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12(b)-1 reform fades into the background

Don't hold your breath waiting for changes in mutual fund marketing fees.

It will be several months — at least — before the Securities and Exchange Commission comes out with an official announcement about its plan to revamp 12(b)-1 fees, experts said.

And when it does, many expect the SEC to float a rule that is significantly different from its current proposal, and to put portions of the proposal — if not the whole thing — out for comment all over again.

The comment period on the SEC's current 12(b)-1 plan ended Nov. 5. That proposal generated more than 1,000 comment letters, which SEC officials now must sift through before proceeding.

“I can't imagine the SEC would look at all of these comments and say, "We like our original proposal and we are going to go forward with it,'” said Russel Kinnel, research director at Morningstar Inc.

The SEC's plate, of course, is already full as a result of the Dodd-Frank financial overhaul law. Given that heavy workload, strong opposition to the proposal and next week's departure of the proposal's engineer, Division of Investment Management chief Andrew C. “Buddy” Donohue, SEC watchers predict that the commission won't say anything official about 12(b)-1 reform until the second quarter of next year at the earliest. Some don't expect the SEC to tackle 12(b)-1 fees before 2012.

“The SEC tried to build a better mousetrap that doesn't work, and I think it's going to be back to the drawing board on this,” said Jeff Puretz, a partner at Dechert LLP. “It's going to take a long time to recover from this.”

John Heine, an SEC spokes-man, declined to comment.

Whether the SEC re-proposes all or portions of the proposal six months or five years from now, observers agree that it will face fierce opposition from the fund and brokerage businesses.

Under the current proposal, fund firms could charge a “marketing and service fee” of up to 0.25%. Anything above that amount would be deemed an “ongoing sales charge,” which would be limited to the highest fee charged by the fund for shares without marketing and service fees.

The proposal also would allow fund companies to create a new class of shares through which broker-dealers could set their own sales charges on mutual funds.

One major criticism of the proposal made by a number of industry groups in their comment letters is that the SEC needs to address the 12(b)-1 issue in the context of all of the other regulations associated with Dodd-Frank.

Specifically, many observers noted that the SEC has to examine 12(b)-1 as they would be affected by a universal fiduciary standard of care.

As mandated by Dodd-Frank, the SEC is conducting a six-month study for Congress about the differences in oversight of investment advisers and broker-dealers, and whether regulatory gaps exist. The study is due to be presented to Congress in January.

How regulators and Congress define the fiduciary standard of care will affect how financial professionals are compensated and how they disclose that compensation, which is directly tied to 12(b)-1 fees, said Barry Barbash, a former director of the SEC's Division of Investment Management and now a partner at Willkie Farr & Gallagher LLP.

“I think it's going to be very difficult to just look at 12(b)-1 without taking into account the other regulatory measures,” he said. “This is just one piece of the marketing and distribution puzzle.”

The piece of the 12(b)-1 proposal that would allow brokers to set their own sales charges could result in lower levels of service for smaller clients, said Kevin Carroll, associate general counsel for the Securities Industry and Financial Markets Association.

It also has the potential to conflict with the prospective rules on the fiduciary standard of care, he said.

“I think the commission is going to have to think about that carefully,” Mr. Carroll said.

It would be appropriate for the SEC and Congress to finalize its rules on the fiduciary standard of care before addressing 12(b)-1, said Dale Brown, president of the Financial Services Institute Inc.

One possibility is that the SEC may break up the proposal and put out for comment the portions of it that are the most controversial, observers said. For example, the SEC may move forward with the proposed cap on 12(b)-1 fees but make concessions for the retirement plan market, which many groups noted in their comment letters needs 12(b)-1 fees in excess of 0.25% to service retirement plans, particularly smaller plans.

The Investment Company Institute, the American Society of Pension Professionals and Actuaries, and The SPARK Institute Inc. all noted in their comment letters that the proposal would be too costly and burdensome for the retirement plan industry.

Money market funds are another area that could get an exemption from the 12(b)-1 cap, because as the ICI noted in its letter, money market funds with 12(b)-1 fees higher than 0.25% are usually used in commercial sweep accounts.

The ICI letter countered the arguments of critics who say 12(b)-1 fees are used as continuing sales charges, saying that money market funds, like retirement plans, use these fees to pay marketing and distribution expenses.

