The SEC released recently a no-action letter in which it permitted share class arrangements (dubbed “clean shares”) under which brokers, rather than mutual funds, would set the commission rates on fund shares for their customers as long as certain conditions are met. The guidance comes as brokers seek to reorganize their business models in the wake of the Department of Labor’s fiduciary rule, which is set to take effect in April of this year. The SEC’s guidance may have a wide ranging effect on how mutual fund shares are purchased and sold in the future.
Under Section 22(d) and Rule 22d-1 of the Investment Company Act of 1940, sales loads and distribution fees are set at the fund level and not by the intermediaries that place their customers into the funds. The rule provides that neither a fund, nor its underwriter, nor “dealers” may sell mutual fund shares at other than the current public offering price stated in the fund prospectus. Capital Group Companies, Inc., however, successfully persuaded the SEC that a broker, acting solely in its capacity as agent for an investor, would not be acting as a “dealer” under Section 22(d) and therefore could charge transaction fees or commissions to its customers on clean shares without violating Section 22(d). This fee arrangement assists brokers in complying with the new DOL fiduciary rule for their retirement accounts, which favors payments to them from the customers rather than third parties like mutual funds. The guidance, however, is not limited to brokers acting on behalf of retirement assets. In that regard, it appears that the brokerage industry is seeking to set the same pricing across all brokerage accounts whether they are retirement or non-retirement in nature. Accordingly, clean shares could appeal to a wide variety of brokerage clients.
Conditions of the Guidance
There are five conditions that must be met for a broker to charge transaction fees on clean shares transactions:
- The broker must 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;
- 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, the 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 Department of Labor rules; and
- Purchases and redemptions of clean shares will be made at net asset value established by the fund (before imposition of a commission).
Some Open Questions
The guidance is clear that clean shares may not be sold with “any front-end load, deferred sales charge, or other asset-based fee for sales or distribution.” The guidance does not prohibit sub-transfer agency or shareholder servicing payments (together, “Servicing Fees”). However, many fund complexes charge a combined Rule 12b-1 distribution and service fee, and it is not clear how a Rule 12b-1 service fee would be treated under the guidance. In addition, Servicing Fees have been the subject of recent SEC scrutiny and, if determined to be distribution in guise payments, could pose an issue for brokers and fund sponsors under the clean shares guidance. It is worth noting also that Capital Group Companies, Inc.’s written request for the no-action letter discussed the need for an open-end fund share class like clean shares that mirrored ETF share economics – i.e., no 12b-1, sub-transfer agency or record-keeping fees charged at the fund level. While the SEC did not restrict the use of Servicing Fees on clean shares, the industry may move in this direction in order to compete with ETFs.
Another question raised is the extent to which other share classes may continue to co-exist with clean shares. For example, a number of mutual fund sponsors have recently filed registration statements to create a new share class that has become known as Class T, in order to retain and attract intermediaries that are subject to the DOL fiduciary rule. Class T shares generally have a sales load that is lower than other existing share classes and, with some exceptions, charge Rule 12b-1 and Servicing Fees, but they permit each intermediary to determine the sales loads that will be charged on fund shares as long as the charges are the same for each intermediary. Brokers that might otherwise have preferred class T shares may instead prefer clean shares, and other share classes that charge loads may become less attractive as the intermediary industry continues to restructure business operations in light of the DOL fiduciary rule.
Mutual fund groups that currently offer no-load share classes may be able to use these classes to create clean shares, rather than creating new classes. If so, depending on the amount of changes necessary in the registration statement, it will be important to analyze the extent to which a filing with the SEC might be necessary. In addition, if a fund offers clean shares to brokers, fund sponsors should review selling agreements and revise selling agreements to comply with the guidance. More generally, mutual fund boards of directors should be prepared for a year of potential share class changes and related filings.