12(b)-1 proposal may hurt investors, advisers contend

The Securities and Exchange Commission’s proposal last week to revamp 12(b)-1 fees could have a number of unintended consequences that could hurt investors rather than help them, according to some observers.

Chief among financial advisers’ concerns is that by pushing more fund companies and advisers away from selling C shares, the proposal, if passed in its current form, would result in fewer choices for investors and ultimately make it more difficult for small investors to gain access to advice.

The proposal also could encourage unscrupulous advisers to churn investors’ accounts and raise operational costs for fund companies, which ultimately could get passed on to shareholders, observers said.

“Mutual funds were designed to benefit [average] middle-class Americans,” said Malcolm A. Makin, president of Professional Planning Group, which manages $725 million in assets. “If brokers feel they can’t be properly compensated, the broker will just find different clients, but those small- and mid-sized investors who can’t afford a fee-only planner may not get the time of day from an experienced broker.”

The proposal, which the SEC unveiled last Wednesday and is open to public comment for 90 days, would allow firms to charge a “marketing and service fee” of up to 0.25%. Anything above that amount would be deemed an “ongoing sales charge” and would be limited to the highest fee charged by the fund for shares without such a sales charge.

For example, if a fund charged a 4% front-end load, another class couldn’t charge more than that amount to investors over time. Separately, funds would be able to create a class of shares by which broker-dealers would determine the pricing.

DEMISE OF C SHARES

The term “12(b)-1” would no longer exist, Mary Schapiro, chairman of the SEC, said during a meeting Wednesday morning. Additionally, fund companies would be required to disclose the marketing and service fees, and the sales charge, in a fund’s prospectus and shareholder report.

The goal of the provision is to enhance disclosure for investors and “eliminate the so-called “hidden sales charges’ that 12(b)-1 fees can represent,” Ms. Shapiro said at the meeting.

Last year, 12(b)-1 fees generated $9.5 billion for fund firms.

By placing a cap on how much funds could charge through their sales charge, the proposal essentially would result in the demise of C shares as they exist today.

Fund companies that sell through intermediaries typically charge 12(b)-1 fees of 1% for as long as the investor owns the fund. That money is then shared with the brokerage firm and used to compensate advisers — in the form of a “trail” — for selling the funds.

But if the proposal passes, these firms will pay brokers only 0.25% for as long as the investor holds the fund, and the 0.75% will convert to zero over a period of years.

“C shares are going to be less attractive and lose much of their prominence,” said John Rooney, managing principal of Commonwealth Financial Network. C shares had $344 billion in assets as of the end of last year, according to the Investment Company Institute.

How drastic and quick the shift away from C shares will be depends on the details of the final rule.

For example, if the sales charge disappeared after three years, that would have a significant impact, Mr. Rooney said. But if brokers continued to get that compensation for five years, it could be OK, he said.

The proposal, if passed, would result in many commission-based brokers’ having the option only of A shares, which have an upfront load and a 0.25% 12(b)-1 fee.

“ELIMINATES CHOICE’

“I am questioning how this helps investors,” said Dale Brown, president and chief executive of the Financial Services Institute Inc. “It eliminates choice.”

C shares often get a bad rap in the industry because over the long term, they cost investors more money, but for investors with a shorter time frame, particularly investors with less to invest, C shares make sense, some advisers said.

“If you are a client and you don’t know what the ups and downs of the market are going to be, do you want to start by paying 5% upfront or do you want to start at 1%?” said Jim Fulp, executive vice president of Raymond James Financial Services Inc.

However, by moving investors to A shares, the proposal could result in more long-term investing, which is what mutual funds were designed for, said Russel Kinnel, director of mutual fund research at Morningstar Inc.

Another potential consequence of the proposal is that it would push more advisers to move from a commission-based to a fee-based business, but some investors would not be able to afford the fees, advisers said. Also, investors often have to pay income taxes on the 1% fees charged in wrap accounts, whereas they don’t pay taxes on 12(b)-1 fees in C shares, Mr. Fulp said.

The cap on the sales charge for C shares also creates an incentive for brokers to churn investors from one fund to another to continue to get paid, said John J. Robinson, managing director of Financial Planning Hawaii Inc.

That is also a concern for the FSI, Mr. Brown said.

“One of the unintended consequences could be that it changes the incentives for advisers in a way that’s not healthy for investors,” he said.

Also, if advisers can’t get paid through 12(b)1 fees, they may put more pressure on fund companies to increase revenue sharing, said Jack W. Murphy, a partner at Dechert LLP.

HIGHER EXPENSES

“The 800-pound gorilla is revenue sharing,” Mr. Murphy said. “When you cap what a fund can pay a broker, that broker still wants to get paid, and that could mean higher expenses for the fund companies.”

Also, the increased disclosure requirements will force fund companies to track how sales charges get paid on an individual level, Mr. Murphy said.

“This will cost money,” he said. “It could well be paid for by the funds and eventually by the shareholders.”

The ICI is reviewing the proposal and will work “to ensure that changes ultimately adopted will benefit fund investors while maintaining the ability to appropriately compensate service providers for valuable services to shareholders,” said spokeswoman Inga Vitols.

E-mail Jessica Toonkel at [email protected].

“The 800-pound gorilla is revenue sharing.”

Jack W. Murphy

Partner

Dechert

Related Topics: Securities and Exchange Commission