SEC Division of Investment Management staff letter: Investment Company Institute

-,
UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON. D.C. 20549

:)IVISIOH OF
MEHT MANAGEMENT
Am ieA c: i ~i-cJ
SECTON
RUL \ ~b-\ PULIC I Io
AV,ATT,.A'RTT.r lC "3C1t6

October 30, 1998

Craig S. Tyle, Esg.

General Counsel

Investment Company Institute

1401 H Street, N. W.

Washington, D.C. 20005-2148.

Dear Mr.. Tyle:
We are writing to you to outline the views of the Division

of Investment Management on certain legal issues arising from the

participation of mutual funds in "fund supermarkets." As' you

know, fund supermarkets are an increasingly popular means through

which investors can buy and redeem shares of mutual funds. As of

late last year, approximately $79 billion had been invested in

mutual funds through no-transaction-fee fund supermarkets, an

increase of over 750% during the prior five years.!

In a typical fund supermarket, the sponsor of the program __

a broker-dealer or other institution - -' makes available various

services to a participating fund and its shareholders. The sponsor offers a menu of services including: establishing,

maintaining, and processing changes in shareholder accounts;

'communicating with shareholders; preparing account statements and

confirmations; and providing distribution services on behalf of,

or with, the fund. For the services that it provides, the

sponsor charges the participating fund a fee that is calculated

on the basis of the amount of 'assets of the fund's shareholders

that is held through the program~ The fee is paid by the fund,

its investment adviser, an affiliate of the adviser, or a

combination of all three entities.

The Commission's Office of Compliance Inspections and Examinations ("OCIE") recently conducted a review of fund supermarkets and several brokerage firms that sponsor fund

supermarket programs. The rßview revealed that different funds

participating in the programs generallyrecei ved the same

Sandra Block, Super-Marketing Mutual Funds Competi tion

Increases with One-Stop Shops, USA Today, Nov. 7, 1997, at lB.

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services from program sponsors, although the funds characterized

the services differently and paid for those services in different

ways. Some funds, for example, characterized all of the services

that they received as distribution-related in nature 'and paid for

those services through plans of distribution adopted pursuant to

rule 12b- 1 under the Investment Company Act of 1940. Other funds

characterized a portion of the services that they received as

administrative in nature and paid for those services outside of

rule 12b-1 plans. In some cases, advisers or their affiliates paid a portion of the fee. In the Division's view, payments of fees for participating

in fund supermarkets may be made pursuant to or outside of rule

12b-1 plans, depending on the purpose of the payments and the

party making the payment. Whether a fund's payment of part or

all of a supermarket fee must be made pursuant to a rule 12b-1

plan depends on an analysis of the purpose for which the payment.

is made. The determination of the purpose of the payment must be

made by' the fund's board of directors and requires careful'

consideration and monitoring.

Discussed below, after, an introductory section describing-

fund supermarkets and certain findings of the OCIE examinations,

are significant issues that we believe are raised by the

participation of funds in fund supermarkets. Following that

discussion, we explain the Division's view of the critical role

played by a fund's board of directors in overseeing the fund's

participation in a fund supermarket.

Fund Supermarkets
Beginning in 1992, several broker-dealers introduced a new

method for investors to purchase and redeem mutual fund shares:

the fund supermarket. A fund supermarket is a program offered by

a broker-dealer or other financial institution through which its

customers may purchase- and redeem a variety of funds, with or without paying transaction fees. The sponsor of a fund supermarket usually charges a fee to

the participating fund if the sponsor does not charge transaction

fees to its customers. The fee generally ranges from .25% to

.40% annually of the average net asset value of the shares of' the fund held by the sponsor's customers. 2 This fee compensates the

2 Recent press accounts have reported that the amount of

these fees may be increasing. See,~, John Waggoner, Schwab

Trying to Raise Fees for Mutual Funds, USA Today, April 22, 1998,

at lB. See also Goldman Sachs Investment Management Industry

Group, Asset Management in the 21st Century: New Rules, New Game,

April 1998, at 16.

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sponsor for permitting the fund to participate in the fund

supermarket and for providing the services used by the fund.

These services can include certain administrative services to

customers who purchase shares of the fund,3 and certain

distribution services for the fund. 4

Fund supermarkets have become quite popular with investors,

as they provide investors with the ability to consolidate their

fund holdings at different fund complexes in a single brokerage

account and to receive 'a consolidated brokerage statement listing

all fund holdings. S The amount of assets invested in funds

through fund supermarkets has increased significantly over the

3 In a typical fund supermarket, the sponsor offers various

administrative services to its customers such as: sub-accounting;

shareholder account set up and maintenance; shareholder

assistance; transaction processing and settlement ;preparation

and distribution of account statements and transaction

confirmations; payment of fund distributions; and distribution of prospectuses. If the custo~ers invested directly in a fund instead of investing through the fund supermarket, the fund

typic~lly would pay its service providers for providing these

administrative services to the customers.

