Potential axing of 12(b)-1 fees worries advisers

PALM DESERT, Calif. — Industry participants were unhappy to learn that repeal will be an option as the Securities and Exchange Commission takes a hard look at the 12(b)-1 rule, which allows mutual funds to generate billions of dollars in fees. “I think it will be on the table,” Andrew J. “Buddy” Donohue, director of the SEC’s investment management division, said of the possibility of a repeal last week at the Mutual Funds and Investment Management Conference in Palm Desert, Calif., sponsored by the Investment Company Institute of Washington. Industry participants should expect to see something from the SEC on the subject “in the next month or so,” he added. That has some industry watchers concerned. “It deserves a fresh look,” Darlene DeRemer, a partner with Grail Partners LLC of Boston, an industry consultant, said about Rule 12(b)-1. “Can we afford to have it gone? I don’t think so.” It’s not hard to understand why. Mutual funds, and hence their shareholders, paid $10.9 billion in 12(b)-1 fees in 2005, according to the most recent data from the ICI. But Mr. Donohue said that the fees no longer are being used as the SEC originally intended. “The primary use of 12(b)-1 fees has shifted from the limited marketing and advertising purposes that were originally envisioned,” he said. “Instead it appears that, in many cases, Rule 12(b)-1 fees are used primarily as a substitute for a sales load or for servicing.” At least one financial adviser said he would like to see the fees disappear. “It’s become outrageously abused,” said Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., a financial advisory firm in Amherst, N.Y. “What they have done is made it a backdoor way to compensate salespeople and raise extra money for the mutual fund companies.” But although many industry experts said Mr. Donohue hasn’t ruled out the repeal of 12(b)-1, it’s probably not realistic to assume it will go away anytime soon. “That’s not going to happen,” said Geoff Bobroff, a mutual fund consultant in East Greenwich, R.I. “Not when so much of the industry is involved in the 12(b)-1 structure.” But if the SEC is serious about taking a hard look at 12(b)-1 fees — and Mr. Donohue said it is — it can adopt one of the many proposals that already have been floated to make the fees more investor friendly, industry experts said. One potential solution is to replace 12(b)-1 fees with a transaction fee, Ms. DeRemer said. In that way, investors would be charged for buying or selling a mutual fund in much the same way they are charged for buying or selling stocks and exchange traded funds, she said. A “unified fee” that includes all fund costs would be even better, said C. Meyrick Payne, a senior partner at Management Practice Inc., a Stamford, Conn., consulting firm for independent fund directors, many of whom dislike 12(b)-1 fees. Unified fees already are the practice in Europe, and proponents argue they make it easier for investors to compare funds. Another potential solution would be to just provide better disclosure, said Scott Kays, president of Kays Financial Advisory Corp. in Atlanta. He doesn’t have any problem allowing funds to charge a 12(b)-1 fee as long as the investor knows that that fee is there — something that doesn’t always happen, he said. What approach the SEC will take is unknown. Although Mr. Donohue said he wouldn’t take repeal of Rule 12(b)-1 off the table, he didn’t say how seriously it would be considered. He hasn’t yet developed a particular view on how best to proceed, he said. “I have a feeling [Mr. Donohue] wants to get rid of it,” Mr. Payne said about Rule 12(b)-1. Not everyone is so sure. “He didn’t say much about [12(b)-1] except to be clear that it would be looked at this year,” said Michael Rosella, the New York-based chairman of the investment manage- ment practice at Paul Hastings Janofsky & Walker LLP of Los Angeles. “The question is, what does that mean?” Whatever it means, it is encouraging to see the SEC tackle an issue that has plagued the industry for years, said Jeff Tjornehoj, a Denver-based senior research analyst with Lipper Inc. of New York. The SEC doesn’t limit the size of 12(b)-1 fees that funds may pay, but under NASD rules, 12(b)-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) can’t exceed 0.75% of a fund’s average net assets per year. According to Lipper’s data, some funds have 12(b)-1 fees as high as 1%. In some cases, that contributes to “sky high” total expenses, Mr. Tjornehoj said.