The U.S. Securities and Exchange Commission has received a handful of detailed comment letters in recent months on the topic of improving fund disclosures and modernizing the regulatory framework surrounding intermediary-driven mutual fund investing.
The SEC initially solicited these comments back in June, as part of its announcement of a new rule, 30e-3, aimed at improving the experience of consumers who invest in mutual funds, exchange-traded funds (ETFs) and other investment funds. That rule goes into effect in early 2021 and permits asset managers to deliver shareholder reports by making them publicly accessible on a free website and sending investors a paper notice of each report’s availability via mail.
At the time, SEC asked the public for their thoughts on how the delivery of fund information could be modernized. Specifically, the SEC called on “investors, academics, literacy and design experts, market observers and fund advisers and boards of directors” to visit www.sec.gov/tell-us to provide feedback on how to improve the experience of fund investors. SEC’s sated aim is to provide more interactive and personalized disclosure.
The Investment Company Institute took up that call and submitted an expansive comment letter that reviews the current framework regulating fees that intermediaries charge funds for distributing required disclosure materials to fund investors, such as shareholder reports and prospectuses. As part of its letter, ICI includes a variety of suggested improvements that, on its assessment, could save investors millions of dollars if effectively implemented. (ICI’s own interest in the matter stems from its members’ natural desire to pay intermediaries less for distribution of mandatory disclosures, which would in turn allow them to either charge less overall for their funds—or to keep as profit the money that otherwise would have gone towards distribution fees.)
Intermediary omnibus trading is the rule
According to ICI, modern mutual fund investing is generally conducted via intermediary omnibus positions—i.e., shareholder positions held with intermediaries such as broker/dealers. This is especially prevalent in the retirement plan domain, and as ICI shows, these omnibus positions today make up a significant portion of all mutual fund assets.
“This means that fund records only identify the intermediary as the record owner, and the fund has limited information about the underlying beneficial shareholders,” ICI explains.
According to ICI, there are clear benefits to this system, such as the fact that it allows intermediaries to take advantage of economies of scale, automate trade processing and implement advanced recordkeeping capabilities. It also permits intermediaries to more closely align their mutual fund and brokerage systems and more efficiently manage their customer’s entire financial portfolio across a spectrum of investments.
However, according to ICI, there are also clear drawbacks. First and foremost, this system of intermediary-driven investing means that fund providers themselves actually have limited information about the identity of their beneficial shareholders—and thus no ability to communicate with them directly.
“Funds therefore must rely on intermediaries to deliver fund materials to these shareholders,” ICI observes.
Is this a serious problem? ICI says yes
According to ICI, the current system “lacks appropriate incentives.” As the firm writes, current SEC rules require funds to reimburse intermediaries “for reasonable expenses incurred in forwarding fund materials to beneficial owners of fund shares.”
ICI says intermediaries generally outsource forwarding of fund materials to a fulfillment vendor that then invoices the fund to pay the expenses. According to ICI’s analysis, this reimbursement system “creates a disconnection between the party that negotiates the vendor fees (i.e., the intermediary) and the party that pays the vendors’ bill (i.e., the fund).”
“Because funds bear the cost of shareholder report delivery, intermediaries have little incentive to negotiate lower delivery rates with the fulfillment vendor or otherwise control costs,” ICI suggests. “To make matters worse, the lack of properly aligned incentives prevents competition and has created a near-monopoly for the predominant vendor, which now has a financial stake in keeping the status quo.”
ICI draws the conclusion that this system means fund shareholders are paying higher costs than is strictly necessary.
“This environment inevitably has led to significantly higher fees than funds pay when they select their own delivery vendor and negotiate the fee,” ICI says. “Individuals can and do purchase fund shares directly from the fund. These shareholder accounts are held directly with the fund and are known as direct-held accounts. Vendors compete to offer funds attractive pricing for delivering fund materials to direct-held accounts.”
According to ICI, a recent member survey found that the median fund pays three-times as much in processing fees for mailing the same shareholder report to an intermediary-held account as compared to a direct-held account. ICI further claims the median fund pays five-times as much to email the same shareholder report to an intermediary-held account as compared to a direct-held account.
The ICI letter argues the New York Stock Exchange’s current fee schedule “is not suited for funds and cements higher fees.”
