SEC Staff Clarifies Application of 1940 Act Section 22(d) to Brokers Selling Clean Shares of Mutual Funds

In response to a request for interpretative guidance, the U.S. Securities and Exchange Commission staff (staff) advised on January 11, 2017 that Section 22(d) of the Investment Company Act of 1940 does not prevent a broker acting in an agency capacity from charging its customers a commission for transacting in “Clean Shares” of a registered investment company (fund).¹ The request, by Capital Group Companies, Inc. (Capital Group),² used the term Clean Shares to refer to a class of fund shares without any front-end load, deferred sales charge or other asset-based fee for sales or distribution. 

The staff also advised that Section 22(d) would not prohibit a principal underwriter of Clean Shares from entering into a selling agreement with a broker under the circumstances described in the Capital Group Letter. In providing this interpretive guidance, the staff noted recent changes in fund sales and brokerage models due, at least in part, to the Department of Labor (DOL) fiduciary rule.³ 

Recent Industry Trends and Regulatory Developments 

Although the Capital Group Letter cited the DOL fiduciary rule as a primary driver for the request, other regulatory developments and industry trends have changed, and will continue to change, the landscape for fund distribution in both retirement and non-retirement accounts. Over the last several years, FINRA has focused attention on broker-dealers for misapplying fund sales charges, sales charge waivers, and discounts on fund transactions, and has scrutinized the suitability of the sale of Class C shares. Collectively, these developments have caused financial intermediaries to re-examine share class structures and features, in an effort to minimize compliance costs. As a result, intermediaries have requested intermediary-specific variations in sales loads, which may differ from those available for shares purchased directly from funds or through other intermediaries. Also, certain intermediaries have demanded the creation of a new share class, known as “Class T” or “transactional class,” designed to harmonize class features and establish a uniform compensation structure (with respect to sales charges) across funds and fund families. These market developments are covered in depth in previous OnPoints.⁴ 

Requirements of Section 22(d) and Rule 22d-1 

Section 22(d) prohibits a fund, its underwriter or any dealer from selling fund shares except at a current public offering price described in the fund’s prospectus, thus prohibiting price competition in sales loads among dealers in fund shares. While Section 22(d) applies to dealers, it does not apply to brokers.⁵ Rule 22d-1 provides a limited exemption from Section 22(d)’s prohibitions, and permits a fund to offer variations in (or to eliminate) the sales load for particular classes of investors or transactions specified in the fund’s registration statement, subject to certain conditions.⁶ Rule 22d-1 was designed to allow funds to set prices for their share classes, and historically the staff has interpreted and applied Rule 22d-1 flexibly.⁷ 

While the DOL fiduciary rule has caused broker-dealers to modify their product offerings and, in some cases, to modify the way they sell fund shares to address the expanded definition of “fiduciary” and perceived conflicts of interest in existing brokerage models, Section 22(d) limits the ability of broker-dealers to do so in the case of funds, because the Investment Company Act requires funds (and not broker-dealers) to set pricing at the fund level. As a result, Section 22(d) and Rule 22d-1 create obstacles for broker-dealers seeking to modify their activities in response to the DOL fiduciary rule. 

Although Section 22(d) does not apply to brokers, the practice of embedding sales charge schedules in fund share classes has created uncertainty about whether certain sales-related activity would cause a broker to be considered a dealer by the SEC, and thus subject to the prohibitions of Section 22(d). A selling broker-dealer’s receipt of payments for distribution from a fund, its underwriter, its investment adviser, or their affiliates may raise questions about whether the selling broker-dealer is acting solely in an agency capacity (i.e., as a “broker”), or on a principal basis (i.e., as a “dealer”). The Capital Group Letter emphasizes that previous staff guidance has recognized that Section 22(d) was not intended to apply to a broker acting in an agency capacity on behalf of its client.⁸ 

Capital Group Request for Interpretive Guidance 

Because of the limitations of Section 22(d) and Rule 22d-1, some broker-dealers have experienced difficulty dealing with sales charges, breakpoints and waivers that vary by fund, as well as adapting to an environment with heightened fiduciary obligations and increased FINRA oversight of broker-dealers’ application of fund-specified breakpoints and waivers to customers. To facilitate investor choice, Capital Group asked the staff to clarify the conditions under which a broker-dealer would be considered to be acting solely as a broker when transacting in fund shares, thereby precluding the application of Section 22(d) to the broker’s charging of a commission not specified by the fund. 

