On June 19, 2007, the Securities and Exchange Commission (“SEC”) hosted a roundtable at which representatives of the mutual fund industry and others were invited to discuss issues related to Rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”). Rule 12b-1 allows fees to be deducted from mutual fund assets to pay distribution and shareholder servicing expenses.
The full-day roundtable was organized as a series of panel discussions covering the following topics: (1) the history of Rule 12b-1; (2) modern-day uses of 12b-1 plans to finance the distribution of mutual fund shares; (3) the costs and benefits of 12b-1 plans; and (4) options for reform of Rule 12b-1. Each panel was moderated by a senior member of the SEC staff, and featured representatives from a cross-section of organizations within the industry, including mutual fund companies, broker-dealers and other financial intermediaries, the NASD, independent trustees, investor advocacy organizations, academia and law firms.1 The SEC Commissioners were also in attendance, and they occasionally asked questions or provided comments.
Although the agendas for the various panels were intended to promote a discussion of Rule 12b-1 from different angles, the following central themes arose from several or all of the panels:
1. Services. The various types of services financed by 12b-1 plans are generally beneficial to funds and investors.
2. Disclosure. Investors would benefit from better, more “transparent” disclosure of both fees paid and services provided for the fees under 12b-1 plans, though better disclosure should not mean more disclosure
3. Internalization Versus Externalization. Views vary widely on the issue of whether the current 12b-1 plan regime should be reformed to “externalize” some or all 12b-1 plan fees by having service providers charge investors directly.
4. Oversight of 12b-1 Plans by Fund Boards. A general consensus exists in favor of modernizing or eliminating the nine factors (listed in the 1980 release adopting Rule 12b-1) that boards currently consider when approving 12b-1 plans, and some panelists were in favor of modifying the board’s role in overseeing distribution to reflect broad oversight instead of annual approval of plans.
These themes, as well as certain questions and comments raised during the panels, are discussed below in the summaries of the discussions at each panel.
In his opening remarks, SEC Chairman Christopher Cox set the tone for the roundtable by declaring a need to re-examine Rule 12b-1 given that its current uses expand far beyond the purposes originally intended by the SEC when it adopted the Rule. In his introduction, Andrew “Buddy” Donohue, Director of the SEC’s Division of Investment Management, noted that 12b-1 fees have evolved from a fee to pay for advertising and marketing to a substitute for front-end sales loads. He added that Rule 12b-1, at a minimum, needs a “tune-up” and that re-examination of the Rule is a top priority of the Division of Investment Management.
First Panel: The History of Rule 12b-1
The first panel was moderated by Douglas Scheidt, Chief Counsel of the SEC’s Division of Investment Management. This panel explored the adoption and subsequent evolution of Rule 12b-1. The panel began with the regulatory history leading up to the adoption of the Rule, including discussion of certain no-action positions taken by the SEC during this period,2 and followed with the procedural history that culminated in the Rule’s adoption in 1980.3 The panel observed that consideration of the Rule took place around the time of an SEC initiative to replace, where appropriate, detailed regulation with the business judgment of issuers’ boards of directors. This explains why the SEC designed Rule 12b-1 as a procedural rule.
The panelists related that the drafters believed that use of fund assets to spur growth could benefit funds, but appropriate safeguards should be incorporated to minimize any conflicts of interest, to provide independent director oversight and to assure that all shareholders were treated fairly in connection with the payment of distribution expenses. They recalled that the SEC intended to monitor the use of 12b-1 fees and make adjustments to the Rule if needed.
The panelists outlined the concerns about 12b-1 plans arising in the years after the Rule’s adoption, including: (1) use of the “no-load” moniker by funds with 12b-1 plans; (2) widespread use of 12b-1 fees in conjunction with a contingent deferred sales load that, over an extended time, accrued finance charges; (3) lack of disclosure about the finance charges imbedded in 12b-1 fees and the long-term nature of 12b-1 plans; (4) growth in the industry not resulting in economies of scale; and (5) plan proceeds provided to distributors that were not spent on distribution and not returned to the fund. Panelists discussed the SEC staff’s 1988 review of Rule 12b-1 in response to these concerns and the resolution of certain concerns by the NASD’s adoption of rules intended to impose limits on 12b-1 plans in 1993.
