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Payments for Distribution in Guise: A Continued Exam Priority

Posted by Sean Cunniff, Investment Management research leader, Deloitte Services LP, on May 28, 2014

It is interesting to see what the U.S. Securities Exchange Commission, Office of Compliance and Inspections (SEC) lists as its exam priorities each year. One topic that has carried over as a national exam priority from 2013 into 2014 is "Payments for Distribution in Guise." This caught my eye since "guise" is an unusual word to see in a regulatory publication. The Merriam-Webster online dictionary lists one definition of guise as "a way of seeming or looking that is not true or real" and includes among its synonyms "charade," "masquerade," and "pretense." Using such language indicates to me that the SEC feels strongly that something is amiss in the payments area and thus is likely to stay focused on the issue.

In the 2013 list of exam priorities, the SEC said that it was looking into a "wide variety" of payments and listed several specific types including revenue sharing, sub-transfer agency, shareholder servicing and conference support fees; the 2014 list states that the SEC is continuing this effort. The bottom line is that the SEC wants to determine if mutual funds are receiving and paying for the services for which they actually contracted, that the fees are reasonable for the services being provided, and that funds are not in fact paying for distribution outside of an approved 12b-1 plan.

Thinking about how funds need to handle this issue brought to mind one of my my favorite high school jobs. It was at the local supermarket, and it provided me with spending money, customer-service skills, (even a prom date) and I really looked forward to work — except on inventory day. On inventory day we spent hour upon hour counting every single item in the store, and I hated it. The work was tedious, boring and frustrating. One night, I asked my boss if it was really worth the effort and he said (in his thick Boston accent), "It's wicked important. Ya can't know what's out of stock, if ya don't know what's in stock, and we always find stuff that has been mispriced or is out of place."

A "payments inventory" may be exactly what some investment managers need. The inventory should identify every single payment made from funds to third parties and should categorize exactly what each payment is for. Conducting such an inventory can be more challenging than it seems, as many investment managers have multiple relationships with distributors across a variety of business lines and funds. Some of these realtionships span decades and have been impacted by mergers, acquisitions and spin-offs. Executives who originally negotiated contracts may have moved on to new roles, and contracts may not be held in a central location. In short, like in a grocery store, the payments may be in the wrong aisle or could be mispriced. A payments inventory can let investment managers know where they may need to "restock" in order to assure that payments have been allocated to the correct entity and are in the correct amount. Invoicing may not always be properly itemized, requiring allocations to be applied. This requires contract and policy alignment.

A payments inventory can also determine if the language of a contract was correctly operationalized, and sometimes a simple miscommunication, typographical error, or system limitation can cause the actual payments to deviate from what was agreed to. Whatever the reason, such errors need to be identifed and fixed in order to reduce contract and regulatory risk; payments inventory and categorization are important first steps toward that goal.

Other leading industry practices include:

  • Creating clear fee-for-service schedules and payment allocation rules
  • Aligning the contract management and update process with the operational payment process
  • Evaluating composite fees by intermediaries to identify potential redundencies
  • Evaluating fees across like intermediaries/services to understand and reconcile outliers

Knowing exactly how much is being paid to third-parties and knowing exactly what the payments are for helps investment managers on a variety of fronts. It allows investment managers to report complete, accurate and timely information to management, fund boards, shareholders and to the SEC.

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