March 10, 2013 3:49 am

Regulators demand scrutiny of payments

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The US Securities and Exchange Commission seal hangs on the facade of its building©Getty

Watching like a hawk: the SEC has made distribution fees an examination priority

How US mutual funds pay distributors and what services they receive is seen as an emerging risk for the Securities and Exchange Commission, a reaction that also highlights the latest push by global regulators for greater transparency.

The SEC’s examination-priorities list for 2013 highlights attention on “payments for distribution in guise” and a renewed interest in continuing sales charges or 12b-1 fees the funds pay to distributors. The added regulatory pressure comes as funds and their advisers find it more expensive to get their products on broker-dealer platforms.

While the SEC has made distribution fees an examination priority, the UK’s Financial Services Authority’s Retail Distribution Review (RDR) banned its version of 12b-1 fees, or continuing commission, on independent advised sales in January. The Netherlands will follow later this year and Germany and Spain are looking to eliminate continuing sales charges by their funds.

“There is definitely a global movement to transparency,” says John Rekenthaler, vice-president of research at Morningstar.

The goal of the RDR is to provide investors with greater transparency on what services they were receiving by unbundling the distribution fee out of the funds’ expenses. The investor who hires the adviser pays them directly rather than the fund paying the adviser commission.

SEC examiners’ visits to fund companies are part of a national effort by the US regulator’s various divisions and regional offices to learn more about the large amount of money paid to distributors, says Andrew Bowden, deputy director of the agency’s Office of Compliance Inspections and Examinations. SEC examiners will conduct so-called sweeps, or site visits of asset managers, advisers and distributors.

The SEC’s review of mutual fund distribution and service payments is being termed a fact-finding mission as examiners gather information on changes over the past decade, Mr Bowden says. These examiners will review whether advisers are receiving more in revenue share than they did five years ago, what funds are forking out for shareholder servicing fees, what services funds are receiving in return, the level of board oversight and what is being disclosed to investors.

“Given the amount of mutual funds sold through distributors, the amount of investor money invested in those funds, and the amount of money paid by advisers and funds to distributors in the past 10 years, it’s an important area to go out and make sure we have a good understanding,” Mr Bowden says.

Rulemaking efforts around distribution fees, commonly called 12b-1 reform, have been a perennial issue with the industry. Elisse Walter, now acting SEC chairman, announced in April 2011 as a commissioner that such reform would take place the summer of that year, but the effort lost momentum as money-market reform and other Dodd-Frank demands took precedence.

There are clear distinctions between the SEC’s new examination of distribution fees and the FSA’s “commission-centric” rule, says David Hearth, partner at Paul Hasting. Perhaps the most notable difference is that the SEC is focusing its attention on how fees are paid, reported and disclosed, as opposed to the FSA moving right ahead and banning continuing sales charges.

But funds, nonetheless, will have to contend with increased SEC scrutiny in how they are paying for distribution. If they do not have enough to cover distribution from their 12b-1 fees, limited to 25 basis points, or record-keeping fees, then they will have to rely on their advisers to cut a payment to the distributor, Mr Hearth says.

“The front-end bill [to get on the platform] is higher,” he adds, saying that in some cases there are continuing basis point charges that stay on the distributor’s platform.

The fund adviser often is left with a “stark choice” between paying out of its own pocket or suspending sales of that fund through that intermediary, Mr Hearth says. “The one thing I don’t see happening is all this [SEC] attention resulting in a rollback of price increases.”

John Bosley, chief operating officer of Bonaire Software Solutions, expects the focus on transparency with the FSA’s RDR and the SEC’s own review of distribution fees to influence other regulators considering ways to improve transparency within their market structures.

The financial crisis and its global implications have additionally spurred even greater communication among regulators, so it should not be surprising to see them looking to each other for potential lessons on future reforms, Mr Bosley says. “If one country sees another taking a leadership role to protect consumers, they will be pressured to do the same.”

Morningstar’s Mr Rekenthaler adds that he expects the SEC’s examination of distribution fees to be “possibly a first step along a longer path” towards further reforms.

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