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October 27, 2014

Distribution Payments in “Guise”: An SEC Examination Priority

The SEC staff  recently issued its examination priorities for 2013.1 One item of  interest to retirement market participants is the staff ’s intention to focus “on the wide variety of  payments made by advisers and funds to distributors and intermediaries.”  According to the staff, such “payments go by many names and are purportedly made for a variety of  services, most commonly revenue sharing, sub-TA, shareholder servicing, and conference support.”  The staff  intends to assess whether the payments are being made in compliance with applicable law, including Rule 12b-1 under the Investment Company Act of  1940 (1940 Act).  In other words, the staff  will be looking for payments that ostensibly are for nondistribution services but instead are for distribution.

Rule 12b-1 provides the exclusive means by which a mutual fund may pay – directly or indirectly – for distribution of  its shares.  The rule requires a written plan adopted by the fund’s board and approved by its shareholders.  The fund must pay for distribution only pursuant to the 12b-1 plan, but it may pay for nondistribution services either pursuant to or outside of  the 12b-1 plan.  Issues arise if  payments outside the plan could be viewed as being made indirectly for distribution.

The SEC staff  previously considered similar issues in the context of  payments made by a fund, its investment adviser and affiliates of  the adviser to sponsors of  “fund supermarkets.”2 The staff  noted that funds participate in supermarkets “to sell more of  their shares and to increase assets under management” and concluded that whether payments to sponsors must be made pursuant to a 12b-1 plan depends on “the purpose of  the payments and the party making the payment.”

The staff  took the position that, because of  the objective of  these arrangements, at least part of  the fees paid to a sponsor had to be considered payments for distribution, i.e., “for services that are primarily intended to result in the sale of  the fund’s shares.” The staff  acknowledged that part of  the fees could be for non-distribution services.  It emphasized the responsibility of  the fund’s board to determine whether the fund was paying, directly or indirectly, for distribution or non-distribution services. In the case of  non-distribution services, the staff  said that the fund’s board should consider the nature of  the services, determine whether the fee paid by the fund for them is reasonable in relation to the value of  the benefits received and the cost to the fund to obtain the services elsewhere and insure that the fund does not pay for services that duplicate services already being provided.

In considering fees paid by the fund’s adviser and its affiliates, the staff  referred to earlier SEC guidance regarding whether an advisory fee paid by a fund toits adviser might constitute an indirect payment for distribution by the fund.3 In the view of  the SEC,  it is impermissible for an advisory contract to serve as a conduit for the indirect payment of  distribution expenses outside a 12b-1 plan.  This situation could arise, for example, if  the advisory fee included an allowance for distribution.  The SEC, however, also takes the position that it is permissible for an adviser to use its own resources, including those arising from its legitimate profits under the advisory contract, to pay for distribution of  the fund’s shares.  Legitimate profits are those an adviser derives from advisory fees which, for purposes of  the 1940 Act, are “not excessive” in relation to the services rendered.  If  the fund’s board is satisfied that an adviser’s distribution payments are being made out of  its own resources, it may conclude that the advisory contract is not a conduit for the indirect payment of  distribution expenses.

The SEC staff ’s current examination priority will focus not only on the purpose of  various kinds of  payments but also on board oversight of  the payments and the adequacy of  disclosures made to the board about the payments.  This focus can be expected to lead to heightened attention by fund boards to payments for non-distribution services made by funds and by their advisers and affiliates.  Those who provide and pay for those services should expect increased scrutiny of  their arrangements, including the nature of  the services being provided and associated costs and profits.


1  SEC, Office of  Compliance Inspections and Examinations, “Examination Priorities for 2013” (Feb. 21, 2013) at 5.

2  Investment Co. Institute (pub. avail. Oct. 30, 1998).

3  1940 Act Release No. 16431 (Jun. 13, 1988)

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John W. Blouch, Securities Attorney, Drinker Biddle Law Firm
Of Counsel

John W. Blouch is of counsel in the firm's nationally ranked Investment Management Practice Group. His practice focuses on the federal securities laws and their application to participants in the financial services industry, such as insurance companies, banks, investment companies, investment advisers and broker-dealers, as well as to companies and individuals generally.

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Of Counsel

Bruce W. Dunne is of counsel in the firm's nationally ranked Investment Management Practice Group.  He focuses his practice on the registration, reporting, exemptive and other provisions of the federal securities laws, with emphasis on their application to investment companies, including retail and variable insurance products mutual funds, insurance company separate accounts and private investment funds, and to investment advisers.  Bruce also has extensive experience in mutual fund reorganizations, organizing new business entities, private and public offerings of...

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