SEC Issues Interpretive Guidance under the Investment Company Act of 1940 that Now Allows Brokers to Charge Their Own Commissions on Sales of Mutual Fund Shares

January 13, 2017

By The Investment Management Practice

In an SEC no-action letter published on January 11, 2017 (the “No-Action Letter”), the staff of the SEC’s Division of Investment Management (the “Staff”) concluded that the restrictions of Section 22(d) of the Investment Company Act of 1940 (the “1940 Act”) would not apply to a broker when that broker acts as an agent on behalf of its customers and charges its customers broker-set commissions for effecting transactions in “Clean Shares” of a registered investment company.[1] The No-Action Letter was issued in response to a request from American Funds’ parent Capital Group Companies, Inc. (“Capital Group”).

The No-Action Letter comes at a time when many fund intermediaries and fund companies are working toward solutions designed to allow continued sales of mutual fund shares under the Department of Labor’s (the “DOL”) Conflict of Interest Rule (“DOL Rule”). In general, the DOL Rule was crafted to address perceived conflicts of interest issues when investment advice is presented to retirement accounts and Individual Retirement Accounts (“IRA”). Under the new DOL Rule, the DOL has, among other things, sought to eliminate conflicts of interest that may arise when a broker recommends one fund over another because of a higher commission payout.[2] In response to the DOL Rule and in an effort to accommodate fund intermediaries, the fund industry has explored certain solutions that would address the landscape under the DOL Rule. For example, certain fund shops have begun to roll out T shares,[3] and more recently, the Staff issued an IM Guidance Update in which the Staff articulated its views regarding certain disclosure issues and other requirements which many fund shops have been grappling with in response to fund intermediaries’ requests for certain share class amendments post the DOL Rule.[4]

In relevant part, Section 22(d) of the 1940 Act prohibits a fund company from selling its shares except at “a current public offering price described in the prospectus” to any person other than to or through a principal underwriter for distribution. In the No-Action Letter, Capital Group noted that while Section 22(d) does not apply to brokers, certain firms are unsure whether their sales-related activities whereby they will apply their own commission to fund transactions could result in their being deemed a dealer by the SEC. Thus, the Capital Group noted in its no-action request that the SEC could resolve this point of confusion by clarifying that when a broker-dealer acts as agent on behalf of its customers and effects transactions in Clean Shares, that it could charge a commission without being subject to the restrictions of Section 22(d). In connection with its no-action request, the Capital Group made the following representations:

The broker will represent in its selling agreement with the fund’s underwriter that it is acting solely on an agency basis for the sale of Clean Shares;
The Clean Shares sold by the broker will not include any form of distribution-related payment to the broker;[5]
The fund’s prospectus will disclose that an investor transacting in Clean Shares may be required to pay a commission to a broker, and if applicable, that shares of the fund are available in other share classes that have different fees and expenses;
The nature and amount of the commissions and the times at which they would be collected would be determined by the broker consistent with the broker’s obligations under applicable law, including but not limited to applicable FINRA and DOL rules; and
Purchases and redemptions of Clean Shares will be made at net asset value established by the fund (before impositions of a commission).

Based in part on the foregoing representations, the Staff concluded that the restrictions of Section 22(d) would not apply to a broker when the broker acts as agent on behalf of its customers and charges its customers broker-set commissions for effecting transactions in Clean Shares. Furthermore, the Staff noted that Section 22(d) does not prohibit a principal underwriter for the Clean Shares from entering into a selling agreement with a broker under the facts described in the No-Action Letter. The Staff concluded that the position articulated in the No-Action Letter does not depend on whether the broker sells Clean Shares to investors in retirement accounts or non-retirement accounts.

Where does the fund industry go from here? Will the No-Action Letter, in conjunction with the DOL Rule, signal the beginning of the end for 12b-1 fees? How will brokers posture a potential sale to a retail client of a share class that bears a 12b-1 fee when a Clean Share class is also available? One can foresee that this dilemma may begin a demise of 12b-1 fees, without the SEC’s fingerprints on the convention’s death. Furthermore, as the No-Action Letter request pointed out, the intent is to put mutual funds on the same playing field as ETFs, which generally do not pay any compensation to third parties out of fund assets, including 12b-1, sub-transfer agency, and record-keeping fees; and as a result of this No-Action Letter, conceptually a mutual fund that offers a Clean Share should be able to sit side by side with a similar ETF on a brokerage platform. On the other hand, this No-Action Letter does pose an interesting question for those ETFs that have an approved 12b-1 plan (even if inactive):[6] if a similar mutual fund now offers a Clean Share, will this result in the ETF with a 12b-1 plan wanting or needing to terminate its plan? Another potential consequence of this No-Action Letter is that brokerage firms are likely to begin setting competitive commission schedules as they try to compete with each other for transaction business. For example, we have already seen certain providers do this in the ETF context.[7] Finally, it appears that through the No-Action Letter the SEC has effectively drawn a line between the broker-dealer distinction, at least for purposes of selling shares of registered investment companies.

If you have any questions regarding this client alert, please contact the Paul Hastings attorney with whom you regularly work.

A copy of the SEC’s No-Action Letter can be found here.

[1] The No-Action Letter characterizes Clean Shares as a class of shares of a registered investment company without any front-end load, deferred sales charge, or other asset-based fees for sales or distribution.

[2] For its part, the SEC has dealt with this issue by bringing enforcement actions against investment advisers. See Administrative Proceeding File No. 3-15549, Administrative Proceeding File No. 3-17169, and Administrative Proceeding File No. 3-17051.

[3] Lord Abbett and Wells Fargo are some of the fund shops that have initiated the introduction of T Shares. T Shares will generally have the following economics: 2.5% front-end load and a 0.25% Rule 12b-1 fee.

[4] See IM Guidance Update No. 2016-06, available at https://www.sec.gov/investment/im-guidance-2016-06.pdf.

[5] The No-Action Letter does not address the effect under Section 22(d) of a broker receiving revenue sharing payments from the fund’s adviser.

[6] For example, the Select Sector SPDR® Trust provides for 12b-1 fees.

[7] Charles Schwab and Fidelity currently offer commission-free ETF trading.

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