Recoupment of Expense Waivers for Multi-Class Funds

Posted by John Braun on Sep 16, 2020 4:38:00 PM

Many funds employ expense limitation agreements aimed at limiting the expense exposure for shareholders. Generally, an expense limitation agreement is based on the fund’s expense ratio (expenses / net assets) and computed each day so that on any single day a fund’s shareholders will not experience an expense ratio in excess of that specified in the expense limitation agreement with the fund’s advisor. data financialThese agreements effectively act as an enticement for potential shareholders to invest in a developing fund by offering a guaranteed maximum expense exposure. Absent this type of agreement, the developing shareholder base would likely be subjected to higher expenses as the fund attempts to build assets.

Most expense limitation agreements have a recoupment feature built-in permitting the advisor to recover amounts previously waived and/or reimbursed (“waiver”) for up to three years and only to the extent that the recoupment does not result in the fund’s expense ratio exceeding the lesser of the expense limitation in place at the time of the recoupment or the expense limitation in place at the time of the initial waiver.

Recently, we have had questions from clients and other industry partners regarding the appropriate tracking and presentation relative to recoupment of previously waived expenses.

Tracking

With respect to appropriate tracking we consider a scenario with a single-class fund as well as a scenario with a multi-class fund below:

In a single-class fund, the treatment and tracking of recoupment is straightforward. Consider the following history for expense waivers and that during fiscal year 2021 the fund has increased assets to the extent that the expense ratio falls below the limitation and the advisor is able to recoup previously waived expenses in the amount of $15,000. The recoupment reduces the earliest expiring waiver available by the same amount, and the advisor is left with the difference between what had been waived and what has now been recouped as available for recoupment going forward limited by the expirations noted.

single class 6

Note: Recoupment is generally permitted for up to three years from the time the expenses were waived and therefore these amounts are reflective of a rolling three-year period.

Now, assume a multi-class fund scenario and keep in mind that Rule 18f-3 of the Investment Advisers Act of 1940 does permit class-specific expenses to be waived at different amounts for different classes but also requires a fund’s Board of Directors to monitor waivers to guard against cross-subsidization among the classes. Consider the following ideals along with the principles of Rule 18f-3:

    1. Potential recoupment must be tracked by class so that the advisor is not able to recoup expenses waived from a class other than that which originally benefited from the waiver which could result in cross-subsidization.
    2. Recall from above that the recoupment can only be collected if the expense ratio falls below the lesser of the expense ratio limitation at the time of the waiver or at the time of recoupment. To measure the expense ratios using different share classes for waiver compared to recoupment considerations could result in mismatching and potentially a perceived violation of the contract.
    3. There could be a scenario where a fund class might be paying recoupment back to the advisor beyond the waiver initially paid by that advisor for that fund class. This scenario is possible when one share class grows significantly compared to other share classes and to the extent that its expense ratio falls below the limitation agreed to by the advisor while other share classes continue to be supported by the advisor through waivers.

The following schedule illustrates the application of expense recoupment in a multi-class scenario with differing recoupment amounts per class.

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Note: Recoupment is generally permitted for up to three years from the time the expenses were waived and therefore these amounts are reflective of a rolling three-year period.

Presentation

There has also been some uncertainty and divergence of practice in the industry in the way of financial statement presentation relative to expense recoupment. With respect to the original waiver of expenses, Financial Accounting Standards Board Accounting Standards Codification (“ASC”) 946-20-50-7 provides clear guidance in that the waivers are to be presented as a reduction of expenses in the Statement of Operations, and industry practice generally results in a “below the line” presentation whereby the statements show gross expenses, waivers as a reduction and then net expenses. The financial highlights follow suit by illustrating the impact of the waivers on the expense ratio generally as gross and net expenses. The terms of the waivers are also to be disclosed in the notes to the financial statements, including a notation regarding the aggregation of waived expenses potentially reimbursable to the advisor but not recorded as a liability as per ASC 946-20-50-6.

In the scenario where an advisor is able to recover expenses previously waived, the result on the Statement of Operations is ultimately an increase in net expenses. But where exactly the line item for recovered expenses by the advisor should be put in the Statement of Operations has been a topic of recent discussion as a result of diversion in practice.

The argument for presenting the expense recoupment “above the line” (in gross expenses) is that this presentation is consistent with the requirements of Form N-1A, which would show gross expenses and then the expense waivers separately for transparency purposes. While this explanation has some validity, the problem is that this suggests that the requirements in Form N-1A are driving the Generally Accepted Accounting Principles presentation. Many would argue they should not be.

Alternatively, those that believe the expense recoupment should be presented below the line feel that the spirit of gross expenses in the Statement of Operations is to present the actual operating expenses of a fund absent the waiver and reimbursements that may be taking place – the true cost of operating the fund for the year. Just as the industry presents expense waivers below the line, so should it present the recoupment of such expenses.

In fact, at a recent virtual conference, an SEC staff member recognized this topic and the fact that the AICPA Investment Companies Expert Panel would be addressing it presently. Ultimately, it sounds likes the SEC is encouraging management of the fund to use its best judgment in terms of presentation and considering relevant facts at hand but that they don’t necessarily have concerns about the placement in the Statement of Operations.

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