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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Opening Statement at the SEC Open Meeting—12b-1 Fees


Chairman Mary L. Schapiro

U.S. Securities and Exchange Commission

Washington, D.C.
July 21, 2010

Good morning. Today, the Commission will take up two matters:

First, we will consider proposals that would restructure the way mutual funds pay for the marketing and selling of their shares.

Second, we will consider whether to adopt rules designed to provide clients with greater information about the professionals who provide them with investment advice.

But, first we begin with the marketing and sale of mutual funds.

Currently, rule 12b-1 governs the way a mutual fund can use fund assets to market and sell the fund to investors. That rule also sets out the way in which broker-dealers can be compensated from the fund for their sales efforts.

Unfortunately, the rule has led to confusion, lack of understanding, and in some cases, some investors paying proportionately more than other investors.

Our proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds. In particular, it would impose limits on the cumulative sales charge—or sales load—that an investor pays.

It also would eliminate the so-called "hidden sales charges" that 12b-1 fees can represent by, for the first time, disclosing and regulating these fees as sales charges. And, it would enable broker-dealers to compete for investors by charging mutual fund sales loads at rates they set themselves—rather than at a uniform fee set by the fund.

Rule 12b-1 was borne of a period in the late 1970s when funds were losing investor assets faster than they were attracting new assets. And, self-distributed funds were emerging, in search of ways to pay for necessary marketing expenses.

At the time, it was thought that investors would benefit if a fund could "grow" by using some of its own assets to market itself and make distribution payments. This, it was believed, would result in improved economies of scale and, ultimately, lower expenses.

Even though funds last saw such sustained conditions nearly thirty years ago, rule 12b-1 has remained intact, even though it was premised on the idea that a fund could use 12b-1 fees as a short-term solution to the problem of shrinking fund assets.

The imposition of 12b-1 fees, however, has been anything but short-term. In fact, very quickly these fees evolved from payment for advertising and marketing to an alternate form of compensation—or sales load—paid to intermediaries selling fund shares. In addition, 12b-1 fees compensate broker-dealers and other fund intermediaries for ongoing marketing and related services including recordkeeping, transfer agency services and overall investor education and consultation.

Despite the evolution in the use of 12b-1 fees—and their emergence as a pervasive element of mutual fund intermediary compensation—the SEC's rules have not evolved. In my view, the regulatory scheme should be squared with the current mutual fund distribution framework—and investor expectations of how they pay for fund sales loads and services.

In essence, 12b-1 fees have become a means to pay broker-dealers and mutual fund intermediaries indirectly out of fund assets, rather than directly out of the investor's pocket. And as the use of 12b-1 fees has evolved, the aggregate dollars paid have ballooned. These fees amounted to $9.5 billion in 2009, nearly $12 billion in 2008 and exceeded $13 billion in 2007—compared to just a few million dollars in 1980 when they were first permitted.

I think that, despite paying billions of dollars, many investors do not understand what 12b-1 fees are. It's likely that some don't even know that these fees are being deducted from their funds or who they are ultimately compensating. In addition, investors may not realize they are paying the equivalent of sales loads or commissions—at a rate of ¾ of 1 percent a year—over the lifetime of their investment. Nor do investors realize that 10, 15, 20 or more years down the road, they may still be compensating the sales person who sold the fund.

As a result of all of these factors, 12b-1 fees have been disparaged as a confusing part of the mutual fund distribution scheme—one that obscures the actual amount a fund investor is paying to intermediaries and one that could result in some investors paying proportionately more sales compensation.

Today's proposals are intended to provide clarity and fairness to a mutual fund distribution system that has become confusing and potentially anti-competitive. At the same time, they are designed to preserve investor choice in selecting distribution methods and to minimize operational disruptions and expensive systems changes.

Today's proposals consist of several core elements.

First, this rule would impose greater equity in the way sales charges are passed along to investors and it would cap the aggregate sales load amount that could be deducted from fund assets.

Investors could continue to pay a sales load either up-front at the time of purchase or over time through the deduction of fund assets paid to the broker-dealer who sold the fund shares. However, the proposals would cap the aggregate amount a fund investor could pay in sales loads over time.

As such, the investor would stop paying the ongoing sales load after a set number of years—and that number of years would be spelled out for investors in writing on their confirmation statements. In addition, sales loads paid over time could not exceed, on a percentage basis, the maximum sales load the investor would have paid if the load had been paid up front at the time of purchase. That means if I was buying shares of a mutual fund that charged a 4 percent up-front sales charge, then that fund could not deduct more than 4 percent over time.

Second, this rule would improve the disclosure provided in a fund's prospectus regarding the fees that are deducted from a fund's assets to pay for sales loads and distribution expenses. Under the proposals, the term "12b-1 fee" would no longer be used. As many have argued, the term hinders rather than furthers direct communication and understanding by investors.

Instead, funds would be required to separately disclose the percentage of fund assets being paid to broker-dealers—and that amount would be listed as an "ongoing sales charge." In addition, funds would separately disclose the percentage of fund assets used as a marketing and service fee, from which third parties are often paid for ongoing services provided to fund investors. The maximum marketing and service fee would effectively be limited to 25 basis points per year.

Third, this rule would require mutual fund confirmation statements to clearly convey that some fees will be deducted from the fund each year to compensate the professional selling the fund. The fund confirmation document—which an investor receives from a broker-dealer confirming a trade—would have to show the percentage of the up-front or ongoing sales charge.

In addition, it also would have to disclose the amount of sales and marketing fees expected to be paid and would have to state that management and other fees will be deducted from the fund and thus indirectly paid by the investor. Such clear disclosure should greatly improve investor understanding that money is being deducted from their fund investments to pay fund intermediaries on an ongoing basis.

Fourth, this rule would pave the way for a new form of improved competition by permitting broker-dealers to sell funds at sales loads that they choose. Rather than sales loads set by the fund in its prospectus, broker-dealers could compete with others—thereby likely leading to lower charges. I believe that mutual fund investors, like all consumers, want the ability to engage in comparative shopping based on price.

Together, today's package of proposed reforms would modernize and improve the mutual fund distribution framework, while hopefully leveling the playing field for investors. I thank the staff for their hard work and creative thinking on this proposal and look forward to hearing more detail about this important, investor-oriented initiative.

But first I would like to thank the many staff members who contributed to this important proposal. First and foremost, I would like to thank Division of Investment Management Director Buddy Donohue, who was a driving force behind the crafting of this initiative. Working with Buddy were Bob Plaze, Hunter Jones, Diane Blizzard, Thoreau Bartmann, Daniel Chang and Thu Ta. In addition, this core team received the strong and able assistance of Paula Jenson, Josh Kans and Ignacio Sandoval in the Division of Trading and Markets; David Becker, Meridith Mitchell, Lori Price, Jill Felker and Sarah Buescher in the Office of the General Counsel; Henry Hu, Harvey Westbrook, Lori Walsh and Woodrow Johnson in the Division of Risk, Strategy, and Financial Innovation; Gene Gohlke in the Office of Compliance Inspections and Examinations; and Lori Schock, Rich Ferlauto and Marc Sharma in the Office of Investor Education and Advocacy.

Now I'll turn to Buddy Donohue to hear more about the staff's recommendation.


Modified: 07/21/2010