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12b-1 Fees Could Face Elimination

Leaders Anticipate Massive Changes to Regulatory Landscape

HUNTINGTON BEACH, Calif. - Mutual fund industry leaders admit that years of deregulation allowed the current economic crisis to unfold, and many are anticipating a backlash of new and excessive regulations to result.

"Markets will overcorrect, and regulators and regulations will overcorrect as well," said Paul Haaga, vice chairman of Capital Research and Management, at the Investment Company Institute's 2008 Operations & Technology Conference. "We will see more regulation than is good for the market."

Once again, 12b-1 fees will be in regulators' crosshairs. Adopted in 1980 to help mutual funds pay for promotional sales and marketing expenses, in order to boost assets under management and reward investors with economies of scale, regulators have become increasingly wary of the use of these fees. Their attention on 12b-1 fees has particularly been heightened as investors clamor for lower fees and low-cost alternatives like exchange-traded funds.

"In 1980, the mutual fund industry was in a period of net redemptions," said Barry Miller, associate director of the division of investment management at the Securities and Exchange Commission. "The idea of 12b-1 fees was to allow funds to use a little [bit of assets] to pay for advertising. Since then, 12b-1 fees and the industry have changed a whole lot."

Approximately half of today's mutual funds have 12b-1 fees ranging from 25 basis points for no-load funds, up to 75 basis points, at the high-end cap, for front-end load funds.

Miller said the SEC staff has been discussing a "whole host of things," including the possible elimination of the fees.

"A 75-basis-point distribution fee is just a substitute for a sales load," he said. "Shouldn't it be disclosed as a sales load?"

Kate Ives, vice president and deputy general counsel at OppenheimerFunds Inc., said the consequences of eliminating 12b-1 fees would be enormous.

"Our biggest concern is how important 12b-1 fees are, especially to the retirement plan marketplace," she said.

Haaga said many people in the industry underestimate the power of vocabulary.

"Vocabulary kills," he said. "For instance, once you call [the nation's $700 billion financial rescue plan] a bailout, you've lost the argument. It should been called a liquidity plan, which is what it was, all along.

"These current 12b-1 proposals are a solution in search of a problem," Haaga said. "The SEC has trouble accepting ongoing payments to advisers. Part of this problem is vocabulary. We use sales terminology, which causes people to think this is a one-time thing. When you call somebody a customer, it sounds like you're selling them something, not providing an ongoing fiduciary service."

Another big change for the mutual fund industry will be the upcoming requirement to mail investors a short, one- to two-page summary of their fund and make the entire printed version available upon request.

Mutual funds will be required to put their full investment prospectus online, but will no longer be required to mail the full prospectus to every investor. Several recent studies have shown that the majority of average investors have little interest in reading the often 200-page prospectuses, and typically toss them in the trash.

"The idea [of the summary prospectus] is to provide more enhanced disclosure through a more enhanced delivery," Miller said. We want to provide a concise, user-friendly presentation of key information in the fund."

The proposal, which has been met with widespread enthusiasm by the fund industry, is expected to greatly reduce the printing, shipping and natural resources required to mail these bulky documents.

"Our company alone kills 161,000 trees a year," Haaga said. "It's crazy that we are still sending millions of accounts footnotes to SEC filings that can be found online. We should save the trees, and get what we have up on the Web."

Public comment periods on the proposal revealed liability concerns and worries about the expense of providing quarterly updates, but Miller said those concerns have been addressed. "Fund companies will have no more liability than the statutory prospectus has now," he said.

Other regulatory changes include the new requirement for mandatory cost-basis reporting, recently passed as part of Congress' Emergency Economic Stabilization Act of 2008, as well as proposed red-flag guidelines to protect against identity theft and changes to point-of-sale disclosure rules.

"We've all known [cost-basis reporting] was pending; now it's adopted," Ives said.

The new law requires cost-basis reporting of the actual cost of acquiring and selling fund shares by brokers to taxpayers and the Internal Revenue Service. It applies to mutual fund accounts beginning Jan. 1, 2012. The red-flag guidelines, which need board approval by Nov. 1, did not initially apply to mutual funds, but now require firms to adopt identity protection measures to protect, prevent and mitigate against identity theft. Ives said the requirements are prudent and along the lines of what the industry is currently doing. "I think you'll find you're already doing this," she said.

Firms should create a special program to guard against identity theft and be sure to involve their board of directors, Ives said.

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