XI. Conclusion.

• Author: Freeman, John P.
• Position: The Mutual Fund Distribution Expense Mess

Rule 12b-1 stands as a monument to the law of unintended consequences. The benefits that 12b-1 fees supposedly would confer remain unrealized, yet the revenues generated under the rule have grown impressively over the years. Any objective analysis of winners and losers under the SEC's 12b-1 regime will show that fund sponsors are doing very well. The distribution system they administer consumes huge sums of money to generate new sales, thereby enriching fund sponsors, but offers no net pecuniary gains to shareholders who pay much of the tab. As the game's big winners, fund sponsors have a vested interest in keeping the game going. The value of the status quo to others, like fund shareholders, is more dubious.

There is no reason to assume prompt action will be forthcoming. Self-congratulation, not self-criticism, is the order of the day in the fund industry and at the SEC. Consider the following recent colloquy between two former SEC Investment Management Division Directors, both of whom currently represent mutual fund industry clients:

MS. MCGRATH: Well, you know, this leads into an overall question that I have always had and that we've discussed to a certain extent, which is why has the fund industry stayed relatively clean over all these years compared to the other segments of the financial services industry, both those regulated by the SEC, the banks and S&Ls, and insurance companies.... [I]s it that big problems, massive scandals haven't been detected? Or is there some weird combination of culture in the industry, this statute, the rules, all the cooks that have to get involved in complying with it that has made this work so that business can go on and grow, while at the same time, the money isn't getting stolen?

MR. GOLDBERG: Well, a cynic might say that this is such an enormously profitable industry, you don't have to steal.

MS. MCGRATH: Well that's true. (444)

Even a cynic would concede that the fund industry is enormously profitable for fund sponsors. But an informed cynic would never concede that there is no stealing going on in the fund industry. (445) The BISYS and Citigroup frauds (446) are shocking, and exemplify the lengths to which faithless fund managers will go to misappropriate shareholders' assets. Still, those startling scams represent only two small pieces of a shameful asset diversion mosaic.

If the fund business is "enormously profitable" for fund managers, for many fund shareholders it has been something different. Between 1984 and 2002, "The average equity [mutual fund] investor earned a paltry 2.57% annually, compared to inflation of 3.14% and the 12.22% the S & P 500 index earned annually for the last 19 years." (447) An average equity investment return that does not keep pace with inflation over a 19-year span is not "enormously profitable." It is scandalous. (448)

Some may contend that there can be no fee thievery in an industry that is subject to market forces. Free market theory adherents may contend competition can be counted on to keep fees low, squeezing out extraordinary profits. But the fund market does not correlate with the free market. Service providers in "highly competitive industries" customarily do not earn pre-tax profit margins exceeding 60% or 70%. (449) Markets function best to keep prices low when consumers can benefit from full disclosure and independent, arm's-length bargaining. Judged by these criteria the fund industry is dysfunctional. (450)

Load funds compete vigorously for investor favor, but they also saddle buyers with the highest cost structure. Load fund competition for selling brokers' favor tends to drive costs up, not down, in the fund industry. (451) Load fund distribution through the broker channel is lubricated with 12b-1 fees but is so costly for investors at the point of sale and thereafter that finance experts confess they "can't seem to locate tangible benefits delivered by brokers." (452) What the experts do find is that "[e]ven before accounting for distribution expenses, the underperformance of broker channel funds ... costs investors approximately $9 billion per year." (453) A marketplace where the least valuable products sell for the highest prices does not qualify as truly competitive. Pricing inefficiencies occur because the fund marketplace is contaminated by weak disclosure, conflicts of interests, and inattentive stewardship, which is precisely why Congress wrote the Investment Company Act in the first place. If markets held the answer, the simple precept of honoring one's fiduciary duty would not be on life support in the fund industry, as it is.

