Board Oversight of Distribution and Financial Intermediaries

One of the SEC’s stated focuses is on payments for “distribution in guise.” Mutual funds are only permitted to pay for distribution of their shares if they have adopted a Rule 12b-1 plan. Funds are not permitted to pay for distribution outside of Rule 12b-1, but they are permitted to pay for shareholder servicing outside of Rule 12b-1. So, the SEC is assessing whether payments made by funds outside of Rule 12b-1 are really payments for distribution.

This focus comes about because of the increasing role of financial intermediaries (such as broker-dealers, fund supermarkets, and financial advisers) in distributing mutual fund shares, particularly through fund supermarkets. Financial intermediaries are now integral to the distribution of mutual funds. These intermediaries also provide a variety of services to fund shareholders that would otherwise be provided by funds, including their transfer agents. These services may include: trade processing, accounting of investor positions, receipt and processing of investor trade orders, servicing of investor accounts, and tax reporting and distribution of other information. Payments to intermediaries for such shareholder servicing are commonly referred to as “subaccounting” or “sub-transfer agent” fees.

So, payments to financial intermediaries cover both distribution and shareholder servicing. This means mutual funds need to ensure that they only pay for distribution if they have a Rule 12b-1 plan, and to ensure that the payments made for shareholder servicing are reasonable and are not payments for distribution in guise. In order for a board of directors to ensure compliance with these items, the board should fully understand the funds’ distribution and shareholder servicing structure by reviewing the following questions:

• What types of intermediaries sell the funds’ shares?
• 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?
• How are the intermediaries compensated for their services?
• What payments does the investment adviser make to the intermediary partners? How are they calculated?
• What process does the funds’ chief compliance officer use to oversee intermediaries’ compliance with regulations and fund policies?

Directors should also review the analysis used to determine that the amounts being paid for shareholder servicing are reasonable. In making this determination, a number of mutual funds follow the “avoided cost” method in which they attempt to determine the “savings” in fees for shareholder servicing that they realized from participating in fund supermarkets, and pay that amount to the sponsors. For example, a transfer agent that charges a fund $18.00 for each account on its records would only charge the fund $18.00 for an omnibus account, where the charge would be much higher if the omnibus account was not used and each customer of the sponsor had an account on the transfer agent’s records. While the “avoided cost” method is utilized by a number of funds, it is not the only permissible method and payments in excess of the avoided costs may be considered reasonable if such payments are comparable to those paid by mutual funds in general for shareholder servicing.