For months, Securities and Exchange Commission Chairman Mary Schapiro has been talking about tackling the issue of mutual fund 12b-1 fees, and 2010 could be the year she does it.

Ask a broker why 12b-1 fees exist and you’ll get a variety of answers. The fees cover marketing and distribution costs, processing and record-keeping costs in a 401(k) plan, payment for brokers, and sale of fund shares. In a speech in Washington, D.C., earlier this month Schapiro said there should be greater transparency around the fees, which could be as high as 1%.

The National Association of Personal Financial Advisors (NAPFA), a professional association of fee-only financial advisors, agrees.

“The purpose of these fees is to offset the marketing and distribution costs incurred by mutual fund companies,” William T. Baldwin, the organization’s chairman, said in a press release. “However, when you peel back the layers you see that some mutual fund companies are making a profit on 12b-1 fees. Fees associated with investments must be treated like an ‘open book’ that is easily understood by all potential investors. Without clearer disclosure, consumers may not be able to make the most educated decision possible.”

In a recent commentary for Morningstar [MORN], Mercer Bullard, the president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, explained that "distribution fees", which is the regulatory term used to describe 12b-1 fees, “actually pay for a grab-bag of services--not just distribution.” Bullard is also the senior advisor for financial planning firm Plancorp Inc. and a former assistant chief counsel at the SEC.

Another issue that has arisen, Bullard said, is that mutual funds that are closed to new investors are still being charged distribution fees even though no new shares are being distributed. This is partly because there are administrative services on funds even after a fund is closed. In addition, 12b-1 fees are “service fees,” which pay brokers for their ongoing relationship with shareholders.

Critics of 12b-1 fees say the reasons for the fees should be clearly stated and it should also be clear whether or not fees are being charged. As it currently stands, some no-transaction fee (NTF) funds are misleading.

“Schwab, Fidelity, and other supermarket sponsors advertise fund options as no-transaction fee funds, in contrast with funds available through their supermarkets that trigger a charge with every purchase of fund shares,” Bullard said.

The reason supermarket investors don't pay transaction fees on these no-fee funds, though, is because Schwab [SCHW] and Fidelity Investments are paid by the funds through 12b-1 fees, he said.

“These fees are paid by fund shareholders, of course, so they are ultimately paying the same fees as shareholders who buy transaction-fee funds,” Bullard said. “An NTF fund is actually a transaction-fee fund whose transaction fees are buried in the fund's 12b-1 fees. Nonetheless, the SEC allows supermarkets to use the NTF label and the confusion of 12b-1 fees to persist.”

But supporters of 12b-1 fees say these charges prevent abuse in the industry. “The brokerage industry needs 12b-1 fees just as RIAs need their annual fees,” Richard Bryant, president of Raleigh, N.C., based Capital Investment Cos., said in an interview last week. “If brokers don’t get paid through 12b-1 fees I have a feeling that a broker will figure out a way to get paid.”

Bryant said that 12b-1 fees allow brokers to get paid for their supervision and constant advice. If 12b-1 fees are eliminated there would be a lot more churning, he said, which is the practice of charging per transaction, which encourages moving clients’ money even when it’s not best for the client. “Churning can breed an unhealthy environment,” he said. “I think the 12b-1 fees help curtail this practice.”

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