the investment lawyer · tion of shares, the related disclosure made to fund boards of directors,...

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Since 2013, the examination arm of the Securities and Exchange Commission (SEC) has made it a priority to focus on payments advisers and

mutual funds make in connection with the distribu-tion of shares, the related disclosure made to fund boards of directors, and boards’ oversight of these payments.1 Th ese payments carry a diverse array of names for services that are themselves varied in char-acter. Th e SEC’s Offi ce of Compliance Inspections and Examinations (OCIE) has conducted industry sweeps and brought enforcement actions, notably the First Eagle case in September 2015,2 zeroing in on fund payments for services cloaked in vague monikers, like sub-transfer agency and shareholder servicing, to determine whether they are in fact pay-ments for fund distribution and preferential treat-ment for funds. OCIE’s goal has been to lift the veil to determine whether these fund payments are made in compliance with the requirements of Section 12 and Rule 12b-1 under the Investment Company Act of 1940, as amended (1940 Act).

Fund distribution payments remain an area ripe for SEC inspection and enforcement, given the confl icts of interest such payments present for fund advisers, who must decide whether to use their own resources or fund assets to fi nance distribution activi-ties. In turn, the issue persists as a major responsibility

of boards of directors whose chief regulatory task is to serve as the fund’s watchdog. In January 2016, the SEC’s Investment Management Division released a guidance update (the Distribution Guidance)3 based on the fi ndings from OCIE’s examinations of a num-ber of mutual fund complexes, investment advisers, broker-dealers, and transfer agents, regarding the characterization of fees paid to fi nancial intermediar-ies. In the examinations, OCIE reviewed the payment of fees characterized as non-distribution related sub-transfer agent (sub-TA), administrative, sub-accounting, and other shareholder servicing fees (collectively, sub-accounting fees). Th e Distribution Guidance is the fi rst SEC release aimed at guiding fund boards in their oversight of distribution arrangements and payments since an October 1998 no-action letter to the Investment Company Institute on fund super-markets (the Fund Supermarkets Letter).4 In a speech to the Practising Law Institute delivered in March 2016, David Grim, Director of the SEC’s Division of Investment Management, described the board’s over-sight role in this context as “critical” and remarked that the Distribution Guidance is a “prime example” of the tools the agency is providing fund directors to eff ectively oversee funds. Another important tool the SEC has traditionally used to steer the fund industry toward compliance is enforcement. And, while the

Six Months after SEC Guidance, Unmasking Hidden Fund Distribution Payments Proves a Heavy Undertaking for IndustryBy Joanne A. Skerrett and Thomas M. Ahmadifar

VOL. 23, NO. 7 • JULY 2016

2 THE INVESTMENT LAWYER


fi rst distribution in guise enforcement action did not implicate fund boards, it nevertheless should serve to both warn boards and illuminate the path forward in directors’ eff orts to properly characterize, assess and evaluate fund distribution arrangements and pay-ments as contemplated in the Distribution Guidance.

Since the Distribution Guidance was issued in January 2016, the fund industry has been abuzz with questions, not the least of them being how boards and advisers should respond and which adviser is next on the enforcement list — industry media pre-dict that the SEC will bring other distribution in guise enforcement actions.5 Already, the SEC’s rec-ommendations to boards are encountering resistance as industry watchers spot potential impediments to implementation, namely an ever-evolving and for-midable intermediary landscape and a lack of a clear, uniform strategy to surmount existing industry challenges.

First Eagle and the Distribution Guidance

On September 21, 2015, the SEC issued its order instituting cease-and-desist proceedings against First Eagle Investment Management, LLC and its wholly-owned broker-dealer subsidiary FEF Distributors, LLC (FEF Distributors).6 First Eagle neither admitted nor denied the SEC’s fi ndings in the case. Th e SEC found that First Eagle and FEF Distributors caused the First Eagle Funds to make payments to two fi nancial intermediaries for distribution-related services outside of a written, board-approved plan under Rule 12b-1 of the 1940 Act. Th ese payments were made under various agree-ments, resulting in the improper use of $25 million in mutual fund assets.7 Th e SEC also found that the improper use of the funds’ assets to pay for these distribution-related services rendered the funds’ dis-closures concerning payments for distribution-related services inaccurate. First Eagle maintained several service agreements with third-party intermediaries; however, the SEC focused mainly on the agreements with entities described as Intermediary One and

Intermediary Two. First Eagle and FEF Distributors treated payments made under the agreements as being for sub-TA services despite the fact that one of FEF Distributors’ two agreements with Intermediary One and its agreement with Intermediary Two called for the provision of distribution and marketing ser-vices. To remedy the 1940 Act violations, the SEC prescribed and FEF Distributors agreed to a num-ber of undertakings. Th e SEC also ordered First Eagle and FEF Distributors to pay a total of $39.7 million — a resounding message to fund advisers and boards that they must take a closer look at how fund assets fl ow through to service providers.8

As illustrated in the First Eagle action, the SEC has zeroed in on the potential for portions of fund-paid sub-accounting fees to also be used for distribu-tion services outside regulatory bounds. In order to prevent these violations, the Distribution Guidance provided three key recommendations:9

1. Mutual fund boards should have a process reasonably designed to evaluate whether sub-accounting services fees are being used to pay for distribution.