At least two panelists addressed what they described as “myths” about 12b-1. These included the commonly held notions that (1) 12b-1 plans were intended to be temporary, (2) the Rule was adopted to address net redemptions that many funds were experiencing in the mid-1970’s, and (3) the Rule was primarily intended to finance advertising rather than replace front-end loads as the primary source of distributor financing. They explained why they believed each of these notions was not accurate. In particular, the panelists appeared to be in general agreement that the current use of 12b-1 plans as a substitute for front-end loads was contemplated at the time the Rule was first adopted. (A panelist on the last panel of the day disagreed with this conclusion.)
When invited to suggest “fixes” to the issues currently presented by Rule 12b-1, one panelist recommended treating separately fees intended to replace sales loads from other asset-based fees and viewing them as contractual obligations to dealers for past distribution services. Another panelist was of the opinion that externalizing distribution fees would be appropriate and that the industry needs to better explain to investors what services are being provided in return for the fee. While all panelists felt that paying for distribution over time is desirable for many investors, the panelists generally agreed that modification of the Rule is in order, and that improved disclosure about the impact of the fee is needed at the time of sale. None of the panelists recommended rescission of the Rule.
Second Panel: Modern-Day Uses of 12b-1 Plans to Finance Distribution of Mutual Fund Shares
The second panel was moderated by Robert Plaze, Associate Director of the SEC’s Division of Investment Management. This panel addressed current uses of Rule 12b-1 in mutual fund distribution arrangements. The panel generally was strongly in favor of retaining Rule 12b-1, citing reasons such as competition, investor choice and simplification of the payment for services through a bundled 12b-1 plan. Specific topics discussed by this panel included the following:
Share classes and use of 12b-1 fees. The panelists discussed typical A, B and C share class distribution arrangements, noting the role of 12b-1 fees in each. Panelists representing both large and small fund groups pointed out that even with 12b-1 plans, distribution is not a profit center for mutual fund groups because funds tend to pay out more for 12b-1 related services than the revenues generated by 12b-1 plans. This is contrary to what the rule drafters had anticipated.
Two panelists maintained that the distribution of mutual fund shares should not be viewed as a one-time transaction event, but instead should be recognized as creating and fostering an ongoing relationship between the securities professional and the investor. The panelists noted that such relationships involve the giving of advice over time with respect to changes in an investor’s personal circumstances, market developments, etc., and that the trail compensation facilitated by 12b-1 fees is an appropriate and necessary method of financing both distribution and personal services from brokers and advisers.
Disclosure and transparency. While panelists generally thought that enhanced disclosure of the fees and services associated with 12b-1 plans would be a positive development, some were concerned about the efficacy of such efforts. Greater transparency, while desirable in concept, could cause more investor confusion. “Effective” communication should be the ultimate goal.
Use of 12b-1 plans by small fund groups. The small fund group representative was a strong proponent of Rule 12b-1, noting that 12b-1 plans may be used by funds to (1) pay financial advisers who recommend or sell fund shares, (2) pay fund supermarkets, (3) pay retirement plan administrators, and (4) offset internal marketing costs (e.g., maintenance of website and call centers, and expenses related to marketing materials and advertising).
Furthermore, one major benefit of Rule 12b-1 is that it has enabled smaller fund companies to exist alongside and compete with larger mutual fund complexes on various platforms.
Impact of intermediaries. Panelists representing retirement plan administrators and mutual fund supermarkets generally outlined the various distribution arrangements and types of services that they provide to funds. Specifically, the supermarket representative noted that, through its maintenance of omnibus accounts, the supermarket provides in a cost-effective manner services that funds would otherwise pay for, including: (1) transaction execution and settlement; (2) payment of dividends and distributions; (3) prospectus delivery; (4) maintenance of branch offices and call centers; (5) maintenance of websites; and (6) recordkeeping and other administrative services.
