Three months ago, financial experts were concerned that the Securities and Exchange Commission was on the verge of eliminating or making major revisions to 12b-1 fees for marketing and distributing mutual funds. A lot has happened since then.
While there was a last-minute push to get legislation on XBRL reporting and a summary prospectus rule passed, the SEC's failure to move on 12b-1 fees before the end of the year has probably stalled any effort for at least a few more years.
So much has happened since October that many of these same experts now think President-elect Barack Obama's administration and his selection of Mary Schapiro as the new SEC chairman will probably have very different priorities.
"The new SEC chair will have a lot more on her plate," said Geoffrey Bobroff, principal of Bobroff Consulting. "She's going to want her own agenda and her own people."
While revisions to mutual fund fees were a higher priority for the current administration, it is unlikely that Schapiro will have the same urgency or appetite for such controversial changes, and 2009 probably won't see any action on 12b-1 fees, he said.
"My own sense is that changes to 12b-1 seemed to be the pet project of [SEC Chairman Christopher] Cox and [SEC Director of the Division of Investment Management Andrew J. 'Buddy' Donohue]," Bobroff said.
The semi-retired Donohue may stay on at the SEC if he's asked, but "I don't see Buddy being there for the long term," he said.
"When 12b-1 fees were first adopted, they were an appropriate and progressive way to view the then-changing world of funds and fund sales," said Mike Rosella, a partner in the corporate practice department of the law firm Paul Hastings. "It made a lot of sense at the time."
Mutual funds are so dependent on 12b-1 fees that it's naive to think they could just be eliminated, he said.
"The fees are a cornerstone of how funds are sold," Rosella said. "Getting rid of the fees would turn the whole industry on its head. If you get rid of 12b-1 fees, you run the risk of changing the whole distribution game. I'm not sure what would replace it."
A 29-Year History
When 12b-1 fees were established in 1980 as a way to help mutual funds gain investors, the industry was far smaller than it is today.
"In 1980, the mutual fund industry was in a period of net redemptions," said Barry Miller, associate director of the division of investment management at the SEC, at a conference in October. "The idea of 12b-1 fees was to allow funds to use a little [bit of assets] to pay for advertising. Since then, 12b-1 fees and the industry have changed a whole lot."
Approximately half of today's mutual funds have 12b-1 fees ranging from 25 basis points for no-load funds, up to 75 basis points, at the high-end cap, for front-end load funds.
Miller said the SEC staff had been discussing a "whole host of things" earlier in the year, including the possible elimination of the fees.
"A 75-basis-point distribution fee is just a substitute for a sales load," he said. "Shouldn't it be disclosed as a sales load?"
A recent study by Standard & Poor's found that among closed funds, 445 share classes charge for distribution through 12b-1 fees. Many of these funds use 12b-1 fees as sales loads, rather than for distribution, meaning the funds don't have to raise fees in other areas to pay for costs.
"Essentially, since 12b-1 fees have evolved as a substitute for sales loads, funds charge these fees to recoup the cost of prior sales even if they are now closed to new assets," the study said.
"The continued existence of 12b-1 fees seems counter-intuitive to investors," the study continued. "However, in the intervening period, investors may be well served if closed funds, particularly very large funds that have efficiencies of scale, voluntarily lower 12b-1 fees."
Sales Incentives, Disclosures
"Being successful in any business means getting access to customers," Rosella said. "People tend to buy something because it's sold to them or because they've heard about it."
When exchange-traded funds came out, they were praised as being a better mousetrap, but even though the newer players have had some great ideas, they have largely struggled to gather assets, he said, mostly because there is no natural way to reward sellers.
"It's important to incentivize someone to sell something," he said. ETFs are lacking "all the things that make Wall Street people want to sell."
The new changes made to prospectus profile rules should help the fee problem, Rosella said, by allowing investors to easily compare 12b-1 fees.
"Competition will lead to lower fees," he said. "If a fund is priced too high, it won't attract the assets. If the information is buried on page 45 of the prospectus, it will never be seen. If the fees are on the front page, investors are more likely to notice them."
Rosella said there are some loopholes in the law that allow some funds to have high 12b-1 fees, so long as they spend the whole amount on intermediaries and don't retain part of the fees as profits.
It's the responsibility of the fund's board of directors to make sure the fees are in line, he said, and smaller funds need all the help they can get.
In May, the SEC staff was reportedly considering putting a cap on the fees, similar to the fees charged for C-Shares that are paid to brokers and other salespeople. Other ideas included splitting the fees into administration, distribution and sales costs.
Many broker dealers resisted changes to the fee structure, arguing that it would hurt investors by causing other fees to increase as a result, but Rosella said they have other reasons for opposing 12b-1 changes.
"They are afraid that if you knew how much you were paying, you'd want to pay less," he said. "People would be saying, 'You're getting paid what? Why don't you get paid half that, and I'll get a higher yield?'"
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