Capital Group noted in its request that, in the absence of clarity regarding the scope of Section 22(d), broker-dealers may seek to move their customers in brokerage accounts to advisory accounts, restrict their customers’ investment options and/or otherwise curtail their customers’ access to investment advice. Capital Group also emphasized that providing guidance in this area would: allow brokers to offer greater transparency to investors;⁹ preserve investor choice in a competitive free market; facilitate compliance with the DOL fiduciary rule;¹⁰ eliminate broker conflicts of interest; and remain consistent with the purposes of Section 22(d).¹¹ In addition, Capital Group likened the principles promoted by the Clean Shares brokerage model to those inherent in the DOL fiduciary rule (namely, the goal to eliminate perceived conflicts in the brokerage model), and compared the Clean Shares compensation structure to the DOL fiduciary rule’s level fee arrangement.¹² Capital Group also likened Clean Shares to ETFs and noted that the requested interpretative guidance would allow mutual funds and ETFs to compete on the same brokerage platforms. 

Conditions and Staff Response 

In advising that Section 22(d) does not apply in circumstances where intermediaries are acting as brokers and not dealers, the staff set forth five conditions for the sale of Clean Shares within the scope of the Interpretive Guidance: 

1. The broker will represent in its selling agreement with the fund’s underwriter that it is acting solely on an agency basis for the sale of Clean Shares; 
2. The Clean Shares sold by the broker will not include any form of distribution-related payment to the broker; 
3. The fund’s prospectus will disclose 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; 
4. The nature and amount of the commissions and the times at which they would be collected would be determined by the broker consistent with the broker’s obligations under applicable law, including but not limited to applicable FINRA and DOL rules; and 
5. Purchases and redemptions of Clean Shares will be made at net asset value established by the fund (before imposition of a commission). 

The conditions appear designed to provide a “safe harbor” for funds, underwriters and broker-dealers transacting in fund shares, as well as broker-dealers charging commissions on such transactions, so they may be considered to be acting as “brokers” rather than as “dealers” for purposes of Section 22(d) – and therefore not subject to the prohibitions of Section 22(d), so long as they comply with the conditions. 

It remains to be seen whether broker-dealers generally will be willing to make representations in selling agreements regarding whether they are acting solely as brokers in transacting in fund shares for their customers. In addition, the second condition narrows the application of the Interpretative Guidance by excluding all classes making distribution-related payments. Further, in a footnote, the staff specifically declines to address revenue sharing payments made by the fund’s adviser or underwriter, although revenue sharing payments are not made from fund assets. 

The fourth condition implicates FINRA limits on commissions (discussed below), as well as the conflict of interest principles underlying the DOL fiduciary rule, and suggests that complying with the conditions would not necessarily ensure compliance with the DOL fiduciary rule or FINRA standards. 

Applicability of FINRA Rules and Standards 

The above conditions raise several considerations for funds and broker-dealers seeking to rely on the Interpretative Guidance, as well as for broker-dealers selling fund share classes that do not fit within the express conditions of the Capital Group Letter. Several FINRA rules apply to brokers seeking to rely on the Interpretative Guidance, especially when considering whether there are commission limits. 

First, the sales charge limits in FINRA’s Investment Company Securities Rule (Rule 2341) will not affect Clean Shares because, by definition, Clean Shares do not have asset-based, front-end or deferred sales charges. In addition, “service fees” paid out of fund assets for “personal service and/or the maintenance of shareholder accounts” under Rule 2341 may be subject to scrutiny because of the condition that Clean Shares not include “any form of distribution-related payment.” If service fees are “primarily intended to result in the sale of fund shares,” they must be paid under a 12b-1 plan.¹³ 

Second, FINRA’s Fair Prices and Commissions Rule (Rule 2121), which requires members (when acting as agents) to charge fair prices and commissions for effecting transactions, will also govern commissions paid for transactions in Clean Shares. FINRA has not established specific limits on commissions; however, Rule 2121 requires members to consider “relevant circumstances,” including expenses, when setting commissions. 

Third, brokers to whom the Interpretative Guidance applies will remain subject to FINRA’s Suitability FAQ (Rule 2111), which would require the broker to have a reasonable basis for recommending a transaction in Clean Shares to investors. 

Implications for Fund Sponsors 

In the Dechert OnPoint, The New DOL Fiduciary Rule: Impact on Mutual Fund Distribution, it was noted that the “bleed-over” effect to non-retirement funds could have a lasting impact on fund distribution channels, particularly those paying differential compensation to intermediaries.¹⁴ To this point, Capital Group stated that there is no reason to treat the activities of a broker selling Clean Shares to retirement investors differently than the activities of a broker selling Clean Shares to non-retirement investors.¹⁵ 

Revenue Sharing: As noted above, in the Interpretive Guidance the staff explicitly declined to address a broker’s receipt of revenue sharing payments, which creates uncertainty about whether such receipt would cause an intermediary to be considered a dealer in connection with transactions in Clean Shares. 

