12(b)-1 reform fades into the background

Staggering under its Dodd-Frank load, SEC appears unlikely to act before mid-2011

Nov 14, 2010 @ 12:01 am

By Jessica Toonkel

Don't hold your breath waiting for changes in mutual fund marketing fees.

It will be several months — at least — before the Securities and Exchange Commission comes out with an official announcement about its plan to revamp 12(b)-1 fees, experts said.

And when it does, many expect the SEC to float a rule that is significantly different from its current proposal, and to put portions of the proposal — if not the whole thing — out for comment all over again.

The comment period on the SEC's current 12(b)-1 plan ended Nov. 5. That proposal generated more than 1,000 comment letters, which SEC officials now must sift through before proceeding.

“I can't imagine the SEC would look at all of these comments and say, "We like our original proposal and we are going to go forward with it,'” said Russel Kinnel, research director at Morningstar Inc.

The SEC's plate, of course, is already full as a result of the Dodd-Frank financial overhaul law. Given that heavy workload, strong opposition to the proposal and next week's departure of the proposal's engineer, Division of Investment Management chief Andrew C. “Buddy” Donohue, SEC watchers predict that the commission won't say anything official about 12(b)-1 reform until the second quarter of next year at the earliest. Some don't expect the SEC to tackle 12(b)-1 fees before 2012.

“The SEC tried to build a better mousetrap that doesn't work, and I think it's going to be back to the drawing board on this,” said Jeff Puretz, a partner at Dechert LLP. “It's going to take a long time to recover from this.”

John Heine, an SEC spokes-man, declined to comment.

Whether the SEC re-proposes all or portions of the proposal six months or five years from now, observers agree that it will face fierce opposition from the fund and brokerage businesses.

Under the current proposal, fund firms could charge a “marketing and service fee” of up to 0.25%. Anything above that amount would be deemed an “ongoing sales charge,” which would be limited to the highest fee charged by the fund for shares without marketing and service fees.

The proposal also would allow fund companies to create a new class of shares through which broker-dealers could set their own sales charges on mutual funds.

One major criticism of the proposal made by a number of industry groups in their comment letters is that the SEC needs to address the 12(b)-1 issue in the context of all of the other regulations associated with Dodd-Frank.

Specifically, many observers noted that the SEC has to examine 12(b)-1 as they would be affected by a universal fiduciary standard of care.

As mandated by Dodd-Frank, the SEC is conducting a six-month study for Congress about the differences in oversight of investment advisers and broker-dealers, and whether regulatory gaps exist. The study is due to be presented to Congress in January.

How regulators and Congress define the fiduciary standard of care will affect how financial professionals are compensated and how they disclose that compensation, which is directly tied to 12(b)-1 fees, said Barry Barbash, a former director of the SEC's Division of Investment Management and now a partner at Willkie Farr & Gallagher LLP.

“I think it's going to be very difficult to just look at 12(b)-1 without taking into account the other regulatory measures,” he said. “This is just one piece of the marketing and distribution puzzle.”

The piece of the 12(b)-1 proposal that would allow brokers to set their own sales charges could result in lower levels of service for smaller clients, said Kevin Carroll, associate general counsel for the Securities Industry and Financial Markets Association.

It also has the potential to conflict with the prospective rules on the fiduciary standard of care, he said.

“I think the commission is going to have to think about that carefully,” Mr. Carroll said.

It would be appropriate for the SEC and Congress to finalize its rules on the fiduciary standard of care before addressing 12(b)-1, said Dale Brown, president of the Financial Services Institute Inc.

One possibility is that the SEC may break up the proposal and put out for comment the portions of it that are the most controversial, observers said. For example, the SEC may move forward with the proposed cap on 12(b)-1 fees but make concessions for the retirement plan market, which many groups noted in their comment letters needs 12(b)-1 fees in excess of 0.25% to service retirement plans, particularly smaller plans.

The Investment Company Institute, the American Society of Pension Professionals and Actuaries, and The SPARK Institute Inc. all noted in their comment letters that the proposal would be too costly and burdensome for the retirement plan industry.

Money market funds are another area that could get an exemption from the 12(b)-1 cap, because as the ICI noted in its letter, money market funds with 12(b)-1 fees higher than 0.25% are usually used in commercial sweep accounts.

The ICI letter countered the arguments of critics who say 12(b)-1 fees are used as continuing sales charges, saying that money market funds, like retirement plans, use these fees to pay marketing and distribution expenses.

But even if the use of fees for those purposes was exempted, the SEC may still hit significant opposition to the 12(b)-1 fee cap because of the operational burdens it poses on the fund industry, observers said.

And some SEC watchers think that the political climate has changed so drastically since the commission started working on the 12(b)-1 proposal that it may have to shelve it for a couple of years to let Dodd-Frank plays out.

“The political winds have changed so that the popularity of this measure has declined,” Mr. Puretz said. “The staff will have to go back and sharpen their pencils.”

E-mail Jessica Toonkel at jtoonkel@investmentnews.com.


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