2. Fund advisers and service providers inform mutual fund boards about intermediary distri-bution and servicing agreements, particularly how sub-accounting services fees may aff ect payment fl ows intended for distribution.

3. Service providers inform mutual fund boards if there are potentially distribution-related activities in connection with sub-accounting services fees.

SEC Guidance Faces Formidable Industry Barriers

According to the Distribution Guidance, boards should be provided with a “complete overall picture” of intermediary distribution and servicing arrange-ments for the funds they oversee. However, the picture that has emerged of the fi nancial interme-diary sector is one of opacity and an imbalance of power that appears to favor fi nancial intermediaries,

VOL. 23, NO. 7 • JULY 2016 3


leaving prospects dim for funds and boards to obtain the clear picture the SEC sees as necessary to their evaluation of fund distribution payments.

Th e perils of the omnibus structure. Th e evolving landscape of the fund servicing industry might be the biggest challenge fund advisers and boards face in implementing the substance of the Distribution Guidance. According to the 2015 Investment Company Factbook,10 in mid-2014, 80 percent of households owning mutual funds outside employer-sponsored retirement plans purchased funds with the help of an investment professional, including registered investment advisers, brokers, indepen-dent fi nancial planners, bank and savings institution representatives, insurance agents, and accountants. Th ese fi nancial intermediaries provide a range of services to fund shareholders such as trade process-ing, advising, and counseling to shareholders; main-taining fi nancial records and account information; disbursing dividends and capital gains distributions and mailing shareholder reports, prospectuses, and trade confi rmations – services that just roughly three decades ago were mainly provided by a fund and its internal or external transfer agent.11

Th e role of fund transfer agents has evolved as most intermediaries have moved away from individ-ual accounts held in a fund’s records to the omnibus structure—in which shareholder accounts are held in the name of the fi nancial intermediary who per-forms traditional transfer agent functions in order to take greater control of the client account and generate additional fees.12 Financial intermediaries maintain the underlying shareholder account infor-mation on their own recordkeeping systems and report share transactions to the fund on an aggre-gate basis—a process known as sub-accounting. While the shift to the omnibus framework has left funds with less information about and control over investor accounts, the omnibus structure has created major effi ciencies for the fund industry with respect to recordkeeping, clearing, and processing of fund trades and has reduced the costs incurred by inves-tors who today are more likely than in the past to

own funds from multiple mutual fund complexes. And even as transfer agents may lose favor with fund sales personnel, they remain part of the regulatory framework of mutual funds and have contractual and fi duciary responsibilities to fund management regarding shareholder servicing functions.13

A consequence of the fund industry’s migra-tion to omnibus accounts is that information that was formerly easily accessible to a fund now exists only on the intermediary’s systems. According to a 2011 research paper by consulting fi rm Barrington Partners, “Th e global challenge to break the ano-nymity associated with these distribution relation-ships has not yet been resolved.”14 No longer is a single transfer agent the gatekeeper and supplier of data associated with core shareholder servicing func-tions to the fund and its board. In addition, many shareholder accounts are held on a disparate array of intermediary subsystems15 and among several inter-mediaries. (A mid-size to large fund complex typi-cally may list 50, sometimes a 100 or more, fi nancial intermediaries on its registration statement on Form N-1A.) Indeed, in the First Eagle case, the adviser entered into dozens of agreements, including two agreements with Intermediary One – a fi nancial ser-vices agreement for a variety of sub-TA services and a selected dealer agreement for services described as generally marketing and distribution; First Eagle also entered into a Correspondent Marketing Program Participant Agreement with Intermediary Two for yet another group of services.

