May 7, 2004
May 5, 2004
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 5th Street, NW
Washington, DC 20549-0609
RE: Comment to Release No. IC-26356 File No. S7-09-04
Dear Mr. Katz:
Our broker/dealer is a limited broker/dealer primarily offering mutual funds and variable annuities for investment in 403b and 457 retirement plans for Public School Districts. We execute all transactions on a Check and Application basis. The majority of the transactions are funded on an ongoing basis through payroll deduction.
The proposed rule to amend the rule under the Investment Company Act of 1940 that governs the use of assets of open-end management investment companies funds and prohibit funds from paying for the distribution of their shares with brokerage commissions would not eliminate the conflicts of interest sought by your proposed remedy and may instead be harmful to funds and fund shareholders.
Please allow me to elaborate on your specific comments:
Are our concerns about this practice justified?
No, we do not share your concern. Mutual Funds are designed to be long term investments. Our job as financial professionals requires us to closely monitor and evaluate the soundness of our clients investment decisions. Our registered representatives or the broker/dealer are often the first called when a client has a question about his/her mutual fund, its dividends or expenses. 12b-1 fees compensate the broker/dealer and the registered representative for our ongoing service and advice. In fact, for some share classes, 12b-1 fees are the only compensation received, as there are no other commissions paid.
Our registered representatives are required to meet with their clients, at a minimum annually, to review the asset allocation of their clients accounts. The clients objectives or financial situation may have changed and the registered representative may need to liquidate a fund and reinvest the proceeds at NAV into a new fund. Most of the time, the only compensation is the 12b-1 fee. On average the annual 12b-1 fee paid is approximately 25 basis points per 1000. So, if we have a client with a balance of 10,000 in a fund, we would receive 25. We believe that amount to be a reasonable fee. Our clients expect us to be compensated for ongoing service and investment reviews. On the other hand, if a purchaser of mutual funds believes that he/she does not ever need the active services of a broker, their option has always been to purchase a no load product even though no load mutual funds contain the very same ingredients of expense, which when aggregated impact the overall return to the client and hold the very same potential for conflict.
In addition, 12b-1 fees allow investors to select among the various classes of mutual funds and choose the manner in which they wish to pay for distribution and related costs over time, either in whole or in part, rather than in a single up-front sales commission. Depending on each fund and an investors individual situation, paying distribution costs over time could potentially be a very cost effective decision for the investor.
Are there alternative measures that we could take to address the use of brokerage commissions to finance distribution?
The SEC could mandate a fixed or set administrative fee, universally applied, to all fund classes which would remove competitive conflicts and compensate for required services. In addition, the SEC should make the disclosure more user friendly through simplifying the language and increasing the size of the font.
Would brokerage commissions be reduced by eliminating the use of commissions to pay for distribution? Would there be greater competition in commission rates?
A key premise of the SEC recommendation is the statement that Selling brokers appear to have significant leverage over funds because the number of distribution channels is limited. This is true of the larger nationally based broker dealer organizations. It is not true for the small broker dealer which makes up a significant percentage of the distribution channel.
Please consider the consequences. If you increase the costs involved in more disclosure or eliminate the incentive for the registered representative to service the account, the client is the one that pays. Since the broker dealers can not reduce their margins the potential exists for the industry to shift their product mix to products that would serve the best interest of their clients but would also compensate them for the service to their clients and the investment companies to remain competitive would need to increase to maximum permitted levels the commission rate paid by the client to pay for the services rendered.
If we ban this practice, would the primary effect be to increase brokers demands on advisers to make payments out of their assets, i.e., revenue sharing? Are we correct in our assumption that properly disclosed revenue sharing payments present more manageable conflicts for funds and broker-dealers?
Yes, we believe that banning the 12b-1 fees will result in the industry substituting this revenue shortfall with increased demands on the advisors to revenue share thus increasing the internal administrative and management fees within the mutual fund. What will happen will be the further elimination of the small broker/dealer from the market place and a further increase in the dominance of the larger firms, reminiscent to the development of the pre Theodore Roosevelt industrial trust model of the early 20th century with the larger firms commanding financial arrangements from the advisors at the expense of less leveraged smaller firms.