New Share Classes and Intermediary-Specific Schedules: To accommodate intermediaries that seek to continue to offer shares with distribution fees and sales loads, certain fund companies are registering new share classes that differ with respect to sales loads, transaction charges and certain ongoing expenses. In addition to new share classes, other fund complexes are implementing intermediary-specific variations in sales loads (which could include breakpoints, discounts, and waivers) that apply uniformly to investors purchasing shares through a single intermediary. In a recent Guidance Update, the staff recognized procedural and disclosure issues faced by fund companies filing new share classes and new variations in sales loads in response to intermediary demands.¹⁶ Such alternatives to offering Clean Shares are not affected by the Interpretive Guidance. However, the Interpretive Guidance should provide comfort to those broker-dealers seeking to charge commissions on Clean Shares. 

Footnotes 

_{1) Response of the Office of Chief Counsel Division of Investment Management (pub. avail. Jan. 11, 2017) (Interpretive Guidance).
2) Capital Group Companies, Inc. (pub. avail. Jan. 6, 2017) (Capital Group Letter).
3) On April 6, 2016, the DOL finalized rules on conflicts of interest pertaining to investment advice in the retirement context. See Definition of the Term “Fiduciary,” 82 Fed. Reg. 20,946 (Apr. 8, 2016). The applicability date for the DOL fiduciary rule is April 10, 2017, although this date may be delayed, and the rule may otherwise be impacted by the change in Presidential administrations.
4) Please refer to the following Dechert OnPoints: The Brave New Fiduciary World has Arrived – The DOL Tries to Find a More Ideal Balance in the Final “Investment Advice” Rules; The New DOL Fiduciary Rule: Impact on Mutual Fund Distribution; Navigating the DOL’s New Fiduciary Rules: A Game Plan for Broker-Dealers; Mutual Fund Sales by Intermediaries – Fall-Out from the DOL Fiduciary Rule and FINRA Enforcement; and SEC Staff Issues Guidance on Fund Fee Structure Disclosures.
5) A broker is a person “engaged in the business of effecting transactions in securities for the account of others.” Exchange Act of 1934, Section 3(a)(4)(A); see also Investment Company Act, Section 2(a)(6). A dealer is “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise.” Exchange Act of 1934, Section 3(a)(5); see also Investment Company Act, Section 2(a)(11).
6) These conditions are: (i) the company, the principal underwriter and dealers in the company’s shares must apply any scheduled variation uniformly to all offerees in the class specified; (ii) the company must furnish to existing shareholders and prospective investors adequate information concerning any scheduled variation, as prescribed in applicable registration statement form requirements; (iii) before making any new sales load variation available to purchasers of the company’s shares, the company must revise its prospectus and statement of additional information to describe that new variation; and (iv) the company must advise existing shareholders of any new sales load variation within one year of the date when that variation is first made available to purchasers of the company’s shares. Investment Company Act, Rule 22d-1.
7) See, e.g., Charles Schwab and Co, Inc. (pub. avail. Aug. 6, 1992) (Schwab No-Action Letter); Linsco/Private Ledger Corp. (pub. avail. Nov. 1, 1994) (LPL No-Action Letter).
8) See “Brokerage Transactions in Redeemable Securities of Registered Investment Companies,” Investment Company Act Rel. No. 87 (Mar. 14, 1941); Schwab No-Action Letter; LPL No-Action Letter.
9) Exchange Act of 1934, Rule 10b-10.
10) Best Interest Contract Exemption, 81 Fed. Reg. 21,002, 21,045 (Apr. 6. 2016) (noting that the Best Interest Contract Exemption requires that the party relying on the exemption must provide point of sale disclosures at or before the time of the transaction and that such disclosures must include, among other things, a statement of the standard of care).
11) According to the Capital Group Letter, the purposes of Section 22(d) are to address riskless trading and the dilution of fund assets, promote orderly distribution, and avoid “unjust discrimination” among investors in the same fund by requiring a rational basis for variation in the sales load.
12) A “level fee fiduciary” receives a fee that is either: based on a fixed percentage of the assets held by the retirement investor or a set fee that does not vary with the investment recommended. Best Interest Contract Exemption, supra note 10, at 21,011.
13) “Rule 12b-1 prohibits mutual funds from engaging, directly or indirectly, in the financing of any activity which is primarily intended to result in the sale of fund shares except pursuant to a 12b-1 plan.” IM Guidance Update, SEC Division of Investment Management, “Mutual Fund Distribution and Sub-Accounting Fees,” No. 2016-01 (Jan. 2016) (citing SEC Rule 12b-1(a)(2) and SEC Rule 12b-1 Adopting Release, “Bearing of Distribution Expenses by Mutual Funds,” Investment Company Act Rel. No. 11414 (Oct. 28, 1980)). 
14) “Differential compensation” refers to compensation that varies by type or amount based on the investment product recommended. Best Interest Contract Exemption, supra note 10, at 20,133-34.
15) Indeed, the Capital Group Letter indicates that the “vast majority of broker-dealers will not be able to (or want to) treat a client’s IRA account and taxable account differently.”
16) IM Guidance Update, SEC Division of Investment Management, “Mutual Fund Fee Structures,” No. 2016-06 (Dec. 2016).}