,4 Fund supermarkets differ from more traditional

distribution channels in that sponsors of fund supermarkets

typically do not solicit their customers to buy shares of any

particular funds. Although the sponsors typically distribute

prospectuses and other information for the funds that participate

in the fund supermarkets, the sponsors typically make no

recommendations about individual funds; they merely provide their customers with marketing and sales information for funds

participating in the supermarkets. Many sponsors include

marketing materials with proxy materials and other mailings to

fund shareholders, a practice that provides a fund's adviser with

the opportunity to "cross sell" other investment products to fund shareholders ~Many sponsors - also make discount advertising space available to a participating fund if the advertisement includes

the telephone number of the sponsor's sales staff, rather than

the fund's telephone number, for inquiries. Some sponsors

conduct conferences for fee-based investment advisers to which

the sponsors provide recordkeeping services. At these

conferences, the sponsors allow participating funds to make

presentations to the advisers about the appropriateness of the

funds for the advisers' clients.

S The sponsor of a fund supermarket usually holds the fund shares of each fund in which its customers invest in an omnibus

account on behalf of the customers, ï. e ., the sponsor is the shareholder of record.

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past few years. 6 Many funds currently participate in fund

supermarkets, and many financial institutions currently sponsor

fund supermarkets. 7

The OCIE Examinations

OCIE conducted its examinations of fund supermarkets for two

principal reasons: (a) fund supermarkets represented a novel

method for investors to purchase and redeem fund shares, which

neither the Commission nor its staff had reviewed closely; and

number of funds participating in fund supermarkets and

the amount of assets invested through fund supermarkets had grown

dramatically. The purpose of OCIE's examinations, among other

things, was: to gain a better understanding of how fund

supermarkets operate; to identify the services that the

supermarkets offer;" and to determine whether the participating

funds were operating in a manner consistent with the federa¡

securities laws. In particular, OCIE sought to determine whether

funds that treated some or all of the fund supermarket fee as

payment for non-distribution services were financing the

distribution of their shares outside of a rule 12b-1 plan, in

violation of rule i2b- 1 under the Investment Company Act of 1940.

(b) the

Of the funds examined, the OCIE staff found that some funds

characterized all of the serVices that they received in

supermarket programs' as distribution-related and paid for them entirely through rule 12b-1 plans. Other funds characterized a

portion of the fee as administrative in nature and paid a portion

of the fee outside of a rule 12b-i plan. In other cases, funds'

advisers or their affiliates paid a portion of the fee.

In OCIE's discussions with the funds that were examined, these funds indicated that they participated in supermarkets in order to sell more of their shares and to increase assets under

management. In essence, these funds used fund supermarkets as distribution channels through which they gained access to the

customers of the supermarket sponsors. Thus, these funds

concluded that at least some of the services that they received

from fund supermarket sponsors were distribution services that

could be paid by the funds only pursuant to rule 12b-1 plans.

None of the funds that OCIE examined currently pays its entire

fund supermarket fee out of its assets outside of a rule 12b-1

6 See supra note 1 and accompanying text.

7 See,~, Hank Ezell, Mutual Fud Supermarkets Make

Their Pitch with One-Stop Shopping, Atlanta Constitution, September 27, 1998, at 12R. (citing a survey by the American Association of Individual Investors that lists 26 fund supermarkets) . ~

Page 5 '"
plan.
The OCIE staff also found during its examinations that the boards of directors of many funds that participate in fund

supermarkets have determined that a portion of the fund

supermarket fee is a non-distribution expense. Those boards

concluded that, because fund supermarket sponsors provide

administrative and other services that otherwise would be

provided by the funds' service providers and paid for by the

funds, the funds are able to reduce the payments that they make

to their service providers. Thus, some funds treat a portion of

the supermarket fee as a non-distribution expense and pay that

portion out of their own assets, but not pursuant to rule 12b- 1

plans. Some advisers also paid a portion of the fee. The OCIE

staff found that most of these funds attempt to (a) identify the

nature of the services provided by the fund supermarket sponsors

that would have been provided by the funds' other service

providers, and (b) calculate the amounts that the funds would

have paid to those entities. Those amounts generally are used as

a basis for determining the portion of the fund supermarket fee to be paid by the funds. Funds typically explained their

analysis as attempting to determine the "savings" in

administrative and other non-distribution fees that they realized

from participating in fund supermarkets. 8

Rule 12b- 1 under the Investment Company Act

Rule 12b-1 under the Investment Company Act of 1940 permits

any open-end management investment company to use its assets to

pay broker-dealers and others for providing services that are

primarily intended to result in the sale of the fund's shares.