Th e fund industry’s growing preference (or resignation) toward omnibus accounts has given fi nancial intermediaries immense power. Fund fi rms appear willing to absorb the costs and lack of control over data in order to have their shares placed on intermediaries’ selling platforms and sys-tems and are often unwilling to demand too much from their intermediaries lest they damage the relationship.16

Th e challenges of the omnibus structure are not new to regulators17 and have been well documented.18 Besides noting these challenges in the recently



as “revenue sharing.” Revenue sharing payments are not deemed an indirect use of a fund’s assets for dis-tribution if the adviser makes the payments from the profi ts of its advisory fee that are “legitimate” or “not excessive.”19 However, if revenue sharing pay-ments amount to an indirect use of fund assets to fi nance distribution, the payments must be made pursuant to a written Rule 12b-1 plan that has been approved by a fund’s board.20

With this regulatory structure in mind, fund boards are tasked with guarding against the inap-propriate use of fund assets. However, fund inter-mediaries’ complex, multi-layered fee arrangements and lack of transparency present a challenge for boards to eff ectively monitor and assess which fees are for distribution and which are not. While many intermediary fee structures mainly mimic the tra-ditional transfer agent fee setup – fi xed dollar per-account fees and basis point fees—the industry has been moving away from these billing methods and toward other options such as out-of-pocket fees, transaction fees, and a combination of these billing methodologies.21

Th e First Eagle case provides a good illustra-tion. Each agreement described in the SEC’s order had its own fee structure and terms. For example the Financial Services Agreement with Intermediary One featured a per account fee ranging between $16-19. Th e Selected Dealer Agreement had a more complex structure with: (1) a one-time fee of $50,000; (2) 25 basis points of total new gross sales of shares of any class sold by Intermediary One, paid monthly; and (3) 10 basis points of the value of fund shares sold by Intermediary One that are held for more than one year, payable quarterly (“for our continuing due diligence, training and marketing”). Under the Correspondent Marketing Program Participation Agreement, Intermediary Two charged an annual fee equal to 5 basis points of the net asset value of outstanding shares of the Funds it sold, billed quar-terly. With a typical fund having up to hundreds of intermediary agreements, keeping track of and allocating such fees to the proper distribution and

proposed transfer agent rulemaking, the SEC has not made signifi cant overtures toward regulatory oversight of omnibus accounts. Rule 22c-2 under the 1940 Act adopted in 2005 requires intermedi-aries to share certain information with funds with respect to monitoring market timing and excessive trading, and there are other rules in place to monitor potential money laundering and suspicious account activity. Emerging cyber security risks and investor self-service initiatives like mobile phone applica-tions could engender a greater sense of urgency on the part of regulators for increased transparency and oversight of omnibus shareholder accounts by regulators. Th e Distribution Guidance also notes the challenges inherent in the omnibus structure but fails or neglects to present any meaningful methods (besides simply asking) for funds or boards to obtain information from fi nancial intermediaries concern-ing these very complex and opaque structures.

Complex Fee Arrangements. Th e securities laws governing fund distribution payments are not voluminous. Fund intermediaries can be compen-sated out of fund assets or by the fund’s adviser or its affi liates. Rule 12b-1 permits a fund to pay for activities “primarily intended to result in the sale of shares issued by” the fund subject to certain lim-its imposed by the Financial Industry Regulatory Authority Conduct Rule 2830. Fees paid for dis-tribution in reliance on Rule 12b-1 must be made pursuant to a written plan approved by a fund’s board, including a majority of independent direc-tors, that describes the services to be provided in exchange for the payment of Rule 12b-1 fees. A fund may also use its assets to pay an intermediary for services that the fund’s board has determined to be non-distribution services. Th ese payments may be structured as “sub-TA” or sub-accounting fees to intermediaries for maintaining the records of individual shareholders and providing account ser-vices that would otherwise be provided by a trans-fer agent if shares were held directly on its records. Certain payments by a fund’s adviser or its affi liates to fi nancial intermediaries are generally referred to

VOL. 23, NO. 7 • JULY 2016 5


non-distribution buckets is a complex and resource-intensive undertaking.

Th e Distribution Guidance notes that some mutual fund boards have established sub-accounting fee caps in an eff ort to diff erentiate between distribu-tion and non-distribution payments. However, the SEC Staff cautions that these caps should be evalu-ated carefully as, for instance, fees paid to a fund’s transfer agent may diff er from fees paid to an inter-mediary for the same services.22 A fund may discover that, due to reverse economies of scale, the fund’s transfer agent may be a less economical choice than a fi nancial intermediary with a larger volume of share-holder accounts. Indeed, industry watchers have noted the lack of clear benchmarks to accurately measure the reasonableness of fees paid out of fund assets for non-distribution services, given the wide range in the nature and quality of services provided by intermediaries.23 As noted above, many fund complexes and their advisers and distributors have a strong interest in having their funds placed onto an intermediary’s selling platform; therefore the actual costs of services provided may not be a primary con-sideration during contract negotiations for these complexes.24 In these contracts, sub-accounting ser-vices fees are often combined with distribution fees, and funds (and their boards) are left with the task of allocating payment totals between distribution and non-distribution service fees.

