fund’s shareholders?

How are fund companies breaking out platform fees between distribution and servicing?

These questions yield a clue to the issues currently motivating the SEC sweeps.


[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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