Mutual Funds and Regulation

Compensation for Mutual Fund Sales Todd Cipperman, Esq., Cipperman & CompanyNovember 1, 2007

2Compensation for Mutual Fund Sales Confidential Copyright 2007 FINRA

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Overview

Loads

Breakpoints

Rule 12b-1 Fees

Multi-Class and Master Feeder Funds

Revenue Sharing

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Sales Load

Purpose: Pay broker-dealer commissions and provide compensation for other marketing expenses related to distribution

Definition: the difference between the price of a security to the public and that portion of the proceeds from its sale which is received and invested or held for investment by the issuer (§2(a)(35) of the 1940 Act)

Authority Rule 22d-1: Sales loads allowed despite Section 22(d) so long as

scheduled variation applied uniformly Rule 6c-10: Permits CDSC in compliance with Conduct Rule 2830

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Sales Loads – Types

Front-End: Load deducted before investment

Back-End (Deferred): Load deducted from redemption proceeds

Contingent Deferred Sales Charge (CDSC): Back-End Load decreases each year shares are held Typically eliminated after 6-8 years Asset-based sales charge (12b-1 fees to compensate brokers)

No Load Funds: No front-end or back-end sales charges; 12b-1 fees less than 25 bps

Level Load Funds: Low (e.g. 1%) load for each year in stated period; 12b-1 fees (trailers to Reps)

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Sales Loads – Limits§22(b) of 1940 Act, NASD Conduct Rule 2830(d)

If no asset based sales charge (12b-1): 7.25% - 8.5% depending on rights of accumulation/quantity discount 7.25% if fund pays a service fee

If asset based sales charge (12b-1): 6.25% if fund has adopted plan under which service fees are paid 7.25% if no service fees paid

No asset-based sales charge (12b-1) greater than .75%; service fees less than .25%

Marketing: Many brokers do not like to sell “load” funds

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Front-End Sales Loads – Typical Schedule

Amount of Purchase As a % of Public Offering Price

As a % of Net Asset Value

Less than $100,0004.75 % 4.99%

$100,000 to $750,0003.75% 3.90%

$750,000 to

$2 Million 2.75% 2.82%

$2 Million or over1.75% 1.78%

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CDSC – Typical Schedule

Years after purchase CDSC

1st year 5%

2nd year 4%

3rd year 3%

4th year 3%

5th year 2%

6th year 1%

After 6th year None*

*Usually convert to Class A

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Breakpoints

The dollar amount at which the Load declines

Right of Accumulation: Combining several transactions to get the benefit of breakpoints

Letter of Intent: Obtain the breakpoint by investing over a period of time

Combining multiple accounts

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Breakpoints – A Breakdown

Failure to give investors benefit of breakpoint discounts especially with respect to multiple accounts, rights of accumulation, letter of intent See NASD Notice to Members 02-85

Failing to notify investors of the benefit of a breakpoint

Fifteen firms agreed to pay $21.5 Million in fines as a result of joint examination Joint SEC/NASD/NYSE sweep 1 in 3 eligible transactions did not get breakpoints

See Report of the Joint NASD/Industry Task Force on Breakpoints (July 2003)

Note: Similar issue with NAV transfer programs (See AXA Advisors (February 26, 2004))

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Legal Authority for Breakpoints

17(a)(2): It is unlawful for any person in the offer or sale of any securities…to obtain money or property by means of an untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading…

10b-10: It shall be unlawful for any broker or dealer to effect for or with an account of a customer any transaction in, or to induce the purchase or sale by such customer of, any security…unless such broker or dealer, at or before completion of such transaction gives or sends to such customer written notification disclosing… the source and amount of any other remuneration received or to be received by the broker in connection with the transaction.

NASD IM-2830-1: It is contrary to just and equitable principles of trade to sell investment company shares just below the point at which the sales charge is reduced on quantity transactions so as to share in the higher sales charges applicable on sales below the breakpoint.

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Rule 12b-1: The Issue

Section 12(b): It shall be unlawful for any registered open-end investment company…to act as distributor of securities of which it is the issuer.

Rule 12b-1(a)(2): A registered open-end investment company will be deemed to be acting as a distributor of securities of which it is the issuer if it engages directly or indirectly in financing any activity which is primarily intended to result in the sale of shares.

Policy- Existing shareholders should not pay costs of acquiring new shareholders

- Indirectly benefiting Advisor in violation of §36

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Rule 12b-1: A Safe Harbor

Mutual Fund may act as its own distributor:

Written plan and written agreements

Approved by shareholders

Approved by Board and Independent Directors/Trustees at in-person meeting Reviewed annually May be terminated at any time by Independent Directors/Trustees Must conclude “reasonable likelihood that the plan will benefit the company

and its shareholders”

Board receives quarterly report of amounts expended and purposes

Agreements can be terminated at any time by independent directors/trustees and terminate upon assignment

No material changes without shareholder and board approval

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Use of 12b-1 Fees

Compensate Brokers

Printing and mailing prospectuses

Printing and mailing sales and marketing materials

Advertising

Mutual Fund Supermarkets

Fund CDSC payments

“Defensive” plans for service and/or marketing fees

Many brokers don’t like to sell funds with 12b-1 fees Not a “No-Load” fund 12b-1 has low-end retail connotation for some investors

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E*Trade Securities (SEC NAL 11/30/05)

Facts• E*Trade rebates 12b-1 fees to customers holding accounts through

E*Trade

• No agreement with fund companies

Issue: Can Board determine that the 12b-1 Plan is reasonably likely to benefit shareholders?

