On the heels of the federal appeals court decision rejecting fee-based brokerage accounts, brokers are facing yet another challenge from consumer advocates who are questioning whether 12(b)-1 fees are being used illegally.
WASHINGTON — On the heels of the federal appeals court decision rejecting fee-based brokerage accounts, brokers are facing yet another challenge from consumer advocates who are questioning whether 12(b)-1 fees are being used illegally.
Using such fees to pay for continuing advice for clients, as the mutual fund and brokerage industries claim to do, could run afoul of the Investment Advisers Act of 1940. Under that law, brokers are prohibited from receiving “special compensation” for investment advice, and it stipulates that they can give advice only if it is “solely incidental” to selling securities, such as recommending a particular stock to buy.
“To convince people of all the great things investors get in return for paying 12(b)-1 fees — the entire focus of that is on how they pay for advice that goes beyond just the transaction in question and covers all sorts of services related to the portfolio and planning,” said Barbara Roper, Pueblo, Colo.-based director of investor protection for the Consumer Federation of America in Washington.
“If it’s true, that isn’t anything that anyone would remotely consider advice that’s solely incidental to brokerage transactions,” she said.
Ms. Roper raised the issue last month at a 12(b)-1 round table sponsored by the Securities and Exchange Commission, which plans to issue a rule proposal to repeal or reform the 12(b)-1 program this year.
Some $11 billion in 12(b)-1 fees are collected annually by brokerage and advisory firms for selling and servicing mutual funds, and many brokerage firms and their representatives depend heavily on the fees for their compensation.
The mutual fund and brokerage industries have argued that the fees serve a valuable purpose by allowing brokers to be paid for providing continuing advice to their clients.
Brokers who get a significant portion of their income from the fees disagree with the argument that using them for advice is illegal.
There is a distinction between asset-based fees in brokerage accounts — which are to be banned as a result of a decision last March by the U.S. Court of Appeals for the District of Columbia Circuit — and 12(b)-1 fees, said Stephen Wershing, president of Ensemble Financial Services Inc. in Pittsford, N.Y. “If you’re doing fee-based brokerage, you’re being asked to assist in choosing securities,” he said. “It’s a lot easier to see that as investment advice.”
The 12(b)-1 fees, on the other hand, are paid for providing administrative services for mutual fund accounts, said Mr. Wershing, who runs a dually registered broker-dealer and investment advisory firm. A significant portion of the fees it collects comes from 12(b)-1 fees.
“They [are not] contingent on purchasing or holding a fund in a particular complex,” he said. “It’s not implied that they’re being paid for investment advice,” Mr. Wershing added.
SEC spokesman John Nester would not comment on the issue.
But SEC Chairman Christopher Cox has said repeatedly that the fees need to be re-examined, because they are not being used primarily to pay for marketing for mutual funds, a purpose for which they were first approved in 1980.
Some brokers insist that their use of the fees is in accordance with what the rule originally intended. “The real reason why 12(b)-1 was adopted in the first place was to see a shift away from upfront sales charges paid by investors and toward asset-based fees,” said John Robinson, managing director of a wealth management firm in Honolulu.
Using 12(b)-1 fees in C shares, which charge 1% of assets, aligns the interest of broker advisers with their clients so that brokers do not have an incentive to churn accounts, he said. “Opponents of 12(b)-1 fees don’t get that,” Mr. Robinson said.
A ‘non-issue’
In a June 18 letter to the SEC, investment advisory firm chief compliance officer Ron Rhoades suggested that using the fees by brokers for advice is illegal under the Investment Advisers Act. “The advice registered representatives give is ongoing, comprehensive, [and] covers financial planning [and] estate planning,” said Mr. Rhoades, an attorney, who is director of research and CCO with Joseph Capital Management LLC in Hernando, Fla. “It’s clear that this is not incidental advice to a sales transaction.”
The fees are charged “at the fund level,” said Travis Larson, spokesman for the Securities Industry and Financial Markets Association in Washington and New York. For that reason, he said, the fees “aren’t applicable under the [Investment Advisers] Act.” However, the SEC is considering requiring payment of the fees directly by clients to make them more visible to investors. If that were to happen, Mr. Larson said, “that might raise incidental-advice issues. But until that change is made, it’s a non-issue.”
Abolishing the fees could put some brokers out of business, said Michael Kickham, a registered representative with Porter Kickham Inc., a brokerage firm in Chesterfield, Mo. “I’d be very, very worried if they just went out and put a bunch of guys out of business,” he said.
“There are a lot of very good brokers who have helped people by getting them into good mutual funds,” Mr. Kickham said. “They did it without a front-end load by getting them into C shares, and they’ve built up this 1% per year commission trail that I think they’ve earned, and obviously, their customers think they’ve earned,” he said.
Better disclosure is what is most needed, Mr. Kickham said.
The Denver-based Financial Planning Association, which successfully sued the SEC to get the broker-dealer exemption rule overturned, has not taken a position on the issue, but the trade group plans to survey its members to see where they stand on 12(b)-1 fees, said Brad White, spokesman in its Washington office.
