Close Close

Portfolio > Mutual Funds

Will the SEC Ban 12b-1 Fees?

Your article was successfully shared with the contacts you provided.

What You Need to Know

  • Use of 12b-1 fees has declined in recent years as the SEC has cracked down on conflicts of interest surrounding the share class.
  • The SEC may seek to repeal the fees in the next few years, Ron Rhoades says.
  • But some compliance experts say 12b-1 fees are better than other forms of distributor compensation.

When Securities and Exchange Commission Chairman Gary Gensler appointed consumer advocate Barbara Roper as his senior advisor last year, speculation began to swirl that the duo may seek to eliminate 12b-1 fees.

The SEC has continued to bring cases against advisors for 12b-1 fee violations since ending its Share Class Selection Disclosure Initiative in April 2020.

Under the initiative, which the securities regulator launched in February 2018, the Division of Enforcement instituted a self-reporting program to protect advisory clients from undisclosed conflicts of interest related to 12b-1 fees and return money to investors.

The division agreed not to recommend financial penalties against investment advisors who self-reported violations.

Since ending the share class initiative, the SEC has levied what industry officials call, in some cases, follow-on actions to firms that had been under investigation during the initiative.

At least 10 actions related to 12b-1 fees have occurred since the initiative ended, with the most recent taking place in January. Those actions have centered on firms charging 12b-1 fees when lower-cost share classes of those same funds were available, as well as, in some cases, cash sweep products that likewise resulted in revenue sharing.

Decline in 12b-1 Fees

The Investment Company Institute reported in March 2021 that the majority of long-term mutual fund gross sales now go to no-load mutual funds (i.e., no front-end or back-end load, nor a contingent deferred sales charge) without 12b-1 fees.

In 2020, according to ICI, 88% of gross sales of long-term mutual funds went to no-load funds without 12b-1 fees, compared with 46% in 2000.

I polled regulatory experts on whether they see the agency — under Gensler and Roper — repealing 12b-1 fees, as well as whether the 12b-1 fee crackdown amounts to “regulation by enforcement.”

The movement toward fee-based advice as well as the SEC’s share class crackdown are two factors prompting the decline in 12b-1 fees, according to the experts.

“The decline of 12b-1 fees reflects the growing movement toward fee-based practices, in which clients pay fees directly,” Ron Rhoades, associate professor of finance at Western Kentucky University and director of its personal financial planning program, told me in a recent email. “This is a positive, because fees can be negotiated by the client, unlike many 12b-1 fees.”

Another development, Rhoades continued, “is the greater transparency achieved in 401(k) accounts, and the move toward ‘unbundled’ fee arrangements.”

Given the decline in the marketplace of 12b-1 fees, “there seems to be little justification for their continuance,” Rhoades argued. “Consumers are confused by 12b-1 fees.”

Lesser Evil

Todd Cipperman of Cipperman Compliance Services takes a different view.

“The SEC has scrutinized and criticized 12b-1 fees at least as far back as the early ‘90s,” Cipperman said.

“The challenge is that the distribution channels will not sell to retail investors without compensation, and most retail investors won’t pay a load. It’s a bit like soft dollars. The SEC doesn’t like them, but what’s the alternative? If the SEC just banned 12b-1 fees, the retail investor would have access to fewer products,” Cipperman argued.

“The result would be that the best actively managed funds would only be available to institutions and high-net-worth investors. For better or worse, 12b-1 fees — highly regulated and supervised by boards — is the lesser of all distribution compensation evils,” Cipperman maintained.

Aron Szapiro, Morningstar’s head of retirement services and policy, added that he also sees “a continued long-term decline in flows to share classes with 12b-1 fees.”

However, he said, Morningstar remains “concerned about other kinds of revenue sharing that is often not disclosed with much specificity, and could also create conflicts.”

Dual Registrants and 12b-1 Fees

Brokers use Class C shares, quite often, as well as class A shares, Rhoades said.