But even if the use of fees for those purposes was exempted, the SEC may still hit significant opposition to the 12(b)-1 fee cap because of the operational burdens it poses on the fund industry, observers said.

And some SEC watchers think that the political climate has changed so drastically since the commission started working on the 12(b)-1 proposal that it may have to shelve it for a couple of years to let Dodd-Frank plays out.

“The political winds have changed so that the popularity of this measure has declined,” Mr. Puretz said. “The staff will have to go back and sharpen their pencils.”

Proposed rule could change economics of fund industry

Citing a need to better protect and inform mutual fund investors, the Securities and Exchange Commission ("SEC") proposed on July 21, 2010 to replace Rule 12b-1 under the Investment Company Act with new rules governing asset-based distribution fees and related disclosure in fund prospectuses, annual and semi-annual reports to shareholders and investor confirmation statements.

Rule 12b-1 allows a mutual fund pursuant to a written "12b-1 plan" that is approved by the fund's board of directors to use fund assets to pay for activities related to the distribution of the fund's shares. The adoption of the Rule in 1980 contributed to a shift away from a traditional model of mutual fund investors paying for intermediaries' services at the time of share purchase (i.e., paying a "front-end sales load") to the 12b-1 model of mutual funds paying sales charges and other fees out of fund assets on an ongoing basis.

Under the proposal, mutual funds would continue to be able to compensate intermediaries using fund assets, but new limitations as to the cumulative amount of such fees and charges would apply.

The proposal divides these asset based fees into "marketing and service fees" of less than 0.25% per annum and higher "ongoing sales charges." Marketing and service fees could be paid out of fund assets for distribution-related expenses such as participation in fund supermarkets, maintenance of shareholder accounts and marketing and distribution strategies, up to the amount allowed for funds to be described as "no load" under NASD Conduct Rule 2830 (currently 0.25% per year). A formal "plan" would not be required to be adopted by the fund's board of directors, but shareholder approval would be required before a fund could institute or increase the rate of a marketing and service fee.

Ongoing sales charges are payments out of fund assets in excess of the marketing and service fees. Such charges would be treated like a sales load and limited, cumulatively, to the highest front-end sales load charged for that fund (or in the absence of a share class with a front-end sales load, a NASD rule-based 6.25% aggregate cap). A fund that has ongoing sales charges may satisfy its obligations to observe this limit by automatically converting to a class of shares with no ongoing sales charge once this cap has been reached. Ongoing sales charges could not be instituted or increased after any public offering of the fund's voting shares or the sale of such shares to persons who are not organizers of the fund.

The proposal also would allow funds and their underwriters to offer share classes to be sold by intermediaries, such as broker-dealers, that could impose their own sales charges or commissions. This would allow intermediaries to compete on the basis of sales charges, just as brokers today charge competitive commissions for transactions in ETFs and other equity securities.

The proposal also increases disclosure. It would amend Rule 10b-10 under the Securities Exchange Act to require, among other items, disclosure of front-end and deferred charges as well as ongoing sales charges and marketing and service fees by broker-dealers in confirmations relating to mutual fund security transactions. Certain other changes to Rule 10b-10 concerning callable debt securities are also proposed.

The SEC states in a footnote that it is considering whether to require point of sale disclosure for mutual fund purchases based on new authority in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC also proposed amendments to Form N-1A, including to require the separation of asset-based distribution fees into ongoing sales charges and marketing and service fees, and amendments to Investment company Act Rules 11a-3, 17a-8, 17d-3, 18f-3 and Forms N-3, N-4, N-6 and N-SAR, Regulation S-X and Schedule 14A.

If adopted, the proposal would have a profound impact on the economics of mutual fund distribution by broker-dealers and other intermediaries. Davis Polk is preparing a more comprehensive memorandum on the proposal and its potential effects that will be available to clients in the near future.

The proposal's comment period ends November 5, 2010.

SEC proposes regulation of distribution fees and enhanced disclosure

The Securities and Exchange Commission today voted unanimously to propose measures aimed to improve the regulation of mutual fund distribution fees and provide better disclosure for investors.

