Fundsters, when it comes to distribution, forget "shadow banking" and brace yourselves for "shadow regulation".

Frank Nasta, managing director and head of J.P. Morgan Funds Management Legal at J.P. Morgan Asset Management, coined the "shadow regulation" term (a play on the "shadow banking" epithet hurled by banking regulators at non-bank financial services firms like asset managers) this morning when discussing the "industry chatter" about the SEC preparing to go after some asset managers with respect to how they pay intermediaries. Nasta was speaking on the general session "U.S. and Global Trends in the Regulation of Payments to Intermediaries" panel at the Investment Company Institute's (ICI's) 2015 Mutual Funds and Investment Management Conference at the JW Marriott Desert Springs in Palm Desert, California.

ICI general counsel David Blass (an SEC veteran who joined the ICI in the fall) moderated the panel, which also included: Bella Caridade-Ferreira, CEO of London-based Fundscape; Greg Sheehan, partner at Ropes & Gray; and John Zerr, general counsel for U.S. retail at Invesco Advisers.

In his opening remarks yesterday, Blass addressed the "Distribution in Guise" sweep that the SEC has been working on for more than two years. This morning Blass, Nasta, and Sheehan all reminded fundsters that word on the street (and hints from the SEC) suggest that the sweep is going to soon result in some enforcement action against asset managers. Blass clarified that statements from SEC staff suggest that they're examining "about 15 fund complexes" in the sweep, and that broker-dealers (i.e. the intermediaries being paid by the funds) are also being looked into. It all hinges on what does, and doesn't, count as distribution services that should be paid for via 12b-1 fees versus other services that can be paid for out of fund assets.

Blass showed ICI data that tracks transfer agency fees falling since 1991 when described in inflation-adjusted hard-dollars and staying flat when described in basis points.

And Blass and the other panelists pushed back against any "regulation through enforcement," which Nasta characterized as shadow regulation.

"I have no idea what the SEC's looking at from an enforcement perspective or what they're seeing," Blass said. "These are sound practices that are based on legal reasoning that's been established for at least a decade or longer."

"The SEC has been looking at this for well over two years now," Nasta said. "The industry chatter and rumors are that there will be enforcement actions."

Sheehan said he's worried that the SEC is applying a principal 1998 letter on bundled fund supermarket fees and applying it to unbundled fees, like sub-accounting fees. And Nasta added a warning that some in the SEC see sub-transfer agency (sub-TA) fees "are nothing more than distribution in disguise," hence the title of the sweep.

"Everyone in this room should be concerned about that," Nasta said. "Regulation through enforcement is far from the best way to go about regulating something."

The panelists urged the SEC to instead use the regular rulemaking process if they want distribution payments to intermediaries to be handled differently.

"Any changes should not happen until there is a full and fair, open and honest, transparent discussion with all the affected parties," including the SEC, fundsters, B-Ds, investors, and 401(k) recordkeepers, Nasta said.

Blass also offered words of warning for fundsters with smaller shops. If the SEC fixates on "what in their view is reasonable" in terms of distribution payments on an absolute basis, smaller fund firms may have difficulty getting onto platforms since they lack the leverage of larger players.

If the SEC does act, through enforcement or rule-making (or rule-tweaking), beware the unintended consequences. Caridade-Ferreira offered her take on some recent rule-changes in the United Kingdom. There, regulators made it so that investors have to pay for their financial advisors directly, eliminating revenue-sharing payments to advisors and the like. Smaller investors, she says, have been driven out of the market by the fees and even by the advisors and banks who don't want to risk running afoul of the rules for clients they can't make much money on. And she says other parts of Europe are going the same way.

"We now have a growing advice gap in the UK," Caridade-Ferreira said, adding that the change is also encouraging "vertical integration," with big advice players combining with big fund firms to adapt to the changing rules. "Innovation, creativity, boutique managers, they're finding it much more difficult ... to get in touch with the advisors advisors and communicate their wares. Big complexes can afford better prices."

The one unintended upside? Caridate-Ferreira says the regulatory change in the UK "cleverly put the advisor in the driver's seat" when it comes to evaluating costs and performance and the like. That, she says, has led to what "may be too much of a focus" by advisors on driving down fund fees. 

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