SEC likely to consider tighter restrictions on 12(b)-1 fees

By Frederick P. Gabriel Jr.

The Securities and Exchange Commission is taking a close look at 12(b)-1 fees — again.

When first introduced in 1980, 12(b)-1 fees were supposed to be a temporary measure to help small mutual funds recoup costs associated with selling shares, such as printing, mailing and advertising. Today, however, nearly two-thirds of all funds charge such fees and use the billions of dollars collected to defray costs associated with selling through intermediaries.

The use, or misuse, of 12(b)-1 fees has been on the SEC's radar screen for a couple of years. But now that the spotlight in the mutual fund trading scandal has shifted to fund fees, the commission — under the direction of Chairman William H. Donaldson — is likely to put its words into action.

"We're looking at 12(b)-1," SEC Commissioner Harvey Goldschmid said Jan. 24 at a gathering in Oxford, Miss., of regulators, shareholder advocates and fund company executives. "All I can tell you is that when you are looking at something, it means running the spectrum from elimination to modification."

Among those participating in the Mutual Fund Summit were John C. Bogle, the founder and former president of The Vanguard Group Inc. in Malvern, Pa.; Paul G. Haaga Jr., chairman of the Washington-based Investment Company Institute, and an executive vice president and director at Los Angeles-based Capital Research and Management Co.; and Don Phillips, a managing director at Morningstar Inc., a mutual fund research company in Chicago.

Shareholder advocacy group Fund Democracy Inc. and the University of Mississippi law school, both based in Oxford, sponsored the two-hour meeting.

Industry watchers say it is unlikely the SEC will totally dismantle Rule 12(b)-1, in part because of the huge sums of money involved. Instead, they say, the commission is likely to propose changes that would tighten restrictions on how that money is used.

Among modifications to Rule 12(b)-1 that the commission is supposedly considering is one that would ban fund companies from using 12(b)-1 fees to pay for directed brokerage expenses.

"I think Chairman Donaldson has gently hinted — although it wasn't very gentle — that directed brokerage is likely to go," Mr. Goldschmid said.

In an effort to get ahead of regulators, several fund companies, including Boston-based Putnam Investments LLC, have voluntarily put the kibosh on their directed brokerage arrangements. These involve sending trades to certain brokers in return for those brokers' efforts to sell the funds.

In December, the ICI, the fund industry's main trade group, also came out in favor of banning directed brokerage.

Barry Barbash, former head of the SEC's division of investment management and now a lawyer in Washington, said the SEC's re-evaluation of Rule 12(b)-1 is long overdue.

"When 12(b)-1 was adopted by the SEC in 1980, it was a very good rule in the sense that it was well thought out," he said at the meeting. "But if there's any criticism of the SEC over time, it's that the rule hasn't been adapted to keep up with what the industry has done."

Mr. Phillips noted that high 12(b)-1 fees have pushed some managers to assume more risks than they might ordinarily because the charge is paid for by the fund, thereby reducing the fund's overall performance.

"Fund managers are competitive," he said. "If you give them higher costs that are taken against their performance, they'll go out and try to find a way to win the gain."

But Craig Tyle, general counsel with the ICI, warned of rushing into a move to do away with Rule 12(b)-1.

"At the end of the day, Rule 12(b)-1, as it has been used, has given investors more choices," he said. "They can choose to pay an upfront load or they can choose to pay the same cost over time."

Frederick P. Gabriel Jr. is a reporter with InvestmentNews, a sister publication of Pensions & Investments.