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News August 28, 2006 Issue

Mutual Fund Boards Digging Into 12b-1 Fees

How much are we paying? What are we getting?

Why are we charging a 12b-1 fee on a fund that is closed to new investors?

Should our B shares convert to A shares after a certain number of years?

According to several industry lawyers, mutual fund directors are asking tougher questions and demanding more information about the level of 12b-1 fees paid by their funds and the services the funds receive in return.

Boards "are under increasing pressure" to determine whether 12b-1 fees are reasonable in relation to the services being provided, said Bingham Dana partner Hardy Callcott. They "want a full accounting" of exactly what the fundís 12b-1 fees are paying for. "There is definitely a sense that the adviser and the CCO need to get more information than they would have gotten three or four years ago from the intermediaries about what exactly [the fund] is getting in return for the 12b-1 fees," he said.

Boards "are a little more skittish on 12b-1 fees than they have been in the past," agreed Diana McCarthy of Drinker Biddle. "I think thereís a lot more scrutiny of 12b-1 fees just generally. Iíve seen some of my clients roll out 12b-1 fees on new classes of shares and not implement them."

Dechert partner Robert Helm suggested that the heightened scrutiny reflects the fact that boards have been more sensitive to the wide range of regulatory issues surrounding 12b-1 plans. "Boards have been made aware of the fact" that the rules that govern payment of service fees and payment of 12b-1 fees "are rather complicated" and "impose on boards certain obligations," said Helm. "Is this a new requirement or a new trend? No, it is not new." But he agreed that directors are focusing on 12b-1 more intently. "They probably are doing a better job," he said. "They probably are more aware of what can go wrong . . . . and are making sure as directors that they have more fully-formed knowledge of the actual practices that their distributors are engaged in . . . . The truth is, thereís probably a better understanding of this."

Like the other lawyers, Helm reported that boards are demanding more information about 12b-1 fees and seem to be focusing more intently on what types of services are being obtained under the 12b-1 plan. "Directors are probably making a concerted effort about where the money goes and what it pays for," he said. However, as boards investigate, they may be pleasantly surprised by what they learn, Helm added. Itís not just a matter of "money going into a salesmanís pocket."

Kirkpatrick & Lockhart partner Robert Zutz said that he is aware of a number of instances where boards have recognized that 12b-1 fees are receiving "higher scrutiny" and therefore are "probing even more than perhaps in the past with respect to these arrangements." Boards, he said, "are trying to make sure that they are dotting the iís and crossing the tís." Zutz said that heís recently worked with a number of boards that have requested "more detailed reports" from their funds. "The requests that they make are evolving over time and are responding to industry developments," he noted. For example, some boards are asking for more granular detail on distribution expenditures, such as "a breakdown of the actual underlying recipients." This practice, he noted, varies from fund group to fund group. "If youíve got a really big fund group with 500 selling group agreements," the board may not be able to review all those line items, he explained. In contrast, smaller fund groups with fewer relationships "will in some cases want to see those breakdowns."

Zutz also reported that some boards have asked for analysis of 12b-1 data above and beyond the quarter-by-quarter reports required to be provided under Rule 12b-1. "Iíve seen a couple of fund boards ask for additional cumulative information," such as year-to-date information. Moreover, he said that some boards are asking for comparisons to last yearís year-to-date information, and for other type of "trend" information.

Whatís driving the increased scrutiny?

In recent years, a number of plaintiffsí class action suits have alleged that funds have paid excessive fees to their management companies. These suits typically include a charge that the funds in question paid improper 12b-1 fees.

For example, in the Eaton Vance Mutual Funds Fee Litigation, the plaintiffs alleged that the fundsí directors "ignored or failed to review written reports of the amounts expended pursuant to the Eaton Vance Funds Rule 12b-1 Plan, and the information pertaining to agreements entered into pursuant to the Rule 12b-1 Plan, on a quarterly basis as required and hence failed to terminate the plans and the payments made pursuant to the Rule 12b-1 Plan, even though such payments not only harmed existing Eaton Vance Funds shareholders, but also were improperly used to induce brokers to breach their duties of loyalty to their prospective Eaton Vance Funds investors."

More generally, thereís an increased trend towards board independence. C. Meyrick Payne of Management Practice noted that under Rule 12b-1, the decision about whether to keep a 12b-1 plan was "remanded exclusively to the independent directors." In other words, under the rule, a fundís independent directors must decide, on an annual basis, whether to approve the continuance of the 12b-1 plan. "For years, that decision power was essentially played down," said Payne. "It is only since all the things that have happened," such as Sarbanes-Oxley, the market timing scandal, and the advent of a "stronger SEC" that directors "have started to focus in on the places that they have decision authority and are actually exercising their authority to do that." And, Payne added, boards are seeking their own guidance on such issues, by "looking for analysis separate and distinct from the management company."

Where does all the money go?

In thinking about 12b-1 fees, it is useful to categorize them in four general buckets:

  • brokersí initial sales compensation;
  • brokersí ongoing shareholder services;
  • traditional marketing charges; and
  • expenses of the fundís own distributor.