Externalization. The SEC staff moderator asked whether shareholders should pay for distribution from individual shareholder accounts rather than from mutual fund assets.4 One panelist did not believe that this should be an “either/or” issue; instead, new fee structures should be encouraged. Other panelists did not view externalization as resolving any issues. There was a general feeling that funds deliver better service at lower costs than any other alternative investments, and internalization spreads costs for the benefit of shareholders.
Role of mutual fund directors. Consistent with the preceding panel, the panelists were strongly in favor of modernizing the nine factors for board consideration listed in the 1980 release adopting Rule 12b-1.
Third Panel: The Costs and Benefits of 12b-1 Plans
The third panel was moderated by Eric Sirri, the Director of the SEC’s Division of Market Regulation. This panel focused on whether 12b-1 plans provide benefits to investors or instead operate to obfuscate the fees and charges investors bear.
Benefits of 12b-1 plans. Panelists identified various investor benefits attributable to 12b-1 plans, including: (1) services, such as website support, call center support, and information concerning the relative advantages of various classes; (2) consistent with the preceding panels, the ability of financial advisers to maintain an ongoing service relationship with their investors, a valuable service; and, finally, (3) a pricing structure that most investors prefer – namely, asset-based fees spread over time rather than front-end or back-end fees.
Costs of 12b-1 plans. One panelist representing an investor advocacy group asserted that investors often do not appreciate that fund performance is diminished when the fund bears the expenses associated with a 12b-1 plan. Another panelist echoed this, saying that most investors do not understand the impact of 12b-1 fees on performance, particularly over the long term. Both of these panelists seemed to suggest that investors may not be able to judge the “price” they are paying in lost performance for the services they receive from their brokers.
Investor understanding. Panelists generally acknowledged that investors may not fully understand 12b-1 fees and urged greater “transparency” of the fees, and “efficient communication.” While the panelists discussed different means for communicating information, such as point of sale disclosure, point of recommendation disclosure, confirmation and account statement disclosure of the dollar amounts of fees deducted, there was no consensus on a particular approach. One proposal was for a different name for the fees that conveys more meaningful information about the fee.
Board determination factors. Commissioner Paul Atkins asked the independent trustee representative whether the board considers the nine factors outlined in the 1980 release adopting Rule 12b-1. The panelist noted that some of the factors are outdated, but explained that his board utilizes the other factors in its review, as well as other pertinent factors it has identified.
Externalization. Two panelists argued that distribution fees should be “externalized,” that is, charged separately to investors. Others expressed concern that externalizing distribution expenses might raise fees for small investors.
Fourth Panel: Options for Reform of Rule 12b-1
The final panel was moderated by Mr. Donohue. This panel explored options for change with respect to Rule 12b-1. In response to a question from Chairman Cox as to whether Rule 12b-1 should be maintained with improved disclosure, or whether panelists would recommend more significant changes, panelists generally appeared to be in favor of retaining the Rule with modifications, rather than outright rescission of the Rule. One panelist suggested that the SEC should not assess Rule 12b-1 in isolation, but rather evaluate mutual fund distribution more generally in the larger context of broker-dealer compensation.
Role of mutual fund directors. The panelists echoed earlier sentiments that the factors boards consider are outdated, given the current uses of 12b-1 fees. Two panelists recommended that the SEC reform the role of mutual fund directors with respect to directors’ oversight of distribution of fund shares. One of these panelists added that directors should be aware of and responsible for all of the fund’s distribution arrangements, including revenue sharing, but they should not be required to pass judgment every year on the level of distribution expenses.