The rule was intended, in part, to address the potential

conflicts of interest between a fund and its investment adviser

that are created when a fund bears its own distribution

expenses.9
8 Tyically, the fund's adviser would present to the fund's

board of directors a methodology for measuring the "savings" in

administrative and other fees resulting from the fund's

participation in the supermarket. The board typically would

approve payments to the sponsor by either fixing the percentages

of the fee that the fund and the adviser would payor by

approving a formula by which the adviser would determine the

amount of the fund's payment each month.

9 When a fund pays these expenses, the fund's investment

adviser is spared the cost of bearing the expenses itself, and

the adviser benefits further if the fund's expenditures result in

an increase in the fund's assets and a concomitant increase in

advisory fees. See Bearing of Distribution Expenses by Mutual ~

Rule 12b- 1 generally requires, among other things, that any

payments by a fund in connection with the distribution of its

shares must be made pursuant to a written plan, often referred to

as a "rule 12b-1 plan," that has been approved by the fund's

shareholders and by the fund's board of directors, including a

maj ori ty of the directors who are not interested persons of the, fund and who have no direct or indirect financial interest in the

operation of the plan or in. any agreements related to the plan

("'financially independent directors"). 10 The requirements -of the

rule are designed to ensure that a fund's financially independent

directors are not unduly influenced by management, are fully

informed, and are able to exercise reasonable business judgment

in determining whether the plan is in the best interests of the

fund.
The Commission has taken steps to ensure that funds clearly disclose to investors any fees paid pursuant to rule 12b-1 ,. plans.11 Funds are required to disclose, in their prospectuses,.

fees paid pursuant to rule 12b-1 plans as a separate item.~in

their fee tables, and are required to disclose, certain information about those fees when describing their distribution

arrangements.12 Funds also are required to provide detailed , information describing the material aspects of their rule ,:12b-i plans iri their statements of additional information, and must

,file a copy of their rule 12b-1 plans as an exhibit to their

Funds, Investment Company Act Release No. 10252 (May 23, 1978).

10 Under the rule, the plan may continue in effect for more

than one year only if the directors, including a majority of the

financially independent directors, annually approve the plan~

The rule authorizes the shareholders, or a majority of the

financially independent directors, to terminate the plan at any

time. The rule also requires that a plan provide that it may not

be amended to increase materially the amount to be spent. for

distribution without shareholder approval, and all material

amendments of the plan must be approved by the financially

independent directors. A fund may not adopt a rule 12b- 1 plan

unless the selection and nomination of the fund's independent

directors are committed to the discretion of such directors.

11 See Accounting for Distribution Expenses, Investment

Company Act Release No. 15808 (June 12, 1987).

12 See Form N-1A, Item 3 and Item 8 (b). See also

Registration Form Used by Open-End Management Investment

Companies, Investment Company Act Release No. 23064 (Mar. 13,

1998) (revising the caption "12b-1 Fees" to "Distribution (and/or

Service) (12b-1) Fees" to enable investors to better understand the nature of these fees). ~

registration statements. 13

As noted above, many of the funds that were examined by OCIE

treat all or part of the fund supermarket fee as a distribution

expense and pay the fee out of their own assets pursuant to their

rule 12b- 1 plans. Some funds pay a portion of the fund

supermarket fee out of their own assets, but not pursuant to a

rule 12b- 1 plan, and some of their advisers or the advisers'

affiliates pay the remainder of the fee. Whether payments of

fund supermarket fees must be made pursuant to rule 12b- 1

primarily depends on (a) whether the payments are being made for

services that are primarily intended to result in the sale of the fund's shares, and (b) whether the fund or another party is making some or all of the payments.

A. Payment of" Fees bv Funds Pursuant to Rule 12b- 1 Plans ."1' When a fund participates in a fund supermarket primarily to sell its shares to investors, at least part of the fee must be

considered to be compensation paid to the sponsor for providing

distribution services, i. e ., services primarily intended to resul t in the sale of the' fund's shares. In such a case, the
part of the fee paid for distribution may be paid by the fund
only pursuant to a rule 12b-1 plan.
If a fund has adopted, a rule 12b-1 plan, then the f~nd may pay for distribution expenses to the extent permitted unaer its 14 A fund that pays all of its fund supermarket fee :
plan. pursuant to a rule 12b- 1 plan need not determine which portion of

the fee is primarily for distribution services or which portion

is primarily for administrative services.

