From the February 2016 issue of Investment Advisor • Subscribe!

12b-1 Fees in Crosshairs at SEC — and DOL

The SEC continues its focus on fund expenses, but DOL's fiduciary rule will take aim at such fees as well

The SEC and the DOL are both working to limit the fees investors pay. The SEC and the DOL are both working to limit the fees investors pay.

While the Securities and Exchange Commission continues its crackdown on 12b-1 fees, it's important to remember that the Department of Labor's upcoming rule to redefine fiduciary under ERISA will place its own type of curbs on 12b-1 fees.

[Ed. Note: The DOL sent its rule to redefine fiduciary on retirement advice, formally the Conflict of Interest Rule — Investment Advice, to the Office of Management and Budget for its mandatory review late on Jan. 28. If put through an expedited review of what industry observers say would likely last 50 days, rather than the typical 90-day review, that would mean DOL would issue the rule before April. Read more here.]

In the first month of the new year, the SEC issued guidance that warned advisors and broker-dealers to pay more attention to these fees, and also announced it took yet another enforcement action against an advisor related to 12b-1 fee violations.

A recent SEC exam sweep of investment advisor and mutual fund complexes’ distribution fees, including 12b-1 fees, prompted SEC staff to issue the guidance in early January.

Unlike securities industry lingo that places vague labels on items like 12b-1 fees and sub-transfer agency fees, the Employee Retirement Income Security Act refers to compensation, which is defined as “the payment of any money or things of monetary value,” noted Fred Reish, head of the ERISA team at the law firm Drinker Biddle & Reath in Los Angeles.

So ERISA's definition of compensation — money and things of monetary value — is “much broader than securities terminology,” Reish said, and considers payments of compensation through two lenses: fiduciary (reasonable fees relative to the services) and prohibited transactions.

“What's changing [with the upcoming release of DOL's fiduciary rule early this year] is that all of a sudden all of these advisors [to retirement plans and IRAs] will be fiduciaries” and the rule will subject those advisors to the fiduciary prohibited transaction rules; therefore they won't be able to “give advice that affects their own compensation, which includes 12b-1 fees.”

In their guidance, staff within the SEC's Division of Investment Management (IM) stressed that mutual fund fees “have a direct impact on investor returns,” noting that, for example, “because investors may evaluate funds based on the specific levels of 12b-1, management and other fees, potential mischaracterization of fees may lead them to invest in funds that they would not otherwise have selected.”

Fees and Consumer Advocates

SEC Chairwoman Mary Jo White said last year that 12b-1 fees were in her sightline, but no rulemaking has as of yet been proposed to put further restrictions on them. White was urged last year by consumer advocate groups like the Consumer Federation of America to “resurrect” the plan that the agency put forth early in the Obama administration for 12b-1 fee reform.

12b-1 fees are an annual marketing or distribution fee on a mutual fund. The fee is considered an operational expense and, as such, is included in a fund's expense ratio, and is generally between 0.25% and 1% (the maximum allowed) of a fund's net assets.

But the groups told White that one way brokers “obscure the costs that investors incur for their services is by charging for those services through 12b-1 fees rather than through up-front commissions.”

The groups told White that while there is “nothing inherently wrong with charging for services in incremental payments, this practice suffers from several important shortcomings. Because 12b-1 fees are not considered commissions, they are not subject to FINRA commission limits. Because the fees are buried within the administrative fee charged by mutual funds and annuities, investors often fail to understand how much they are paying or what they are paying for through these fees.”

Susan Ferris Wyderko, president and CEO of The Mutual Fund Directors Forum, said that the “detailed” guidance would indeed help boards and advisors “struggling to apply the previous decades-old staff guidance to today's vastly different distribution environment.”

A week after releasing the guidance, the SEC ordered an advisor to appoint a dedicated chief compliance officer as part of a settled enforcement action alleging 12b-1 fee violations, which revolved around the firms’ reps pushing clients into funds that charged a 12b-1 fee.

