From: John H. Robinson
Nancy M. Morris, Secretary
Re: File Number 4-538 SEC Request for Public Comments Regarding 12b-1 Reform
Dear Ms. Morris:
This letter is being submitted in response to the Security and Exchange Commission’s request for public feedback regarding the Commission’s plan to reform SEC Rule 12b-1. In this letter, I advance the position that Rule 12b-1 should not be repealed, but that certain aspects of the rule may merit reform.
I. Misperceptions Regarding the Origin and Intended Application of Rule 12b-1
To begin, I would like to address recent public comments made by a number of SEC senior staffers, including SEC Chairman Cox and Investment Management Division Director Andrew Donohue, to the effect that Rule 12b-1 fee is in need of reform because it is outdated and is no longer applied in the manner in which it was intended when it was adopted in 1980. This is the mantra that is most frequently advanced by opponents of 12b-1 fees. Unfortunately, this perception is factually incorrect and does not accurately reflect the original intent and subsequent history of the rule. Proof of this assertion is found in the attached two attached documents detailing the administrative history and evolution of Rule 12b-1. The first document is a letter from the American Bar Association’s Section on Business Law which was submitted to the SEC in its first request for public comments on this issue in 2004. The second is the January 27, 2004 Congressional testimony of Lipper, Inc. executive Jeffrey Keil before the U.S. Committee on Governmental Affairs Subcommittee on Financial Management, the Budget, and International Security.
With respect to the origins of Rule 12b-1, the historical record shows that the concept of using fund assets to attract investors through advertising was born in the wake of the 1973-74 bear market out of pleas from the mutual fund industry for support during a time when funds were experiencing net outflows. However, an important fact that is overlooked by Rule 12b-1 opponents is that by 1980 the stock market had recovered and mutual fund assets were rising rapidly. By 1980, the SEC was aware the mutual fund outflow crisis had long ended, but enacted Rule 12b-1 anyway in an effort to foster competition by lending support to the growing fledgling no-load fund industry. As described in both the ABA and Lipper documents, it is important to note that the SEC, in adopting Rule 12b-1, intentionally did not limit the future potential applications of 12b-1 fees because it hoped the rule would lead to further innovation and competition at and among the mutual fund companies which would ultimately benefit investors both in terms of lower expenses and broader choices. Clearly, the SEC did not intend, as opponents of the rule claim, for Rule 12b-1 to be merely a temporary measure.
In reflecting upon the evolution of the fund industry in the 27 years since Rule 12b-1 was adopted, it is readily apparent that the rule did indeed foster tremendous competition and innovation. Investors now have literally thousands of mutual funds from which to choose. Further, for those who argue that Rule 12b-1 failed in its goal of lowering fund expenses, it is significant to note that the rule facilitated the rise of the so-called “fund supermarket platform”. Today, legions of cost conscious do-it-yourselfers utilize discount brokerage fund platforms, and, through them, have access to thousands of no-load mutual funds including literally hundreds of index funds – a sector of the fund industry where price competition has been particularly fierce.
A second aspect of recent public statements from SEC representatives which should be addressed is the implicit suggestion that reform is needed because the myriad applications of 12b-1 fees that have developed since 1980 somehow occurred under the radar of prior SEC administrations. Again, a review of the administrative history as presented by the ABA’s Section on Business Law letter and Mr. Keil’s Congressional testimony reveals that the SEC was actively involved at every step of the way in reviewing and approving each new application of the rule. Perhaps the most obvious example of this is the SEC’s adoption of Rule 18f-3 in 1995 which formally permitted mutual fund companies to issue multiple share classes of non-money market mutual funds. The SEC’s intent at the time was to offer investors choices in the ways in which they purchased advisor-distributed mutual funds, and, through 18f-3, it again succeeded.
More recent evidence of the SEC’s involvement in actively reviewing the merits of Rule 12b-1 is found in the SEC’s extensive 2004 review of the issue. Although certain reforms did arise from this review, after collecting thousands of comments from people and institutions on both sides of the debate, the SEC, under Chairman Donaldson, elected not to move forward with a proposal to repeal the rule. As a part of its 2004 consideration of the issue, the SEC also sanctioned an independent ad-hoc task force formed by the NASD to investigate and review “distribution arrangements, including fees paid pursuant to Rule 12b-1 under the Investment Company Act of 1940 and revenue sharing.” This 20 member task force included no-load and full service mutual fund representatives, brokerage executives, business school professors, and securities law attorneys. In its 2005 final report, the Mutual Fund Task Force specifically concluded that “many of the developments in distribution payments since the adoption of Rule12b-1 have benefited investors…” and that “the most important changes that the Commission should consider are those that make the costs and potential conflicts associated with mutual fund distribution more visible to the retail investor.” In other words, the focus of 12b-1 reform should be on improving disclosure rather than on eliminating 12b-1 fees altogether.
