Mutual Funds and Regulation
Compensation for Mutual Fund Sales
Todd Cipperman, Esq., Cipperman & Company
November 1, 2007
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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
4.75 %
4.99%
3.75%
3.90%
2.75%
2.82%
1.75%
1.78%
Less than $100,000
$100,000 to $750,000
$750,000 to
$2 Million
$2 Million or over
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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
Retail
Investors
Feeder Fund
for retail investors
•12b-1 fees
•TA fees
•Servicing Fees
401(k)
Investors
Defined
Benefit
Plans
Feeder Fund
for 401(k)
•TA fees
•Servicing Fees
Master Fund
(e.g. equity)
•Investments
•Low Fees
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
NASD Reminds Members of Their Responsibilities Regarding Sales of Mutual
Fund Shares and Dealer Agreements (11/22/05)
 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
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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, Esq.
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 brokerdealers. 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.
150 S. Warner Road
Suite 140
King of Prussia, PA 19406
tcipperman@cipperman.com
www.cipperman.com
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