Fund boards as reform leaders-missing in action.

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

The SEC's blueprint for 12b-1's operation counted heavily on board diligence and oversight and that plan has failed. Under the SEC-established 12b-1 plan-adoption regime, full disclosure would precede careful judgments by decision makers. Fund boards and shareholders would carefully evaluate the rule's perceived benefits and costs prior to adopting a plan, expenditures would be reviewed by the board quarterly, annual reviews would test whether the 12b-1 expenditures were yielding the expected returns, and so forth. This failed plan relied on fund boards carefully exercising their business judgments to insure that funds and fund shareholders gained financially. Here is how the 12b-1-fee approval system is supposed to work, according to an ABA-authored set of behavioral guidelines for mutual fund directors:

In considering the establishment or renewal of a fund's Rule 12b-1 plan, the board of directors has an express duty to request and evaluate, and the distributor has an express duty to furnish, such information as may reasonably be necessary to make an informed determination. To approve the plan, the board must decide, in the exercise of its reasonable business judgment and in light of its fiduciary duties under applicable state law and under the 1940 Act, that the plan is reasonably likely to benefit the fund and its shareholders. In addition, the board must be satisfied that the amounts to be paid by the fund are reasonable in light of the distribution services that have been performed and that they represent a charge within the range of what would have been negotiated at arm's-length. A fundamental factor to be considered in connection with all Rule 12b-1 plans is whether the distribution method under consideration provides for a reasonable financing alternative under the facts and circumstances of the particular fund and the type of investor to which the plan is directed. (381) Twenty-seven years have passed since Rule 12b-1 was promulgated, and we are still waiting for the first competent study showing that 12b-1 plans are likely to generate net financial benefits to mutual funds and their shareholders. As discussed above, the data show the opposite. It is also unclear how a competent, responsible fund board "in the exercise of its reasonable business judgment and in light of its fiduciary duties," authorizes the sale of Class B, well knowing that, as one financial writer put it, "[they] always have been second-class investments."...