February 2, 2023

The staff of the Division of Investment Management (“Staff”) wishes to remind mutual funds, their boards of directors/trustees (“Boards”) and their legal counsel about the implications under the Investment Company Act of 1940 (“Act”) of fee waiver and expense reimbursement arrangements that result in different advisory fees being charged to different share classes of the same fund (“differential advisory fee waivers”).[1] In particular, the Staff is highlighting section 18 of the Act and Rule 18f-3 thereunder.

Background:

Many mutual funds operate as multi-class funds in reliance on Rule 18f-3 under the Act. Rule 18f-3 provides a limited exemption from sections 18(f)(1) and 18(i) of the Act to permit an open-end fund to issue multiple classes of voting stock representing interests in the same portfolio, provided certain conditions are met.[2] Among other things, the rule requires certain differences in the expenses, rights, and obligations of different classes; permits certain other differences among classes; specifies the matters on which class voting is required; and prescribes how income and expenses must be allocated across classes.[3] The rule also requires a fund’s Board to approve a written plan setting forth the separate arrangement and expense allocation of each class and any related conversion features or exchange privileges based on a finding that the plan is in the best interests of each class individually and of the fund as a whole.[4]

Rule 18f-3(b) expressly allows expenses to be waived or reimbursed by the fund’s adviser, underwriter or any other provider of services to the fund.[5] The Commission, in adopting the rule, was explicit that, although permitted under the rule, waivers and reimbursements were not intended to become “de facto modifications of the fees provided for in advisory or other contracts so as to provide a means for cross-subsidization between classes.”[6] The Commission also stated that fund Boards “must monitor the use of waivers or reimbursements to guard against cross-subsidization between classes” consistent with its “oversight of the class system and its independent fiduciary obligations to each class.”[7]

The provisions in section 18 of the Act effectuate the Congressional policy stated in section 1(b)(3) of the Act that the national public interest and the interest of investors are adversely affected “when investment companies issue securities containing inequitable or discriminatory provisions.”[8]

Differential Advisory Fee Waivers

One of the principles underlying Rule 18f-3 is that the advisory fees charged to shareholders of all classes of a mutual fund should generally be the same percentage amount.[9] As shareholders of the same mutual fund, investors receive the same advisory services, no matter in which class they are invested. Differential advisory fee waivers that are long-term or permanent, or effectively long-term or permanent, and are not substantiated with a clearly defined temporal purpose, could, in the staff’s view, present a means for cross-subsidization between classes in contravention of Rule 18f-3.

In the staff’s view, whether a differential advisory fee waiver presents a prohibited means of cross-subsidization between classes is a facts-and-circumstances determination that the mutual fund’s Board in consultation with the investment adviser and legal counsel should consider making and documenting after considering all relevant factors.[10] For example, a fund’s Board may be able to conclude that a long-term waiver of an advisory fee for one class of shares, but not other classes of shares, does not provide a means for cross subsidization in contravention of Rule 18f-3 if the Board finds that (1) shareholders in the waived class pay fees to the adviser at the investing fund level in a funds-of-funds structure for advisory services, and (2) 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, such that the waiver for the waived class is demonstrably not being subsidized by other classes.

For a fund that already has such differential advisory fee waivers in place, its Board may wish to consider, specifically within the context of Rule 18f-3, whether such waivers present a means for cross-subsidization, whether the steps they are taking to monitor such waivers to guard against cross-subsidization are (and continue to be) effective, and/or whether alternative fee arrangements may be appropriate. Relatedly, the fund should consider the extent to which the Board’s consideration of these issues under Rule 18f-3 should be disclosed to the fund’s shareholders.[11]

If you have any questions about this bulletin, please contact:

SEC Division of Investment Management
Chief Counsel’s Office
Phone: 202.551.6825
Email:IMOCC@sec.gov