Th e SEC has unequivocally placed the decision-making onus squarely on fund boards when it comes to distribution spending, including the type and extent of distribution services to be fi nanced and the amounts to be expended. In adopting Rule 12b-1, the SEC relied heavily on directors, particularly independent directors, to protect the funds’ interests and those of their shareholders to minimize poten-tial confl icts of interest. Th e Distribution Guidance invokes the Rule 12b-1 Adopting Release and reiter-ates that “directors bear substantial responsibility for determining whether fees paid by a mutual fund are for distribution”25 and recommends that, regardless of whether a fund has or is considering adopting a

Rule 12b-1 plan,26 fund boards should have a pro-cess in place reasonably designed to help them assess whether fund payments are being made directly or indirectly for distribution activities.27

Industry-wide Action May be Necessary. As dis-cussed above, the Distribution Guidance recom-mends that boards obtain a full understanding of the overall intermediary distribution and servic-ing arrangements and utilize information from service providers and intermediaries to inform their reasonable business judgment about whether fund-paid fees are being used for distribution in some manner. Accomplishing these tasks means overcoming the challenge of gathering data from disparate (and possibly unwilling) organizational sources to create that comprehensive picture favored by the SEC.

Industry watchers have noted that nowhere in the Distribution Guidance has the SEC prescribed any action for intermediaries. Unlike transfer agents, intermediaries are generally not subject to the fund regulatory structure while transfer agents, under Rule 38a-1 of the 1940 Act, are required to have pol-icies and procedures reasonably designed to prevent violation of the federal securities laws and are also subject to other securities laws. Th ere are no similar requirements for fund intermediaries under the 1940 Act, though intermediaries are subject to broker-dealer regulations and other rules by the Financial Industry Regulatory Authority. If the SEC cannot compel intermediaries to provide the information and cooperation contemplated by the Distribution Guidance, it may take a collective eff ort from the fund industry to do so. Th e industry has done this before when it came together with the Depository Trust and Clearing Corporation to create the Fund/Serv platform for processing fund trades and again with “Networking” through which funds and inter-mediaries used the National Securities Clearing Corporation to allow the exchange and reconcilia-tion of customer account-level information between fund companies and intermediaries.28 Some in the industry see a similar need for a global platform or



multiple-linked platform strategy with a single tech-nology solution that would bring together transfer agents and fund service providers along with data repositories and wirehouses to increase data avail-ability and accessibility.29 Th e fund industry itself has made some moves to improve oversight and counter the lack of transparency in the omnibus accounting space. Th e FICCA framework30 devel-oped in 2008 describes areas of compliance that an independent accounting fi rm would assess to mea-sure an intermediary’s compliance controls related to specifi ed activities it performs for shareholder accounts. Th e auditor then issues an opinion on the design and operating eff ectiveness of the interme-diary’s compliance controls and funds, boards and fund chief compliance offi cers may choose to rely upon the auditor’s opinion that their intermediaries have or do not have an adequate compliance con-trol environment. While these assessments are cur-rently utilized by some intermediaries, they have yet to be universally adopted. Some funds have come to rely on Service Organization Controls Reports, or “SOC-1” reports, issued under the American Institute of Certifi ed Public Accountants’ Statement on Standards for Attestation Engagements (SSAE) No. 16, which provides funds with data on their service providers’ internal controls over fi nancial reporting.

Illuminating the Path Forward for BoardsSo far, the SEC has given no indication that fund

directors should fear enforcement action related to their oversight of fund distribution payments and arrangements and nowhere in the First Eagle case is any director singled out for criticism. However, the SEC has targeted directors in the recent past for lax oversight in the Section 15(c) advisory contract approval process31 and it is not inconceivable that directors could be targeted in the distribution con-text. Th erefore, it is imperative for boards to increase their oversight of fund distribution payments and enhance their policies and procedures in light of the Distribution Guidance and the lessons of First Eagle.

