SEC Gets in on 401k Fiduciary Rule Compliance

It does not address the external fees intermediaries may impose

The SEC might be feeling left out.The SEC might be feeling left out.

The SEC’s Division of Investment Management released a Guidance Update on December 19, addressing certain procedural issues that have arisen in connection with the so-called fiduciary rules [1] adopted by the Department of Labor.

The Guidance Update will make it easier for mutual funds to create and administer compensation arrangements tailored to comply with the fiduciary rules. It does not address, however, the extent to which brokers may independently set their compensation.

Challenges Under the Fiduciary Rules

Among other things, the fiduciary rules seek to limit conflicts of interest that might arise if a fiduciary were to receive different compensation for recommending different investment products, such as mutual funds.

One problem for intermediaries is that mutual funds do not pay uniform sales loads. Thus, in order to comply with the fiduciary rules, several brokerage firms are establishing their own breakpoint for sales loads and only offering mutual funds that comply with their breakpoint schedule. Other firms have asked that mutual funds offer a share class (often designated as “T Shares”) that strip away all forms of sales compensation, so the firm can charge a direct account or administrative fee on their client’s retirement assets.

The problem for mutual funds is that Rule 22d-1 requires a mutual fund to amend its registration statement to disclose any new variations in its sales loads, and the fund must file any such amendment in accordance with Rule 485(a) under the Securities Act.

The SEC staff reviews each post-effective amendment filed under Rule 485(a), which will not become effective until 60 days after filing (unless accelerated by the SEC).

In addition to having to register a new class of T Shares, mutual funds face the prospect of having to amend their prospectus to include every breakpoint schedule devised by an intermediary. Moreover, the fund would need to disclose breakpoint schedules on an intermediary-by-intermediary basis, which would add to the length and complexity of the prospectus.

The problem for the SEC staff is that thousands of mutual funds will be filing post-effective amendments ahead of the April 10, 2017 initial compliance deadline. Many of these filings will be duplicative insofar as every fund in a complex will be adding the same share class(es) and adopting the same compensation schedules for intermediaries.

The Guidance Update addresses the mutual funds’ problems by (1) allowing funds to disclose intermediary breakpoint schedules in a standalone document (an “Appendix”) and (2) reminding funds that they can request selective review and template filing relief for these post-effective amendments. This should reduce the burden on the SEC staff while allowing mutual funds to satisfy the needs of their intermediaries under the Fiduciary Rules.

Sales Load Appendix

Although Form N-1A requires the prospectus to disclose “any arrangements that result in breakpoints in, or elimination of, sales loads,” under the Guidance Update, the SEC staff will “not object if lengthy sales load variation disclosure for multiple intermediaries is included in an appendix to the statutory prospectus.”

A fund must comply with the following conditions in order to use an Appendix:

  • The section of the prospectus that includes breakpoint disclosure must include a prominent statement to the effect that different intermediaries may impose different sales loads and that these variations are described in the Appendix.
  • The cross-reference to breakpoints in the narrative explanation to the fee table must cross-refer to the Appendix.
  • The Appendix must specifically identify the name of the intermediary. It also must include sufficient information to allow an investor that purchases fund shares through a specific intermediary to determine which scheduled variation applies to its investment, which may depend on the type of account held at the intermediary.

A mutual fund may use the Appendix as a standalone document, separately from the statutory prospectus, so long as the fund:

  • incorporates the Appendix into the prospectus by reference and files the Appendix with the SEC together with the prospectus;
  • includes a legend on the front cover page of the Appendix explaining that the information disclosed in the Appendix is part of, and incorporated in, the prospectus;
  • includes a statement on the outside back cover page of the prospectus that information about the different sales loads variations is provided in a separate document that is incorporated by reference;
  • delivers the Appendix with the prospectus; and
  • posts the Appendix on its website, if the fund uses a summary prospectus.

Managing Post-Effective Amendments

The Guidance Update also encourages mutual funds to request selective review and template filing relief in connection with filings made to comply with the Fiduciary Rules. Selective review would focus on disclosures added to describe a new share class or incorporate an Appendix, without reviewing previously disclosed information.

A fund must request selective review in the cover letter for a filing, which should include:

  1. a statement as to whether the disclosure in the filing has been reviewed by the staff in another context;
  2. a statement identifying prior filings that the fund considers similar to, or intends as precedent for, the current filing;
  3. a summary of the material changes made in the current filing from the previous filings; and
  4. any specific areas that the fund believes warrant particular attention.

Rule 485(b)(1)(vii) also permits mutual funds to request template filing relief. This relief allows a fund complex to file an individual amendment under Rule 485(a) (the “Template Filing”), but then file other amendments under Rule 485(b) (“Replicate Filings”) containing the same disclosures on behalf of other funds in the complex.

The SEC staff would review and comment on the Template Filing, but they would not review the Replicate Filings, which would become effective immediately. A request for template filing relief must state the reason for making the amendment and identify the Template Filing and Replicate Filings. Funds seeking template filing relief must also represent that:

  • The disclosure changes in the Template Filing are substantially identical to disclosure changes that will be made in the Replicate Filings.
  • The Replicate Filings will incorporate changes made to the disclosure included in the Template Filing to resolve any staff comments.
  • The Replicate Filings will not include any other changes that would otherwise render them ineligible for filing under rule 485(b).

A fund complex may combine template filing relief with selective review to streamline the amendment process as much as possible.

No Substantive Guidance Provided

The Guidance Update does not provide any assurances that adopting intermediary-specific sales load breakpoints or offering T Shares will satisfy the requirements of the fiduciary rules. Moreover, the Guidance Update does not address the question of what external fees intermediaries may impose. Section 22(d) requires a dealer to sell mutual fund shares “at a current public offering price described in the prospectus.”

The SEC staff has previously allowed brokers to impose external sales charges in limited circumstances, but the Guidance Update does not address whether they may impose such charges on T Shares. It remains to be seen whether the SEC or its staff will address this issue before the fiduciary rules take effect.

Stephen Keen is senior counsel with law firm PerkinsCoie.

[1] 29 CFR Parts 2509, 2510, and 2550.

“This article is made available by the lawyer or law firm publisher for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. By reading this article you understand that there is no attorney client relationship between you and the article author. This article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state. Originally published by Perkins Coie; © 2016 Perkins Coie LLP.”

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