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SEC Urged to Reform 12b-1 Fees, Block Risky ETFs

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Consumer advocates are urging Securities and Exchange Commission Chairwoman Mary Jo White to reform a host of regulations that they say are failing to “effectively” serve retail investors’ needs. They called for the securities regulator to act now on a fiduciary rule for brokers, to reform 12b-1 mutual fund fees and to stop the approval of risky ETFs.

In their March 10 letter to White, the Consumer Federation of America, Fund Democracy, AFL-CIO, Americans for Financial Reform, Consumer Action and Public Citizen say their concerns “reflect the fact that it has been some time since a comprehensive agenda of retail priorities has been clearly communicated to (or by) the Commission,” and that the Commission “can no longer afford to relegate … retail investor protection priorities to a back burner.”

As to 12b-1 fees, the groups urged White to ensure the agency “resurrects” the plan that it 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%-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.”

While there is “nothing inherently wrong with charging for services in incremental payments, this practice suffers from several important short-comings. 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.”

On whether to put brokers under a fiduciary standard, the groups say that despite the agency’s “extensive study” of the matter, and “although investor advocates have consistently identified this as the single most important step the Commission can and should take to improve protections for average investors,” the SEC “has still not taken concrete steps to address the problem.”

The groups told White that it’s time for the agency to adopt one of two “simple solutions”: prohibit broker-dealers from holding themselves out as advisors unless they are regulated accordingly or adopt a uniform fiduciary standard designed to ensure that brokers and advisors alike are required to put the interests of their clients first when offering personalized investment advice.

Adopting a rule, “while an essential first step, is not enough however,” the groups write. The Commission “must also enforce the standard in a way that holds broker-dealers and investment advisors alike accountable, not simply for disclosing conflicts of interest, but also for acting in the best interests of their customers despite any such conflicts.”

The groups also say that the SEC has failed to examine the compensation and other business practices that create conflicts of interest between investors and the broker-dealers and investment advisors they rely on for advice, as required under the Dodd-Frank Act. “Brokerage firms have adopted compensation practices that create significant and unnecessary conflicts between the interests of their sales representatives and the interests of their customers,” the groups write.

“Where that examination uncovers evidence of particularly harmful conflicts, the Dodd-Frank Act directs the Commission to act to ban or limit the practices that create the conflicts.”

Another area in need of reform is compensation disclosure, the groups assert, stating the the agency must begin work “immediately” to develop disclosures that provide investors with “straightforward information about costs and conflicts associated” with the services provided by financial professionals.

The groups note that the Financial Industry Regulatory Authority, however, “has begun to comprehensively examine conflicts of interest within the firms it regulates.”

The groups also told White that Commission staff’s practice of approving in recent years new and exotic versions of ETFs through “ad-hoc exemptive orders” poses “significant risks that are likely to be poorly understood by unsophisticated retail investors.”

For example, the group cite Commission staff allowing ETF providers to create their own indexes “just so they can create an ETF to track those indexes,” as well as “create inverse and leveraged ETFs, and even create actively managed ETFs.”

Most recently, the SEC approved a form of ETF “that allows investors to be provided with current per share net asset values (NAVs) for which the fund has no legal responsibility, which effectively repeals one of the most important requirements for such funds,” the groups state.

Furthermore, they state, allowing “investors to trade on the basis of these purportedly current NAVs, notwithstanding that the NAVs have no necessary relationship to investors’ ultimate transaction price, which will not be set until the end of the day.”

As ETFs have grown in complexity, the Commission “appears never to have conducted the kind of thorough analysis of the regulatory regime governing ETFs necessary to ensure that it offers appropriate protections for retail investors,” the group say. “This kind of comprehensive review should consider whether disclosure alone is a sufficient safeguard, or whether certain conditions should be placed on the types of ETFs that can be created and marketed to retail investors.”

— Check out Are Actively Managed ETFs Really the Next Big Thing? on ThinkAdvisor.


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