Another blow occurred to 12b-1 fees at the June 19, 2007 SEC Roundtable Discussion on 12b-1 Fees. With all five commissioners looking on, Consumer Federation of Americaís long-time consumer advocate, Barbara Roper
, raised the issue as to whether payment of 12b-1 fees to broker-dealer firms and their registered representatives violated the Investment Advisers Act of 1940 (IAA).
After many speakers during the day discussed the ongoing advice provided by broker-dealers to customers, funded by 12b-1 fees, Ms. Roper noted that such advice appeared to not be "incidental advice" permitted under the broker-dealer exclusion from the definition of "investment adviser" found in the IAA. Moreover, payment of 12b-1 fees looked very much like payments to broker-dealers under fee-based accounts, and hence "special compensation," which payment arrangement was recently struck down by the District of Columbia U.S. Court of Appeals.
It was over three years ago, in early 2004, that SEC commissioners first indicated their desire to review the continued utilization of 12b-1 fees. Noting that 12b-1 fees were being utilized in ways that may not always comply with current laws, SEC staffers at the time noted the use of 12b-1 fees to fund supermarkets and in lieu of sales loads to brokers. This is far removed from their original purpose as a temporary means to finance fund distribution, in expectation that a fund that was larger would decrease a fundís expenses through economies of scale.
SEC Chairman Christopher Cox recently spurred on the review of 12b-1 fees, noting that their use had "strayed far from their original purpose" and that it "was time for a thorough re-evaluation." Chairman Cox also referred to 12b-1 fees earlier this year as "sales loads in drag."
Written comments submitted to the Commission by this writer on June 18, 2007, and available on the SEC's website
, explain why payment of 12b-1 fees to broker-dealer firms often violate the IAA. Brokers and dealers are not subject to the requirements of the Investment Advisers Act ("IAA") where their investment advice is (1) "solely incidental to the conduct of [their] business as a broker or dealer," and (2) the broker or dealer "receives no special compensation therefor." 15 U.S.C. ß 80b-2(a)(11)(C) (2000).
As was made clear from many comments submitted from securities industry representatives and individual registered representatives, 12b-1 fees are often utilized to compensate broker-dealer firms for a wide range of ongoing advisory services which are not directly connected to a securities transaction. Even the NASD recently acknowledged that 12b-1 fees were not "transactional sales charges," but rather ongoing "assets under management" relationship compensation, in a comment letter dated April 19, 2007 to the SEC regarding Regulation R. While some 12b-1 fees may be utilized for legitimate purposes, to compensate broker-dealers for the actual costs of service (acting as custodians, providing prospectuses and annual reports to clients, etc.), it was clear from the many comments submitted that many broker-dealers utilized a substantial portion of both the (NASD-maximum) 0.25% annual "service fee" and the 0.75% annual "asset-based sales charge" to compensate registered representatives for ongoing "investment advisory" services Ė which are only permitted under the IAA.
Will powerful advocates such as the Financial Planning Association, Consumer Federation of America, Fund Democracy, the Public Investors Arbitration Bar Association, and state securities regulators (through the North American Securities Administrators Association), again band together to challenge certain 12b-1 fee payments as impermissible under the IAA? These organizations successfully challenged the SECís broker-dealer fee-based accounts rule (a.k.a. the "Merrill Lynch Rule") in court, and the SEC recently decided not to appeal the U.S. Court of Appeals decision which overturned that rule.
Itís too soon to tell what legal challenges may arise. However, any rule-making on 12b-1 fees by the SEC is likely to be very closely scrutinized by consumer and industry organizations.
Many other issues relating to 12b-1 fees were raised in the SECís Roundtable Discussion and the written comments which were submitted, including but not limited to: (A) Should 12b-1 fees be utilized to finance 401(k) administration and other costs? (B) Are Class C shares in a customerís best interests, when Class A shares would be cheaper for a long-term investor in the long run? (Remember all the controversy about Class B shares a short time ago.) (C) Why should a customer with $200,000 in a mutual fund pay so much more than a customer with $1,000 in a mutual fund, through the imposition of 12b-1 service fees, when the custodial costs are nearly identical? Are these and other practices of broker-dealer firms, including fund supermarkets, fair? (D) What fiduciary duties do fund directors possess in their annual evaluation of 12b-1 fees?
12b-1 fees are now also caught up in larger issues receiving attention within the securities industry and by regulators, including:
How can fees and expenses associated with mutual funds be better disclosed Ė including not only 12b-1 fees but also disclosures of transaction costs (bid-ask spreads, market impact, and opportunity costs due to delayed or canceled trades) resulting from trading of securities within the fund and opportunity costs resulting from cash holdings?
How can "hidden" forms of compensation to broker-dealer firms be better quantified and brought to the attention of investors, such as soft dollar compensation and payments for shelf space?
How often should disclosures occur when broker-dealer firms receive compensation from mutual funds on an ongoing, regular basis?
Where is the line of demarcation between "incidental advice" to sales transactions (which registered representatives may provide in brokerage relationships), and "investment advisory services"? As noted in the recent U.S. Court of Appeals decision, the IAA arose from a consensus that investment advisers could not furnish clients unbiased, competent and personal continuous advice regarding their investments unless all conflicts of interest between the investment counsel and the client were removed. Should the "investment adviser" definition be more broadly applied, as the U.S. Court of Appeals noted that Congress intended?
Should all financial intermediaries who provide advice to retail investors possess broad fiduciary duties to always act in the best interests of the client? Note that the CFP Board of Standards adopted such a standard for all of its Certificants effective July 1, 2008.
As the securities industry continues to move from a "product manufacturerís representative" model (i.e., registered representative) to a "purchaserís representative" model (i.e., investment adviser), what additional disintermediation pressures will be brought to bear, and will downward pressure on mutual fund total fees and costs be accelerated in the years ahead?
Some commentators have previously predicted little change in 12b-1 fees will result from the SECís review. However, there was much "nervous laughter" arising from Barbara Roperís comments at the Roundtable Discussion. Given the rise of this new issue Ė that most 12b-1 fees are impermissible "special compensation" under the IAA for advice which is not "incidental" Ė it now appears that the continuation of 12b-1 fees in their present form faces major hurdles.
Outright repeal of 12b-1 fees may now be increasingly likely. At the minimum, substantial changes in the permitted uses of 12b-1 fees should be anticipated. Hopefully the SEC will permit a long transition period before full implementation of any new rules, so as to enable the mutual fund industry, registered representatives, and broker-dealer firms to possess sufficient time to adjust.
Ron A. Rhoades is Chief Compliance Officer and Director of Research for Joseph Capital Management, LLC, a Florida-based registered investment advisory firm.
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