Initial sales compensation. A relatively large chunk of all 12b-1 fees collected by funds is used to finance the payment of initial sales compensation to broker-dealers. According to a February 2005 Investment Company Institute study on the use of 12b-1 fees, 40 percent of all 12b-1 fees are used for this purpose. The mechanics vary, but typically the fundís distributor fronts the cost of paying the initial sales compensation to the selling broker and then recoups that amount in the form of 12b-1 fees received over time. Alternatively, the distributor may take out a loan to front the initial sales compensation and use the incoming 12b-1 fees to pay off the loan. Or, the broker may not receive any upfront sales compensation and instead be paid for his initial selling efforts by 12b-1 fees collected over time.

Ongoing shareholder servicing. Under the NASD sales cap rule, up to 25 basis points of a 12b-1 fee may be used for service fees, which the NASDís rule defines as "payments by a fund for personal service and/or the maintenance of shareholder accounts." This, according to the ICI study, is the most common use of 12b-1 fees, with 52 percent of all 12b-1 fees being used for this purpose.

What exactly are these "ongoing shareholder services?" The ICI, in a May 2004 comment letter to the SEC, listed the following types of activities as examples: "processing shareholder transactions, maintaining shareholder records, and mailing account statements, fund communications, and reports to shareholders." Additionally, the group noted that the broker serves as the "point of contact" with the fund.

According to Adviser Compliance Associates senior principal consultant Carl Rizzo, this is the area in which directors have been asking the toughest questions. Directors, he said, are asking: "What are we paying for here? Is it shelf space? Are there real shareholder services that are being provided? Or is this a Ďgravy trainí for certain brokers?" Directors, he said, "really drill into it," demanding clear and accurate descriptions of the services being provided and spending more time weighing the reasonableness of what has been provided against the amount paid. "Some of the more vigilant boards with proactive counsel are saying, ĎLetís learn a little more about this.í"

Are boards right to be suspicious about shareholder servicing fees? "Trail commissions," as theyíve come to be known, are, "for all practical purposes just another form of continuing sales compensation," noted Mayer Brown partner Kathie McGrath. She added, however, that service fees compensate brokers for holding the accounts, which does involve a cost and which takes a burden off the fundís transfer agent. "Maintaining shareholder accounts that hold mutual funds and answering the occasional question about them probably is something that is worth paying for," she said.

In Zutzís view, paying service fees of up to 25 basis points "is for better or worse a routine industry practice." He pointed out that it is "obviously explicitly permitted by NASD rules and certainly permissible under Rule 12b-1." Zutz said that he was not aware of fund boards questioning the propriety of service fees. "Iíve not personally, in my narrow slice of the universe, heard of people challenging the propriety of service fees of up to 25 basis points," said Zutz. "It seems to be an extremely common industry practice for a number of years."

Of course, he added, "the broker really needs to be offering the services." But the extent to which customers utilize those services obviously varies. "Some clients probably never call the broker other than to make the purchase or sale," he said. "Other clients are probably calling the broker every day." In any event, "if you want somebody to help you out and give you some advice, they have a going rate."

Traditional marketing charges. The relatively small amount of 12b-1 fees that are used to pay for print advertising and traditional marketing materials is generally viewed as non-controversial. According to the ICI study, only two percent of all 12b-1 fees are used for promotion and advertising purposes.

Payne said that he suspected that the percentage of 12b-1 fees being used for such expenses might be larger. "I donít think itís that small a bucket," he said. In his estimate, the amount of 12b-1 fees being paid for marketing materials is greater than two percent but "not more than 25 percent." The reason the percentage might be higher, he said, is because of what he views as an increased emphasis on "brand-building" among fund complexes. "I think the great trend in the industry is to build brands," he explained. "It costs real money to build brands." Brand-building campaigns might include television ads and public relation campaigns. "I think directors are concerned about how that money is being spent on building the brand," he said. The money to pay for such marketing "comes from many different pockets," with "the most important pocket" being 12b-1 fees. Brand-building is "hugely important" Payne added. "Somebodyís got to pay for it."

Expenses of the fundís own distributor. Lastly, an estimated six percent of 12b-1 fees are used to pay the fundís own underwriter, according to the ICI study. This amount is used, for example, to pay salaries of the distributorís internal sales force (a.k.a. wholesalers).

SEC guidance. Many in the industry would agree that the current SEC guidance on 12b-1 fees, originally published in 1980, is outdated. In February 2004 the SEC sought comment on whether shareholder account-level service charges should be imposed in lieu of 12b-1 fees, or whether Rule 12b-1 should be rescinded. Industry commenters were uniformly opposed to both notions. However, a number of commenters suggested that the SEC issue updated guidance for fund boards on how to evaluate 12b-1 fees. For example, the ICI, in its May 2004 comment letter, suggested that with respect to shareholder and administrative services being obtained with 12b-1 fees, boards be instructed to consider factors such as the nature of the services to be rendered and whether the fee for these services is reasonable in relation to the value of those services and the benefits received by the fund and its shareholders, as well as the costs that would otherwise be incurred by the fund or payments that the fund would be required to make to another entity to perform the same services.

The ICI also suggested that the SEC issue guidance that boards, when evaluating the use of 12b-1 fees to pay for initial sales compensation, consider competitive conditions, such as comparative 12b-1 fees. The group recommended that boards consider the cost of a 12b-1 plan to the fund and its shareholders, including the effect of 12b-1 payments on the fundís expense ratio and investment performance, and other factors.