The marketing and selling costs involved with running a mutual fund are commonly referred to as a fund's distribution costs. To cover these costs, the companies that run mutual funds are permitted to charge fees known as 12b-1 fees. These fees are deducted from a mutual fund to compensate securities professionals for sales efforts and services provided to the fund's investors.

12b-1 fees were developed in the late 1970s when funds were losing investor assets faster than they were attracting new assets, and self-distributed funds were emerging in search of ways to pay for necessary marketing expenses. These fees amounted to an aggregate of just a few million dollars in 1980 when they were first permitted, but that total has ballooned as the use of 12b-1 fees has evolved. These fees amounted to $9.5 billion in 2009.

"Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it's likely that some don't even know that these fees are being deducted from their funds or who they are ultimately compensating," said SEC Chairman Mary L. Schapiro. "Our proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds."

The SEC's proposal would:

  • Protect investors by limiting fund sales charges.
  • Improve transparency of fees for investors.
  • Encourage retail price competition.
  • Revise fund director oversight duties.

There will be a 90-day public comment period after the SEC's proposal is published in the Federal Register.



The Securities and Exchange Commission today voted to propose a new and more equitable framework governing the way in which mutual funds are marketed and sold to investors. In particular, the proposed changes would replace existing provisions, including Rule 12b-1, that allow mutual funds to use their assets to compensate securities professionals who sell shares of the fund.


As with any business, running a mutual fund involves costs, including the costs of marketing and selling the fund to prospective investors. These marketing and selling costs are commonly referred to as a fund's distribution costs.

To cover these costs, the companies that run mutual funds are permitted to charge fees, known as 12b-1 fees. These fees are deducted from mutual funds to compensate securities professionals for sales efforts and for services provided to the mutual fund investors.

But, many investors are unaware that these fees are being deducted and are unaware who these fees are ultimately compensating. Nor may they realize that the amounts the fund spends for such costs directly reduce the value of the investors' shares of the fund.

Last December, SEC Chairman Mary Schapiro stated, "When it comes to these fees, there is a need for more fundamental change than merely disclosure reforms and a name change. We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate. For example, do they result in investors overpaying for services or paying for distribution services that they may not even know they are supposed to be getting?"

In 2009, these fees amounted to $9.5 billion and exceeded $13 billion in 2007 — compared to just a few million dollars in 1980 when they were first permitted.

Today, the Commission will consider proposing rules to provide a new framework governing how mutual fund companies collect fees to cover the costs of marketing and selling mutual funds.

  • The proposal would:

Protect Investors by Limiting Fund Sales Charges

Limiting "Ongoing Sales Charges": When an investor buys shares of a mutual fund, there is frequently an accompanying sales charge (or load) that compensates the broker-dealer who helped sell the shares. The charge can be paid up front or over time. Typically, different "classes" of a fund involve different sales charge arrangements.

Front-end sales charge: A "front-end" sales charge is paid up front when the investor buys the shares. The amount of a front-end sales charge is limited by FINRA rules. Such charges cannot exceed 8.5 percent, or a lower limit (down to 6.25 percent) depending on other fees charged by the fund.

Asset-based sales charge: An "asset-based" sales charge is paid over time out of the fund's assets — in other words, out of the fund itself — rather than out of each individual investor's account. Existing rules also limit asset-based sales charges. The current limit on the rate is 0.75 percent per year, but there is no limit on how long a fund can pay these charges if it continues to make significant new sales to investors. As a result, shareholders may pay asset-based charges through the fund for as long as they own the fund.

The proposal would limit the amount of asset-based sales charges that individual investors pay. In particular, the proposal would restrict these "ongoing sales charges" to the highest fee charged by the fund for shares that have no ongoing sales charge. For example, if one class of the fund charges a 4 percent front-end sales charge, another class could not charge more than 4 percent in total to investors over time. The fund would keep track of how long investors have been paying ongoing sales charges.

Separately, funds could continue to pay 0.25 percent per year out of their assets for distribution as "marketing and service" fees, for expenses such as advertising, sales compensation and services.

Improve Transparency of Fees for Investors

Enhance Disclosure Requirements: Currently fund distribution costs are not well understood by investors, in part because these costs are often referred to obscurely as "12b-1 fees." In addition, fund transaction confirmation statements delivered to investors typically do not include sales charges.

