SEC Division of Investment Management staff letter: Sedgwick Consulting Group

! (\1l ~ \ ¡'t l) _ \ I.~ ) ACT
.__.- -.:
~-:\ G::('-l~C_~: (r ".' UNITED STATES __ ---------- SECURITIES AND EXCHANGE COMMl¥SIa-tl---------. . )iS i 9+ (èê:) ~ WASHINGTON. D.C. 20549 ~ABi~ITY FUEL I.. \ ~

AVAIL L DIVISION OF

INVESTMENT MANAGEMENT May 17, 1993

Managing Director

Financial Management Division

sedgwick consulting Group

winterton House, Nixey Close, Slough

Berkshire SL1 1NG

United Kingdom

Dear Mr. Budden:

This responds to your letter of March 17, 1993. In your

letter, you state that you are considering distributing mutual

funds of united states organizations to united states investors.

You ask for information on commonly used distribution channels in

the united states, if united states investors use independent

financial advisers to purchase mutual funds, and for information

on the rates of commission payable on the sale of mutual funds.

You also inquire as to whether United states investors, at the

time of retirement , receive advice on investing in mutual funds,

and as to the availability of performance information for United

states mutual funds.

The securities and Exchange Commission (the "Commission")

regulates mutual funds and other investment companies primarily

under the Investment Company Act of 1940 (the "1940 Act"). Under

section 22 (d) of the 1940 Act, a registered investment company,

and a principal underwriter or a dealer in its shares, cannot

sell the shares except at a current public offering price

described in the prospectus. This provision effectively

prohibi ts competition of sales charges at the retail level, and

as a result, the Commission has taken various actions to regulate

the costs associated with the distribution of mutual fund shares

and to foster retail price competition.

In the united States, mutual fund shares either are

distributed by underwriters and marketed directly to the public,

or are distributed through retail dealers, including independent

financial advisers. Tradi tional1y, most funds assessed a "front￾end sales load," which is a sales charge that is deducted from a

purchaser's initial investment to cover the broker's commission

and other sales expenses.

Front-end sales loads are regulated in several ways. In 1976, the National Association of Securities Dealers ("NASD"), a

self-regulatory organization, adopted a rule subjecting sales

loads to a maximum cap of 8.5% of a share's offering price. 1/

This "maximum sales charge rule" was expressed in terms of a

front-end sales load, as this was the main type of sales charge

assessed at that time. Moreover, since 1970, investment advisers

of registered investment companies have been subj ect to a

fiduciary duty with respect to the receipt of compensation for

services and of payments paid to them by funds. 2J And in 1985,

the Commission adopted Rule 22d-1 under the 1940 Act to permit

scheduled price variations in, or elimination of, front-end sales

loads to particular classes of investors or transactions, subj ect

to adequate disclosure to existing shareholders and prospective investors. V In the 1970s, no-load funds, whose distribution costs are

borne by the funds' investment advisers, became very popular. In

response to the growth in this area of the industry and other

developments, the Commission in 1980 adopted Rule 12b-1, which

allows the use of fund assets to cover costs associated with

distribution..1 These" 12b-1 fees," as they are commonly

called, are deducted from a fund's assets before net asset value

is calculated and may be assessed continuously. Funds that

assess 12b-1 fees instead of front-end sales loads typically levy

charges ranging from .50% to 1.25% of a fund's net assets. These

fees generally pay for initial sales charges and for "service

fees," which compensate dealers for ongoing sales and shareholder

servicing efforts. 2/ Moreover, many funds use 12b-1 fees in

conj unction with sales loads. A common practice is for a fund's

sponsor or underwriter to finance the sales commission paid to a

retail dealer for the initial sale of the fund's shares, and then f:. 1/ Subsections (b) and (d) of Article III, section 26 of the

NASD Rules of Fair Practice (the "NASD Rules"). The United

States Congress, in a 1970 amendment to section 22 (b) of the

1940 Act, authorized the NASD to promulgate this rule.

2J See section 36 of the 1940 Act. This provision has been construed to include "distribution" fees paid out of a

fund's assets to finance the fund's distribution pursuant to'

Rule 12b-1 under the 1940 Act.

V Investment Company Act Rel. No. 14390 (Feb. 22, 1985). 11 Investment Company Act Rel. No. 11414 (Oct. 28, 1980).

2/ As discussed in more detail on page 3, the NASD recently amended the NASD Rules to limit 12b-1 fees to .75% of a fund's net assets, and to limit service fees paid to a fund's dealer to .25% of a fund's net assets. These ,I amendments will take effect on July 7, 1993.

to assess a periodic 12b-1 fee to recoup the costs of the

commission.
At about the same time that Rule 12b-1 was adopted, some

mutual funds began applying for exemptive orders from the

Commission to levy contingent deferred sales loads ("CDSLs"). §.

