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SEC Reg BI Will 'Force Changes' in Revenue Sharing: Morningstar

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The Securities and Exchange Commission’s Regulation Best Interest will “force changes” in revenue sharing arrangements as brokers work to mitigate conflicts to comply with the rule, a new Morningstar paper asserts.

Reg BI “will both challenge and alter the industry in its fund-distribution practices,” the Morningstar authors write in their just-released paper, Regulation Best Interest Meets Opaque Practices.

Modern conflicts, Morningstar writes, “mostly involve revenue sharing — the practice of a fund sharing money back with broker-dealers under a variety of opaque arrangements.”

Because brokers now have an obligation to mitigate and disclose the kinds of conflicts that revenue sharing can create, “we expect certain kinds of arrangements to get increasing scrutiny as the regulation goes into force,” the Morningstar authors write.

The paper assets that because not all revenue-sharing payments create conflicts, Morningstar built a taxonomy of revenue-sharing payments from the least to most likely to create conflicts of interest: educational expenses; platform fees; data fees; select lists; and payments based on sales, assets or accounts.

“Critically, the degree to which any revenue-sharing arrangement creates a conflict depends on the magnitude of the payments and the degree to which the payments are directly tied to sales,” the paper states.

The authors recommend that policymakers as well as market participants use Morningstar’s taxonomy when evaluating revenue-sharing arrangements for the level of conflict they create.

“We also recommend that the SEC collect data on revenue sharing in a structured, standardized format to facilitate further research in this area,” the authors state.

The authors maintain that conflicts embedded in popular share classes “are often opaque and harder to evaluate than other conflicts of interest.”

The paper maintains that “the degree to which revenue sharing creates conflicts of interest depends on the magnitude of the payments and the degree to which they are tied to sales.”

While the SEC has not historically regulated revenue sharing, the agency has begun to crack down on the practice via its Share Class Selection Disclosure Initiative, which zeros in on advisors placing clients in higher-cost mutual fund share classes that charged 12b-1 fees without disclosing that there was a lower-cost option in the same fund.

Aron Szapiro, Morningstar’s director of policy research, told thinkAdvisor in a Monday email message that Reg BI implementation ”will likely accelerate existing trends that are making funds with loads and 12b-1 fees increasingly less popular,” adding that the trend away from these share classes “are years old.”

As the paper explains, revenue sharing typically flows from a fund’s advisor to a third party that sells the fund.

“In contrast to payments from the expense ratio for distribution, the SEC has not focused on revenue-sharing payments from the fund sponsor to the broker—perhaps because these do not factor into the fund expense ratio,” the paper states. “However, precisely because these payments are not disclosed in the expense ratio, they are more opaque and more likely to create a conflict of interest for broker/dealers and advisors selling mutual funds.”


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