Put 12(b)-1 reform on the front burner

The SEC should move with haste to revamp 12(b)-1 fees. As reported in the Nov. 15 issue, it may be several months — if not more than a year — before the Securities and Exchange Commission reissues a proposal aimed at making clear how much mutual fund shareholders pay for investing prowess and how much they pay for fund marketing or financial guidance. When the SEC finally does move forward, it is likely to float a rule change 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. Apparently, the enthusiasm with which the SEC first stepped into the 12(b)-1 quagmire is being sapped by the enormous workload generated by the Dodd-Frank financial overhaul law, as well as by the recent departure of Division of Investment Management director Andrew C. “Buddy” Donahue, the chief architect of the current reform proposal. The SEC undoubtedly also is feeling stymied by strong opposition to the proposal. That opposition was expressed ad nauseam in the more than 1,000 comment letters that the proposal generated.

RIGHT THING TO DO

To be sure, there are lots of good reasons for putting 12(b)-1 reform on the back burner. But there is one infinitely better reason for moving forward: It is the right thing to do for investors. If the goal of the SEC is to protect investors, there are few steps that the commission can take at the moment that would do a better job of accomplishing that goal. Compared with a majority of provisions contained within the Dodd-Frank reform legislation, 12(b)-1 reform has the potential to affect — and protect — more investors. Mutual funds have become an integral part of the savings of most Americans. Consider, for example, that 45% of U.S. households owned mutual funds in 2008, up from a mere 6% in 1980. The estimated 92 million individuals who now own mutual funds come from all walks of life and have a wide variety of financial goals. Over the past decade, according to data from the Investment Company Institute, investors have paid more than $100 billion in 12(b)-1 fees. Just 2% of such fees goes toward advertising and promotion — the expenditures for which they were originally intended. About 40% goes toward compensating financial advisers and brokers for their initial assistance, and 52% is earmarked for shareholder services, according to the ICI. The vast majority of investors are unaware that they are paying 12(b)-1 fees — much less what that money is spent on. It is the SEC's responsibility to make sure that mutual fund investors understand each and every fee associated with their investments. Only then can investors decide whether a particular fund is acting in their own best interests. The SEC proposal — unimaginatively called Rule 12(b)-2 — undoubtedly would help the SEC fulfill its responsibility to American investors. In its current incarnation, Rule 12(b)-2 essentially would replace the 12(b)-1 charge with two fees: an annual 25-basis-point “marketing and service fee” and an “ongoing sales charge” that would disappear when the cumulative amount of the charge equaled the amount of any front-end load charged by a different share class of the fund. The proposal, however, isn't without drawbacks. First, there is the risk that it would provide an incentive for advisers to sell only upfront-load shares and provide no after-sales support. Even worse, it could encourage less scrupulous advisers to switch clients into funds when the continuing sales charge were about to end so as to start the meter ticking again.

KEEP IT SIMPLE

Acknowledgement of these risks must be reflected in the next draft of the SEC's 12(b)-1 reform proposal. At the very least, that draft should put in place some mechanism for assuring that advisers who collect a continuing fee for putting clients in a particular mutual fund are, in fact, providing continuing services — including, but not limited to, annual reviews of clients' investment goals and risk assessments. The revised proposal should also mandate clear, simple, upfront, verbal and written disclosure of all fund fees and what they mean to the investor before a purchase is completed. This disclosure should be made on one sheet of paper, separate from the prospectus. After suggesting for more than a decade that the 12(b)-1 rule is in need of an overhaul, it is time for the SEC to carry out those reforms.