Today, many boards use the guidance set forth in the Fund Supermarkets Letter to inform their evaluation of distribution related fees and arrange-ments.32 In the Fund Supermarkets Letter, the SEC staff outlined observations and fi ndings from OCIE examinations of fund supermarkets and brokerage fi rms that sponsor fund supermarket programs and provided certain factors to help boards 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 benefi ts received by the fund and its sharehold-ers and (b) the payments that the fund would be required to make to another entity to perform the same services.”33 Th e Distribution Guidance notes that this framework remains useful but recommends that boards request information about additional issues from the adviser, other relevant service provid-ers, and intermediaries.34 Whether these “additional issues” are enough to lift the veil on distribution in guise payments remains to be seen. What does seem apparent is that the SEC expects diligent and meticulous parsing by boards of whatever infor-mation is obtained from intermediaries. Th e SEC acknowledges the evolution in fund distribution structures and the related shift in the purpose and use of Rule 12b-1 fees. Indeed, the Distribution Guidance stated that certain of the guidance fac-tors the SEC outlined in the Rule 12b-1 Adopting Release35 may no longer be pertinent to directors’ evaluation of whether a Rule 12b-1 plan should be implemented or continued and thus it would not be necessary for boards to make a fi nding about each of the factors laid out in the Rule 12b-1 Adopting Release if such factors are not pertinent in the cur-rent environment.36 Th e Distribution Guidance also stated that boards should consider and docu-ment other pertinent factors, even factors not noted in the Rule 12b-1 Adopting Release, if such factors form the basis for their decision to use fund assets for distribution.

Some Practical Steps that Boards Can Take. Some fund boards have begun to take action, including

VOL. 23, NO. 7 • JULY 2016 7


forming committees around reviewing their fi nan-cial intermediary relationships. Th ese committees oversee and monitor the relationships with interme-diaries that distribute fund shares and then report back to the wider board on a quarterly basis. Th ese committees can be tasked with reviewing and moni-toring intermediary data in various formats, for example, intermediary questionnaires; certifi cations from service providers to confi rm that the services provided are not for distribution or do not contain distribution benefi ts; sub-TA grids showing fee out-liers; auditor reports tracing the fl ow of payments from fund to transfer agent to intermediary; and reports that identify potential red fl ags in the fl ow of cash. Board committees also monitor checklists that describe and summarize contractual provisions with intermediaries; track the changes in sub-TA fees over certain periods, for example, quarter over quarter; and hold educational sessions to stay current on industry best practices.

With the possibility of increased information from advisers, distributors and intermediaries, fund boards might enlist the help of fund counsel or inde-pendent trustee counsel to determine the informa-tion to request, to suggest the process by which to request that information and to help evaluate that information. Boards can direct funds to provide information at certain times, for example in connec-tion with the renewal of the 12b-1 plan or during the 15(c) advisory contract renewal process. Boards may also wish to construct a written request for fund intermediaries akin to requests sent to advisers dur-ing the contract renewal process. Further, boards can use the Distribution Guidance to determine and then request from funds information that had previously not been provided. For instance, the Distribution Guidance provided a set of indicia for boards to consider when reviewing fund payments in order to determine whether the payment is being used to pay for distribution, including: (1) distribution-related activity conditioned on the payment of sub-accounting services fees; (2) tiered payment structures; (3) lack of specifi city or the bundling of

distribution and non-distribution services; (4) distri-bution benefi ts taken into account when negotiating sub-accounting services fees; (5) large discrepancies in sub-accounting services fees paid to intermediar-ies; and (6) sales data.

During the SEC’s Compliance Outreach Program National Seminar held in April 2016, rep-resentatives from large fund complexes noted the burdens funds encounter in obtaining information for boards and how funds in turn are responding to the Distribution Guidance. Some fund com-plexes have found it helpful to overhaul their entire approach and have made intermediary oversight a joint undertaking among departments, for exam-ple, fund shareholder services, compliance, and legal departments. Among other actions funds have taken are: (1) a wholesale review of all intermediary contracts to seek out discrepancies and ambigui-ties; (2) a detailed review of intermediaries’ busi-nesses and processes; (3) requesting FICCA and SOC-1 reports as well as reports from National Quality Review, which assesses and reviews data from SOC-1s and FICCA reports, providing a basis for comparison; and (4) improving sharing of and access to intermediary reports among sepa-rate departments and committees within the fi rm. In addition, some funds are retooling their report-ing to boards by providing boards with a full spec-trum of intermediary fees and payments to review; preparing annual reports for boards on distribu-tion fees and quarterly reports to chief compliance offi cers.

Th e regulatory landscape concerning fund dis-tribution payments is not exactly teeming with guidance. Th e Fund Supermarkets Letter and Distribution Guidance, which provide more elabo-rate insight than Rule 12b-1 under the 1940 Act, are themselves not law and cannot be enforced on their own even though the SEC may use other pro-visions, such as Rule 38a-1, to argue that its recom-mendations should be part of a fund’s policies and procedures reasonably designed to prevent viola-tions of Section 12(b) and Rule 12b-1. At this stage,



Th e Distribution Guidance advises fund boards to develop a holistic understanding of the intermediary distribution and servicing arrangements for funds to inform their reasonable business judgment about whether sub-accounting and other fund-paid fees represent payments for distribution, in whole or in part. Th e following charts contain questions a board may ask fund management and materials it may request in order to aid its understanding of fund distribution arrangements.*

Questions to Ask

Characterizing Fees and Payments

Is there a written Rule 12b-1 Plan in place? If not, how are fund distribution expenses paid?

