12(b)-1 fee fix plan gets mixed reaction

The mutual fund industry should consider itself lucky if, as expected, the SEC this summer recommends placing a cap on 12(b)-1 fees some investor now pay annually via "level loads," industry experts said. But the industry, and some industry observers, said any move to cap level loads — most commonly designated as Class C shares — could prove costly and harm fund participants. It's widely believed that the Securities and Exchange Commission is considering such a move, along with a proposal that would break 12(b)-1 fees into at least two parts: a sales load and a portion that pays for shareholder servicing and distribution-related administration.
Capping fund shares that charge a level load, however, would do little to change how the industry operates, said Don Phillips, a managing director at Morningstar Inc. of Chicago. It's a far cry from the outright elimination of such fees Andrew J. "Buddy" Donohue, director of the division of investment management at the SEC, said last year was an option on the table (InvestmentNews, April 2, 2007).

'DOING CARTWHEELS'

The industry "should be doing cartwheels" if capping level loads is the biggest change the SEC can come up with, Mr. Phillips said. Few fund companies have substantial assets in C shares. For example, the American Funds group, advised by Capital Research and Management Inc. of Los Angeles, had more assets in C shares ($78.01 billion at the end of March) than any other fund group, according to Morningstar. That sounds impressive, but the shares account for only about 7% of the assets held at American Funds. Franklin Templeton Investments Inc. of San Mateo, Calif., ranked second in terms of C share assets with $46.47 billion, according to Morningstar. That represents roughly 15% of its assets — a substantial but still relatively small amount. OppenheimerFunds Inc. of New York was next with $23.16 billion, accounting for about 14% of its total assets, followed by BlackRock Inc. of New York with $20.81 billion, or roughly 20% of its total assets, and Fidelity Investments of Boston with $10.28 billion, accounting for just over 1% of its total assets, according to Morningstar. However, some firms may use other share classes in addition to, or in lieu of, C shares to indicate level loads, industry experts said. Any cap on 12(b)-1 fees charged by shares with level loads would presumably affect all such shares, not just C shares. It's a potential problem for companies that offer such shares, be-cause they may lose assets. Brokers looking to get paid on an continuing basis may move their business to fee-based brokerage ac-counts, said Geoff Bobroff, a mutual fund consultant in East Greenwich, R.I. "To me, that's the big concern for the industry," he said. Only those funds on the "ap-proved" list will be made available to clients in such accounts, Mr. Bobroff said. Fund companies with assets in C shares, or other level-load shares, may not make the list, or will have to compete with a whole new set of fund providers, he said. "People like [The Vanguard Group Inc. of Malvern, Pa.] maybe will pick up clients," said a top producer in the Northeast for Raymond James Financial Services Inc. of St. Petersburg, Fla., who asked not to be identified. But major change is unlikely, he said. A look at American Funds proves his point. In 2001, it launched C shares that automatically convert to Class F shares in the first month after the 10-year anniversary of the purchase date, reducing the annual expenses investors pay. It's a model some industry ex-perts said the SEC will probably follow when crafting its expected 12(b)-1 recommendations. The model proves that brokers won't abandon C shares just because they may eventually lose an annual stream of revenue, Mr. Phillips said. Of course, C shares sold by American Funds will not convert for at least three more years. It's highly unlikely, however, that brokers who still have clients in those shares will run out at that time and look for new C shares for their clients, Mr. Phillips said. It's hard to imagine any investor — let alone an investor in C shares — sticking with any fund for that length of time, he said. It makes the whole debate over whether fund companies will suffer as a result of a cap on the 12(b)-1 fees charged by C shares and other level-load share classes "moot," said Jeff Keil, president of Keil Fiduciary Strategies LLC, an industry consulting firm in Littleton, Colo. Even if brokers were to jump out of such share classes, assets in those shares in most cases are such a small portion of a fund company's total that it wouldn't be that disastrous, said Sam Campbell, director of research at Financial Research Corp. of Boston.

'NOT IN DECLINE'

"That probably wouldn't be a huge deal," he said. "At the end of the day, C shares are not in decline, but certainly, as a percentage of [fund groups'] overall business, they aren't huge." It's likely that the mutual fund industry won't see it that way. Mutual fund companies declined to comment, but there have already been rumblings of discontent in the industry. Karrie McMillan, general counsel of the Washington-based Investment Company Institute, said in March that a cap on fees is problematic. If fund companies are forced to ensure that C share investors pay no more in 12(b)-1 fees than investors in Class A shares, it could pose an administrative nightmare for the companies, forcing them to come up with a "conversion rate" for the different share classes, she said. "It could be very difficult for some companies," Ms. McMillan said. If the proposal looks anything like what is expected, however, the industry should count its blessings, Mr. Phillips said. "The SEC has got to do something about 12(b)-1," he said. "They can't rattle the saber and say everything is on the table, and then come back and say everything is OK." E-mail David Hoffman at dhoffman@investmentnews.com.