The SEC’s Division of Investment Management issued a no-action letter on January 11, 2017 explicitly permitting brokers to set their own commission rates for sales of so-called “clean shares” of mutual funds. Previously, as required by Section 22(d) of and Rule 22d-1 under the Investment Company Act of 1940 (the 1940 Act), commission schedules were fixed by share class at the sales load rates established in fund prospectuses. Now, under specified conditions, brokers may impose their own commission schedules on customers investing in “clean shares” (shares without fund-imposed sales loads or distribution fees). For the first time, commissions paid by shareholders to brokers may be de-coupled from sales loads paid by shareholders to funds. 

Background on DOL Fiduciary Rules. Mutual funds have historically funded commissions to brokers and other financial intermediaries through sales loads (payable at the time of purchase or redemption) and “12b-1” distribution fees (payable on an ongoing basis from fund assets). Current mutual fund platform offerings in the United States reflect a wide variety of commission structures, which has become a critical issue to brokers and other retirement plan fiduciaries seeking to comply with the so‑called fiduciary rules recently adopted by the U.S. Department of Labor (DOL). Under the DOL rules, which generally focus on disclosure of conflicts of interest, it is problematic for brokers to receive different commission levels from different funds because they have an incentive to recommend funds with higher rates. 

The financial intermediary industry has responded to the DOL fiduciary rules in a number of ways, including by driving mutual fund registrations of a new Class “T.” This new share class carries a maximum front-end sales load of 2.5% and a 12b-1 distribution fee of 0.25% that will allow intermediaries to set their own commissions in keeping with detailed prospectus disclosure. As noted in a prior Perkins Coie client update, the SEC staff essentially blessed the Class T share structure in a December 2016 SEC Guidance Update. 

Some intermediaries have likely decided to avoid the headache of DOL compliance by ceasing to offer mutual funds in the types of commission-based retirement accounts covered by the fiduciary rules. Calls have been made for the SEC to provide an exemption from the provisions of Section 22(d) to facilitate intermediaries’ setting of uniform mutual fund commission rates on their platforms. Speculation about whether the new presidential administration will delay or repeal the DOL fiduciary rules abounds, and Congress has introduced a bill seeking to delay the rules’ effectiveness by two years from the scheduled April 2017 date. Momentum for substantial industry change seems unlikely to abate, however, in the wake of brokers’ demands for uniform fund pricing in the IRA and non-retirement channels.

Section 22(d) Non-Action Letter. As intermediaries and fund groups continued to gear up for the looming April 2017 compliance date for the DOL rules, on January 6, 2017 The Capital Group filed a request for interpretive guidance regarding its plans to charge customers commissions on sales and redemptions of a special, “clean” mutual fund share class with no sales loads, 12b-1 distribution fees or other types of asset-based fees for sales or distribution. The SEC staff’s corresponding no-action letter issued on January 11 confirmed that, for share classes of mutual funds without sales loads or other asset-based distribution fees, the restrictions of Section 22(d) would not be applicable to a broker acting as an agent on behalf of its customers and directly charging its customers commissions for effecting transactions in “clean shares.”

In the letter, the SEC staff limited the Section 22(d) relief to brokers (not dealers) and to conditions where:

• The broker represents in its selling agreements with fund underwriters that the broker is acting solely on an agency basis for the sale of “clean shares;”
• “Clean shares” sold by the broker do not carry any form of distribution-related payments to the broker;
• The mutual fund discloses in its prospectus that an investor transacting in “clean shares” may be required to pay a commission to a broker, and, if applicable, that 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 are collected are determined by the broker consistent with the broker’s obligations under applicable law; and
• Purchases and redemptions of “clean shares” are made at net asset value as established by a fund before the imposition of any broker commission.

The Section 22(d) no-action letter comes as a significant development with many fund groups in the middle of implementing plans to offer Class T shares before April. Funds may very well move ahead with their Class T shares launches, and they may also register new “clean” classes or adjust the fee and expenses structures of existing classes to meet the conditions of the no-action relief. 

At present there is no way to know whether Class T shares, with the more traditional sales load and 12b-1 fees, or “clean shares” will become brokers’ preferred tool for addressing the types of commission-based conflicts identified by the DOL rules. The fate of the rules is far from clear, and both classes may very well thrive or falter in the new status quo. The SEC’s no-action relief letter provides a welcome ray of certainty in this unsettled environment.

© 2017 Perkins Coie LLP