The acid test: does rule 12b-1 benefit mutual fund shareholders?

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

That the SEC's staff filibustered for years against Rule 12b-1 attests to a deeply ingrained skepticism among a highly knowledgeable group of fund industry experts about the basic precept that fund sales financially benefit existing shareholders. The Commission and its staff greeted with skepticism the industry's purported justifications for allowing assets to be diverted to spur sales. (143) By deferring to fund directors' business judgment, the SEC elected to give fund industry leaders an opportunity to prove their theories worked. The SEC's business judgment experiment has now been running for more than 26 years.

1. The Economies of Scale Argument Is Unsubstantiated

   A recurring claim made by the industry prior to Rule 12b-1's adoption was that by generating sales and thereby growing funds' assets, administrative and management costs would fall, allowing fund shareholders to, in essence, realize a net gain on their invested marketing dollars. (144) The idea was that money could be taken from mutual fund shareholders by the fund's adviser or distributor to pay for 12b-1 marketing efforts, with the diverted funds being put to work in a way that would yield savings through economies of scale realized as the fund grew in size. This theory has not panned out. The SEC's staff found in its December 2000 report on fund expenses "that, everything else equal, funds with 12b-1 fees had total expenses that were higher than those of other funds, but by an amount that was slightly less than the maximum 12b-1 fee." (145) In other words, the SEC found that funds spending more 12b-1 money saw their expense ratios rise by approximately the amount of money diverted. This is a far distance from validating the contention that 12b-1 payments would in essence pay for themselves. More recently, an SEC-employed economist, Dr. Lori Walsh, conducted private research that carefully reviewed data concerning 12b-1 fees, and concluded:

   While funds with 12b-1 plans do, in fact, grow faster than funds without them, shareholders are not obtaining benefits in the form of lower average expenses or lower flow volatility. Fund shareholders are paying the costs to grow the fund, while the fund adviser is the primary beneficiary of the fund's growth. (146) Dr. Walsh did not mince words, finding that "shareholders do not obtain any of the benefits from the asset growth." (147) This finding vindicates opponents of using fund assets to subsidize sales who warned about funds shareholders being exploited by their funds' conflicted managers. (148) The findings made by the SEC staff and Dr. Walsh accord with other similar studies; the evidence is overwhelming that 12b-1 payments do not generate net financial benefits for fund shareholders. (149)

   Another serious problem with the growth begets savings scenario is that asset growth in the fund industry does not guarantee costs will drop at all. A Government Accounting Office report published in 2003 found that a sample of 46 large stock mutual funds which, together, had a growing asset base, (150) also had experienced rising average expense ratios, with costs growing from 0.65% of assets in 1998 to 0.70% in 2001. Meanwhile, the average mutual fund shareholder, until very recently, has tended to find expenses creeping higher. (151) Decade after decade of rising costs casts doubt on the concept that asset growth can be counted on to generate economies of scale for shareholders, however the asset growth may be financed. Moreover, scholarly research has identified "a negative persistence in fund performance [for large funds] supporting the hypothesis that funds can become large and inefficient." (152) Indeed large equity funds sometimes "close to new investors if the fund becomes too large to effectively deploy capital." (153)

   The fact that fund asset growth financed by 12b-1 fees fails to yield tangible benefits for fund shareholders has a serious legal ramification. Cost efficiency is Rule 12b-1's touchstone. Prior to adopting or renewing a fund's 12b-1 plan, fund directors are required to consider "whether the plan has in fact produced the anticipated benefits for the company and its shareholders." (154) After all, it would be a breach of fiduciary duty for directors to take and spend shareholder money with no honest, reasonable expectation that spending the money would leave shareholders better off. Twenty-six years of experience with Rule 12b-1 has failed to generate a single competent, objective study concluding there is a positive net financial return flowing to shareholders derived from the 12b-1 marketing investments paid for by those fund shareholders. This cold reality ought to trouble a conscientious mutual fund director called on to approve a 12b-1 plan. So should Dr. Walsh's damning observation:

   Although it is hypothetically possible for most types of funds to generate sufficient scale economies to offset the 12b-1 fee, it is not an efficient use of shareholder assets.... Fund advisers use shareholder money to pay for asset growth from which the adviser is the primary beneficiary through the collection of higher fees. (155) Predictably, the fund sponsor's trade association and lobbying organization attacked Dr. Walsh's scholarly effort, complaining to the SEC's Chairman that it "unfortunately presented an unbalanced view." (156) In reality, what was unbalanced was the ICI's criticism, not Dr. Walsh's analysis.

   When it promulgated Rule 12b-1, the SEC specifically encouraged directors to evaluate the "possible benefits of the plan to any other person relative to those expected to inure to the company," "the effect of the plan on existing shareholders," and the success of the plan. (157) Lori Walsh's findings are pertinent to each of these factors and ought to be disturbing to any fund board member conscientiously seeking to honor his or her fiduciary duty under Rule 12b-1. Predictably, the fund industry's lobbying organization, the ICI, criticized Dr. Walsh for leaving readers with "a negative impression about the impact of 12b-1 fees on fund shareholders," (158) which she did, and for disregarding "how 12b-1 fees are currently used," (159) which she did not do. On the latter point, the ICI attacked Dr. Walsh for not accepting that 12b-1 is today used mainly in ways not envisioned when Rule 12b-1 was promulgated, principally as a means of funding sales of load funds through the spread load mechanism discussed above. This criticism is unfair.

   In truth, after finding that the original justifications given for Rule 12b-1's adoption held no water, Dr. Walsh evaluated the use of Rule 12b-1 as a load funding device. She found Rule 12b-1 plans to be "an inappropriate means" for use by investors to pay load fees. (160) First, she criticized the lack of transparency that makes it impossible for a fund shareholder to calculate the load actually being paid via 12b-1 either annually or in the aggregate. (161) Second, she pointed out that, since 12b-1 charges are assessed at the fund level, shareholders with large accounts are assessed higher dollar charges per account than shareholders with smaller accounts. (162) In contrast, under the normal front-end load sales charge system, economies of scale in selling effort are reflected by breakpoints, which reduce the load as the amount purchased increases. Finally, Dr. Walsh noted that the "opacity" of fee charges fostered by 12b-1 makes it difficult for shareholders to monitor or act on the conflict that exists between the fund's adviser and its shareholders. (163) In sum, the ICI's attack on Dr. Walsh's analysis and findings was groundless. While it is true that 12b-1 fees are harvested today for purposes not clearly foreseen in...