The exam sweep that preceded the 12b-1 fee guidance was part of the SEC's “distribution-in-guise” initiative, which is designed to protect investors from improperly paying mutual fund distribution fees. The initiative resulted in the SEC levying its first enforcement action in this area last September against First Eagle Investment Management and FEF Distributors.

A $40 Million Warning to Mutual Fund Companies?

In that case, the SEC fined both firms almost $40 million for using fund assets belonging to shareholders, rather than their own assets, to pay distribution costs from January 2008 to March 2014. Once collected, those funds will be distributed to the affected shareholders, according to the SEC.

The SEC enforcement director, Andrew Ceresney, said when the First Eagle action was taken that “First Eagle and FEF [Distributors] inappropriately used money belonging to the shareholders of the funds to pay for services clearly intended to market and distribute the shares.” Unless part of a 12b-1 plan, he said, “the firm should bear those costs, not the shareholders.” FEF is an affiliated distributor of First Eagle funds.

The IM staff guidance basically advises “funds’ boards and managers on how to assess the permissibility of fees paid to intermediaries, and also requires the fund board to determine whether payments made to intermediaries (such as sub-transfer agent, administrative, sub-accounting or similarly categorized shareholder servicing fees) are disguised distribution payments only permissible pursuant to shareholder-approved 12b-1 distribution plans,” explained Cipperman Compliance Services in an email alert.

The IM staff requires the fund's advisor and other service providers “to provide the board with sufficient information to make such determinations,” Cipperman said. The guidance also outlines the information that the board should receive including services rendered, amounts paid, fee structures and reasonableness.

Several practices also deserve heightened board scrutiny, the guidance states, including “distribution activity conditioned on receipt of fees, the absence of a 12b-1 plan, tiered payment structures, bundling of services and large disparities in fees paid to different third-party providers.”

The IM staff recommends that funds adopt compliance policies and procedures to review and identify payments that may be made for distribution-related services.

Fund boards should consider adding “a distribution review similar to the advisory contract review process, whereby the advisor must deliver significant information for the board to deliberately consider any shareholder servicing payment according to the staff's guidance,” Cipperman advised.

“Fund CCOs need to get working on policies and procedures and testing protocols.”

Holding an RIA Responsible

In the first 2016 action against an advisor for 12b-1 violations, the SEC's order instituting an administrative proceeding states that since 2010, Everhart Financial Group (EFG), a registered investment advisor, principally invested its clients in the mutual funds offered by a single family of mutual funds via the Mutual Fund Complex. The MFC offers two share classes to investment advisors, with the only meaningful difference being that one share class charges 12b-1 fees and the other does not.

Despite significantly higher fees, some advisor reps at EFG “nearly always” invested non-retirement individual advisory accounts in shares that charged a 12b-1 fee, which was paid to EFG's principal owners, who also were licensed registered reps of a registered broker-dealer, the SEC order states.

Receipt of 12b-1 fees “not only created a conflict of interest that was not adequately disclosed to EFG's clients, but favoring 12b-1 funds over others was inconsistent with EFG's duty to seek best execution for its clients,” the SEC said.

In addition, EFG had several compliance failures, including the lack of annual compliance reviews for several years, and also issued insufficient disclosures regarding the receipt of 12b-1 fees. The SEC said the firm also failed to file and deliver an accurate Form ADV.

The SEC required the firm to retain an independent compliance consultant, notify all advisory clients of the enforcement order and pay significant fines and disgorgement.

The agency also found that EFG's founder, Richard Scott Everhart, did not perform required annual compliance reviews from 2008 through 2011 and in 2013 and 2014.

Cipperman noted that investment advisors, funds and broker-dealers should appoint “a dedicated CCO with relevant regulatory experience either by hiring a full-time employee or by retaining a competent third-party compliance firm that offers outsourced CCO services.”

The SEC “has warned, through enforcement actions and speeches, that firms that slough off compliance on otherwise engaged (or inexperienced) executives run significant risk of compliance breakdowns and enforcement actions,” Cipperman said.

--- Read Debate on Fiduciary Is Over; Battle for ‘Best Interest’ Rages On on ThinkAdvisor.

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