13 Form N-1A, Item 15 (g) and Item 23 (m) .
14 ' The fund may do so regardless of whether its payment of the fees is intended to compensate the sponsor, in whole or in

part, for providing non-distribution services. The Commission

previously has stated that' funds may pay for non-distribution

expenses pursuant to rule 12b- 1 plans. See Payment of Asset-

Based Sales Loads by Registered Open-End Management Investment

Companies, Investment Company Act Release No. 16431, at note 129

(June 13, 1988) ("Release No. 16431") (when proposing amendments

to rule 12b-1, the Commission stated that "rule 12b-1 does not

specifically prohibit the payment of non-distribution expenses

under a 12b- 1 plan...."); Charles Schwab & Co., Inc., at note 2

(pub. avail. Aug. 6, 1992). Funds', however, are not required to

pay for non-distribution services pursuant to rule 12b-1 plans

even if the recipient of the payment also is involved in the

distribution of fund shares. See Release No. 16431, supra at note

126.
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B. Pavrent of Fees by Funds Outside of Rule 12b- 1 Plans

If a fund has not adopted a rule 12b-1 plan, then it cannot',

use fund assets to pay for services that are primarily intended

to result in the sale of the fund's shares. Thus, any portion of

the supermarket fee that is primarily for distribution services

cannot be paid out of the fund's assets. A fund that has' not

adopted a rule
12b-1 plan, however, may use its assets to pay a

fund supermarket sponsor for services that the fund's board has

determined to be non-distribution services.

C. Pavrent of Fees by Funds' Investment Advisers

If a fund's investment adviser makes distribution-related

payments out of its own resources, rule 12b-1 generally would not

apply because the payments are not being made out of fund

assets. is Thus, if a fund's investment adviser pays all ofthe fund supermarket fee, or the portion of the fee that' is for ..

services that are primarily intended to result in the sale of fund shares, rule 12b-1 generally would not apply.

Rule 12b-1 could apply, however, in certain cases in: which

the adviser makes distribution-related payments out of its own

resources. As the Commission has stated, "an indirect use of

fund assets for distribution would result if any allowance were made in the investment adviser's fee to provide money to finance

distribution. II 16 Thus, for example, if' a fund approved an increase in the advisory fee of its investment adviser so that

the adviser could pay for distribution services for ,the fund, such payments could be made only pursuant to a rule 12b-1..plan. In future examinations, OCIE staff will 'closely scrutinize any

increase in a fund's investment advisory fee that appears to be

for the purpose of compensating the fund's investment adviser for

paying the fund's supermarket fee.

Role of the Fund's Board of Directors

The poard of directors of a fund that participates in a fund

supermarket plays a critical role. The board is responsible for

determining whether any portion of a fund supermarket fee paid

(or to be paid) by the fund is for distribution, i. e., services

primarily intended to result in the sale of fund shares. Whether

is See Bearing of Distribution Expenses by Mutual Funds,

Investment Company Act Release No. 11414 (adopting rule 12b￾1) (Oct. 28, 1980) '("Release No. 11414"). See also Release No. 16431, supra note 14, at text accompanying note 124.

16 Release No. 16431, supra note 14, at text' accompanying

note 124.

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or not any particular payment of a fund supermarket fee by a fund

is for distribution services or non-distribution services is primarily a question of fact for the fund's board of directors to:, determine.17 This responsibility necessarily entails considering

the nature of the services used by the fund or provided to the

fund by the supermarket sponsor. The sponsor's characterization of the services that it offers is one factor that the board

should consider in making this determination.

A fund's board could determine that the entire fund

supermarket fee paid by the fund is for services that are

primarily intended to result in the sale of the fund's shares.

In such a case, the board could conclude, consistent with its

obligatians under rule 12b-1, that the entire fund supermarket

fee is for distribution services and should be paid pursuant to the, fund's rule 12b-1 plan. A fund's board, on the other hand, could determine that" only a portion of the fund supermarket fee paid by the fund is for

distribution. services. When determining whether a particular .

payment is for distribution or non-distribution services, the

board should review both the distribution and non-distribution

'services provided by the fund supermarket sponsor . The board

should determine whether the portion of the fund supermarket fee

that is paid by the fund for non-distribution services is

reasonable in relation to (a) the value of those services and the benefits received by the fund and its shareholders and (b) the. payments that the fund would be required to make to another

entity to perform the same services. If, for example, a fund pays a supermarket fee of .25%, and the board of directors determines that the value of the non-distribution services

provided by the fund supermarket sponsor is .20%, then the board

could conclude, consistent with its obligations under rule 12b-1,

that the portion of the fee that is attributable to non￾distribution services is .20% and that portion need not be paid

by the .fund pursuant to a rule 12b- 1 plan.

