March 24, 2004
Johnathan G. Katz, Secretary
RE: File No. S7 09-04
The SEC proposal to prohibit directed commissions is right on target. However, the SEC should go further and prohibit "soft dollar" transactions and revenue sharing arrangements.
For the most part, mutual funds are sold. Even the low-cost Vanguard group advertises in the general media and markets its funds selectively to its current stockholders. Besides advertising, other distribution costs include front-end loads, 12b-1 fees, contingent deferred loads, directed commissions, revenue sharing, and so on. Even soft dollar transactions, which are used ostensibly to buy research, could be used indirectly to pay for distribution.
Once it is accepted that mutual funds are sold, the question of who should pay the distribution costs arises. In its proposal, the SEC articulates the principle that an investor who purchases a mutual fund should pay the distribution costs associated with that purchase. Other investors should not bear these costs. This principle of fairness is to be applauded and should be applied whenever possible.
The distribution costs of mutual funds fall into two categories: those that cannot be allocated to individual shareholders and those that can be allocated. An example of the first type of cost is general advertising expense; an example of the second type is a front end load.
Directed commissions often represent a payment to a specific broker for selling the shares of a fund. In conformity with the fairness principle, any benefit that the selling broker receives should be borne by the buying stockholder and not by all shareholders in the fund. The difficulty lies in measuring the precise benefit to the broker of directed commissions and then in allocating this benefit over a broker's clients. The SEC's proposal to prohibit directed commissions eliminates this difficulty. If the distribution costs associated with directed commission are necessary to sell the shares in a fund, these costs will appear elsewhere in perhaps a 12b-1 fee or an increased load.
The SEC has asked for comment on whether funds should deduct that portion of 12b-1 fees that are associated with a particular client from that client's portfolio. The SEC should go ahead with this proposal, providing such a deduction does not create a taxable event. The SEC should further require that those 12b-1 fees that cannot be allocated be similarly expensed over all stockholders. In this way, each stockholder will know the dollar amount of 12b-1 fees charged to his or her account.
Directed commissions are just one way that a mutual fund can pay for distribution costs. If directed commissions were prohibited, a mutual fund might just turn to other techniques to pay for distribution costs. For example, a mutual fund manger could circumvent such a prohibition by substituting soft dollars for directed commissions. Of course, a manager would state that such soft dollars were used solely to purchase research, and it would be very difficult to establish that they were not so used.
A direct way to prohibit the use of soft dollars by investment advisors of mutual funds is to repeal Section 28(e) of the Securities Exchange Act of 1934. The SEC has argued that Section 17(e)(1) of the Investment Company Act of 1940 prohibits soft dollars but for the exception in Section 28(e). Repealing Section 28(e) would thus have the effect of prohibiting the use of soft dollars by investment advisors of mutual funds.1
Revenue sharing arrangements are similar to directed commissions. In a revenue sharing arrangement, the investment management firm distributes from its management fee a payment to a broker for selling the fund. Thus, all stockholders in the fund pay the distribution fee, not just the buying stockholder. Thus, if the SEC follows its fairness principle that buying stockholders should be charged with their direct distribution-related costs, the SEC needs to prohibit revenue sharing arrangements as well.
The SEC has asked whether it should prohibit 12b-1 fees. In my judgment, 12b-1 fees serve a useful purpose in that they can substitute for front end loads and ongoing advisory services, and thus should be retained. Nonetheless, the SEC should consider whether there should be some tightening on how 12b-1 fees are used. For example, should 12b-1 fees be used to pay for anything other than distribution costs?
The SEC is on the right track in articulating the principle that buying stockholders in a mutual fund should bear direct distribution costs, and not all stockholders in the fund. In implementing this principle, the SEC should prohibit not only directed commissions, but also soft dollars and revenue sharing arrangements.
The above analysis was based on meeting the narrow goal of charging distribution expenses to those who benefit from those expenses. Quite apart from this narrow goal, a convincing argument can be made to prohibit directed commissions and soft dollars on the ground that these practices are fraught with the potential for abuse: for example, excessive and unwarranted turnover that transfers the assets of a fund to the benefit of the investment advisor. The recent cases on market timing suggest that concerns about abuses in the management of mutual funds are not unwarranted.
Marshall E. Blume