Conclusion:• Rebate is one factor Board should consider

• What percentage of the fees are rebated?

• Agreement with the fund could violate Sections 18(f), 22(d) and 48(a) – aiding and abetting liability

• (Tax issue: Preferential Dividend?)

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Rule 12b-1(h): Directed Brokerage

Investment Company may not compensate a broker or dealer for the sale of shares by directing to the broker or dealer:• Portfolio securities transactions, or• Any other remuneration or fees (e.g. step-outs)

Investment Company may not direct transactions to a broker or dealer that promotes or sells its shares unless it has adopted policies and procedures reasonably designed to prevent:• The person responsible for selecting brokers to consider such sales activity;

and• The entering into of any agreement under which the company directs

portfolio securities transactions to a broker in consideration for the sale of shares

Note: NASD recently eliminated 2830(k)(7)(B), which allowed NASD member to sell a fund that considered sales as a factor in selecting brokers to execute fund trades

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NASD Fines 8 Firms $7.75 Million

Payment of directed brokerage in exchange for preferential treatment for certain funds

Violation of 2830(k) (Anti-Reciprocal Rule)

“We continue to pursue conduct which puts the interests of firms ahead of the interests of customers.” (Barry Goldsmith)

Preferred Partner/Shelf Space programs

Step-Out trading

Lord Abbett Distributor LLC (mutual fund distributor)

National Planning Corp.: non-cash compensation for credits toward rewards conference

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Multi-Class Funds

Without an exemption, multiple classes would violate prohibition on issuing senior securities. §18(f)(1) of 1940 Act.

Rule 18f-3: Multiple Classes permissible:– Each class has a different arrangement for shareholder services and/or

distribution and may pay different expenses (other than advisory, custodial, management)

– Approval by independent trustees

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Multi-Class Funds: Suitability

Typical fund family• Class A: Front-End Load• Class B: CDSC• Class C: Level Load

Class B may avoid load but 12b-1 fees increase expenses for long-term investors

• Consider benefit of breakpoints• See In re Michael Flanagan et.al. (January 31, 2000); In re Morgan

Stanley DW Inc. (November 17, 2003); In re Citigroup Global Markets, Inc. (March 23, 2005)

Many brokerage firms have stopped selling Class B shares.• See IM 2830-1• See NASD Alert “Class B Mutual Fund Shares: Do They Make the

Grade?” (June 25, 2003)

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Master-Feeder: Purpose

Asset Allocation

Marketing to multiple distribution channels• Institutional/Retail• Qualified/Non-Qualified• Insurance Company separate accounts• Onshore/Offshore

Multi-Class fund (Rule 18f-3) not flexible enough

Registration Costs

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Master-Feeder Types

Unaffiliated: limit to 3% of acquired fund

Affiliated i.e. part of same group of investment companies (held out to investors as related for investment and investor services):• All securities owned within the same family

• Master does not charge for distribution or aggregate sales loads not ` excessive under NASD rules

• Master cannot be a fund-of-funds

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Master-Feeder Example

Master Fund(e.g. equity)•Investments•Low Fees

Feeder Fundfor retail investors•12b-1 fees•TA fees•Servicing Fees

Feeder Fundfor 401(k)•TA fees•Servicing Fees

Retail Investors

401(k) Investors Defined

BenefitPlans

Master Fund(e.g. bond)•Investments•Low Fees

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Revenue Sharing: The Challenge

Pressure to distribute

Brokers could/would not sell front-end load funds

Regulatory scrutiny of Back-End Load shares

12b-1 fees inadequate• not “No Load”

• NASD Limits

Multi-Class Funds too restrictive

Master-Feeder too complicated

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Revenue Sharing: Direct Payments

Direct payments for production

Client Administration/Sub-TA arrangements

Sponsorship of conferences and seminars

Payment of marketing expenses

Directed brokerage and step-outs

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Revenue Sharing Limits

Payor (Fund Company)• Rule 12b-1• Disclosure• Restrictions on Loads• Section 36 of the 1940 Act • Rule 206(4)-3 of the Advisers Act (See also Dana Investment Advisors, Inc.