If a fund's board determines that none of the supermarket

fee was for distribution services, and the fund paid the entire

fee out of its own assets,18 the Division believes that the board

17 See Release No. 16431, supra note 14, at notes 129 &

173 . See also The Shareholder Services Group, Inc., at text

accompanying note 5 (pub. avail. Aug. 12, 1992).

18 For example , some funds' may continue to participate in

fund supermarkets to obtain administrative services from the sponsors, ~, fund supermarkets typically require participating funds to continue paying fund supermarket fees to the sponsors

for continuing to provide administrative services to their

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would need to be able to satisfy itself that its determination

was supported by all factors relevant to its characterization of

the purpose of the services. These factors would include, among

others, the nature of the services provided; whether the services

provide any distribution benefits; whether the services provide

non-distribution related benefits and are typically provided by

fund service providers; the costs that the fund could reasonably

be expected to incur for comparable services if provided by

another party , relative to the total amount of the supermarket

fee; and the characterization of the services by the fund

supermarket sponsor. In future examinations, OCIE staff will

closely scrutinize the analysis conducted by such a fund's board

of directors.

As part of its assessment of a fund's participation in a

fund supermarket, the fund's board of directors should examine

any supermarket fees that are paid by the fund's investment

adviser. As the Commission has stated: '

(W) hen an adviser finances the distribution of fund

shares, the directors of the fund, in discharging their

responsibilities in connection with the approval of the

advisory contract, must satisfy themselves either that

the management fee is not a conduit for the indirect

use. of the fund's assets for distribution, or that the

fund has complied with rule 12b- 1. . . . (T) here is no indirect use of fund assets for distribution if . the adviser makes distribution-related payments out of its

own resources.... (I) t is appropriate to ... view such

expenditures as having been made from the adviser's profits under ~he contract. To the extent that such ' profits are "legitimate" or '!not excessive," i.e., not in violation of section 36 of the Act, no indirect payment for distribution occurs.. .. If the fund's

directors are satisfied that any distribution payments

by the adviser are made out of its own resources

(including, but not limited to, the profits under the

advisory contract), the directors may reasonably

conclude that the advisory contract is not a conduit

for the payment of distribution expenses. If such a'

conclusion is reached, the fund need not adopt a 12b-1

plan to cover distribution payments borne by the

19 adviser. customers who purchased shares of the funds, even if the funds

discontinue selling their shares through the fund supermarkets.

19 See Release No. 16431, supra note 14, at text

accompanying notes '124-29 (footnotes omitted). See also Release

No. 11414, supra note 15.

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The fund's board should periodically review its

determinations to ensure that any payments by the fund or its

adviser to a fund supermarket sponsor are consistent with rule

12b- 1. W The board also should ensure that the fund is not paying the sponsor for services that duplicate services already

being provided to the fund. In light of the importance of the

board's role in overseeing a fund's participation in a fund

supermarket, OCIE staff will closely review the actions taken by

boards of funds that participate in fund supermarkets.

Conclusion
Rule i2b-1 does not prohibit funds from paying fund

supermarket fees in different ways and for different purposes. A

fund's board of directors, however, has the responsibility to

determine whether any portion of a fund supermarket fee that is

directly or indirectly paid by the fund is primarily for.

distribution and, if so , to ensure that any such payments are made pursuant to a rule 12b- 1 plan. We would appreciate your informing your members of the views

expressed in this letter. If you have any questions or require

additional information about these issues, please contact me or

Mercer Buiiard, Assistant Chief Counsel, at (202) 942-0660.

Thank you for your assistance.

Very truly yours,

~~
D~Ugids Scheidt

Associate Direc~or and

Chief Counsel

W We also note that any portion of a fund supermarket fee

that is paid by a fund and allocated to ass~t-based sales charges

or service fees must comply with rules of the National

Association of Securities Dealers, Inc. ("NASD"). Rule 2830(d)

of the Conduct Rules of the NASD imposes aggregate limits on the

front-end, deferred and asset-based sales charges paid by a fund

distributed through àn NASD member. The rule also limits the

annual amount of "service fees" that such. a fund may pay, and

prohibits a fund from describing itself as "no-load" if the

fund's total charges to provide for asset-based sales charges

and/or service fees exceed .25% of the fund's average annual net

assets. See also Investment Còmpany Institute (pub. avail. Aug.

22, 1994).

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