Eight months after holding a roundtable discussion on its Rule 12b-1, the SEC is planning a "complete overhaul" of the rule, according to SEC Chairman Christopher Cox. Yes, "complete overhaul" are the words Cox used in a speech on February 8 at the SEC Speaks conference in Washington. Cox said that Buddy Donohue, head of the SEC's Division of Investment Management, is preparing to issue a formal rule proposal sometime this spring.
While the SEC has divulged few details about the changes that are in store, industry officials doubt that any rule would get passed this year since the SEC is down two commissioners and the length of Cox's stay at the Commission is questionable. But these officials are providing educated guesses about what modifications may be likely.
First, let's recap how we got to this point in the debate. The SEC began re-examining its 12b-1 rule because critics have argued that it's gone well beyond its original intended use as a marketing and distribution fee. Instead, 12b-1 fees are used to pay for a wide array of services--mainly compensating brokers, these critics say. When I attended the 12b-1 roundtable at SEC headquarters last June, complaints that were aired included the obscurity of the 12b-1 term itself and its lack of clarity. "The [12b-1] name alone is one that only a '40 Act attorney could relate to," Don Phillips, president and CEO or Morningstar, said in a recent interview. "No investor says, 'Yes, I know exactly where my dollars are going with a 12b-1 fee.'" It's hard to tell if the 12b-1 fee is "going for operational costs, distribution costs, sales costs?" Phillips continues. So better disclosure of 12b-1 fees may be one area the SEC is focusing on, Phillips says.
"Certainly there is ample room for better disclosure of 12b-1 fees."
Having said that, however, when told the 12b-1 fee is going to their advisor, or that it pays for services from their mutual fund supermarket or 401(k) recordkeeper, most investors are fine with paying the fee. After getting this type of explanation, investors would likely say, "I get a lot of value from meeting with my advisor and I know I don't have to write a check out to that person, they're getting paid through my security, so that's a good thing," Phillips says. So outright repeal of 12b-1 fees, he says, seems unlikely. "12b-1 pays for a lot of services that people like and perceive to get value from."
In his speech Cox said "most retail investors don't know" that 12b-1 fees permit mutual funds to pay out nearly $12 billion a year in investors' assets for purposes such as reimbursing brokers for their expenses of marketing the funds to other investors, and for various administrative services. During the roundtable last year, Cox said the Commission "would be conducting a major reevaluation of how [the 12b-1 rule] is or isn't serving investors."
A Solution to a Non-Problem?
Dale Brown, president and CEO of the Financial Services Institute (FSI), says he's not "aware of the major problem [the SEC] is trying to fix" with12b-1 fees. There's no indication "that there's been a huge outcry from investors about 12b-1 fees," Brown says, arguing furthermore that the fees are "hugely important to investors, particularly small investors," because the fees make it possible for them to "invest and continue to have access to ongoing help and service." Plus, he says, the 12b-1 fee not only gives an advisor incentive to work with smaller accounts, "12b-1 fees are a very important stream of income that gives independent advisors the capacity to have staff in place and invest in systems and other things to provide the ongoing service [to small investors] and not be dependent on generating more transactions."
Commission-based brokers receive a significant stream of income from 12b-1 fees, but the SEC may decide to do away with the long-held practice of letting brokers receive continuous 12b-1 trails long after they've sold a client a mutual fund, opines Roberta Ufford, a principal at Groom Law Group in Washington. The SEC may decide that "broker payments might not forever trail the way they do now," she says. "Why should a broker continue to get a percentage of your investment years after you put your money in the mutual fund? In many cases the broker doesn't have a relationship with the investor anymore and doesn't provide any services."
The Fees and Recordkeepers
In the 401(k) plan recordkeeping world, however, notes Ufford, "those [12b-1] trails or fees that come out of mutual funds get used to provide current recordkeeping services. So if you were to change the [12b-1 fee] structure so that the fees don't come out of the fund and get shared with the recordkeeper or other shared service providers, there has to be another way to pay for plan services," and says "it's not clear what the best way would be." The fee could be deducted from participant accounts, she says, but if it was that easy, plans would have already done that.
David Goldstein, partner at Sutherland Asbill & Brennan in Washington, says he and his colleagues and other industry professionals are pretty certain that the "SEC will update or modernize the things that independent directors of mutual funds need to do to approve 12b-1 fees."
A list of "risk factors" that a mutual fund board should consider were listed in the release that accompanied the original 12b-1 rule, he explains, but those risk factors are outdated and "hard to apply in the modern age." For instance, the risk list "really didn't contemplate that 12b-1 fees would be used in lieu of front-end loads," he says. "So the orientation of these factors is not relevant anymore and in some respects they put unrealistic burdens on fund directors. In particular, if you read them literally, they expected mutual fund directors to look at how the money is spent in the sense of not just who it was paid for, but how did those people who got it spend it?" he continues. "But in the modern age where a fund group might have agreements with hundreds of different brokers to sell their shares, there's no way they can collect and distill information to give to the board about what each broker did with the money."
So it's likely, muses Goldstein, that the SEC will "eliminate the unwritten expectation today that fund directors are really doing a qualitative assessment on the quality of services that the 12b-1 fees buy for shareholders, and make it more of an analysis of whether the fees overall are bringing the benefits to the fund that the plan expects rather than 'Is the service from the intermediaries worth what's being paid for?'"
The worst part for advisors and the financial services industry as a whole now is not knowing what actions the SEC may take concerning 12b-1, but Phillips says advisors can take some comfort in the fact that "individual investors have clearly voted that they want--and are willing to pay for--the help of professionals to help them with their investments." As long as there's demand for advisor services "and a very adaptive financial services industry, there's going to be a happy match made between investors and advisors," he says. "There may be some turbulence in the interim to figure out how that's done" if 12b-1 changes are implemented, but those changes "won't make the advisor services any less in demand or any less profitable."
Washington Bureau Chief Melanie Waddell can be reached at firstname.lastname@example.org.