Even before Fundgate took the industry by storm, critics were calling into question the use of 12b-1 fees. And now regulatory action appears imminent.

Since the summer, the number of closed funds charging investors 12b-1 fees has increased, according to data recently released by Standard & Poor's. As of Dec. 8, S&P listed 605 funds out of a database of 15,000 domestic mutual funds as being closed to new investments. Of those, more than 25%, or 153 funds with a total of 274 share classes, charge an average 12b-1 fee of 0.64%. Ninety-four of those charge 1% of the fund's net assets, the maximum allowed by the SEC.

Back in August, S&P (see MME 8/18/03) released a report indicating 139 funds with a total of 232 share classes were charging an average 12b-1 fee of 62 basis points. Seventy-four of those were charging the 1% maximum.

A fund's 12b-1 fees are taken from its assets to cover distribution and shareholder servicing expenses. Distribution expenses include advertising and compensating those who sell a fund's shares. However, some critics claim that once a fund is closed, it no longer needs to market the fund.

Phil Edwards, managing director of fund research at S&P, said it all boils down to transparency. While Edwards said that the improved economy likely contributed to the increase in closed funds charging the fees (since more funds reached their capacity due to the rally), the use of 12b-1s should be reexamined.

"The definition of 12b-1 fees seems to have broadened over time. We need to take another look at that and give investors an opportunity to see the pricing and make a judgment for themselves. The lower the expenses, the better the return on the fund," Edwards said.

The August S&P report was met with heavy criticism from many in the fund industry. Dreyfus, which was prominently listed in the report, said at the time that the study neglected to account for the shareholder servicing portion of the 12b-1 expenses. In addition, several of the firms on the list said that the fees are often used to compensate intermediaries for continuing service to shareholders.

"Most of the use of the fees involve the paying of commissions to the salesperson or the sales costs of administering the account," said Chris Wloszczyna, ICI spokesman. "The S&P report is often misinterpreted," Wloszczyna said. "If you look at the funds that are closed, but continue to have the 12b-1 fees, most are variations of A, B or C share classes, which are set up to give shareholders an alternate way of paying the broker. One method is simply the up-front method, and another is in installments through the 12b-1 fee. If you choose that method, you spread that payment over time."

Russ Kinnel, director of fund analysis for Morningstar of Chicago, said 12b-1 fees will undergo increased scrutiny, even more so than other fund fees, because they are tied to sales practices "which are in definite need of reform."

Kinnel said that if one looks at the stated definition of 12b-1 fees and their intended use as a marketing tool, it is hard to defend the fees for closed funds, and even in open funds.

"If a fund says the 12b-1 fee is for marketing, then they are really saying it shouldn't be there in the first place. But, if they take the position that it is there to compensate the broker or the supermarket for the services it is giving the shareholder, then maybe it is a defensible position," Kinnel said. "In a sense, it comes back to what's the legal rationale for putting it there in the first place."

The fees are obviously in the sights of regulators. In a mid-December speech, SEC Chairman William H. Donaldson said that a week from this Wednesday, Jan. 14, the Commission will consider, among other things, how rule 12b-1 applies to funds' use of brokerage commissions in order to facilitate the distribution of fund shares.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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