As he explains, Class C shares charge 12b-1 fees, up to 1% a year. Class A shares charge a commission of up to 5.75%, with breakpoint discounts for larger investments. These shares may also charge 12b-1 fees, up to 0.25% annually.

“Nothing is wrong from a regulatory standpoint with the sale of such,” Rhoades said. However, “the difficulty comes when a broker is a dual registrant, as many are.”

Then, two questions arise:

First, Rhoades said, “are you choosing the arrangement that is in the ‘best interests’ of the customer or client?”

In other words, he said: Would the client be better off buying mutual funds in a brokerage account, or paying 12b-1 fees in an investment advisory account?

Second, “if the dual registrant is using an investment advisory account (as an RIA) for a client, and receiving a fee directly paid by the client, can a 12b-1 fee be justified?” he continued.

“Typically, no, as 12b-1 fees don’t add any value to a client,” Rhoades said. “The SEC has gone after dual registrants for having clients invest in funds with 12b-1 fees, on the basis of inadequate disclosure. Then, more recently, the SEC actions have applied the duty of best execution (which brokers possess), which is a quasi-fiduciary (limited fiduciary) duty.”

The only way dual registrants “who have clients in investment advisory accounts can recommend funds with 12b-1 fees, without getting in trouble (or at least ‘gray areas’) is when the 12b-1 fees are rebated back to the client (such as by lowering the investment advisory fee),” Rhoades explained. “This rebating makes the billing process prone to errors, however — which in turn could give rise to regulatory action.”

12b-1 Fee Repeal Ahead?

While the SEC examined 12b-1 fees just over a decade ago, “I would anticipate that the SEC move, at some point in the next few years, to again revisit 12b-1 fees. A progressive SEC would likely repeal 12b-1 fees,” Rhoades maintained.

Brokers, Rhoades continued, should “not be building a practice around 12b-1 fees, given the likelihood of their termination by the SEC at some point in the future.”

Rhoades stated that it’s “far better for brokers to move toward fee-based accounts, billing clients directly via one of several different types of methods (AUM, fixed annual fees paid quarterly or monthly, hourly, project-based flat fees, etc.). As brokers continue to migrate away from product-derived compensation, and toward fee-based accounts, the marketplace will become more competitive.”

James Lundy, partner at Faegre Drinker’s Chicago office, and a former SEC attorney, said he’d be very surprised to see the SEC tackle a 12b-1 fee rulemaking this year.

“The 12b-1 fee area may be one of the SEC’s greatest ‘regulation by enforcement’ successes, from the SEC’s perspective,” Lundy said. “So it is not at all a surprise that the majority of long-term mutual fund gross sales now go to no-load mutual funds without 12b-1 fees. This is due to the industry taking notice of the 12b-1 fee self-reporting initiative from 2018 and proactively revising practices accordingly.”

Alex Russell, managing director, White Collar, Regulatory & Internal Investigations at Bates Group, agreed that as a result of the share class initiative “and various carry over matters, firms are focused on reducing or eliminating the use of 12b-1 fee paying share classes despite the clear allowance of those fees by law.”

As a result, Russell said, “’regulation by enforcement’ is a reasonable description of the recent activity.”

Cipperman disagrees.

“It’s a false accusation in this area” to say the SEC is engaging in regulation by enforcement, he said. “The SEC has been very clear about how to approve and pay 12b-1 fees. There have been rules, FAQs, speeches, reports, etc. The law is pretty clear. I don’t have a particular issue with the SEC’s enforcement program in this area. We don’t need more rules.”

Ken Joseph, head of the Disputes practice at Kroll, noted that “regulation by enforcement in lieu of rulemaking, guidance, or precedent has been a familiar refrain by some that have landed in the regulatory crosshairs.”

Even before the formal share class initiative, “the Commission has been very clear about the fiduciary duty, conflict, suitability, and compensation disclosure obligations of registered advisers,” Joseph said. “The enforcement actions, buttressed by the risk alerts and announced priorities of the SEC, plus voluntary reforms that the industry have made have already had a significant impact on improving the practices that the Commission has found to be in violation.”


© 2023 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.