(SEC NAL 10/12/94)• 2830(k)• Private Rights of action (Cf. Oppenheimer, Merrill Lynch)

Recipient (Broker or Adviser)• Conduct Rules 2110 (equitable principles of trade), 2230 (confirmations),

2830(k) (quid pro quo arrangements)• Section 17(a)(2) of the 1933 Act• Rule 10b-10• Section 206 of Advisers Act (fiduciary responsibility)• Private Rights of action

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NASD Member Alert

Dealer Agts should delineate responsibilities

Failure to comply with agt that results in harm to shareholders would violate Rule 2110

Comply w/ prospectus and applicable law

No late trading or market timing

Apply breakpoints

Members should review dealer agreements

P/P procedures to ensure compliance

NASD Reminds Members of Their Responsibilities Regarding Sales of Mutual Fund Shares and Dealer Agreements (11/22/05)

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NYSE Guidance on Sales Practices(IM 05-54 and 06-38) Directed Brokerage

• New 12b-1: no directed brokerage as compensation for distribution• Due Diligence – reps from fund company re p/p, selection criteria• Policies and Procedures – reviews to identify correlation• Employee Training – part of Firm Element• Internal Reviews – promptly investigate reports

Revenue Sharing• Broad defn: percentage of advisory fees, equity call• Deliver disclosure of “existence, substance, and scope”• Do not rely on Prospectus/SAI• Applies to all investment products

Variable Annuities• Full disclosure of fees, surrender charges, tax penalties (deliver prospectus)• Stringent suitability analysis • No switching without clear economic justification

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Revenue Sharing: In re Morgan Stanley DW Inc. (Facts)

Partners Program: 16 out of 115 complexes

Payments:• 15-20 bps on gross sales• 5 bps on aged assets paid to reps• Higher commissions on Partner products and more compensation for

Branch Managers• Hard dollars and brokerage commissions

Benefits of “Preferred List”:• Access to reps through training, seminars, broadcasts• Priority review of fund materials

Note: Similar facts in actions against Quick & Reilly, Piper Jaffray, Edward Jones, Citigroup Global Markets

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Revenue Sharing: In re Morgan Stanley DW Inc. (Violations)

§17(a)(2): MSDW sold securities and obtained money without disclosing conflict of interest and payments

Rule 10b-10: Confirmation did not disclose the source or amount of all remuneration

2830(k): Favoring the sale of mutual fund shares based on receipt of commissions

Reliance on disclosure in Prospectus and SAI insufficient No disclosure that MSDW receives payments No disclosure about portfolio brokerage to MSDW in exchange for

enhanced sales and marketing No description of marketing advantages

Note: Also found violation of §17(a)(2) for inappropriate “B Share” Sales

Other possible violations: Rule 12b-1, §17(d) (joint enterprise), Best Execution

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Revenue Sharing: In re Morgan Stanley DW Inc. (Disclosure)

Website disclosure: Existence of the Program Participating Fund complexes Maximum amount received (in bps) Source of payments Maximum amount that Reps receive (in bps) Reps and Branch Managers receive greater compensation

Mutual Fund Bill of Rights to be sent to all retail customers on an annual basis

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Revenue Sharing:In re Putnam Investment Management

Facts Brokerage commissions for shelf space Negotiated formulas; “non-binding” letters

Violations Failure to disclose conflicts of interest to Board Failure to disclose to shareholders

Remedy $40+ Million in fines Approval by Board; Best Execution analysis Disclosure

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Revenue Sharing: Dept. of Enforcement v. American Funds Distrib., Inc.

Alleged Facts AFD directed Fund brokerage to top sellers Target commissions based on prior year sales Expectation of access to Reps Commission chart delivered to affiliate investment adviser

Causes of Action 2830(k): quid pro quo for sale of fund shares 2110: A member, in the conduct of his business, shall observe high

standards of commercial honor and just and equitable principles of trade.

NASD Hearing Panel imposed $5 Million fine Not acting with intent or reckless (voluntary changes) Appeal?

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A Changing Landscape

Separation of investment management from distribution

Citigroup/Legg Mason

Merrill Lynch/Blackrock

Pressure on Individuals Compliance Officers (See In re CapitalWorks Investment Partners and Mark

Correnti) In re Treadway

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Conclusion

Brokerage Firms, Advisers and their Reps demand compensation

Tremendous competition to grow assets and access distribution

Heightened potential for conflicts of interest

Follow the money

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Todd Cipperman is the principal of Cipperman & Company, which provides legal consulting services to investment managers, investment advisers, broker-dealers, mutual funds, hedge funds, and technology providers. Cipperman & Company provides a wide range of services for the industry including regulatory advice, product development, distribution arrangements, compliance programs, and client and vendor agreements.  Mr. Cipperman has more than 15 years of experience in the investment management and financial services industries. As a principal of Cipperman & Company, he has represented a wide range of investment management clients with a focus on distribution issues facing advisers and broker-dealers. He previously served as general counsel of a public mutual fund and financial technology firm, including its $65 Billion proprietary mutual fund family. He has also served as general counsel of one of the largest international equity managers. He spent several years in private practice on Wall Street representing both buy and sell side clients in investment management and capital markets transactions. He is a graduate of the University of Pennsylvania Law School and Cornell University.

Todd Cipperman, Esq.

150 S. Warner RoadSuite 140

King of Prussia, PA 19406tcipperman@cipperman.com

www.cipperman.com