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SEC to Revisit 12b-1 Fees­­, Again

Rule Could Undergo Fundamental Changes in 2010, Schapiro Says

Thirty years after the Securities and Exchange Commission allowed an exemption to help mutual funds pay for promotional sales and marketing expenses, the agency is once again considering revising or renaming these controversial charges, known as 12b-1 fees.

But judging from the SEC's history of inaction on this divisive issue, not to mention the mutual fund industry's staunch defense of the use of these fees to support investors and sales intermediaries, many industry executives don't expect a major change to actually see the light.

"When it comes to these fees, there is a need for more fundamental change than merely disclosure reforms and a name change," said SEC Chairman Mary Schapiro earlier this month. "We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate."

Schapiro said the mutual fund industry collected more than $13 billion from 12b-1 fees in 2008, up from just a few million dollars in 1980 when they were first permitted.

"After 30 years of growth and change in the mutual fund market, it is past the time to reassess their need and their effectiveness," she said. "The problem is that our investors may have no idea these fees are being deducted or who they are ultimately compensating."

Investment companies use income from 12b-1 fees-usually between 0.25% to 1% of assets under management-to pay for a variety of sales expenses and services, mainly by third-party intermediaries, such as brokerage houses, independent financial consultants, banks or supermarket platforms.

Vocal opponents of these mutual fund fees are quick to remind investors that ongoing expenses are a cost drag on total returns and even a 25-basis point charge can seriously erode returns over a 30-year period, but many mutual fund leaders maintain that the whole point of 12b-1 is to charge ongoing fees for ongoing services.

"These are not products; these are ongoing relationships," said Paul Haaga, executive vice president and a director of American Funds' Capital Research and Management Co., during a previous SEC roundtable on 12b-1 fees. "We have to devise a system that provides compensation for the entire relationship."

12b-1 fees are clearly disclosed on mutual fund statements, but the full breakdown of charges can be tricky to find and comprehend. The mysterious-sounding name doesn't help explain what the fee is for, and it can cause many fee critics and paranoid bloggers to wrongly assume it's some sort of slush fund that pays for everything from nice ballpoint pens bearing corporate logos to luxury Super Bowl tickets and decadent, dwarf-tossing bachelor parties.

12b-1 "sounds like some type of plastic explosive," said Jeffrey Keil, a principal at Keil Fiduciary Strategies, during the previous 12b-1 roundtable.

A more conventional name like an all-in-one fee or a distribution and sales load would be more accurate, but still doesn't adequately describe the nature of these fees.

"Vocabulary kills," Haaga said. "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."

In reality, revenue collected from 12b-1 charges pay for ongoing service fees, advertising expenses and spread load transaction fees. Industry leaders say most mutual funds could not sell their products if they had front-end load sales charges.

Haaga said the distinction between sales costs, distribution, advice and administrative services has become increasingly blurred. Having a tightly regulated, special rule for distribution-related expenses would be unnecessarily challenging for directors, he said.

12b-1 fees are a significant part of industry revenue, and they support a great deal of intermediary activity, such as the selling and servicing of products, as well as a combination of these activities, said David Hearth, a partner in the investment management practice at the international law firm Paul Hastings.

He said 12b-1 is less like a fee and more like a tax on funds to provide benefits and promote the sale of products. It should be up to the fund board to determine if the 12b-1 fee is reasonable, he said, and an independent board would be in a much better position to make such a judgment than the SEC.

"If they change it at all, the SEC should amend 12b-1 to make it more flexible about the broad range of activities for which it could be used," Hearth said.

Strong Talk

The SEC's Division of Investment Management brought in some of the industry's top experts for a 12b-1 roundtable in June 2007, but other than some strong talk and a general agreement that something should be done, nothing actually got done.