Will the securities and Exchange Commission repeal 12b-1 fees? It depends on whom you ask, but SEC staff will recommend changes that Chairman Christopher Cox and the Commissioners should take on the 12b-1 rule by year end. (Editor’s note: An earlier version of this article stated that Chairman Christopher Cox has vowed to either repeal or revamp the Commission’s 12b-1 rule by year-end.) The Commission held a roundtable discussion in mid June on its 12b-1 rule, and some surprising facts were aired.
Critics of 12b-1 have argued that it has been used to pay for a wide array of services–mainly compensating brokers–that go beyond its original intended use as a marketing and distribution fee. But Joel Goldberg, a former director of the SEC’s Division of Investment Management who’s now a partner in the asset management group of Willkie Farr & Gallagher in New York, revealed at the roundtable that the SEC knew full well when it crafted the 12b-1 rule in 1980 that it would be used to compensate brokers for providing services to mutual fund shareholders. Goldberg should know–he was one of the rule’s authors.
A big proponent of ending 12b-1 fees is Barbara Roper, director of investor protection at the Consumer Federation of America. At the roundtable, she told the SEC commissioners and Cox that she questions whether payment of 12b-1 fees to broker/dealers and their registered reps violates the Investment Advisers Act of 1940. Advocates of 12b-1 argue that the fees are justified because of the advice and ongoing services that brokers provide, she told me during a separate conversation. “If that’s an accurate depiction, then it sounds like ‘special compensation’ for advice to me, and it should trigger regulation under the Investment Advisers Act.” She also said during the roundtable discussion that the advice provided by brokers to their clients, which is funded by 12b-1 fees, does not appear to be “incidental advice” permitted under the broker/dealer exclusion from the definition of “investment adviser” found in the Advisers Act.
Ron Rhoades, an advisor with Joseph Capital Management in Hernando, Florida, agrees that payment of 12b-1 fees to broker/dealers often violates the Advisers Act. He told the SEC in a recent comment letter (the SEC stopped taking comment letters on 12b-1 on July 19) that while some 12b-1 fees may be utilized for legitimate purposes–”to compensate broker/dealers for the actual costs of service (acting as custodians, providing prospectuses and annual reports to clients)”–the many other comments submitted show that “many broker/dealers utilized a substantial portion of both the NASD maximums–the 0.25% annual ‘service fee’ and the 0.75% annual ‘asset-based sales charge’–to compensate registered representatives for ongoing ‘investment advisory’ services–which are only permitted under the Investment Advisers Act.”
Given that brokerage firms are now scrambling to comply with the October 1 deadline of transitioning their fee-based accounts to either a commission account or an investment advisory account that charges fees, Rhoades told me in a separate e-mail that “should the SEC repeal 12b-1 fees, or limit them substantially, I would hope the SEC permits a very long transition period (at least a year) for broker/dealer firms to adjust” as scads of registered reps depend on the fees for “a substantial portion of their income.”
Michael Sharp, general counsel of Citi Global Wealth Management, told roundtable attendees that “12b-1 fees have been a wild success.” The amount of 12b-1 fees that shareholders pay through mutual funds reached nearly $12 billion in 2006, according to the Investment Company Institute (ICI)–a huge jump from the few million dollars shareholders paid in the early 1980s.
Get Rid of Them Altogether…