So-called 12b-1 fees are paid by a mutual fund out of a fund's assets to cover distribution expenses and sometimes shareholder service expenses. Those expenses include, among other things, costs of compensating those who sell fund shares.
The 12b-1 fee is considered an operational expense and, as such, is included in a fund's expense ratio. It is generally between 0.25% and 1% (the maximum allowed) of a fund's net assets. Even no-load mutual funds may still have a service fee of up to 0.25%. This fee is effectively passed on to the client because it diminishes his or her overall investment return.
Investment advisor reps of many advisory firms are, in their separate individual capacities, affiliated with an Securities and Exchange Commission-registered firm and a FINRA member broker-dealer. That broker-dealer will generally have selling arrangements with various mutual funds, which includes the receipt of 12b-1 compensation from the fund. In such event, in addition to the ongoing advisory fee earned by the advisory firm, the rep can receive an ongoing portion of the 12b-1 compensation.
For example, advisory firm Jones employs representative Smith, who recommends to a client (or purchases with discretion) $1,000 in the XYZ mutual fund, a fund that has a selling arrangement with Smith's broker-dealer. By so doing, in addition to Jones earning an advisory fee (1%), Smith will receive a portion of the 12b-1 fee (0.25%) paid by XYZ to the broker-dealer. Thus, on the $1,000 purchase, Jones earns an advisory fee of $10, and Smith may receive up to 100% of the 12b-1 fee from his broker-dealer, or $2.50. Thus, two different fees are received on the same transaction and the client is not receiving any additional benefit.
The overriding issue is whether this practice can be addressed and the conflict waived by disclosure, or whether it's a breach of fiduciary duty regardless of the level of disclosure. Is it possible to obtain the client's informed consent to such a practice? The conflict is exacerbated if the advisory firm is purchasing the funds on a discretionary basis. Given the current aggressive regulatory environment, it is conceivable that the SEC would bring an enforcement case, especially when this practice is not clearly disclosed to the client and the firm has no practices in place to monitor the activity.
What should your firm do about using funds that charge 12b-1 fees? Although this practice isn't expressly prohibited, it appears firms are starting to move away from this conflict due to increased SEC scrutiny. In addition, this practice will likely result in an ERISA prohibited transaction in cases where a fiduciary purchases securities with discretion and receives additional compensation.
The advisor may be able to mitigate the risk of enforcement if the firm can clearly demonstrate that it employs an unbiased quantitative and qualitative screening process for fund selection, and that 12b-1 fees were not part of the screening process. Regardless of whether an analysis is performed, an advisor must make conspicuous disclosures regarding this practice on its Form ADV Part 2A.
An additional way to address (and potentially resolve) this issue is to use the 12b-1 fees to reduce the client's advisory fee. By so doing, the receipt of the 12b-1 fees are obtained for the benefit of the client, not the advisor or its representative.
A specific item in Form ADV Part 2A deals with this practice:
“If you or any of your supervised persons accepts compensation for the sale of securities or other investment products, including asset-based sales charges or service fees from the sale of mutual funds, disclose this fact and respond to Items 5.E.1, 5.E.2, 5.E.3 and 5.E.4.”
Item 5.E.1 adds that the advisor must “[e]xplain that this practice presents a conflict of interest and gives you or your supervised persons an incentive to recommend investment products based on the compensation received, rather than on a client's needs.”
This is not to say that an investment advisor's affiliates must cease accepting 12b-1 fees, but the SEC may allege that the advisor breached its fiduciary duty by charging an advisory fee on the same mutual fund from which the rep is also receiving 12b-1 fees. Further, the rep's broker-dealer may prohibit this practice if FINRA or the SEC determines that it does not meet the “high standards of commercial honor, and just and equitable principles of trade” outlined in FINRA Rule 2010.
--- Read "SEC Fines 3 AIG Advisor Group BDs $9.5M on Excess Fund Fees " on ThinkAdvisor.