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Default Rate Feature – Direct Payment on Ongoing Dealer Service Fees
This article was originally published in the Investment Funds Practitioner in July 2014.
Further to staff’s continued focus on mutual fund fee structures and dealer compensation models, we have recently become aware of certain investment fund series that have a default rate feature attached to the direct payment by investors of ongoing dealer service fees. Staff have reviewed the disclosure documents of several fund families to evaluate the extent of this practice. While not all funds or fund managers have this practice, staff have seen similar disclosure among those that do.
As reflected in the disclosure, typically the fund manager does not pay trailing commissions for ongoing dealer services out of the management fee for these series. Instead, investors in these series pay their dealers directly and the fund manager facilitates this direct payment by regularly (typically, each quarter) redeeming investor holdings of the series and remitting the proceeds to the dealer.
In terms of the amount of the fee, the disclosure for these series typically provides that, in the absence of receiving instructions from the dealer as to the rate of the fee within a stated range (for example, 0 to 1.5% of average net asset value per security), the fund manager will apply a stated default rate, which may be as much as the maximum rate of the stated range (in our example, 1.5%).
We understand that fund managers may have introduced the default rate feature to help optimize the administrative efficiency of dealer back offices and assist dealers who may wish to transition from the embedded fee (i.e. trailing commission) model to a direct payment model of paying ongoing dealer service fees.
While we generally do not take issue with fund managers facilitating direct payment arrangements, and would expect that a maximum rate be disclosed where the fund manager facilitates such payments, staff are of the view that no such payment should be made pursuant to the application of a default rate. We further consider that disclosure related to the direct payment arrangement should be made in the "Fees and Expenses" section of a simplified prospectus in the table under “Fees and Expenses Payable Directly by You” rather than only in the "Dealer Compensation" section, as is often currently the case.
In staff’s view, the default rate feature is inconsistent with a critical attribute of the direct payment series, namely the negotiation of the service fee, which is intended to provide investors with heightened transparency and a clear expectation of the services to be rendered in exchange for the negotiated fee. While the default rate feature may contribute to administrative efficiency, it may have the unintended consequence of replacing the negotiation of the service fee. Staff’s view is that the default rate feature blurs the lines between the attributes of the direct payment series and the embedded fee (trailing commission) series and is potentially misleading for investors.
We have consulted with staff in the OSC’s Compliance and Registrant Regulation Branch, who further note that ongoing dealer fees of this kind are “operating charges” that dealers must disclose to their clients under the provisions of Part 14 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations.
We have indicated to filers our expectation that new funds not have a default rate feature. Going forward, we anticipate that on the reviews of renewal prospectuses, we will be asking fund managers for enhanced disclosure on these facilitated, direct payment arrangements, and in instances where a default rate feature exists, for the fund manager to tell us what would be a reasonable transition period needed to remove the application of any default rate.
We continue to review and monitor developments on mutual fund fee structures and dealer compensation models and will provide further guidance as needed. Issuers and their counsel are encouraged to contact staff in the planning stage of any structure that may give rise to questions concerning this issue.