Revenue Sharing

Perrin Halstow, an agent at Corvale Securities, recommends the Merrowgate Income Fund to a retail client. Corvale receives ongoing revenue sharing payments from the fund distributor for placing the fund on its recommended list, and Halstow personally receives a higher payout on that fund family than on others. He mentions neither arrangement. Under the Uniform Securities Act, his conduct is:

1. A.lawful, because the fund was a suitable recommendation for this clientSuitability does not excuse concealing a material conflict of interest.
2. B.lawful, because the payments are made to the firm rather than to the client accountWhere the money goes is what creates the conflict. It does not remove the duty to disclose.
3. C.unlawful, because a material conflict of interest in how the firm and the agent are paid must be disclosed to the clientCorrect. Compensation arrangements that bias a recommendation are material facts that must be disclosed.
4. D.unlawful only if the client actually loses money in the fundThe omission is complete at the time of the recommendation and does not depend on performance.

Why: An agent must disclose material facts a reasonable investor would want to know in deciding whether to follow a recommendation, and that includes conflicts of interest arising from how the firm and the agent are paid. Revenue sharing from a fund distributor and a differential payout both give the agent a financial reason to prefer one fund over another. Concealing them is an omission of a material fact in connection with the offer or sale of a security.

Fernsby Capital offers its flagship equity fund in several share classes. The R6 class carries a 0.42% total expense ratio with no 12b-1 fee and no payments to intermediaries, while the R3 class carries a 0.97% expense ratio including a 0.50% 12b-1 fee and additional revenue sharing paid to recordkeepers. A large corporate retirement plan pays its recordkeeper directly through a flat per-participant fee. Which class fits, and why?

1. A.Either class, because the total cost to participants is identical once the flat per-participant fee is taken into accountThe costs are not identical - R3 is 55 basis points more expensive, and the flat fee is paid either way, so R3 layers a duplicate charge on top.
2. B.R3, because retirement plan assets must be held in a class that carries an asset-based distribution feeNo rule requires a 12b-1 fee in a retirement plan. Institutional and R6 classes are widely used precisely because they carry none.
3. C.R3, because a 12b-1 fee gives the plan access to ongoing service from the fund's distributor that R6 shareholders do not receiveThe plan's servicing comes from its own recordkeeper, which it already pays. The 12b-1 fee would fund a service the plan is not using.
4. D.R6, because the plan already pays for recordkeeping outside the fund, and R3's 12b-1 and revenue sharing would charge participants a second time for the same serviceCorrect. R6 exists for plans that pay administrative costs directly, avoiding duplicate compensation to intermediaries.

Why: R6 shares strip out distribution and shareholder-servicing payments entirely, which suits a plan that already compensates its recordkeeper directly. Choosing R3 for such a plan would mean participants pay twice for the same service - once through the flat fee and again through the 12b-1 and revenue sharing embedded in the fund. Higher-cost R classes exist for plans that use fund-level payments to offset their administrative costs. The clue is that the plan pays the recordkeeper directly. Review: retirement share classes. Trap: assuming any R class is interchangeable with any other.

Kesteven Advisors, the investment adviser to a fund family, pays Brantwood Securities an amount out of its own profits, over and above the 12b-1 fee the funds pay, in exchange for Brantwood placing Kesteven funds on its preferred list. This arrangement is best described as:

1. A.A 12b-1 distribution feeA 12b-1 fee is paid by the fund out of its own assets under a board-approved plan. This payment comes from the adviser's profits and is additional to it.
2. B.A payment prohibited under FINRA rules governing investment company salesRevenue sharing is not banned. It is regulated through the conflict-of-interest and disclosure requirements rather than by prohibition.
3. C.A contingent deferred sales chargeA deferred sales charge is paid by the investor on redemption. Nothing here is charged to any shareholder.
4. D.Revenue sharing, paid from the adviser's own resources and creating a conflict that must be disclosedCorrect. The payment is outside fund assets but inside the conflicts the selling firm must identify, address and disclose.

Why: This is revenue sharing. The payment comes from the adviser's or distributor's own resources rather than out of fund assets, so it does not appear in the fund's expense ratio. It nonetheless gives the selling firm a financial reason to favour one fund family over another, which is a conflict that must be identified and addressed under Regulation Best Interest and disclosed to customers.

Verrindale Allocation Group charges its retail clients nothing. It builds model portfolios, recommends specific mutual funds to clients, and is paid entirely by the fund sponsors whose funds it recommends, at an annual rate tied to the assets its clients hold in those funds. Under the Uniform Securities Act, Verrindale:

1. A.Is not an investment adviser, because it receives no compensation from the persons it advises.Incorrect. The definition does not require the client to pay.
2. B.Is an investment adviser, because compensation from any source satisfies the compensation element.Correct. The source of the compensation is irrelevant.
3. C.Is a broker-dealer rather than an investment adviser, because it is paid by the sponsors.Incorrect. It effects no transactions; being paid by sponsors does not convert advice into brokerage.
4. D.Is not an investment adviser, because recommending mutual funds is not advice about securities.Incorrect. Mutual fund shares are securities and recommending them is advice about securities.

Why: The compensation element of the investment adviser definition is satisfied by compensation from any source, not merely by a fee billed to the client. Payments from fund sponsors measured by client assets are economic compensation for the advice, so all three prongs are met and Verrindale is an investment adviser.