After a day's worth of discussion among industry executives, regulators, academics and investor advocates about the utility and future of 12b-1 fees, one theme emerged: something should be done.
What that should be is a little more difficult to divine from the Securities and Exchange Commission roundtable discussion held at agency headquarters last week.
Opinions ranged from "it ain't broke, don't fix it," to a call for total elimination and a revamping the way funds pay brokers. Yet the reality is, that while the name may change, the fees themselves, and demand for the services they pay for, won't disappear, experts said.
"They are the cornerstone of the mutual fund industry," said Michael Rosella, head of the investment management practice group at New York law firm Paul Hastings after the meeting.
The fees, named for the section of securities law that provided for them 27 years ago, have swelled in total size and in function. Today, 12b-1 fees are applied to everything from getting space on a platform, to compensating brokers for providing advice, to mailing annual prospectuses, to maintaining fund companies' websites.
When the mutual fund industry was fledging, with $50 billion in assets, some funds were reluctant to adopt 12b-1 provisions, preferring instead to stick to front-end loads. In 1980, funds collected $12 million in these marketing and distribution fees, according to Douglas J. Scheidt, chief counsel of the SEC's division of investment management.
In 2006, with the $10 trillion fund industry in full flight, companies collected-and distributed to service providers and brokerages-$12 billion worth of these fees.
Investor advocates and industry insiders alike agreed that 12b-1 fees provide services investors need, appreciate, and for which they might not even object to paying. The problem is, most investors have no idea that they're even paying these premiums, or what services they are getting in exchange.
At the conclusion of last week's event, SEC Chairman Christopher Cox said that whatever the SEC proposes, with the end of this year as the tentative deadline, will likely center on disclosure.
American Funds Chairman Paul G. Haaga, Jr. said ending confusion should start with the very name. Jeffrey C. Keil, principal of Keil Fiduciary Services in Denver, agreed. "The term is very confusing. They sound like some type of plastic explosive or something," he said.
Beyond the name, more needs to be done to explain what they do, panelists agreed.
The average investor does not know what a load is, let alone understand an ongoing commission structure like those used under section 12b-1, said Barbara Roper, director of investor protection for the Consumer Federation of America.
And it's not just the investors who need better guidance. Directors who vote on such marketing and distribution fees need to be able to understand what the fees cover, and whether they are fair, said John A. Hill, an independent chairman at Boston-based Putnam Investments. But the SEC guidelines that boards rely on are anachronistic, and fail to reflect the way fees are used today.
Today, typically 25 basis points goes straight to broker/dealers, to get shelf space on platforms or supermarkets. Often, fund companies pay those surcharges upfront, and use 12b-1 fees to recoup the outlay later.
"Let's call it what it is: a contractual obligation on the part of the fund to pay back an amount of money," said Kathryn Bradley McGrath, a partner with law firm Mayer, Brown, Rowe and Maw, who previously worked at the SEC.
Haaga warned against making the fees look like part of the cost of opening accounts. "These are not products, these are ongoing relationships," he said. "We have to devise a system that provides compensation for the entire relationship," Haaga said.
Advantage Financial Group Chairman and Chief Executive Joseph R. Russo said the best solution may be to combine all fees into a single expense ratio.
"An all-in-one fee might, indeed, be the answer and may, indeed, drive price to the lowest level," Russo said.
When it comes to price, there is little evidence that investors really consider it when making investment decisions.
"Investors buy performance first, performance second and performance third," agreed Hill, who also voiced support for the all-in-one approach. While such a strategy won't make the granular costs more transparent, it will bring separate costs buried in the prospectus to the forefront.
But Keil countered that such lump-sum accounting prohibits investors from seeing exactly how their money is being spent-whether it's on television ads or website portal enhancement-thereby obscuring factors that might affect their evaluation of a manager.
Richard M. Phillips, a partner at Kirkpatick & Lockhart Preston Gates Ellis, argued that what investors really care about is the bottom line. "Effective communication of 12b-1 fees means dollars-and-cents communication," he said. Such account-level disclosure has been suggested in the past, but many fund companies complained it would be too onerous.
Morningstar Managing Director Don Phillips said that expenses should be broken into "buckets." Such a method would show the total expense ratio divided into terms investors can understand, such as administration, portfolio management, broker/dealer charges and advertising.
Rosella noted that funds that adopt such transparency actually have an opportunity to show that external forces, not greed, drive their costs. Broker compensation has long been one of the most controversial topics in the industry, not to mention the one subject to most enforcement action, Richard Phillips said.
Nonetheless, Don Phillips warned against offering too much detail. "Let the market decide how much each should be," he said. "To see the cost of running the website broken out [is not] a step forward."
Roper said that whatever the disclosure is would require regulators to reconsider how companies should communicate with their customers. Disclosure post-sale works if the goal is only to alert consumers to what they are paying their brokers. If the goal is to help investors contrast funds, disclosure must occur succinctly and directly, orally or in writing, at the time of sale. Either way, Roper said, "I don't have a huge amount of confidence that it will change investor behavior, but it doesn't mean it's not worthwhile."
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