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Will 12b-1 Fees Survive?

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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…

Not surprisingly, the majority of fee-only advisors abhor 12b-1 fees and think they should be abolished–as I found out in an ad hoc e-mail survey that I conducted recently. However, Charles Stanley of Capital Financial Advisors in La Jolla, California, told me via e-mail that 12b-1 fees can be good for pure commission brokers, because they allow brokers to have “some compensation for taking care of their customers without having to sell them something new or churning the account.”

While commission brokers would be hurting without 12b-1 fees, so, too, would small mutual funds, Mellody Hobson, president of Ariel Capital Management, told the SEC during the roundtable. She said that small fund companies like Ariel, which has $7 billion under management in mutual funds, “could not exist without 12b-1 fees.” Ariel, she said, uses 12b-1 fees in four ways: to pay advisors and consultants to market the fund; to compensate the big mutual fund platforms like Charles Schwab and Fidelity; to pay 401(k) plan administrators (which is a growing piece of Ariel’s business); and to offset Ariel’s internal marketing and advertising costs.

Or Bring Them Into the Light…

The problem with 12b-1 fees “is their secrecy,” says John Deyeso, an advisor with Financial Filosophy in New York. Indeed, roundtable panelists also agreed that how 12b-1 fees are used needs to be explained more thoroughly to investors. “We have found that most investors have an understanding that the [12b-1] fee compensates the broker for future account services even though they do not know what services they will receive,” adds Roger Kruse, a planner with FFP Wealth Management in Coon Rapids, Minnesota. Indeed, some panelists at the roundtable even suggested renaming the off-putting and obscure 12b-1 term.

As for where the 12b-1 fee should come from, Deyeso says that if mutual funds “really see 12b-1 fees as a necessary cost of doing business, then pay [the fee] out of the operating budget of the fund family, and not out of the [mutual] funds directly.”

Jeffrey Broadhurst, an advisor with Broadhurst Financial in Philadelphia, believes that 12b-1 fees are just flat out “wrong.” He asks: “Why should the product set the compensation for the advisor? Why should an annuity pay 10%, a mutual fund A [share] pay 5.75%, and a B [share] pay 4% with a 0.25% trail?” He uses DFA institutional shares, which pay no commission or 12b-1 fee. “Clients pay us an advisory fee,” he says. Barry Kaplan, an advisor with Cambridge Southern Financial Advisors in Atlanta, agrees that institutional fund shares, which carry no 12b-1 fees, are the way to go. “How can anyone with a straight face call [12b-1] a marketing fee when closed mutual funds continue to charge 12b-1 fees?”

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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