Half-hearted SEC regulation has hurt investors.

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

A respected money manager recently condemned the SEC's approval of 12b-1 fees in strong, unequivocal terms steeped in frustration and disappointment:

In 1980, the Securities and Exchange Commission caused considerable damage to mutual-fund shareholder interests by permitting mutual funds to pay for marketing and distribution expenses directly from fund assets.... Ironically, a December 2000 SEC study on mutual-fund fees and expenses concluded that 12b-1 fees essentially represented a net transfer from the fund shareholders to the fund management company.... In other words, mutual-fund advisers who charge 12b-1 fees take nearly the entire 12b-1 fee to the bank. The SEC continues to allow 12b-1 fees, even while explicitly recognizing the "inherent conflict of interest between the fund and its investment adviser."... Without the blessing of the SEC, fund directors could scarcely approve something as damaging to investors as 12b- 1 fees.... Shame on the SEC for allowing 12b-1 fees, shame on the directors for approving them, and shame on the mutual funds for assessing them. (257)

Recognizing that 12b-1 reflects a failed policy judgment is one thing, cleaning up the financial waste and legal mess it continues to generate is something else again. It turns out that turning off a spigot pumping nearly $12 billion annually into Wall Street's coffers is a task for which there is no constituency, even at the agency proud to bill itself as "[t]he investor's advocate."

1. The Failed "Clean Up" Effort--Rule 12b-1 Is "Untouchable"

   In late 2002, the SEC Historical Society sponsored a roundtable discussion of notable Investment Company Act historical events, including 12b-1's birth and maturity. (258) In the course of those proceedings SEC Investment Management Division Director Kathryn McGrath referenced as "her biggest failure" her largely ineffectual efforts to "tackle and clean up 12b-1," in the 1980s. (259) The reason given for the failure is deeply disturbing, for it had nothing to do with legalities, public policy, or investor protection. It centered on political clout. McGrath lamented, "There was too much money flowing through 12b-1 fees to make it touchable." (260) This is a telling and deeply disturbing admission from someone who sought to reform a glaring problem while serving as a high SEC official. The money flowing to Wall Street through 12b-1 in the 1980s is a pittance compared to the nearly $12 billion generated annually by the rule today. (261) If 12b-1 was "untouchable" in the 1980s, one cannot be optimistic about reform today. All signs are that Rule 12b-1 has become politically sacrosanct. In Rule 12b-1 we have an "untouchable" rogue rule drafted and sponsored by the SEC, the so-called "investor's advocate," that annually is draining close to $12 billion from American investors, and there is no help in sight.

2. The SEC's Equivocation Over Directed Brokerages Payments for Distribution

   When it adopted Rule 12b-1, the SEC took pains to make clear that both direct and indirect uses of funds assets to pay for distribution costs were covered by the rule. (262) This requirement has been honored in the breach. Over the years, the SEC turned a blind eye to various means used by the fund industry to evade the 12b-1 principle requirement: fund assets may be used to pay for distribution only if embodied in 12b-1 plans approved by fund board after a finding of likely benefit to the fund and its shareholders. (263)

   In 2003, Congressman Richard H. Baker zeroed in on the fund sponsors' practice of padding funds' non-distribution expenses to generate cash to use to compensate brokerage firms for giving a preferred distribution sales push used to sell fund shares. Congressman Baker demanded information from the SEC relating to directed brokerage, soft dollar payments, and revenue sharing. (264) He sought information about "how these arrangements work, the impact of these expenses on investors, the legal issues raised by such arrangements with respect to Rule 12b-1, directors' obligations with respect to these arrangements, and the transparency of these arrangements and their associated costs." (265) Following the ensuing investigation, the SEC staff conceded that 12b-1 fee payments, though lush, still left the industry hungry for additional sources of funds to finance selling efforts:

   [F]unds intensely compete to secure a prominent position in the distribution systems that selling broker-dealers maintain for distributing fund shares. Over the past decade, selling broker-dealers have increasingly demanded compensation for distributing fund shares that is in addition to the amounts that they receive from sales loads and rule 12b-1 fees. To meet this demand, fund investment advisers have increasingly made revenue-sharing payments to the selling broker-dealers, which may be a "major expense" for some investment advisers. Further, the allocation of fund brokerage to "supplement" the advisers' payments to broker-dealers for distribution generally is bundled into the commission rate and not separately identifiable or reported as 12b-1 fees. (266) An SEC investigation completed in 2004 confirmed that various fund sponsors were inflating brokerage expenses to generate cash to pay fund sellers in order to boost sales. (267) Specifically, the Commission's staff "found that the use of brokerage commissions to facilitate the sale of fund shares is widespread among funds that rely on broker-dealers to sell their shares." (268) The potential for abuse was so obvious and serious that three securities industry groups, the ICI, the Securities Industry Association, and the Mutual Fund Directors Forum, each supported eliminating arrangements whereby fund brokerage payments are diverted to reward brokers for selling fund shares. (269) Concern over the practice culminated in the SEC amending Rule 12b-1 to make clear that fund managers were prohibited from using fund brokerage to compensate broker-dealers for selling fund shares. (270) Interestingly, the SEC's 7800-word release outlawing directed brokerage conspicuously failed to attack sponsors participating in the banned practice for breaching their fiduciary obligations to fund shareholders. (271)

   A very plausible reason why the SEC chose not to take fund sponsors to task for breaching their fiduciary duties by inflating fund brokerage costs to pay for distribution outside of Rule 12b-1 is that in 1981 the Commission had given the green light to the practice. (272) As with Rule 12b-1's adoption a year earlier, the seemingly modest, innocuous action taken by the SEC in 1981, with the belief fund managers would discharge their fiduciary duties, paved the way for excesses and abuses harmful to investors. The SEC's long-standing indifference to directed brokerage is particularly disturbing, for it allowed devious fund managers to hide selling costs amidst brokerage charges, costs that are invisible to investors at the point of sale and which never show up in funds' expense ratios. (273)

3. More SEC Laxity-Using "Advisory Profits" to Pay for Distribution

   One source of money to pay indirectly for distribution is brokerage fees; as discussed above, the SEC allowed this evasion of the rule through directed brokerage payments until quite recently. A more serious loophole relates to fund advisers paying "brokers out of their own pockets for selling fund shares ("revenue sharing')." (274) Fund retailers are hungry for this revenue sharing money. Consider this commentary from PFS Investments Inc., a member of the Primerica group of companies and a subsidiary of Citigroup, which markets mutual funds:

   PFS Investments Inc.... endeavors to collect a mutual fund support fee, or what has come to be called a revenue-sharing payment, from the fund families we offer to the public. These revenue-sharing payments are in addition to the sales charges, annual service fees (referred to as "12b-1 fees"), applicable redemption fees and deferred sales charges, and other fees and expenses disclosed in a fund's prospectus fee table. Revenue-sharing payments are paid out of the investment adviser's or other fund affiliate's...