The best of intentions sometimes go awry. But, despite the 12b-1 rule's departure from its original spirit, dismantling the rule is not a viable option, research firm Lipper concludes in a recently released study.

The 12b-1 rule was originally enacted to allow some smaller funds to pass along advertising and distribution costs to investors and charge them as a percentage of a fund's assets in an attempt to provide some relief to funds without kingly resources.

It has since evolved into a different beast altogether. The idea was that this fee would be used to help a fund increase in size, which in turn would help the shareholder because as assets rise, costs drop.

Today, about two-thirds of the 11,635 mutual funds in existence end up charging investors a total of as much as $10 billion a year in 12b-1 fees, according to the research firm. The industry's dependence on the 12b-1 rule is "high," with most of the $10 billion mainly remitted to financial advisers, said Jeff Keil, vice president of Lipper's Global Fiduciary Review.

Extremely Disruptive'

"Dismantling the rule would be excessively disruptive to financial advisers and possibly even their clients," he said, adding that Lipper is urging regulators to reshape the rule, not repeal it.

Were 12b-1 fees eliminated, fund shareholders would likely lose the benefit of professional financial assistance, Keil said. The service element tied to 12b-1 fees would also suffer, he said. "The ongoing servicing of shareholders allows for some investor handholding. Advisers need some incentive to do that."

"Given the firm entrenchment of 12b-1 in the fund business today, the rule cannot realistically be dismantled, lest the business be crippled to the detriment of shareholders," Lipper penned in the report. As such, Keil is scheduled to testify before the House of Representatives Committee on Governmental Affairs' Subcommittee on Financial Management on Tuesday, Jan. 27.

Nonetheless, Lipper's report did suggest some core changes to bring the legislation up to date with today's economy. The firm calls for an alteration in the language of the rule from "temporary" status to "ongoing" since 12b-1 fees have been considered a temporary measure. Additionally, Lipper suggests a fund sponsor's ability to collect distribution expenses in subsequent years be nixed, as proposed by the SEC in 1988.

Furthermore, the research firm advocates requiring additional "concrete analysis" by a fund's board of directors as to the correlation between a fund's 12b-1 expenses and the benefits to shareholders. Boards, Lipper says, should be provided with legal constructs, or "tools," so that the they can effectively compare the cost/benefit ratio for shareholders.

Clear guidelines as to what payments and expenditures can be paid from 12b-1 fees are also needed. Sales charges shareholders incur must not exceed limitations set by the NASD, and circumstances in which this ceiling can be broken must be eliminated, Lipper said.

Additionally, Lipper proposes an investor education initiative about 12b-1 fees as well as increased transparency in offering documents or annual reports about the uses of distribution expenses. Beginning last spring, both the ICI and the NASD launched investor education initiatives on breakpoints on their respective Web sites (see MFMN 2/19/03, 3/10/03).

The 12b-1 fees have been in the spotlight for some time now, with SEC Chairman William Donaldson setting the controversial charges firmly in his sights. Even his predecessor Harvey Pitt had called for a reexamination of the rule and its purpose back before he resigned his post with the SEC (see MFMN 9/23/02).

The 12b-1 Rule is a section of the Investment Company Act of 1940, but was only conceived in 1980. It was originally intended as a temporary way for direct-marketed fund groups to stop assets from shrinking as well as allow those firms to compete with much larger, more powerful, dealer-sold complexes. Firms are allowed to charge up to 1% of a fund's assets annually.

Donaldson said the Commission will consider a proposed amendment to the 12b-1 rule at an open meeting on Feb. 11, that would make it illegal for funds to use brokerage commissions to compensate broker/dealers for selling mutual fund shares.

Donaldson said it is often unclear what an investor is paying in fees in regards to 12b-1 fees. A broker/dealer can be compensated from many different areas for selling a Class A mutual fund share, which has a front-end load, but investors are kept in the dark about what they are paying in fees, Donaldson said. The B/D is compensated not only from the dealer concession based on the front-end load, but they can also benefit from the 12b-1 fee and revenue-sharing. Additionally, B/Ds can receive compensation from both 12b-1 fees and revenue-sharing arrangements when selling Class B or C shares, which don't carry front-end loads.

"Yet under the current confirmation requirements, investors are not provided transaction-specific information regarding these fees," Donaldson said in his Jan. 14, open meeting speech.

Some industry critics and investor advocates have been calling for the elimination of the 12b-1 rule. Some have even suggested that the charging of 12b-1 fees and the cost to shareholders is an even bigger scandal than the market-timing and late-trading schemes.

However, Keil doesn't see that movement gaining much traction. "I think there is a very slim chance that 12b-1s will be repealed," he said, stressing once again that the rule remains a valid concept that simply needs to be updated.

"It needs an overhaul to bring it into the 21st century."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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