SEC seen capping fees on C shares

The Securities and Exchange Commission is expected to issue a proposal by summer that would cap 12(b)-1 fees that investors in Class C mutual fund shares are charged, according to the general counsel of the Investment Company Institute. Based on its discussions with the commission, the powerful Washington-based mutual fund trade group believes the SEC will propose that C-share investors pay no more than investors in Class A shares, said Karrie McMillan, ICI's general counsel. That could pose an administrative nightmare for fund companies, forcing them to come up with a "conversion rate" for the different share classes, she said. A review of Rule 12(b)-1 by the SEC has been under way for some time. The 12(b)-1 fees paid by shareholders through mutual funds rose from a few million dollars in the early 1980s to almost $12 billion in 2006, according to the ICI. Critics, however, contend that the primary use of 12(b)-1 fees has shifted from paying for fund marketing to substituting for a sales load or fund servicing. In an interview this week in Phoenix at the Mutual Funds and Investment Management Conference, which the trade group organized, Ms. McMillan suggested that a cap on C shares "could be very difficult for some companies." Officials at the SEC could not be reached for comment. In a recent interview (InvestmentNews, Jan. 7), Andrew J. "Buddy" Donohue, director of the SEC's division of investment management, said that capping fees, particularly on C shares, was a possibility. With C shares, "there's never a conversion" to lower A share fees, he said. "It goes on forever," until the investor sells the shares, Mr. Donohue added. Unlike A shares, which charge a one-time, front-end load, or B shares, which charge a back-end load, C shares charge a level load applied annually as a fixed percentage of a fund's average net assets. In many — but not all — cases, that means that investors who stay in C shares for a number of years will end up paying more than in-vestors in A or B shares. In its 2006 report, "Mutual Fund Share Class Limits and Share Class Suitability," Morningstar Inc. of Chicago found that C shares are almost always the best choice for investors who plan to hold their shares for three years or less. Geoff Bobroff, a mutual fund consultant in East Greenwich, R.I., said it was understandable that the ICI would be opposed to capping C shares. "It would require an organization to redo their C shares or arguably issue a new share class," he said. Mr. Bobroff said the situation could become a complicated mess, but it was not beyond solving.

LOOKING TO AMERICAN

For example, C shares offered by the widely popular American Funds group, which is advised by Capital Research and Management Co. of Los Angeles, automatically convert to Class F shares in the first month of the 10-year anniversary of the purchase date, reducing the annual expenses investors pay. If the SEC proposes capping C shares, that could become the model for the industry, Mr. Bobroff said. Such a model could benefit both investors and the fund in-dustry, said Don Phillips, a managing director at Morningstar. An investor in C shares who pays more than other investors would not likely be a satisfied customer, he said. But if a fund's shares were to convert at some point into another share class with lower fees, that same C share investor could become a very loyal investor. "It would legitimize C shares and make sure they stay around," Mr. Phillips said. If the SEC were to propose more drastic measures to curb 12(b)-1 fees, the fund industry could have it much worse, he said. SEC officials are believed to be considering making 12(b)-1 fees more transparent or eliminating the fees altogether, Mr. Phillips said. However, during a panel discussion at the ICI conference, Ms. McMillan said that what the SEC had shown of its proposed rule was "generally well received."

THREE ISSUES

That might signal that the SEC won't repeal 12(b)-1 fees or make drastic changes that are unpalatable to the fund industry, Mr. Phillips said. In discussing potential changes to Rule 12(b)-1 during a panel discussion at the conference, Mr. Donohue highlighted three issues. David Hoffman can be reached at dhoffman@investmentnews.com First, he said, the SEC would consider "additional disclosure" concerning 12(b)-1 fees. Second, Mr. Donohue said, the SEC needs to revisit the role played by fund directors in evaluating 12(b)-1 fees. Many have said they don't feel qualified to make judgments about the fees' suitability. And finally, he said, more thought should be given to what to call a 12(b)-1 fee. Industry critics have complained for years that the typical investor has no idea what a 12(b)-1 fee even is. Mr. Donohue said the SEC would make its recommendations by summer. Since efforts to address the 12(b)-1 issue have failed in the past, there is skepticism that the SEC can produce an understandable proposal, Mr. Phillips said. But he predicted that the SEC would succeed this time. "I think it will happen," Mr. Phillips said. E-mail David Hoffman at dhoffman@investmentnews.com. "I THINK IT WILL HAPPEN." Don Phillips Managing director Morningstar