What are the Rule 12b-1 fees paying for:

Are they compensating registered representatives for selling shares and/or for providing advice? Are they paying for placement on preferred lists? Are they reimbursing distributors for expenses of maintaining their sales platforms, e.g., training and education regarding the features of the fund? Are they paying for wholesalers’ sales and educa-tional efforts? Are they reimbursing distributors for share-holder servicing costs such as answering investor inquiries?

Characterizing Intermediary Services

What types of intermediaries sell the Fund’s shares?

What are the primary distribution channels? What are the funds and the adviser paying to use these channels?

What is the distribution strategy associated with each of the intermediary partners?

What services are provided to fund shareholders by each type of intermediary partner?

Do any of the sub-transfer agency services provided contain “distribution benefi ts”?

What other services and products have fund inter-mediaries off ered to the fund along with traditional services? Are these products and their purposes clearly identifi ed?

Are they reimbursing distributors for administra-tive costs such as providing and mailing account statements, sub-transfer agent accounting, and mailing prospectuses and shareholder reports?

How are the intermediaries compensated for their services?

Do the distributor, adviser, and/or any other party pay any of the intermediaries additional amounts, such as through revenue sharing payments? If so, what is the purpose of these payments, and how are they calculated?

there is still a lack of clarity and it may take another major enforcement action in a less clear-cut case of distribution in guise than the First Eagle case to shed more light on the types of payments that truly raise red fl ags with regulators—since the transgres-sions in the First Eagle case were arguably beyond

dispute. And with the enduring opacity of the fund intermediary industry sector, funds and their boards may fi nd the lessons of First Eagle and the lofty ideals of the Distribution Guidance while leaving them forewarned may not necessarily have left them forearmed.

VOL. 23, NO. 7 • JULY 2016 9


Questions to Ask

Improving Oversight and Monitoring

Does the fund’s compliance program contain explicit policies and procedures meant to prevent violation of Section 12(b) and Rule 12b-1?

Has the role, duties of and fees paid to the funds’ transfer agent been recently revisited?

Are the funds paying higher shareholder service fees to intermediaries than they are to the transfer agent for the same services and, if so, can the diff erence be justifi ed?

What oversight is in place relative to the services pro-vided by intermediaries?

What oversight is in place regarding the amount and nature of fees being paid to intermediaries?

Are the services that each intermediary has been con-tracted to perform clearly defi ned and understood?

Is the same true of the fees paid to each intermedi-ary, particularly in terms of the respective distribution and shareholder services components?

Have fund management’s oversight responsibilities been clearly defi ned, assigned and documented for monitoring the services performed by and fees paid to intermediaries?

Has there been a recent comprehensive overview of all of the fund’s intermediary contracts, taking into account disparities in fees paid for the same or simi-lar services, frequency of fee increases and changes in services provided?

Fostering Greater Transparency

How are relationships with fund intermediaries man-aged? Who are the key point persons managing those relationships?

Which advisory employees negotiate fees and agree-ments with fund intermediaries? What factors do these employees take into consideration in approving intermediary contracts and fees?

Which intermediaries have proven most responsive to data inquiries by the fund?

Which intermediaries are most fl exible in negotiating contractual provisions?

Can intermediaries be persuaded to provide detailed contracts and fee statements that clearly show the ser-vices provided and the payments for each service?

Have there been recent intermediary fee increases? How have intermediaries characterized the nature of benefi ts or services to be gained from these fee increases?

Is there an opportunity to enhance the content or timing of existing reporting regarding intermediary relationships?

Materials to Request and Review

All contracts with fund intermediariesInternal analysis of trade activityCompliance questionnairesIntermediary self-certifi cationReview of third-party audit (including FICCA and SOC-1 Reports) and regulatory reportsAnalysis of fee benchmarksReports of Intermediary site visits

Directors or their representatives can review the fund’s disclosure relating to distribution payments in the prospectus and/or statement of additional informa-tion (SAI) for adequacy and accuracy.

Directors also can ask the adviser to review the fund’s own prospectus and SAI disclosure, and ask the prin-cipal underwriter to review any disclosure that selling brokers are providing to their clients regarding rev-enue sharing payments.



Joanne A. Skerrett and Thomas M. Ahmadifar are associates in the Investment Management Practice Group at Sullivan & Worcester LLP.

NOTES1 US Sec. & Exch. Comm’n, Nat’l Exam Program, OCIE

Examination Priorities for 2013 (2013), https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2013.pdf.