The proposal would require the fund to identify and more clearly disclose distribution fees. In particular, the fund would have to disclose any "ongoing sales charges" and any "marketing and service fees" in the fund's prospectus, shareholder reports and investor transaction confirmations. Transaction confirmations also would have to describe the total sales charge rate that an investor will have to pay.

Encourage Retail Price Competition

Allow Funds to Sell Shares Through Broker-Dealers Who Establish Their Own Sales Charges: Currently all broker-dealers who sell shares in a fund must sell those shares under terms established by the fund and disclosed in its prospectus. This means that dealers cannot compete with each other by reducing sales charges.

The proposal would enable funds to sell shares through broker-dealers who determine their own sales compensation, subject to competition in the marketplace. As a result, broker-dealers could establish their own sales charges, tailor them to different levels of shareholder service, and charge shareholders directly, similar to how commissions are charged on securities such as common stock.

The proposal would prevent funds that rely on this exemption from deducting other sales charges from fund assets for that class of shares. This restriction would prevent double-charging.

Revise Fund Director Oversight Duties

Revise Director Duties to Reflect Current Market Practices: Currently, before using fund assets to pay for fund distribution expenses, a fund must adopt a written plan describing the arrangement. The fund's board of directors must initially approve and annually re approve the plan. But the economic realities of long-term distribution arrangements often mean that fund distribution plans are re-approved year after year, with no change.

The proposed amendments, which would set automatic limits on fund fees and charges, would eliminate the need for fund directors to explicitly approve and re-approve fund distribution financing plans. As a result, fund directors would have more time to devote to other important matters.

Directors would still have responsibility for overseeing ongoing sales charges and marketing and service fees in the same manner that they oversee other fund expenses, subject to their general fiduciary duties.

  • The proposal would provide a transition period for the new rules, and also would revise confirmation statement requirements regarding callable debt securities.

There will be a 90-day public comment period after publication of the proposal in the Federal Register.

Schapiro: SEC will act on 12(b)-1 fees this year

The Securities and Exchange Commission will reassess the $13 billion per year in 12(b)-1 fees collected by brokers as compensation for selling and servicing mutual funds, SEC Chairman Mary Schapiro said today. Speaking at a conference in Washington, Ms. Schapiro noted that the 12(b)-1 fee issue is one of the initiatives that the SEC will move on this year.

“The problem is that investors may have no idea these fees are being deducted, what services they are paying for or who they are ultimately compensating,” she said. “That's why I believe we need to critically rethink how 12(b)-1 fees are used and whether they continue to be appropriate.”

She acknowledged that changing the 12(b)-1 system, on which brokers depend to cover the cost of providing service to their customers, “is no small matter.” But since the fees were first allowed in 1980, the mutual fund market has grown and changed, and “it is past time to reassess their need and their effectiveness,” she said.

Ms. Schapiro also said she will push her agency to move ahead on a point-of-sale-disclosure proposal that would require brokers to provide investors with information about securities products and services, their compensation — and conflicts of interest — at the time investors are making decisions, rather than after sales have been made.

“In the past, there has been significant industry resistance to this seemingly level-headed concept,” she commented. “I am hopeful, however, that a focus on the needs of retail investors will prevail.”

The top U.S. securities regulator pushed on Thursday to reform mutual fund fees that traditionally used to stimulate fund growth and help cut shareholder expenses.

The so-called "12b-1" fees, charged by mutual funds for marketing and fund promotion, have been criticized for no longer serving their original purpose.

"When it comes to these fees, there is a need for more fundamental change than merely disclosure reforms and a name change," Securities and Exchange Commission Chairman Mary Schapiro said at a consumer conference.

"We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate," she said.

The fees were adopted in 1980 after a period when mutual funds were experiencing huge net redemptions. Their purpose was to stimulate fund growth, promote a more stable fund asset base and create economies of scale that would reduce shareholder expense.

But critics say the fees are often used to cover administrative expenses or the initial commission costs rather than the fund's advertising and distribution costs.

"Of course, in 1980, they may have made sense; but after 30 years of growth and change in the mutual fund market, it is past the time to reassess their need and their effectiveness," said Schapiro who has asked her staff to craft recommendations for the commission to consider next year.

