On February 2, 2023, the Division of Investment Management Staff (the “Staff”) of the Securities and Exchange Commission (SEC) published a Staff Bulletin regarding fee waiver and expense reimbursement practices for investment companies registered under the Investment Company Act of 1940 (the “1940 Act”).[1] Specifically, the Staff expressed concerns about cross-subsidization that can arise through the use of fee waivers or expense reimbursements that benefit one share class of a fund to the detriment of another. Fund sponsors and boards should consider this an opportune moment to review their existing multiple share class structures to assess if there is any risk of cross-subsidization and confirm that their practices comply with Rule 18f-3 of the 1940 Act and the fund’s related compliance policies. While the Staff presents the Bulletin as a “reminder” to fund boards, it effectively serves as a warning of future SEC action or enforcement.
Mutual Fund Share Classes
Rule 18f-3 under the 1940 Act provides a conditional exemption for the use of multiple share classes by registered open-end funds, which would otherwise be prohibited by the senior securities prohibition under Section 18(f)(1) and the equal voting rights requirement of Section 18(i). In adopting Rule 18f-3, the SEC recognized that multiple share class arrangements can offer investors a choice of methods for paying distribution costs or to allow the fund to use alternative distribution channels more efficiently.[2] However, the SEC cautioned that it would be inappropriate to rely on Rule 18f-3 in a way that would give rise to the issuance of “securities containing inequitable or discriminatory provisions.”[3] To address potential conflicts of interest, Rule 18f-3: (i) limits the permissible differences in expenses and voting rights among classes; (ii) specifies permissible methods of allocating expenses; and
(iii) requires a fund’s board to approve a plan detailing each class’s arrangement for the distribution of securities and the services provided to each class, among other things. Finally, the board must determine that the plan is in the best interests of each class individually and the fund as a whole.[4]
Risks of Cross-Subsidization
In the Bulletin, the Staff reiterates the SEC’s guidance from the Adopting Release that a fund’s board is obligated by its independent fiduciary duties to monitor the use of waivers or reimbursements to guard against cross-subsidization between share classes.[5] For example, in the Bulletin, the Staff referenced the SEC’s statement in the Adopting Release that “the investment advisory fee charged to each class generally must be the same percentage amount.”[6] However, determining whether a fee waiver or expense reimbursement operates as a cross-subsidization among share classes is a facts and circumstances determination and can prove challenging in practice. For example, while it may appear that a fee waiver/expense reimbursement for an institutional share class is subsidized by a retail class of shares without such waiver or reimbursement, one could argue that a substantial increase in the fund’s assets under management from the institutional investors that creates economies of scale for the fund and reduces costs for all the fund’s shareholders arguably benefits the retail investors. The SEC specifically acknowledged the potential for this type of benefit in adopting Rule 18f-3 and permitting multiple share classes.
The Staff highlighted two specific scenarios that it believes could present inappropriate cross-subsidization between classes in contravention of Rule 18f-3: (1) differential advisory fee waivers that are (or effectively are) long-term or permanent, and (2) differential advisory fee waivers that are not substantiated with a clearly defined temporal purpose. The Staff also suggested that funds should not rely on prior Staff no-action relief that does not explicitly address fee waivers under Section 18 of the Act and Rule 18f-3 as support for any cross-subsidization analysis under Rule 18f-3, and specifically referenced its 2016 no-action letter to American Century Investment Management, Inc. (the “ACIM Letter).[7] In the ACIM Letter, the Staff stated that it would not recommend enforcement action under Section 15(a) of the 1940 Act if an investment adviser to an “investing fund” and certain “underlying funds” in a fund-of-funds structure reallocated a unitary management fee from the underlying funds to the investing fund, without obtaining approval of the shareholders of the investing fund. The investment adviser proposed to “reallocate” this fee by causing the underlying funds to offer a new share class and agreeing to waive all advisory fees for that class. However, the class with the waived fee would only be available to the investing fund.[8]
The Staff suggests that a fund that operates a fund-of-funds structure with a similar fee arrangement must ensure that any fee waivers at the underlying fund level comply with Rule 18f-3, which was not addressed in the ACIM Letter. The Staff advises that in a similar scenario, to comply with Rule 18f-3, a board could conclude that any fee waiver does not result in cross-subsidization by, for example: (1) finding that shareholders in the waived class pay fees to the adviser at the investing fund level for advisory services, or (2) finding that such fees, when added to the advisory fees that are paid by the waived class, after giving effect to the waiver, are at least equal to the amount of advisory fees paid by the other classes, so the waiver for the waived class is demonstrably not being subsidized by other classes.
As noted above, the fact-specific nature of the cross-subsidization inquiry requires a board to consider each fund on a case-by-case basis. At a minimum, the Bulletin makes it clear that a board should ensure that it has considered any potential cross-subsidization issues and memorialized the findings required by Rule 18f-3, including the supporting rationale for such findings. Perhaps most notably, the Bulletin is directed at fund boards, although of course fund sponsors and other stakeholders should be equally concerned.
[1] See Differential Advisory Fee Waivers, SEC Division of Investment Management Staff Bulletin (Feb. 2, 2023).
[2] See Exemption for Open-End Management Investment Companies Issuing Multiple Classes of Shares; Disclosure by Multiple Class and Master-Feeder Funds; Class Voting on Distribution Plans, SEC Rel. No. IC-20915 (Feb. 23, 1995) (the “Adopting Release”).
[3] Id. at n.30.
[4] Rule 18f-3(d) under the 1940 Act.
[5] See Adopting Release, supra n.2, at 11879.
[6] See Adopting Release, supra n.2, at fn.12.
[7] See American Century Investment Management, Inc., SEC No-Action Letter (Dec. 20, 2016).
[8] The investment adviser would then charge a new management fee at the investing fund level. This would enable the investment adviser to waive fees at the investing fund level, which it otherwise would not be able to do with the existing classes of the underlying funds.
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