A CDSL is a sales charge assessed upon redemption, the amount of

which is contingent upon when the shares are redeemed.

Generally, the longer shares are held, the lower the CDSL that is

assessed when the shares are redeemed. CDSLs are sometimes used

in conjunction with 12b-1 fees, and these arrangements are known

as "spread loads." Retail dealers commonly use spread loads to

finance front-end sales loads by advancing commissions to their

salespersons and then recouping the costs through the contingent

sales loads and 12b-1 fees.

The Commission recently approved an amendment to the NASD

Rules to subject all sales charges, including 12b-1 fees, to the

8.5% maximum sales charge limit, and to tailor the rule's

application to different sales compensation structures, including

CDSLs. 11 The amendment will also, among other things , prohibit

a fund from assessing a 12b-1 fee that exceeds .75% of a fund's

net assets, and will limit service fees to .25% of a fund's net

assets. This rule change will take effect on July 7, 1993.

Some funds now allow investors to choose how they pay for

distribution expenses. Pursuant to exemptive orders from the

Commission, funds have offered "multiple class" arrangements,

where classes represent different distribution arrangements that

are subject to different sales charges, while representing

interests in the same portfolio of securities. There are three

basic types of these arrangements. "Mul ticlass" funds were created to compete for the short-term investments of certain

institutional investors, who wanted services tailored to their

particular needs. Under these arrangements, particular classes

of shares are sold to specific institutional investors, who

select only the shareholder and distribution services they wish

to provide to their customers owning shares of a particular

class. The funds then make payments to the institutions for

providing these services to the class shareholders. "Dual

§. Under section 6 (c) of the 1940 Act, the Commission, by order

upon application, may exempt any person, security or

transaction from any provision of the 1940 Act or its rules

or regulations, if it is necessary or appropriate in the

public interest and consistent with the protection of

investors and the purposes intended by the 1940 Act.

11 Securities Exchange Act Rel. No. 30897 (July 7, 1992).

distribution" funds generally have two classes of shares, each

subject to different distribution charges, thereby allowing

investors to choose the method of financing distribution best

suited to their investment objectives. "Conversion" funds are a

variation on dual distribution funds, where investors may still

choose between classes, but after a specified time, one class

converts to the form of distribution in the other class. The

conversion feature limits any 12b-1 fees paid by each shareholder

to an amount approximately equal to the distribution expense

incurred on the shareholder's behalf in the primary distribution.

There are several pending proposals that may affect how

mutual fund distribution is financed in the future. In 1988, the

Commission proposed Rule 6c-10 under the 1940 Act, which would

codify the exemptive orders permitting the assessment of

CDSLs. §/ This rule would also permit the assessment of other

deferred loads, such as installment loads, which would be

deducted from a shareholder's account on a periodic basis. Also

in 1988, the Commission proposed an amendment to Rule 12b-1 that

would effectively preclude the use of spread loads as an

alternative to front-end sales loads. ~ This was due to concern

with the "hidden" nature of spread loads, as 12b-1 fees are

deducted as an expense at the fund level and CDSLs are deducted

from redemption proceeds.
In addition, the Division of Investment Management, in a

study of the investment company industry it issued in 1992,

recommended that the Commission repeal the retail price maintenance provision in section 22 (d) of the 1940 Act. lQ This proposal was due mainly to the belief that section 22 (d) 's primary purpose has been rendered moot. 11 The Division also

§/ Investment Company Act Rel. No. 16619 (Nov. 2, 1988).

~ Investment Company Act Rel. No. 16431 (June 13, 1988).

10/ See SEC Division of Investment Management, Protecting

Investors: A Half-Century of Investment Company Regulation,

The Sale of Open-End Investment Company Shares 291-346 (May

1992) ("Protecting Investors study").
11 Under the system of backward pricing of shares used when the

1940 Act was passed, the price of a mutual fund share was

based upon the fund's net asset value per share determined

at the close of the market on the previous day. Insiders could often purchase fund shares without paying sales loads, which, under this system, enabled them to engage in riskless

trading of the shares. By requiring all investors to pay

the same sales load, Section 22 (d) reduced the degree of

believed that this anticompetitive provision had the effect of

raising, not lowering, mutual fund share prices to investors, 12/

and that competition would result in lower sales loads, which

would increase, rather than decrease, sales of mutual fund

shares. l1 The Commission has not yet considered this proposal,

which also requires Congressional approval. The study also

suggested that the Commission adopt a rule to codify the

exemptive orders permitting multiple classes of mutual fund

shares. 14/ The Division is currently drafting a rule proposal

for the commission's review.