The SEC's review of the fees began under Schapiro's predecessor Christopher Cox, who has said there is an opportunity to give mutual fund investors clearer information so they know how much they are paying in marketing, advertising and distribution fees.

"The problem is that our investor may have no idea these fees are being deducted or who they are ultimately compensating," Schapiro said.

"That's why I believe there needs to be a better approach," she said.

NAPFA backs rethink of 12(b)-1 fees

The National Association of Personal Financial Advisors today applauded Securities and Exchange Commission Chairman Mary Schapiro’s call for reexamining 12(b)-1 fees.

In a statement, the industry group said it agrees with Ms. Schapiro’s recent comments, in which she questioned whether 12(b)-1 fees charged by mutual fund operators are appropriate.

“The purpose of these fees is to offset the marketing and distribution costs incurred by mutual fund companies,” NAPFA Chairman William Baldwin said in a statement. “However, when you peel back the layers you see that some mutual fund companies are making a profit on 12(b)-1 fees,” said Mr. Baldwin, who is president of Pillar Financial Advisors, which manages about $600 million.

NAPFA has made a recommendation calling for mutual fund operators to fully disclose expenses to prospective customers before they invest in a fund.

The group, which represents fee-only financial planners, also wants the 12(b)-1 charge to be renamed so that it’s clear it covers brokerage firm reimbursement for account maintenance expenses. In addition, NAPFA has called for fund operators to disclose a fund’s total fees and costs — including 12(b)-1 fees — in quarterly account statements.

Australia reviews funds costs and returns

MORE than $13 million a day is being sucked from Australian retirement savings because of underperforming retail superannuation funds and commissions paid to financial planners, according to industry super funds.

The claims are contained in an Industry Super Network submission to the Government's Super System Review, which today unveils draft findings from the first phase of its year-long inquiry.

The three-phase review, led by former Australian Securities and Investments Commission deputy chairman Jeremy Cooper, will also today release the issues paper for its third and final stage, examining the structure of Australia's $1 trillion super industry.

In its submission for the Cooper Review's second phase, examining the operation and efficiency of the system, ISN argues that most super fund members are passive and disengaged, leading to a market failure requiring regulatory intervention.

It argues that default funds - the funds workers are placed in if they do not make an active choice - should be chosen on set criteria and should continue to be included in industry awards.

The issue of default funds has bitterly divided the super sector. Retail funds, the for-profit rivals of the industry super funds, were mostly overlooked when default funds for major industries were named during the Federal Government's industrial award modernisation process last year.

Retail funds have faced criticism - especially from industry funds - over fees and commissions, especially the perceived conflict of interest in paying commissions to financial advisers. The Investment and Financial Services Association, which represents retail funds, this year pledged to phase out in-built commissions.

The Cooper Review's second issues paper canvassed the possibility of a government-operated, national default fund.

ISN's submission calls for workplace default funds to be chosen on objective criteria - requiring the fund to be of sufficient size and scale, to not pay commissions to intermediaries and to cap fees.Its submission estimates that the commission system is costing members $13 million a day, including $8 million in lost investment income from retail sector under-performance over the past 13 years.

ISN does not accept that commissions are a legitimate or acceptable cost to individual investors or the system, but rather 'inertia costs' which create an indefensible drag on the system as a whole and on individual retirement systems, the submission said.

ISN also calls for a no-disadvantage test to apply when a worker is flipped into a different fund when he or she leaves their job. It reiterates its call for financial planners to be required by law to act in their clients' best interests, and for commissions to financial advisors to be banned.

In its submission, Australian Institute of Superannuation Trustees, the peak representative body for the $450 billion not-for-profit super sector, laid out eight changes it believes could reduce costs and promote efficiency in the super industry.

Among these are better use of tax file numbers and the use of technology to to streamline the collection, distribution and publication of superannuation data and statistics.

The AIST also argued the Government should extend the criteria that default funds must comply with, that all funds be required to publish quantifiable investment objectives by which they would be judged, that fees be more clearly disclosed and that investment managers' fees be performance-based.

- CLARIFICATION: A story in The Age on Saturday carried the headline Call for law change on commissions. As referred to in the story, the Financial Planning Association is asking the Federal Government for a new law to define planners' fiduciary obligations.


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