The pressure on the continued existence, of section 12b-1 fees in mutual funds continues to grow, as does the scrutiny of disclosure to fund investors. In remarks delivered to the Mutual Fund Director’s Forum on April 13, 2007, SEC Chairman Christopher Cox announced that the SEC planned a “thorough re-evaluation” of the these fees. He said that the SEC would take a “hard look at current practices” and called upon “independent directors to take a fresh look at the way this use of investors’ funds has evolved.” He added that the SEC is in the midst of “a broad initiative to examine the adequacy of investor disclosures by mutual funds and other investment vehicles in a typical 401(k) plan.”
Chairman Cox explained that when the SEC adopted Rule 12b-1 more than 25 years ago, the premise for that approval was that the permitted fees would be relatively short-lived. The purpose of these fees was to nurture fund growth, a priority at a time when mutual fund redemptions were exceeding deposits. The Commission expected that the fees would be “used to solve specific distribution problems” as they arose, and for a time, that was the usual practice. Cox used this example of the intended use: a no-load fund would use relatively low 12b-1 fees to offset the costs of advertising and the cost to print and mail prospectuses and sales literature.
Over time, these fees have been used for other purposes, such as a substitute for front-end loads. He noted: “The transformation of the 12b-1 fee from a distribution subsidy to a sales load is now so nearly complete that the primary purpose to which the $11 billion in 12b-1 fees last year were put was to compensate brokers.” A secondary purpose is to use these fees to pay for administrative expenses in connection with existing fund shareholders. He noted that even funds that are closed to new investors are still collecting 12b-1 fees. He also described these uses as “barely recognizable” in light of the rule’s original purpose.
Chairman Cox, in his presentation, noted that Rule 12b-1 puts “considerable burdens” on the independent directors of funds. The rule requires a majority of a fund’s independent directors to approve a 12b-1 plan and mandates continuing oversight, including annual approval of the 12b-1 plan. Independent directors are also supposed to review all amounts spent as part of the 12b-1 plan, using applicable fiduciary standards from the Investment Company Act and state law. He posited a standard for the review of the use of these fees. He stated that the rule was intended to increase the number of investors in a fund so that this administrative cost was spread over a larger pool of investors. Thus, one factor independent directors must consider “is whether the fees paid to the management company and other vendors, as a percentage of total fund assets, has risen or fallen as the fund has grown.” Cox indicated that if the expense ratio is not falling as the fund grows, then the use of 12b-1 fees for marketing and distribution expenses “is very likely harming, not helping, the current investors.”
Chairman Cox appeared to signal that outright repeal of Rule 12b-1 is a distinct possibility, commenting that the mutual fund industry now totals $10 trillion and counting, so it is “no longer at risk of suffering crib death.” He added that the original premises of the rule “seem highly suspect in today’s world.” He concluded that portion of his speech by stating that the “time surely has passed” when it was justified to indulge in an irrebuttable presumption “in favor of using fund assets to compensate brokers for sales of fund shares.”
Turning to investor disclosures, Chairman Cox noted that various factors allow the financial services industries “to skim off much more of the assets they handle than would be the case in a well-functioning market.” When this is considered in the context of the retirement time horizon of even middle-aged plan participants, this skim can “result in truly astronomical shortfalls.”
To address these concerns, the SEC will hold “roundtable discussions” with “leading experts” and will publish a concept paper outlining issues and suggested solutions. The Commission has already perceived a consensus for the “creation of more succinct, easy-to-understand disclosure documents for investors” that highlight the key mutual fund information of most importance to investors. The Commission also wants to work with other plan regulators to develop “an approach to 401(k) disclosures that permits each investor to obtain the information necessary to [make] a sound investment decision.”
The Commission also plans to devote more attention to “soft dollars,” which Chairman Cox suggested “can serve as an incentive for fund managers to disregard their best execution options.” He viewed this as a disclosure issue, because “soft dollars make it more difficult for investors to understand what’s going on with their money.” He noted that the SEC had recently issued interpretive guidance on this subject, but he made it clear that the SEC will have more to say on this subject.
We can expect to see more activity from the SEC directed at plans and their service providers as discussions and lawsuits over fees in plans continue.