II. Consideration of the Potential Dangers of Ill-Conceived Reform Measures
One potential reform measure that appears to be under consideration by the SEC is the complete repeal of Rule 12b-1. It is important to consider the potential impact this measure could have on investors, fund companies, and the markets as a whole. Since the largest percentage of 12b-1 fees are paid to full service brokerage firms, it is reasonable to expect the group affected most by the change to be investors who have chosen to work with financial advisors in the retail brokerage environment. This group of investors has invested billions of dollars in an array of advisor-distributed share classes. Therefore, it is important to consider how the elimination of 12b-1 fees might alter the advisor client-relationships if the advisor was no longer receiving ongoing compensation for his services. Two changes would likely emerge. First, more affluent investors would probably be encouraged to migrate to investment advisory mutual fund wrap accounts (assuming the advisor is dual registered as both a registered representative and an investment advisor representative). Industry data suggests that such a change would likely result in a significant cost increase to the investor. Specifically, using the advisor-distributed share class with the highest ongoing service expenses, Class C shares, as an example, investors currently pay a 1% maximum ongoing 12b-1 fee. In contrast, the average annual fee for wrap accounts is 1.3% and rising (Source: Investment Advisor Association/National Regulatory Services 2005 joint publication, “Evolution Revolution”.) Part of this expense differential may be attributable to an unwritten general consensus that a 1% ongoing fee is a reasonable price to pay for a skilled advisor’s service and guidance. However, under many RIA wrap platforms, in order for the investment advisor to net a 1% fee, he must charge more than 1% to recoup administrative fees levied by the fund custodian. Alternatively, investors with smaller fund account balances and investors who are clients of brokers who are not dually registered would likely be forced to self-direct if they wish to continue to own mutual funds, since their advisors would no longer be paid to guide them. Further, one could reasonably expect some advisors to recommend their clients eliminate mutual funds altogether and migrate instead to commission based products. The benefit of such a migration is obviously debatable. Thus, it is intuitively predictable that the complete repeal of Rule 12b-1 would likely have an immediate negative impact on millions of retail investors in the retail brokerage distribution channel.
Additionally, it is important to consider the disruption the repeal of 12b-1 fees might have on mutual fund companies and the stock market as a whole. Again, it seems reasonable to predict that the greatest impact would be felt by those fund companies that rely on retail brokerage firms for distribution. Most advisor-distributed mutual fund companies with B and C share classes have lending agreements in place that enable them to front advisor compensation to the distributing wirehouses. These loans are secured by pledges of future 12b-1 fees. Clearly, there is a danger that the sudden repeal of Rule 12b-1 could lead to financial crises among certain fund companies, since the companies would no longer be permitted to repay their loans out of fund assets. Among the no-load fund companies, it could also be argued that the repeal of Rule 12b-1 might lead to financial hardship at smaller mutual fund complexes that rely on 12b-1 fees to compensate discount brokerage fund supermarkets for inclusion in their platforms. Thus, another potential detriment of the repeal of Rule 12b-1 might be diminished investor choice. Although the impact such a change might have on the overall stock and bond markets is difficult to predict, it is plain to see that repeal of Rule 12b-1 has the potential to be disruptive as fund companies struggle to adapt or, in some cases, fold themselves out of existence. Mass liquidations and lower investor demand in general could potentially trigger significant declines in the stock and bond markets.
A second change that is being proposed regarding 12b-1 fee reform is to shift collection of the fee from the fund level to the account level. The benefit of this proposal is that it would make 12b-1 fees more transparent to investors, just as they are under wrap fee arrangements. Although the prospect of greater transparency is obviously appealing, there are a number of problems with this approach. First, and most importantly, from the investor’s perspective, such a move would have adverse tax consequences as many investors would be forced to sell shares to pay the fee each month or each quarter. The sales of these shares would be each be taxable events that must be reported on the investor’s tax return. One can imagine how complex and cumbersome this might be for an investor who has built an asset allocation model consisting of 10-15 different mutual funds. Second, it is far more efficient for the fund companies to collect the fees at one time from fund assets and distribute them proportionally to the wirehouses than it would be for the wirehouses to collect the fees from each individual account. As Paul Haaga, vice chairman of Los Angeles based Capital Research and Management Co. stated in a recent interview, “we [the fund companies] have no incentive to set it [12b-1 fees] higher than necessary and every incentive to set it low. The cost of collecting the fee through advisers would be higher. They are going to receive it, so they’re going to set it higher.”
In terms of groups that might benefit from the repeal of Rule 12b-1, it is reasonably predictable that large no-load fund complexes, mutual fund research and rating services, certain media publications, and other institutions serving the do-it-yourselfer investor market place would likely see market share increases and/or revenue gains. However, if the primary focus of the reform movement is the retail investor, it is difficult to envision how individual investors would inure any great benefit in terms of cost savings or broadened choice. Similarly, in the event that the collection of 12b-1 fees is shifted from the fund level to the account level, it seems likely that the overall investor costs may actually rise. Confronted with this prospect, investors might be wise to openly question whether this means of creating transparency is worth the added cost.
III. Practical Reform Measures for Consideration
Although the focus of this discussion thus far has been in pointing out the problems and dangers of radical reform or repeal of Rule 12b-1, an objective review of current applications of the rule suggests that there may be some areas that could benefit from reform. Potential reform measures are as follows:
IV. Closing Remarks
In closing, I sincerely appreciate the opportunity to provide feedback to the SEC on this important issue. Recent public remarks by several senior SEC staffers and by several of the panelists who have been invited to speak at the upcoming June 19, 2007 Rule 12b-1 round table discussion suggest that the decision to either repeal or dramatically reform Rule 12b-1 may have already been made. For the reasons outlined above, I hope that is not the case. I would also like to suggest that the SEC include at least one financial advisor among its panelists, since the advisor-client relationship is on the front line of the debate. As a financial advisor, I believe that including an advisor on the panel would add a unique perspective and would add balance to some of the panelists on the opposing side of the debate. Thank you for your consideration.
John H. Robinson