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Pitt Proposes 12b-1, Distribution Review

WASHINGTON - In a speech that some thought signaled a get-tough attitude toward the mutual fund industry, Securities and Exchange Commission Chairman Harvey Pitt told executives late last month that the SEC would review distribution fees for mutual funds.

Pitt, speaking on the last day of the Investment Company Institute's general meeting here, said that 12b-1 fees, or fees that fund companies use to pay for such distribution costs as advertising and broker compensation, were largely intended to be temporary.

Indeed, Rule 12b-1 was enacted by the SEC in 1980 to help funds sell more shares after the industry argued that shareholders would benefit from increased economies of scale. Fund companies charge these 12b-1 fees, which typically range from 10 basis points to 100 basis points, directly to investors rather than taking the expense out of the investment advisor's overhead.

But many funds now use 12b-1 plans as an ongoing way to pay for marketing and distribution arrangements, Pitt told executives listening in a sparsely seated auditorium at the Washington Hilton and Towers Hotel.

He said the SEC will review the rule "in the context of today's distribution practices." Asked whether the SEC will do away with 12b-1 fees altogether, Pitt said it is "premature to decide."

ICI spokesman John Collins said that Pitt's comments don't provide the industry group with much indication of what might come out of the review. "There isn't, at this stage, much to go with," he said. But he added that "the ICI is prepared to be very attentive to whatever the SEC does, and we'll cooperate should they wish to have information from us on this."

Tim Schwartz, the operations manager at Schwartz Investment Counsel in Bloomfield Hills, Mich., said Pitt's remarks gave him the impression that the SEC would eventually kill the 12b-1 fee, which he thinks is a bad idea.

The fees are "important to a lot of fund companies," he said. "Without that, companies are going to have a lot more trouble getting their products out to shareholders."

"If you take away these fees, investors won't know what products are out there and what their options are," he said.

But Philadelphia based consultant Burton Greenwald said the fees aren't likely to be banned. "They're pretty well established, I think. It's not only going to be a review of 12b-1, it's going to be a broader review of distribution. In that respect you're going to get some greater disclosure in respect to different fees that funds pay now."

Greenwald said funds currently disclose such fees in their prospectuses, but "the language is so vague and general" that the SEC might set more specific standards.

Little has changed in the way that fund companies use 12b-1 plans since they were enacted more than two decades ago, he said. So why would the SEC choose to review them now? The answer, Greenwald said, lies in the difference between the SEC's current chairman and his predecessors, particularly Arthur Levitt, who resigned his post in February of 2001.

"Distribution has been the backwater of the SEC for a decade or more," Greenwald said. "Levitt was not concerned about distribution."

Instead, the former chairman was known for seeking regulation that would provide clear language in fund disclosure reports as well as rules governing the role of independent directors on fund boards, Greenwald said.

Pitt, in contrast, "is looking into areas that have not seen the sunlight for many years in terms of a public overview," he said. "So I think it's a natural evolution here."

The chairman's speech last month, his first to the mutual fund industry as a whole, was seen by some as particularly harsh, likely because of Pitt's repeated mention of increasing distrust among investors in the wake of Enron's bankruptcy and investigations into the dealings of securities analysts and accounting firms such as Andersen.

"I thought he was deliberately being a bit tough with the industry," said C. Meyrick Payne, a senior partner at Management Practice of Stamford, Conn. "For a guy who has been very much at the forefront of self-regulation, he came across as more deliberate" in his intentions to impose new rules.

It could have been worse, Greenwald said. "I expected him to be much more aggressive in his public comments," he said. "I thought he was going to be much stronger in chiding the industry and being more concerned with corporate governance. The industry should be sort of a guardian in terms of governance issues. He didn't speak on that subject at all. I'm surprised."

Greenwald said he expected a firmer hand from Pitt during last month's remarks because the chairman "is under enormous political pressure in Congress" and has had "very faint support" from the White House.

Other Issues

Nonetheless, Pitt noted quite a number of areas where he sees room for improvement in fund governance. He also addressed the questions of hedge funds, fairness in proxy voting by fund advisors and clearer disclosure for investors.

He proposed an investigation of so-called "private investment funds," or vehicles that "are structured to avoid regulation," such as hedge funds.

"The information we have about them is sketchy," Pitt said, adding that the SEC would look into fraud, conflicts arising from managing both hedge funds and mutual funds, and the marketing of hedge funds to investors via direct and intermediary channels.

He also said that the SEC is considering rulemaking petitions from the AFL-CIO, one of the country's largest organized labor groups, as well as other organizations, which ask that mutual funds disclose rules for voting proxies of individual securities. "We are also considering whether investment advisers must disclose their votes, particularly on contested matters," Pitt said.

In addition, Pitt wants to make disclosure reports simpler for individual investors to understand. He proposes wider use of "profile documents," which are shorter and more concise than a prospectus.