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.”
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.