by Kenneth P. Moon, Ph.D.

In recent years, the implications of revenue sharing have come to the forefront of the media, regulators, and legislators alike. Pundits argue that regulators need to address the potential problems inherent in the current structure of revenue-sharing arrangements by imposing more restrictive disclosure requirements on fund providers. In essence, several lawsuits highlight the need that some action needs to be taken. More frequent reports are surfacing related to how investors were "steered" into a particular mutual fund (or family of funds) simply because the investors' plan provider participated in a revenue-sharing arrangement. The purpose of this paper is to argue that new regulations relating to more "transparent" disclosure are not sufficient to meet the needs of investors. Revenue sharing is inherently flawed because a plan provider cannot uphold its fiduciary responsibilities, even when it does not violate provisions of the Employee Retirement Income Security Act (ERISA). How can a plan provider uphold such responsibilities when it can choose to include/exclude funds simply because they do (or do not) participate in revenue sharing?

Revenue Sharing Defined

Revenue sharing, as defined by the Securities and Exchange Commission, occurs when the investment advisor to a fund, or another affiliate of a fund, makes payments to a broker/dealer. In some cases, the investment advisor may describe those payments as reimbursing the broker/dealer for expenses it incurs in selling the shares. Those payments, regardless of whether they are labeled as reimbursements, may give the broker/dealer a greater incentive to sell the shares of that fund or affiliated funds.¹

Revenue sharing can take many forms. A common means of revenue sharing in the mutual fund industry is the use of 12(b)1 fees. Another common method of revenue sharing between investment management firms and other service providers to retirement or savings plans is an agreement known as a sub-transfer agency agreement. Many mutual fund groups choose to pay a one-time finder's fee for the placement of the money with the fund. Alternatively, a final form of revenue sharing is a collective investment fund revenue-sharing fee. Such fees are very similar to the mutual fund 12(b)1 fees. Whether the fee is based as a percentage of the money invested, or as a stated dollar amount, the bottom line is that revenue sharing (by its very definition) provides an incentive for the broker/dealer to promote some funds relative to others.

Proposed Increase Disclosure

The question of whether such a practice is ethical can be approached on several fronts. First, one could argue that such fees can have a significant impact on the investment portfolio of a plan participant. According to the McHenry Revenue Sharing Report, a 45-year-old participant with a hypothetical rollover balance of $300,000 could have her balance reduced by as much as $213,000 by a retirement age of 65.² Figure 1 depicts the potential impact of a small percentage charged to the investor's account to cover the cost of revenue sharing. The "no revenue sharing" scenario assumes a $300,000 rollover and a continued $10,000 investment at an assumed rate of 10 percent annually. The "with revenue sharing" scenario assumes a one-half of 1 percent fee, resulting in an annual return of 9.50 percent. As can be seen by the graph, the investor would have accumulated $213,153 less due to the fund's expense to cover the revenue-sharing arrangement.

While this impact is potentially significant, approaching the idea of revenue sharing from this view is no different than arguing against other "excessive" fees funds may charge that will eventually erode a participant's wealth. This type of an approach does not address the potential root problem associated with revenue sharing and the role of a fiduciary.

A second approach is followed by legislators and regulators alike. From this view, the argument is made that more complete disclosure is the answer. The House of Representatives recently passed a bill aimed at making mutual fund costs more transparent. The bill, The Mutual Funds Integrity and Fee Transparency Act (H.R. 2420), requires the SEC to revise regulations under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940 to improve disclosure with respect to an open-end management investment company. Among the areas where improved disclosure must be made is the following:

• Information concerning so-called "revenue sharing"—that is, payments by any person other that the company that are intended to facilitate the sale and distribution of the company's shares (such as payments by the company's investment advisor or an affiliate of the advisor to a broker that sells fund shares).

To this end, The National Association of Securities Dealers has proposed amending Rule 2830 to require disclosure of revenue sharing and differential cash compensation arrangements relating to the sale of investment company securities. As pointed out by the Financial Planning Association, the NASD proposes to amend the definition of "cash compensation" to include cash payments received as a condition for inclusion of a fund on a preferred sales list, in any other sales program (for shelf space) or as expense reimbursement. The NASD also proposes to add a definition of "differential cash compensation" that would encompass any compensation arrangement in which a brokerage firm pays a rep different rates of compensation depending on which mutual fund shares are sold.³ As argued below, consistent with the position of the FPA, I believe these first steps by the NASD do not go far enough. Further, it is argued that even more transparency will not necessarily remove the incentive for broker/dealers to fall into a conflict of interest trap.

In line with the NASD proposals, the SEC recently published for comment its proposal of two new rules and rule amendments under the Securities Exchange Act of 1934 that are designed to enhance the information broker/dealers provide to their customers.⁴ The two new rules, 15c2-2 and 15c2-3, would require brokers, dealers, and municipal securities dealers to provide customers with information about distribution-related costs that investors incur when they purchase those types of securities. The confirmation rule goes a step further by requiring disclosure of distribution-related arrangements involving those types of securities that pose conflicts of interest for brokers, dealers, and municipal securities dealers, as well as their associated persons.