“The NYSE fee schedule sets maximum rates for what constitutes ‘reasonable’ delivery expenses that funds must reimburse, in addition to actual out-of-pocket costs such as printing and mailing,” the ICI says. “The NYSE fee framework is ill-suited to distribution of fund materials, however, and the fees that apply to funds bear little relation to the actual work and cost of distributing fund materials. As a result, fees charged pursuant to the schedule are higher than necessary to compensate for reasonable delivery expenses.”
ICI says that processing fees will likely reduce any future cost savings associated with Rule 30e-3.
“The SEC recently adopted Rule 30e-3 under the Investment Company Act of 1940 to, among other things, provide cost savings to shareholders (i.e., by allowing funds to mail a notice instead of the full shareholder report, which will reduce printing and mailing costs). An additional processing fee will apply to these Rule 30e-3 Notices, however, and this will greatly reduce potential cost savings,” ICI argues. “Without further SEC action, this added processing fee may largely offset the cost savings from the reduced printing and mailing costs.”
What’s the solution?
ICI goes on to argue that the SEC should permit funds to select the fulfillment vendor and negotiate the price for distribution of fund materials. ICI says this will realign incentives and reintroduce market competition, eliminating the need for a regulator-set fee schedule and allowing vendors to compete for funds’ business.
Specifically, ICI says two potential solutions exist for the SEC to encourage greater competition. First, the SEC “can make clear that Section 14 rules under the Securities Exchange Act of 1934 permit funds to choose how to deliver fund regulatory materials and require intermediaries to provide on request to funds or their selected agent (i.e., vendor) a data file with only the shareholder information necessary for delivering these materials.”
Secondly, ICI says the SEC can allow funds to choose how to deliver fund regulatory materials by not applying the objecting beneficial owner (OBO)/non-objecting beneficial owner (NOBO) distinction for the purpose of distributing fund regulatory materials.
“If the SEC pursues neither of these two solutions, it must rework the fee schedule to create a fee schedule for funds that is separate from the existing NYSE fee schedule, recognizing that the fees for forwarding of fund materials to intermediary-held accounts are unrelated to the fees for forwarding of operating company proxy materials; replace the existing fees and layered application structure with simple flat fees that reflect actual costs, using cost for direct-held accounts as a guide; clarify that funds cannot be charged for managed accounts where funds are not required to forward materials; eliminate unreasonable billing practices, such as remittances, that maximize intermediary and vendor profit at shareholder expense; create a robust regulatory oversight framework; and mandate regular independent review of fee rates and vendor billing practices.”
Intermediaries disagree with ICI’s take
Among the comment letters submitted alongside the ICI’s take are letters from MFS Investments and Broadridge Financial Solutions. The former, being written by a fund provider, voices strong support for ICI’s positions, while Broadridge, as a provider of disclosure and communication solutions, argues the current framework works well.
“The total unit cost of a communication to investors holding funds in street name is at least 20% lower on average, under regulated fees, than the same communication to investors holding shares directly with fund companies where unregulated, market-based fees apply,” Broadridge says. “Due to investments in technology, the unit cost for a communication to shares held in street name has declined by over 40% over the past 10 years.”
According to Broadridge, the NYSE Preference Management Fee has been effective in reducing costs for the industry by aligning fund companies, broker/dealers, and technology services providers on the goal of reducing the total costs of regulatory communications.
“At the same time, the fee ensures that every distribution is consistent with the specific delivery preferences of 140+ million retail accounts (based on independent reviews by Big Four firms),” Broadridge says. “With continued investment, significant further savings are possible. The facts demonstrate that the fee continues to prove its worth many times over to fund companies through growing annual savings on the costs of paper, printing, and postage.”
According to Broadridge, over the past 10 years, cost savings have increased more than six-fold, from $71 million in 2008 to $440 million in the 12 months ending April 30, 2018. Broadridge says the annual cost savings are nearly 10-times greater than the Preference Management Fees invoiced ($45 million) and three-times greater than all regulated fees invoiced ($147 million).
While comments were due to the SEC on this topic by October 31, the form for submitting comments is still open at the time of publication of this article. If and when that form closes, industry stakeholders already have another opportunity to submit related comments, as the regulator is now collecting comments with respect to the possibility of allowing/requiring annuity and insurance product providers to make up-front disclosures with summary prospectuses—similar to those allowed for mutual funds. These comments can also be submitted through www.sec.gov/tell-us.