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SEC Probes Whether 12b-1 Fees Are Used Properly

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The Securities and Exchange Commission is examining fees paid to intermediaries by mutual funds “to discern” if the agency’s 12b-1 rule is “being adhered to” and “what funds are paying intermediaries for,” Paula Drake, chief counsel in the agency’s Office of Compliance Inspections and Examinations, said Thursday.

As the SEC’s examination branch, Drake told attendees at the Mutual Fund Directors Forum’s Policy conference in Washington, OCIE is “looking at any area that we think has potential conflicts or risks. It’s through intermediaries that you see the path of growth in the mutual fund arena — through 12b-1 fees, revenue sharing, sub transfer agency fees…; we want to understand what is happening in this very important area to investors.”

Distribution fees, or so-called 12b-1 fees, are paid by a mutual fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses. The SEC’s 12b-1 fee rule, which was promulgated in 1980, permits a fund to pay distribution fees out of fund assets only if the fund has adopted a 12b-1 plan authorizing their payment.

“The plan has to be written and adopted by the board and it has to be disclosed to the shareholders,” Drake said during her Thursday remarks.

Distribution fees include fees paid for marketing and selling fund shares, such as compensating brokers and other financial professionals who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature.

The 12b-1 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.

Mercer Bullard, president and founder of Fund Democracy Inc. and associate professor of Law at University of Mississippi School of Law, told ThinkAdvisor in a Thursday email message that the SEC is concerned “that some firms are using fund assets to pay for distribution outside of a 12b-1 plan.” Susan Wyderko, ‎president and CEO of the Mutual Fund Directors Forum, queried Drake as to what OCIE is looking for in its 12b-1 related exams. “We’re looking for a robust and substantial process of the flow of information to the [fund] board, and documentation,” Drake said. “Does the board have a process to make this determination” regarding payment of 12b-1 fees? she continued. Also, “is the board getting the information that it needs from advisors to make this determination?”

Wyderko then asked Drake how precise the SEC expects fund boards to be in allocating fees to shareholder servicing or distribution.

“We haven’t announced a formula for exactly what we are requiring, we’re not giving a recipe,” Drake replied. “We’re not questioning the legitimacy of paying intermediaries, and we’re not questioning those payments, but we are saying there must be a process within the [12b-1] rule and disclosure.”

Fund Democracy and other groups like the Consumer Federation of America told White in a March 12 letter to resurrect the plan that the agency put forth early in the Obama administration for 12b-1 fee reform.

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 shortcomings,” the letter says. “Because 12b-1 fees are not considered commissions, they are not subject to [Financial Industry Regulatory Authority] 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.”

— Check out SEC Urged to Reform 12b-1 Fees, Block Risky ETFs on ThinkAdvisor.


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