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From Securities Regulation Daily, January 7, 2016

Post-sweep guidance addresses potential Rule 12b-1 violations

By Jacquelyn Lumb

A recent sweep examination of mutual fund complexes, investment advisers, broker-dealers, and transfer agents prompted the Division of Investment Management to issue guidance relating to mutual fund distribution and sub-accounting fees. The exams raised concerns that a portion of some funds’ sub-accounting fees may have been used to pay for activities that are primarily intended to sell mutual fund shares. Fees can have a direct impact on investor returns and the mischaracterization of fees may lead some to invest in funds they otherwise would not have selected, according to the guidance.

Recommendations. Given the potential for the inappropriate use of fund assets and the prohibition of Rule 12b-1(a) on paying for distribution-related activities outside of a Rule 12b-1 plan, the staff offered three recommendations. First, if a fund has or is considering the adoption of a Rule 12b-1 plan, its board of directors should have a process in place to evaluate whether a portion of the sub-accounting fees is used either directly or indirectly to pay for distribution.

Second, advisers and other relevant service providers, such as transfer agents, distributors, and administrators, should inform the board about intermediary distribution and servicing arrangements, including how the level of sub-accounting fees may affect other payment flows that are intended for distribution.

Third, advisers and other relevant service advisers must inform the board if certain activities or arrangements are potentially distribution-related. If they are, the board must carefully evaluate whether the payments are appropriate.

Rule 12b-1. Rule 12b-1 prohibits mutual funds from financing any activity that is primarily intended to result in the sale of fund shares, except pursuant to a 12b-1 plan. The prohibition applies to payments that are clearly identified as distribution fees, and also to payments that claim to be for some other purpose but are used in ways that finance distribution. The rule is designed to help control the conflicts of interest that may arise when a mutual fund pays for distribution expenses out of fund assets. Advisers may encourage funds to bear the distribution-related expenses to help the fund grow, which increases fee revenues. Boards of directors have a fiduciary duty to either eliminate conflicts of interest or to mitigate the conflicts and provide full disclosure of their existence.

The staff observed during the sweep that many mutual funds did not have explicit policies and procedures as part of their compliance programs to prevent violations of Rule 12b-1. The prohibitions of the rule apply even to funds that have not adopted a 12b-1 plan, according to the guidance, so these funds should have policies and procedures to prevent violations of the rule.

Indicia of payments for distribution. The guidance provides indicia that a payment may be used to pay for distributions based on the staff’s observations during the examinations. One example is where an intermediary conditions certain distribution-related activity on a fund’s payment or rate increase of sub-accounting fees. Another is the lack of a 12b-1 plan, which should prompt a board to inquire further about how fund distribution expenses are paid. Tiered payment structures also may raise questions about the services for which the fund is actually paying.

The staff also observed situations where intermediaries did not provide a clear list of services in exchange for sub-accounting fees, or where sub-accounting and distribution were bundled into a single contract. The staff also encountered cases where distribution and sales benefits were taken into account by the adviser and other service providers when recommending, instituting, or raising sub-accounting fees, which increases the risk that distribution benefits or services may be driving the arrangement.

Additional indicators are large disparities in sub-accounting fees paid to intermediaries and sales of additional strategic sales data. Boards should consider whether the differences in services support different payment rates, and whether payments for sales data are distribution-related.

The growth in omnibus relationships and various payments to intermediaries increases the possibility that a portion of funds’ sub-accounting and other fees may be direct or indirect payments for distribution. To ensure that these payments do not violate Rule 12b-1, the staff recommends that boards have policies in place to evaluate the payments and have sufficient information about all of the fund’s distribution and non-distribution intermediary arrangements to assist in their evaluations.

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