Why SEC Is Cracking Down on 12b-1 Fees and ‘Distribution-in-Guise’

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:

1. Maintaining separate records for each customer in the omnibus account for each fund
2. Transmitting purchase and redemption orders to the funds
3. Preparing and transmitting account statements for each customer
4. Transmitting proxy statements, periodic reports, and other communications to customers
5. Providing periodic reports to the funds to enable each fund to comply with Blue Sky requirements
6. 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.