Shortcomings of Increased Disclosure

The reasoning behind the apparent need for more complete and transparent disclosure is to promote more informed decision-making by investors in securities issued by open-end management investment companies. Accordingly, the view of legislators and regulators is that the problem relates to investors' inability to make truly informed decisions without more transparent disclosure. The key point behind the SEC position is that these disclosures (not withstanding exception) are considered "point of sale" disclosures, thereby allowing investors to make a more informed decision. Hence, the problem will be solved if mutual funds and their affiliates simply give the investor more information. I argue that, while more transparent disclosure is helpful and a step in the right direction, it does not address the true potential problem that these revenue-sharing payments and arrangements pose. Specifically, why do legislators and regulators believe more disclosure will address the potential conflict of interest that may arise?

The point of this article is to note that more disclosure is not the cure for the problem. I believe the governing bodies are merely treating the symptoms and not adequately trying to cure the illness. How can a fiduciary be expected to truly uphold his or her duties when mutual funds are offering incentives to sell their products in place of a competitor? An advisor can present a client with disclosure after disclosure, and still direct that client's money into a "preferred" fund. This is not an unrealistic scenario given a recent Department of Labor (DOL) Advisory Opinion regarding the issue.

In a 1997 Advisory Opinion relating to Frost National Bank, the (DOL) highlights the role of the fiduciary and what constitutes a potential problem.⁵ Specifically, the opinion reiterates that Section 406(b)(1) of ERISA prohibits a fiduciary with respect to a plan from dealing with the assets of the plan in his or her own interest or for his or her own account. Section 406(b)(3) prohibits a fiduciary with respect to a plan from receiving any consideration for his or her personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan.

Further, under section 3(21)(A) of ERISA, a person is a "fiduciary" with respect to a plan to the extent that the person (1) exercises any discretionary authority or control respecting management of the plan or any authority or control respecting management or disposition of its assets, (2) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of the plan, or has any authority or responsibility to do so, or (3) has any discretionary authority or responsibility in the administration of the plan.

The basic decision of the DOL was that Frost National Bank did not violate the prohibited transaction provision because the subtransfer agent fees Frost received did not benefit the plan. Further, the DOL noted that Frost reserved the right to add or remove mutual fund families that it makes available to plans. Under these circumstances, the DOL was unable to conclude that Frost would not exercise any discretionary authority or control to cause the plans to invest in mutual funds that pay a fee or other compensation to Frost. But because fees received did not benefit the trustee, a violation of the fiduciary role was not indicated. As long as Frost did not benefit (the participant benefited), the DOL concluded that Frost was not in violation of ERISA provisions.

In essence, the DOL held the position that as long as subtransfer agent fees did not benefit the plan, no breach of ERISA was present. One key point was that Frost implemented a dollar-for-dollar offset against the fees. As long as the plan does not "directly" benefit from the revenue sharing, it is permissible for a fiduciary to receive such payments. I contend that in spite of the offset, plan participants are not getting a true fiduciary standard because Frost reserved the right to exclude mutual funds that did not offer revenue sharing compensation. In other words, even though no direct monetary benefit accrued to the trustee, the participant is not given the full spectrum of choices available. This is essentially the same problem as when an advisor recommends its own funds relative to those of a competitor, given the employer offers several plan providers.

Is the inclusion of funds simply on the basis of revenue sharing truly in the best interest of the participant? I think not. The participant should have available all choices, regardless of whether the fund practices revenue sharing. The observation of excluding noncompetitive funds (regardless of whether the trustee is reimbursed directly) is a violation of the fiduciary responsibility. In essence, plan providers cannot uphold their fiduciary responsibilities when they choose to include or exclude funds based solely on the fund's participation in a revenue sharing arrangement. The inclusion of the funds should be based on the benefit to the participant, not based on the benefit to the plan provider. Money received does benefit the plan, regardless of exactly how it is accounted for. Otherwise, why would Frost choose to exclude plans that were not competitive?

Conclusions

The bottom line is that more disclosure (though beneficial) will not solve the inherent problem of potential conflicts of interest. Plan providers cannot uphold their fiduciary responsibility when they include or promote funds that share revenues and exclude funds that do not. The promotion or solicitation of the funds should be based on the benefit to the participant, not based on the revenue stream directed to the plan provider. Consistent with the position of the Financial Planning Association, I believe more disclosure is not sufficient. Even if fund providers inform investors that a class of funds participates in revenue sharing, investors still rely (to some extent) on the advice of the provider. How can the investor make a truly informed decision if funds are excluded simply because they do not participate? The new rules need to be aimed more in the direction of eliminating potential conflicts of interest, rather than merely requiring more information for the investor to digest. The only true way to accomplish this is to restructure revenue sharing so the promotion or elimination of investment choices does not occur.

Kenneth P. Moon, Ph.D., is an assistant professor of finance at the University of Northern Colorado and also is the director of the University's Certified Financial Planner™ Program. Please direct comments or suggestions to Kenneth.moon@unco.edu.

Endnotes

1. Federal Register, 69, 27 (2004): 6498.  
2. "McHenry Revenue Sharing Report," McHenry Consulting Group (2001). The report may be viewed at www.mchenryconsulting.com.
3. Financial Planning Association letter, "Comment on Proposed Amendments to Rule 2830 (Investment Company Securities)," October 17, 2003.
4. Federal Register, 69, 27 (2004).
5. DOL Advisory Opinion 97-15A, May 22, 1997.