Rule 12b-1 does not deserve all of the blame for fund industry regulatory and competitive ills, but it is a good place to start. The rule has given us a fund marketplace where we find deceptive selling of Class B shares, deceptive competition with the no-loads, fund brokerage fees fattened to provide soft-dollar and shelf space payoffs, advisory fees fattened to provide revenue-sharing sales push for selling brokers, and adoption of 12b-1 plans in the face of precious little evidence that fund shareholders, on balance, benefit from the pay-outs. This state of affairs suggests a fund industry that is far from scandal-free; it suggests a rogue industry where shareholder abuse is rampant, with government regulators turning a blind eye toward the problems. In the words of a former SEC official: "12b-1, I think, really needs to be revisited. I think that it's now becoming a method for the brokerage industry to siphon off assets out of the funds. And I think that so much of the money just goes right through to pay brokers...." (454) A government-sponsored rule, throwing off almost $12 billion per year, paid for by shareholders who get no net financial benefit, (455) is a boondoggle in search of a sensible rationale.

Fund shareholders should not expect the SEC to rescue them any time soon. The self-proclaimed "investor's advocate" seemingly finds the fund industry's distribution expense problems too daunting or, more likely, too politically charged. Though "full and fair disclosure" is a securities law mantra, the fund industry, operating under the SEC's regulatory thumb, features abysmal, deceptive disclosure. Selling costs and advisory expenses have been masked as brokerage charges, load funds masquerade as no-loads, dollars taken in as advisory fees goes out the door by the billions to pay for distribution, often with no written contracts, and such expense data as does exist is buried so deeply that finance Ph.D.'s have trouble finding and deciphering it. (456) The status quo is intolerable.

The mutual-fund industry needs to be put on a rigorous, uniform, detailed disclosure regimen. Every expense item needs to be clearly defined so industry cost information can be standardized and examined by academics, Wall Street analysts, journalists, plaintiffs' lawyers, expert witnesses, and judges. With visible, accurate, intelligible data to study, these groups can be trusted to do a better job holding the industry accountable than the SEC.

A chilling anecdote helps snap into focus the SEC's susceptibility to political manipulation. In the course of a discussion of notable events in the history of the Investment Company Act, including 12b-1's birth and maturity, former SEC Investment Management Division Director Kathryn McGrath noted her largely ineffectual efforts to "tackle and clean up 12b-1," (457) in the 1980s. She lamented that her attempt was foiled because, "[t]here was too much money flowing through 12b-1 fees to make it touchable." (458) This is a telling admission from someone who stood on the firing line as a high government official. The money flowing to Wall Street through 12b-1 back in the entire decade of the 1980s was a pittance compared to the billions generated annually by the rule today. (459) If 12b-1 was "untouchable" and too tough to "tackle" in the 1980s, (460) nobody cannot be optimistic about an SEC-sponsored federal "clean up" today. The same pessimism applies to any SEC efforts to clean up revenue sharing, the mutual fund industry's "dirty little secret." (461) This shady practice, featuring massive payments often unsupported by written contracts, pumps huge amounts of cash into the broker-dealer community over and above compensation from load fund commissions or 12b-1 fees. (462)

After more than 60 years of intensive government regulation, we find the load mutual fund business sporting a dysfunctional governance model grounded on conflicts of interest, and a haphazard, costly distribution system where false labeling of expense items is rampant. The system is built on disproved hypotheses, hidden payoffs, and deceptive marketing ploys. Watching over it is a federal agency that functions more as the fund managers' crony than as a defender of the public good. That a seasoned SEC veteran labeled 12b-1 as "untouchable" signals that any change for the better for fund shareholders is not apt to come from the politically-influenced agency that ostensibly regulates the investment management industry. If it ever is to arrive, change must travel via orders issued by federal judges still able to recall what it means to be a diligent and honest fiduciary.

(1.) Daisy Maxey, Mutual Funds Pass $10 Trillion Mark, WALL ST. J., Nov. 30, 2006, at C11. The industry's asset base was up from less than $7 trillion in 2000. Id.

(2.) INV. CO. INST., 2006 INVESTMENT COMPANY FACTBOOK 46 (2006), available at http://www.ici.org/statements/res/2006_factbook.pdf. According to John C. Bogle, a fund industry pioneer, "on average during 1999-2001, our families--the very backbone of the U.S. economy--saved $385 billion per year ... and placed $320 billion of it in mutual funds." John C. Bogle, Founder and Former CEO of The Vanguard Group, The End of Mutual Fund Dominance, Speech Before the Financial Planning Association (April 25, 2002), available at...