2 First Eagle Inv. Mgmt, LLC, Investment Company Act Release No. 31822, Investment Advisers Act Release No. 4199, 6 Fed. Sec. L. Rep. ¶ 48,010 (Sept. 21, 2015) [hereinafter First Eagle], available at https://www.sec.gov/litigation/admin/2015/ia-4199.pdf.

3 US Sec. & Exch. Comm’n, Div. Of Inv. Mgmt., No. 2016-01, Mutual Fund Distribution And Sub-Accounting Fees (2016), https://www.sec.gov/investment/im-guidance-2016-01.pdf [hereinafter Distribution Guidance].

4 Investment Company Institute, SEC No-Action Letter (Oct. 30, 1998) [hereinafter Fund Supermarkets Letter], available at https://www.sec.gov/divisions/investment/noaction/1998/ici103098.pdf.

5 Beagan Wilcox Volz, “William Blair Case Proves Distribution Fees Remain SEC ‘Priority,’” Ignites.com, Mar. 2, 2016, http://ignites.com/c/1305523/148003/wil l iam_blair_case_proves_distribution_fees_remain_priority?referrer_module=emailMorningNews&module_order=0&code=YW5OclpYSnlaWFIwUUhOaGJtUjNMbU52YlN3Z05EQTVNek15TXl3Z01UWXpOemM0TkRBeE5nPT0

6 First Eagle, supra n.2, at *2. 7 Id. at *3. 8 Id. at *9. 9 Distribution Guidance, supra n.3, at 2. 10 Inv. Co. Inst., 2015 Investment Company Fact Book

104 (55th ed. 2015), https://www.ici.org/pdf/2015_factbook.pdf.

11 According to “Evolution of the mutual fund transfer agent … ”, in the early 1980s the majority of investors opened mutual fund accounts directly with the fund transfer agent who would then handle fund share purchases and sales. PricewaterhouseCoopers, “Evolution of the Mutual Fund Transfer Agent: Embracing the Challenges and Opportunities 4” (2015), https://www.pwc.com/us/en/asset-management/investment-management/publications/assets/pwc-mutual-fund-transfer-agent-evolution.pdf.

12 Inv. Co. Inst., Navigating Intermediary Relationships 7 (Sept. 2009), https://www.ici.org/pdf/ppr_09_nav_relationships.pdf.

13 Th e SEC apparently still views transfer agents as important and in late 2015 released an advanced notice of proposed rulemaking, which highlights sev-eral areas of regulation the SEC intends to update in what would be the fi rst revision of transfer agent rules since 1977. See Transfer Agent Registration, 80 Fed. Reg. 81,947 (Dec. 31, 2015) (to be codifi ed at 17 C.F.R. pt. 240), available at https://www.sec.gov/rules/concept/2015/34-76743.pdf.

14 Barrington Partners, Evaluating the Next Generation Transfer Agent Environment: A

Directors can ask for written materials or oral presen-tations and periodic reports on the funds’ distribution and marketing system and the adviser’s and the under-writer’s efforts regarding this system.

* In 2009, the Investment Company Institute and the Independent Directors’ Council suggested questions, some of which are included above, that may help a fund’s board to have a general understanding of the fund’s system of distribution, shareholder servicing and the intermediaries involved in distributing fund shares and servicing fund shareholders. See INV. CO. INST., NAVIGATING INTERMEDIARY RELATIONSHIPS 7 (Sept. 2009), https://www.ici.org/pdf/ppr_09_nav_relationships.pdf.

VOL. 23, NO. 7 • JULY 2016 11


Global Perspective 3 (2011), http://www.mfdf.org/images/DirResPDFs/2011_Evaluating_the_Next_Generation_Transfer_Agency_Environment_-_A_Global_Perspective.pdf.

15 Deloitte, “The Omnibus Revolution: Managing Risk Across an Increasingly Complex Service Model 2” (2012), https://www2.deloitte.com/content/dam/Deloitte/us/Documents/fi nancial-services/us-the-omnibus-revolution.pdf.

16 Barrington Partners, supra n.14, at 3, 13. 17 Distribution Guidance, supra n.3, at 2. 18 See, e.g., Deloitte, supra n.15. 19 Bearing of Distribution Expenses by Mutual Funds, 45

Fed. Reg. 73,898 (Nov. 7, 1980) [hereinafter defi ned as the “Rule 12b-1 Adopting Release”].

20 Distribution Guidance, supra n.3, at 10. Th e Distribution Guidance also highlighted other areas of focus for fund boards, e.g., potential Section 36(b) confl icts of interest. Section 36(b) under the 1940 Act imposes a fi duciary duty on fund advisers with respect to the receipt of compensation. Distribution-related payments would be implicated under Section 36(b) in instances when an adviser pays fund fees to its own affi liates who then make distribution-related payments to intermediaries. Th e SEC cautions that in such cases fund boards should analyze the fees for potential distribution aspects applying the same stan-dard used in evaluating advisory fees during a fund’s Section 15(c) review process. Id.

