This past week the SEC announced a $40 million enforcement action against investment advisor First Eagle Investment Management and its affiliated broker-dealer FEF Distributers for what it touted as the first to arise from its “distribution-in-guise” initiative.
Advisors to funds have been anxiously awaiting some sort of guidance since the SEC first announced the initiative several years ago, but as is all too often the case, it has finally arrived in the form of an enforcement action.
To understand what the SEC is really after with its distribution-in-guise initiative, it’s helpful to take a step back to 1980: Ronald Reagan defeated Jimmy Carter in the presidential election, the U.S. Olympic hockey team defeated the Soviet Union in the Miracle on Ice, and the fund industry was feeling defeated by a “significant and consistent outflow of cash from its funds.”
As SEC Financial Economist Lori Walsh elaborates:
The investors that remained in the funds were paying increasingly higher expenses, as the fixed costs of the funds were spread over ever fewer shareholders. The industry asked the SEC to allow advisers to use fund assets to pay for distribution costs. This would allow funds to compete on a more level playing field with other investment products that did not charge upfront loads, leading to a net cash flow into funds and scale economies for shareholders. The SEC adopted Rule 12b-1 in October 1980.
In short, Rule 12b-1 was at least partly born out of the desire to juice the sale of fund shares so that fund shareholders could collectively benefit from the resultant economies of scale. The Rule thus permits fund assets (i.e., shareholders’ wallets) to be used to promote the sale of fund shares by paying for marketing and distribution of the fund.
The Rule calls for such marketing and distribution payments to be made pursuant to a plan, which must be approved annually by individuals with a fiduciary duty to act in the best interests of fund shareholders: the fund’s board of directors. To satisfy disclosure concerns, the specific amount to be drawn from a fund’s net assets to pay for marketing and distribution must be disclosed to shareholders in the prospectus as a line item of the fund’s annual operating expenses.
Fund assets increase, the advisor to the fund earns more fees from the fund, fund marketers and distributors get paid and each shareholder individually bears less fixed costs. Seems like a win-win, right?
Fast forward to 1998: The Clinton/Lewinsky scandal unfolds, Google is founded and fund supermarkets are all the rage. Think of a fund supermarket as just that: a supermarket bearing the name of any custodial brokerage firm that offers its brokerage clients the ability to purchase and sell a variety of funds through its platform.
An investor is offered a “one-stop shop” that can hold a variety of investment products in a single networked or omnibus account as opposed to the investor needing to open a variety of disparate accounts directly with each fund company.
For the privilege of having their funds available at such supermarkets (or “intermediaries,” to use broader, more modern parlance), funds and/or their advisors may pay the intermediaries a variety of fees.
Here’s where the crux of the distribution-in-guise initiative begins to unfold: depending on what services the intermediary performs in exchange for these fees, the fund may need to pay at least some of these fees pursuant to a 12b-1 plan.
If the services received by a fund are primarily intended to result in the sale of fund shares (i.e., marketing or distribution services), such fees must be paid pursuant to a 12b-1 plan if paid out of fund assets. If the services received by a fund are primarily services that would otherwise need to be performed by the fund’s transfer agent (i.e., sub-TA services), such fees may legitimately be paid out of fund assets without a 12b-1 plan.
In the First Eagle order, the SEC outlined several examples of sub-TA services that may be paid out of fund assets without a 12b-1 plan:
- Maintaining separate records for each customer in the omnibus account for each fund
- Transmitting purchase and redemption orders to the funds
- Preparing and transmitting account statements for each customer
- Transmitting proxy statements, periodic reports, and other communications to customers
- Providing periodic reports to the funds to enable each fund to comply with Blue Sky requirements
- Providing standard monthly contingent deferred sales charge reports
If a fund desires to receive marketing and distribution services from an intermediary and does not have a 12b-1 plan from which to draw, the fund’s advisor can generally pay such fees if it does so out of its legitimate profits. Legitimate profits do not include marking up the advisory fee it charges the fund just so it can make marketing and distribution payments to an intermediary.
Guidance to this effect appeared in the seminal 1998 ICI No-Action Letter (aka Schwab Supermarket Letter) that to date has been the standing order for funds and intermediaries. If anything, the First Eagle order reinforces the 1998 ICI No-Action Letter.
The bottom line is that fund assets can’t be used to pay for distribution outside of a 12b-1 plan.
First Eagle’s intermediary agreements outright called for intermediary payments to “distribute fund shares” outside of its 12b-1 plan to the tune of almost $25 million over the course of six years, so it’s understandable that the SEC took issue. First Eagle the investment advisor should have paid the $25 million in distribution costs out of its own profits, says the SEC, rather than billing fund shareholders.
It’s no secret that a lot of money changes hands among investment management industry participants, and it’s likely that the practice of “revenue sharing” isn’t going anywhere any time soon. For now the SEC seems less concerned with direct advisor to intermediary revenue sharing (with proper disclosure), but will not tolerate misallocating revenue sharing costs to fund shareholders.