Disclosure and transparency. The panelists agreed with the views expressed earlier that more transparent disclosure of the expenses borne by investors under 12b-1 plans is desirable. Two panelists felt this could be accomplished, at least in part, through disclosure on account statements. However, other panelists cautioned that better disclosure would not necessarily result in more price competition because many investors do not make investment decisions based on the “price” of a mutual fund or share class. Two panelists offered views as to what they considered better or more “transparent” disclosure. One thought that breaking down mutual fund expenses into the following three categories by function (rather than legal character) would best serve investors: (1) portfolio management; (2) client service; and (3) administrative. This would avoid identifying expenses by subtle legal characterizations (e.g., activities “primarily intended to result in the sale of shares”). The other panelist thought that a single “unitary fee” approach would be the most transparent. Both indicated that more than three categories, though more accurate, would confuse investors.
Externalization. Perhaps the most important issue that this panel focused on was the pros and cons of externalizing distribution expenses or fees. One panelist noted that under the current regime, internalization of distribution fees has the following negative consequences: (1) reduced transparency of the impact of the fee; (2) multiple classes of shares that are confusing to investors; (3) mutual fund directors having an uncomfortable oversight role; and (4) reduced price competition because funds competing with each other for shelf space at intermediaries become “price takers” rather than “price setters.” At the same time, he pointed out that externalizing distribution would entail a very expensive transition and have negative tax consequences for most investors. Another panelist favored retaining the current regime because he believed that externalizing distribution expenses or fees would: (1) increase such costs for smaller investors; (2) possibly price small investors out of the brokerage channel; (3) reduce transparency with regard to such fees because fees charged by various intermediaries cannot be easily compared with one another; and (4) have negative tax consequences for most investors.
Service component of 12b-1 fee versus distribution component. There was consensus among the panelists that the 0.25% service fee component of most 12b-1 plans has not been a problem for the mutual fund industry or investors and that fund shareholders generally receive valuable services for such fees. More than one of the panelists asserted that such fees permit small funds and new funds to obtain space in fund supermarkets and retirement plan platforms and thereby increase competition in those distribution channels. Consistent with this view of service fees, the panelists generally were of the opinion that B and C class shares should be the focus of the SEC’s inquiry into Rule 12b-1. In contrast, several panelists were of the opinion that the distribution fee component of a 12b-1 plan, functioning as a substitute for a front-end sales load, is less transparent than a front-end load and likely inhibits price competition.
Panelist recommendations. Towards the end of the panel, Chairman Cox prompted feedback from the panelists by asking them for their views as to what changes they would recommend to Rule 12b-1 to improve it if only modest changes are made, as well as what changes they would recommend if they could change anything they wanted with the Rule. This resulted in distinct “modest change” suggestions and some “radical change” suggestions.
In the modest change category, three panelists urged a focus on improving the transparency of disclosure about 12b-1 fees. Two of these panelists thought this could be accomplished through improvements to account statements. One panelist recommended modifying board oversight of 12b-1 plans while another recommended a focus on class C shares.
In the radical change category, one panelist urged the SEC to change its regulatory focus from 12b-1 plans and the use of mutual fund assets for distribution, to regulation of distribution more generally, particularly broker-dealer compensation. Another panelist recommended unitary fee arrangements as being the most transparent and useful for most investors and suggested that this approach was workable because those investors who wanted more information about a fund could easily obtain it. A third panelist thought the unitary fee idea a poor one, but urged changing how mutual fund fees and expenses are broken down for disclosure purposes by consolidating them into the three categories identified above (i.e., portfolio management, client service, and administrative). Finally, one panelist urged the SEC not to change Rule 12b-1 at all because it has served investors and the industry well over many years and advocated a “don’t fix what isn’t broken” position.
The SEC has invited the public to submit comments on Rule 12b-1 until July 19, 2007. In this regard, the SEC has stated that it is particularly interested in comments addressing alternative approaches to regulating the financing of distribution of mutual fund shares. We will continue to assess the potential impact of Rule 12b-1 developments and will keep you apprised of future developments.