21 PricewaterhouseCoopers, supra n.11, at 6. 22 Distribution Guidance, supra n.3, at 5. 23 Deloitte, supra n.15. 24 Id. 25 Distribution Guidance, supra n.3, at 3. 26 Distribution Guidance, supra n.3, at 2. Th e

Distribution Guidance also noted that during its examinations OCIE found that many mutual funds did not have explicit policies and procedures as part of their Rule 38a-1 compliance programs designed to prevent violations of section 12(b) and Rule 12b-1. Th e Distribution Guidance cautioned funds to develop such compliance policies and procedures and went even further to note that the prohibitions

of Section 12(b) and Rule 12b-1(a) apply also to mutual funds that have not yet adopted a Rule 12b-1 plan. Industry observers note that many fund groups do not have formal compliance policies and proce-dures related to Rule 12b-1 but that in light of the Distribution Guidance many may begin to put such policies in place. Id. at 5.

27 Distribution Guidance, supra n.3, at 2. 28 PricewaterhouseCoopers, supra n.11, at 25. 29 Barrington Partners, supra n.14, at 17. 30 Inv. Co. Inst., Financial Intermediary Controls

and Compliance Assessment Engagements 3 (2014), https://www.ici.org/pdf/27847.pdf (“Recogn-izing the benefi ts of creating a standardized and effi cient way for fi nancial intermediaries to report on the eff ectiveness of their control environment, a working group of Investment Company Institute (ICI) member fi rms and representatives of the four national accounting fi rms developed the Financial Intermediary Controls and Compliance Assessment (FICCA) engagement framework in 2008.”).

31 Press Release, US Securities and Exchange Commission, “SEC Charges Investment Adviser and Mutual Fund Board Members With Failures in Advisory Contract Approval Process” (June 17, 2015), available at https://www.sec.gov/news/pressrelease/2015-124.html. See also Press Release, “US Securities and Exchange Commission, Former Mutual Fund Directors Agree to Settle Claims Th at Th ey Failed to Properly Oversee Asset Valuation” (June 13, 2013) available at https://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171574878.

32 In the Fund Supermarkets Letter, the SEC wrote: “Th e board is responsible for determining whether any portion of a fund supermarket fee paid (or to be paid) by the fund is for distribution, i.e., ser-vices primarily intended to result in the sale of fund shares. Whether or not any particular payment of a fund supermarket fee by a fund is for distribution services or non-distribution services is primarily a question of fact for the fund’s board of directors to determine.” Fund Supermarkets Letter, supra n.4, at *8-9.



33 Id. at *9. Th e factors involved in this determina-tion include: (1) the nature of the services provided; (2) whether the services provide any distribution-related benefi ts; (3) whether the services provide non-distribution-related benefi ts and are typically pro-vided by fund service providers; (4) the costs that the fund could reasonably be expected to incur for comparable services if provided by another party, relative to the total amount of the fee; and (5) the characterization of the services by the intermediary. Distribution Guidance, supra n.3, at 18.

34 Th ese additional issues include: (1) information about the specifi c services provided under the mutual fund’s sub-accounting agreements; (2) the amounts being paid; (3) 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; (4) whether any of the ser-vices could have direct or indirect distribution ben-efi ts; (5) how the adviser and other service providers ensure that the fees are reasonable; and (6) how the

board evaluates the quality of services being deliv-ered to benefi cial owners (to the extent of its ability to do so). Distribution Guidance, supra n.3, at 4.

35 In the Rule 12b-1 Adopting Release, the SEC sug-gested nine factors fund directors should consider with respect to approving implementation or contin-uance of a Rule 12b-1 plan: (1) the need for indepen-dent counsel or experts to assist directors in reaching a determination; (2) the nature of the “problems” or “circumstances” that make the plan necessary or appropriate; (3) the causes of such problems or circumstances; (4) how the plan would address or alleviate the problems; (5) the merits of alternative plans; (6) the interrelationships between the plan and distributors; (7) the possible benefi ts of the plan to other persons relative to the benefi ts to the fund; (8) the eff ect of the plan on existing shareholders; and (9) in deciding whether to continue a plan, whether the plan has produced the anticipated benefi ts to the fund and its shareholders.

36 Distribution Guidance, supra n.3, at 14.

Copyright © 2016 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer, July 2016, Volume 23, Number 7, pages 1, 4–14,

with permission from Wolters Kluwer, New York, NY, 1-800-638-8437, www.wklawbusiness.com