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Zurich Scudder Funds Seek to Shift Costs

A plan of Zurich Scudder of Boston to add 12b-1 fees to several Kemper and Scudder funds will allow the firm to skirt potential problems with regulators and should create new distribution opportunities, according to industry executives and analysts.

The company is seeking to convert a separate 25 basis point administrative service fee the funds had charged into a 12b-1 fee on 16 Kemper funds and three Scudder funds, said Peter Jacobs, director of product management for Zurich Scudder's retail funds.

"We just wanted to make sure there wasn't any uncertainty about [the fee]," he said. "Our structure was unusual. I frankly don't know of anybody else that had it ... We just wanted to make sure we were consistent with the SEC rules." The change will not result in any increase in overall expenses for any of the funds, he said.

Zurich Scudder filed preliminary proxy statements Feb. 6 seeking to add 12b-1 fees to A, B and C shares of the funds. The firm is adding the fees because it claims the administrative services provided by Kemper Distributors of Chicago could be construed as distribution services and in violation of 12b-1 regulations, according to the proxy. Zurich is taking the measure " avoid legal uncertainties due to the ambiguity of the language contained in rule 12b-1 and eliminate any doubt that may arise in the future regarding whether the services performed by KDI under the Services Agreement are distribution' services, ..." according to the proxy. Rule 12b-1 considers any investment company that "engages directly or indirectly in financing any activity which is primarily intended to result in the sale [of shares]" to be acting as a distributor. Therefore, any expenses thus incurred should be recouped with a 12b-1 rather than any other fee.

Zurich Scudder's plan is a smart one because it will provide a greater amount of flexibility in distributing its funds, said Matthew McGinness, an analyst with Cerulli Associates of Boston.

"I think that having a 12b-1 fee does have distribution advantages whether or not it's the intent of converting the fee," he said. "12b-1's are typically used as building blocks for revenue-sharing payments to a third party administrator, 401(k) retirement plans, ... or wrap fee programs."

Zurich's decision also makes sense from a compliance standpoint, said Pamela Wilson, a lawyer with Hale & Dorr of Boston. Administrative services provided by distributors can sometimes blur the lines between shareholder servicing and sales, she said.

"There's this borderline area where the person involved in distribution, like Kemper Distributors, is providing shareholder services that are intended to have the effect of making the fund more attractive and user friendly and more retentive," she said. "But at the same time, you are paying someone who is engaged in distribution and to a certain extent, you may be intentionally or unintentionally rewarding that person for distribution as well as shareholder service."

To eliminate any possibility that the fee could be deemed to be misused, it makes sense to add a 12b-1 plan even if the services are not directly related to distribution, she said. Very often fees for administrative services also cover services designed to retain clients, Wilson said.

"It can vary a lot," she said. "What [they] are doing is the shareholder handholding job - taking the phone calls, making the explanations, sitting down with people. Doing, of course, a lot of the same things that a broker does. So it can be very hard to distinguish shareholder service that isn't technically distribution, from things that make the fund more attractive or things to bring people into the fund, which is distribution."

The Securities and Exchange Commission has been vigilant about how funds without 12b-1 fees pay for services that could be indirectly involved in the sale of funds, said Wilson.

The SEC is generally concerned about payments to brokers for the distribution of fund shares, said Douglas Scheidt, chief counsel of the division of investment management for the SEC.

"I could see where if a fund complex thinks that it's not clear and a potential liability ... the safest thing to do would be to adopt a 12b-1 plan," said Scheidt.

The SEC addressed the issue in an Oct. 30, 1998 letter to the Investment Company Institute. The letter was in response to fund advisers that raised the fees of 100 percent no-load funds in order to compensate for supermarket fees. The letter, written by Scheidt, also addressed no-load funds that do not have 12b-1 fees.

"If a fund has not adopted a rule 12b-1 plan, then it cannot use fund assets to pay for services that are primarily intended to result in the sale of the fund's shares," Scheidt said in the letter.

While several of the Zurich Scudder funds that are adding 12b-1 fees were offered in fund supermarket programs, the funds paid for those fees out of the 25 basis point administrative service fee, said Jacobs.

"There were some supermarkets like Schwab that charge 35 basis points in which case we take 25 basis points from the ASF [administrative service fee] and 10 of the management fee," he said.

But that might not be the best way for Zurich Scudder to pay for supermarket fees, said Ramy Shaalan, senior funds analyst at Wiesenberger/Thomson Financial of Rockville, Md. Thomson Financial is the publisher of this newsletter.

"I'm not sure if that makes sense," he said. "Other fund companies go the distance. I mean to dip into their management fee to make up for an otherwise legitimate 12b-1 fee? ... Management fees are kind of the last area where you want to cut in. Especially [since] Kemper doesn't have the reputation of paying high fees to their managers."