The SEC is looking at capping the 12(b)-1 marketing and sales charge fees that fund investors pay and is preparing to issue a proposal early this year concerning the approximately $12 billion a year paid in such fees.
The regulatory authority wants to change the focus of the current cap on sales charges that can be charged by funds and brokerage firms, said Andrew "Buddy" Donohue, director of the Securities and Exchange Commission's division of investment management.
A cap for investors "wouldn't necessarily have to be a dollar cap," said Jennifer McHugh, Mr. Donohue's senior adviser. "It could be based on how long an investor has paid 12(b)-1 fees," she added.
The perspective of the Financial Industry Regulatory Authority Inc. of Washington and New York, which sets limits on 12(b)-1 charges under the SEC's oversight, "has been to look at it from the perspective of the fund and the underwriter, and not an individual investor," Mr. Donohue told
InvestmentNews in an exclusive interview.
"Rather than looking at it from the top down, we're trying to see if there's a way to look at it from the investor's perspective," he said.
Under the current system, investors who purchase mutual funds in B or C shares could ultimately pay higher fees than they would if they had purchased front-end-load A shares, Mr. Donohue said. In most cases, charges for selling B shares decline over the six to eight years after purchase, while fees for C shares continue as long as an investor holds the shares.
"If I were in a B or C share, should I pay more than in an A share?" Mr. Donohue asked. "The maximum sales charge should be looked at from the perspective of an investor."
Last year, SEC Chairman Christopher Cox pledged to re-examine the 12(b)-1 fee system, which was begun in 1980. He questioned why fees are now used largely to compensate fund brokers, departing from what he said was the original intent, which was to cover fund marketing and distribution expenses.
While no proposal has been sent yet to the full commission for consideration, Mr. Donohue said, SEC staff members are "kicking the tires on some ideas we have. We're pretty far along in our thinking on a number of things."
The primary concern for Mr. Donohue is the 0.75-percentage-point portion of 12(b)-1 fees paid out of mutual fund assets to brokerage firms for selling B and C shares. In addition, 0.25 percentage points go to brokers for servicing client accounts, but that portion of the fee is less controversial.
With C shares, "there's never a conversion" to lower A share fees, Mr. Donohue said. "It goes on forever," he added, until the investor sells the shares.
Furthermore, "you could have an investor in a B share where the fund has performed extraordinarily well," Mr. Donohue said. "Under the FINRA approach, the fund may stop paying" a brokerage firm when the cost of selling the fund's shares has been recouped by the broker, he said. "It's uneven in terms of who gets the benefit when they stop paying. New [investors] in the fund get the benefit when the 12(b)-1 fees stop," Mr. Donohue said.
"Our thought is that caps would not be the best first step," said Dan Barry, director of government relations in the Financial Planning Association's Washington office. "Caps are not a replacement for transparency and disclosure," he said. "Improved disclosures seem to be the most sensible first step in addressing the issues." Giving consumers better information about the fees would lead to the market's effectively limiting the fees, Mr. Barry added.
But the group that represents fee-only advisers disagrees. "We think the idea of capping fees is a good one," said Diahann Lassus, chairman of the industry issues task force for the National Association of Personal Financial Advisors in Arlington Heights, Ill. "We need to find more effective ways of controlling the expenses that consumers are paying," said Ms. Lassus, who is president of Lassus Wherley & Associates PC in New Providence, N.J., which manages about $350 million in assets.
Investors need to have a clear understanding of which share class is likely to be the most cost-effective, said Michael Udoff, managing director and associate general counsel of the Securities Industry and Financial Markets Association of New York and Washington.
"There's nothing inherently right or wrong about A, B or C shares," he said. However, Mr. Udoff added, "you need to do the numbers crunching in terms of your investing horizon."
The current cap system is based on a complex formula that takes into account net sales as well as fund marketing costs, said Ms. McHugh. "The control is placed at the fund level [to ensure] the fund distributor is not overpaid by the fund," she said. "There's no control or check on how much a particular investor has paid."
B shares are losing favor among brokers as a result of regulatory scrutiny, according to Terry Lister, chief regulatory officer with Waddell & Reed Inc., a Shawnee Mission, Kan., brokerage firm. "The industry has gotten the message that B shares are suitable only for a very limited range of investors," because many investors hold fund shares for a relatively short period, he said.
By the end of November, assets in B shares had declined about 12% to $217 billion, from $247 billion at the beginning of 2007, according to Avi Nachmany, director of research and executive vice president of Strategic Insight Mutual Fund Research and Consulting Inc., a mutual fund data resource company in New York.
During the same period, assets in C shares rose 11% to $306 billion, from $276 billion, Mr. Nachmany said.
Emphasis on capping 12(b)-1 fees paid by investors is misplaced, he said. "Under what Mr. Donohue is saying, [fund companies and brokerage firms would] have to shift to another form of fee-based accounts," Mr. Nachmany said.
Shifting the fees outside of the funds would be more expensive and less transparent for investors, Mr. Nachmany said. Under the current 12(b)-1 system, the fees are paid out of fund assets in pretax dollars, and they must be disclosed in prospectuses, he said. Shifting the fees elsewhere would force investors to pay fees in after-tax dollars, and disclosure of the fees is likely to be less clear, Mr. Nachmany believes.
In a survey of nearly 3,000 financial advisers released in August 2007 by the Denver-based FPA, the plurality of those surveyed — about 17% — said that between 26% and 50% of their business income came from 12(b)-1 fees. A total of 34% of the advisers surveyed said they expected the percentage to increase in the next few years, while 48% said they expected it to stay the same.
Sara Hansard can be reached at [email protected].