In response to your other questions, united states investors

may receive investment advice at any time, including at the time

of retirement. Moreover, while the Commission does not compile

fund performance information, there are several private

organizations that do provide such information, including Lipper

Analytical Services, Incorporated, 74 Trinity Place, New York, NY

10006, tel. (212) 393-1300; and Morningstar, Incorporated, 53

West Jackson Blvd, Chicago, IL 60604, tel. (800) 876-5005.

You should note that if you intend to distribute mutual

funds in the united States, you may need to register with the

Commission as a broker or dealer under the Securities Exchange

Act of 1934 (the "Exchange Act"). For more information with

respect to broker-dealer registration obligations, you should

contact the Office of Chief Counsel in the Commission's Division

dilution occurring from this riskless trading. Such

riskless trading, however, has not been possible since 1968,

when the Commission adopted Rule 22c-1 under the 1940 Act to

require "forward" pricing of fund shares. Investment

Company Act Rel. No. 5519 (Oct. 16, 1968).

1Æ See Protecting Investors Study. The Commission, in 1966,

issued a report concluding that, because Section 22 (d)

prohibited competition among retail dealers , competition

among distributors (principal underwriters) had the effect

of raising, rather than lowering, mutual fund share prices

to investors. The Commission found that, instead of

competing for sales through lower sales loads to investors,

underwriters competed for the favor of the retailers who

sold the shares by increasing the sales loads, and thus the

retailers' compensation. SEC, Report on the Public Policy

Implications of Investment Company Growth, H.R. Rep. No.

2337, 89th Cong., 2d Sess. 208-09, 221-23 (1966). l1 See Protecting Investors Study.

~ See Protecting Investors Study.

of Market Regulation. You should also contact the NASD for

information on its registration requirements for selling mutual

fund shares in the united States.

Finally, if you intend to provide advice to investors

regarding the purchase and sale of mutual funds, you also may

need to register with the Commission as an investment adviser

under the Investment Advisers Act of 1940 (the "Advisers

Act"). 15/ I have enclosed copies of the Commission's Investment

Adviser Registration package, which includes a copy of the

Advisers Act, Form ADV, the form used to register as an

investment adviser, and other explanatory materials. I have also

enclosed the Commission's Investment Company Registration

package, and a copy of an unpubl ished article entitled "The

Regulation of Investment Companies in the united states," which

provides an overview of how the Commission regulates mutual funds

and other investment companies. You may want to contact an

attorney for additional guidance in this area. If you have any

further questions, you may write or call this Office at (202)

272-2030.
Sincerely, ~i.
Alison E.

Attorney
Office of Chief Counsel

Enclosures
15/ A broker or dealer registered with the Commission under the

Exchange Act need not also register under the Advisers Act

if the investment advisory services performed are solely

incidental to the brokerage business, and the broker or

dealer does not receive special compensation (other than

sales commissions) for its services. See Section

202 (a) (11) (C) of the Advisers Act.

~

Sedgwick Consulting Group
Sedgwick COnsulting Group Limited

Winterton House, Nixey Close. Slough. Berkshire SL11NG

Telephone 0753-516151. Facsimile 0753-550383

Private & Confidential
Office of Chief Counsel, Our ref JJGB179/al Division óf Investment Management, Your ref U.S. Securities and Exchange Commission, Direct line ext 249

450 Fifth Street, N. W.,
Mail Stop 10-6,
Washington, D.C. 20549,
March 17, 1993 U.S.A.
Dea Sirs,
In confidence, I am giving consideration to distributing mutual funds in the United States, I hasten to add not our own funds, but funds of US organisations to US citizens (as we do in the UK), and would be grateful for some information:

1. Could you advise me of the distri~ution channels most commonly used in the United

States.
2. Do Americans use independent financial advisors to purchase mutual funds.
3. What rates of commission are payable on the sae of mutual funds;

a. Initial commission.

b. Regular commission.

4. Are you aware of whether people receive advice on investment in mutual funds at the

time of retirement ?

5. Can you advise me of the performance information which is available (in the UK we have

Micropal which is computer-based).
I would be most grateful for any similar information you can give me. The reason I ask for this to be kept in confidence, is that at the moment we have not made public our plans, but in due course I would hope that it would be to the advantage of your members, in the same way that we have..n extremely close relationship with the Unit Trust Association in the UK. A member or the SedgwICk Group Registered office. Sedgwick House. The SedgwICk Centre. London El 8DX

Registered in Englana number 114nnnn

..
Yours sincerely,
OJ Lloj d
K J.J.G. Budden
Managing Director
Financial Management Division