Incite: Hey brokers, the SEC is right about 12(b)-1

Despite criticism from the brokerage industry, a revamp of 12(b)-1 fees is long overdue

Jul 28, 2010 @ 8:48 am

By Susan Antilla, Bloomberg News

(Susan Antilla is the author of "Tales From the Boom-Boom Room" and a Bloomberg News columnist. The opinions expressed are her own.)

The mutual fund industry raked in $9.5 billion from the esoteric sales charges known as 12(b)-1 fees in 2009, and that was a lousy year. In the headier markets of 2007, often-clueless investors forked over $13.3 billion in these misunderstood charges, which go mostly to line the pockets of brokers, not to manage investments.

The Securities and Exchange Commission said in a proposal last week that investors would be better-served if there were caps on some of those charges, if confirmation slips properly identify the levies as an “ongoing sales charge” rather than ill-defined “distribution” costs, and if customers are told how much they're paying to fatten their brokers' paychecks.

Stand clear for a torrent of whining and general hysteria from brokerage firms and fund operators. For 30 years, they have luxuriated under regulations that allowed them to dip into fund assets to compensate salespeople who benefit most if they pick a fund with the greatest commissions, not the greatest promise for the customer.

Everybody gets 90 days to tell the SEC what they think of the proposal. Here's some history and observations that would-be commentators might consider:

Regulators can fall for bait-and-switch just like investors do

Business was rotten in the late 1970s, and the fund industry wanted to swipe money from fund assets so it could advertise for new customers. The SEC passed Rule 12(b)-1 in 1980 with the idea that advertising supported by the new fees would bring more assets under management, which in turn would lead to economies of scale that would help investors.

It didn't work out quite that way. Today, only 2 percent of the fees are used for advertising and promotion, according to the SEC, even though that was one of the main purposes the agency intended when it decided to permit the practice.

Beware the financial company that innovates

It took only two years before a financial firm figured out a way to exploit its newfound ability to use assets for advertising. In 1982, E.F. Hutton Investor Services got permission from the SEC to expand 12(b)-1 so that it could pay commissions to brokers.

That practice “soon became common,” Matthew P. Fink, former president of the Investment Company Institute, a fund trade group, wrote in his 2008 book, “The Rise of Mutual Funds.” Sales soared after 12(b)-1 became law. By the end of 2009, 21 percent of investors' household financial assets were in mutual funds, up from 3 percent when the SEC passed the rule.

Expect to hear hackneyed warnings that consumers will be the ones who wind up hurt

A recent article in InvestmentNews suggested that brokers facing reduced commissions might begin charging a fee for advice, which would be too expensive for some investors. The proposed regulatory changes could even induce less reputable brokers to churn accounts, the article said.

Still, it's hard to imagine how this situation can get any worse for the consumer. The SEC anticipates that investors could save $857.5 million a year if its cap on annual fees is enacted.

Edward Siedle, a former SEC lawyer who investigates money- management fraud from his company in Ocean Ridge, Florida, says brokers can get paid without helping themselves to money from funds. “There is absolutely no basis for saying 12(b)-1 fees benefit investors,” he says. If funds want to entice brokers to sell their products, their money managers “can cut their excessive fees.”

Be wary of the business pitch that extols the virtues of empowering investors

In the years after it became legal to use fund assets to pay brokers, the fund industry began to package the policy with a narrative that suggested investors were getting choices they wanted and needed: They could pay a commission the old-fashioned way before their money was invested, or pay over a period of years, or pay when they decided to sell their shares.

Before 12(b)-1, investors did get turned off when they laid their eyes on sales documents that mapped out the large sums they were losing to commissions. With 12(b)-1, the industry had a great tool to get investors to believe that their expensive fund choices were low-cost no-loads.

“If you tell people they have a choice, then they feel empowered,” Peter Henning, a professor at Wayne State University Law School in Detroit, told me in a telephone interview. “But any number of times, they're just getting bamboozled.”

To put it mildly, the SEC makes its share of missteps. This time, it's on the right track in trying to look after investors, albeit a few decades late. Let's see if the agency can stick with a decent plan once the industry lets loose with its inevitable campaign to water it all down.


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