The SEC plans to decide by the end of the year whether to reform 12(b)-1 fees or eliminate them altogether, and proponents of both alternatives are poised to try swaying its decision.
WASHINGTON — The SEC plans to decide by the end of the year whether to reform 12(b)-1 fees or eliminate them altogether, and proponents of both alternatives are poised to try swaying its decision.
The fees’ fate will take center stage next week at a Securities and Exchange Commission round table. And although observers think it unlikely that the fees will be abolished, most think that the 27-year-old program is in for some changes.
SEC Chairman Christopher Cox has called for either reforming or eliminating 12(b)-1 fees by yearend, because they no longer serve the purpose for which they were created in 1980.
Back then, mutual funds were losing money, and the SEC allowed funds to charge the fees to pay for marketing and distribution expenses. The fees were envisioned as a temporary measure, but they since have evolved into a substitute for sales loads, as well as a way to compensate brokers for servicing accounts on a continuing basis.
About $11 billion in 12(b)-1 fees is collected annually.
The fees shouldn’t be abolished altogether, said Barbara Roper, Pueblo, Colo.-based director of investor protection for the Consumer Federation of America in Washington.
“It is appropriate to expect investors to pay for the services they receive from brokers,” she said.
Ms. Roper, who will participate in the June 19 round table, advocates the direct compensation of brokers by investors, with no involvement of the mutual fund companies, thereby removing incentives for brokers to push particular funds in order to get the 12(b)-1 fees.
“There’s no reason to funnel payments to brokers through the product sponsor,” she said. “Doing that just muddies the water and creates these conflicts of interest.”
Moving the fees to the shareholder level is “the idea that captures the imagination,” said Robert Plaze, associate director of the SEC’s division of investment management. “That would be the idea if you wanted to have significant reform, but not everybody is going to want significant reform.”
‘No incentive’
Taking the opposite view, Paul Haaga, vice chairman of Los Angeles-based Capital Research and Management Co., will argue at the round table that paying a 12(b)-1 fee as a direct mutual fund expense allows investors to spread out the cost of buying a fund. It also makes it easier for advisers to collect the fee.
The fee currently “is set by us [mutual fund companies], and we don’t get it. We have no incentive to set it higher than necessary and every incentive to set it low,” said Mr. Haaga, whose company offers the American Funds. The cost of collecting the fee through advisers would be higher, he said. “They’re going to receive it, so they’re going to set it higher.”
Pushing the fees out to shareholders would likely result in a system similar to wrap fee accounts, where fees are charged directly to investors, Mr. Haaga said. Fees for those accounts average 1% or more, and the accounts usually require high minimum investments.
Most shareholders would face some tax disadvantages in paying the fees directly from their accounts, said Keith Lawson, tax law senior counsel with the Investment Company Institute in Washington, which has indicated that it wants to keep the fees as part of fund expenses.
Funds now deduct the fees before paying income to shareholders, which ultimately saves shareholders from paying ordinary income tax on that portion of their fund income, he said.
If shareholders paid the fees directly, Mr. Lawson said, a portion of the fees would likely be treated as commissions, which could be included in the cost basis of the shares. That would reduce the capital gains tax on the fund shares when they were sold — but shareholders would then have to wait until they sold their shares to recoup that portion of the fees. Further, capital gains tax rates are lower than ordinary income tax rates, so the tax savings would be less than they are under the current system.
Obscured expenses
But tax consequences for most shareholders wouldn’t be great, argued Richard Phillips, who represents brokerage firms and mutual funds as a partner in the San Francisco office of international law firm Kirkpatrick & Lockhart Preston Gates Ellis LLP.
Mr. Phillips, who is also scheduled to participate in the round table, said that moving the fees to the shareholder account level would make them visible to investors in the same way as front-end sales loads.
“It obscures fund expenses” to have the fees taken from fund assets, he said.
Moving the fees outside of the funds’ expense ratios and charging them directly to shareholders would be the best option, agrees another participant on the reform option panel, Don Phillips (no relation), a managing director of Chicago fund research company Morningstar Inc. But the more important issue, he said, is making fund accounting more straightforward. The fees have devalued the service of advisers because “they allowed some people to pretend you could have the services of an adviser for free.”
In addition, removing 12(b)-1 distribution costs from fund expense ratios and charging them directly to shareholders “would be a great way to get rid of the alphabet soup of share classes,” Mr. Phillips said, because most of the different share classes for funds are the result of different distribution costs.
The SEC first advanced the idea of charging the fees directly to shareholders in a 2004 proposal that ultimately abolished directed-brokerage practices. In its comment letter to the SEC at the time, the Denver-based Financial Planning Association opposed singling out 12(b)-1 fees for deduction directly from fund shareholder accounts.
“By harshly illuminating 12(b)-1 fees with a laserlike beam, the approach suggested by the SEC is likely to shroud the context in which these fees appear,” the FPA said in its letter.