Paradigm Equities does not take exception with providing enhanced disclosure to the investor. We share the belief that such disclosure can only add to investor confidence in the fairness of our investment marketplace. However, what does concern us about this proposal and indeed most of the current client disclosure materials is the complexity and lack of clarity in the presentation to the client, and specifically as this proposal is written the fact that it places the burden on the broker/dealer but may not mandate equal compliance on the sponsors to provide a resource for the required information.
If our assumption is incorrect, should we take additional steps to address revenue sharing concerns? If so, what steps should we take?
Increase and revise the disclosure requirements concerning the use of brokerage commissions to pay brokers for selling fund shares in the Funds prospectus. The language should be in plain English with hypothetical examples. The information should be provided in the beginning of the prospectus, the SAI, and the annual reports. Enumerate and disclose the compensation amount and the administrative advisory fees within the mutual fund companies and standardize the fee structure for easy comparison among funds and the long range effect of these fees on performance.
The effect this proposed rule would have on the financial industry as a whole from the broker/dealer view point would be the added financial burden to pay administrative sales support to comply with the added regulatory requirements at the same time the industry would experience reduced income.
For example, two years ago, the financial industry was required to provide privacy notification to all customers of the broker dealer. The cost of postage, paper, and manpower increased our expenses by thousands.
Last year, 17a-3a17 was implemented requiring broker/dealers to communicate and notify each customer within 30 days of opening an account, changing an address, material changes in account information, and within 36 months of the last change, all account information. Again, the new rule requirements increased the broker/dealer expenses by thousands.
This year, new advertising disclosure rules, which required the broker/dealer to re-submit all previously, approved advertising and sales literature for review of the new disclosure requirements the new requirement to implement the National Do-Not-Call requirements and the technology to support the requirement the breakpoint survey and audit and electronic communication oversight. All without any revenue increase.
Finally, the proposed rule point of sale disclosure, we fear will financially impact the industry, including product sponsors/issuers to the extent that may potentially increase commission and/or internal fees in order to compensate for the impact. Compliance with the Proposed Rules would require extensive changes to existing software systems, and a cacophony of procedural and structural changes. The industry has been required to absorb cost related to AML customer identification and the new 17a-3a17 books and records customer notification requirements. The programming, technology, equipment, information resource and financial impact to the broker/dealer required to comply with this proposed rule has not yet been determined.
The SEC estimates that the one-time and annual cost to implement both of the Proposed Rules would total about 781,000, on average, per broker-dealer with an annual cost thereafter of about 540,000, on average, per broker-dealer. Did you consider the small broker/dealer? I fear not. Though actual costs would vary widely among small broker-dealers depending upon the capabilities of their internal or external data processing systems and arrangements, the financial impact to comply with the numerous proposed rules could put small broker/dealers out of business and effectively limit competition and investment resources in smaller, less populated communities. Is this the intent? Again, I think not. If you want to do away with 12b-1 fees then you need to find a replacement so investment professionals have the necessary income with which to comply with all the mandated communications which we must send to our clients.
We oppose the elimination of 12b-1 fees as we provide a valuable service to our clients with ongoing advice on their investments. Do attorneys, doctors, CPAs stop getting paid for future advice and service? We think our work is just as important. We think the proposal will do more harm than good. Our broker/dealer takes our responsibility very seriously.
We are in full agreement that there needs to be some clean up in the mutual fund industry. It is well established that there are companies who have done some unethical things. The role of regulators has always been to ensure that proper disclosure is made so that the investing public can make informed decisions. It is then up to that public to decide what they want to purchase, from whom they want to purchase, and how much value they place on the service provided. Cleaning up the conflicts of interest and behind-the-scenes flow of money that has plagued our industry for some time would clearly fall within that realm. But prohibiting the payment of 12b1 fees, legislating or regulating fees and how they can be charged to an informed client, or dictating how a particular relationship can and can not be structured goes far beyond that scope and violates the most basic principals of our free enterprise system.
We hope that the SEC, other regulators, and our legislators can look beyond the current political frenzy that is taking place in the wake of the recent corporate and mutual fund scandals, financial analyst betrayals, and past regulatory laxity and use sound judgment to avoid solutions that may cause problems far worse than the original problems themselves.
We are here to provide a fair and ethical service to our investors, please dont punish the entire industry for the wrongdoing of the few. Investigate and punish the guilty. This alone would do more to build investor confidence of the Supervisory and Regulatory oversight process than the elimination of customer service this proposed rule may cause. Thank you for your consideration to this response and request.