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12b-1 R.I.P.?

May 11, 2011

The SEC has announced that it will turn its attention back to 12b-1 reform this summer. That’s a grave disappointment to many in the industry who hoped that the 12b-2 proposal would die of neglect — with its most visible proponent, Buddy Donahue, now back in the private sector and with the Commission distracted by the avalanche of Dodd-Frank rulemakings.

Given that SEC Chair Mary Schapiro has expressed her support for change, it doesn’t seem too early to anticipate the demise of 12b-1 fees. Here’s a review of their brief history:

Inception | 12b-1 fees were born quietly in 1980, in the midst of a severe economic recession when funds were experiencing significant redemptions. The fees were designed to defray the expense of producing and distributing sales materials. With a larger marketing effort, funds could attract new assets, which would enable them to realize greater economies of scale — which, in turn, would make it possible for them to reduce fees to shareholders.

Expansion | Funds began to use the revenue from 12b-1 to compensate intermediaries for selling fund shares under “spread-load” arrangements. Since commission payments dwarf the costs of promotional material, 12b-1 fees were much higher than originally anticipated — often as high as 1% of assets per year.

Controversy | Critics soon began to question whether the fees mainly benefited fund managements, who earned higher fees from bigger funds. Consumer advocates argued that, despite prospectus disclosure, 12b-1 charges were “hidden fees” that were little understood by shareholders. Regulators responded by capping the fees and requiring greater disclosure.

Decline | The fund industry begins to abandon “spread-load” arrangements because of the high level of financial risk they entailed, while intermediaries started charging client fees for providing advice directly (often as part of a wrap program) rather than through a fund.

The end? | In 2010, the SEC proposes Rule 12b-2, which would replace 12b-1 fees with “marketing and service fees” and “ongoing service charges”, limited to 0.5% of assets annually and also subject to a lifetime cap.

But was it industry disillusionment or SEC action that played a bigger role in the demise of 12b-1 fees?

I’ll ask a panel of experts that question next week, in the Executive Roundtable kicking off the International Bar Association’s 22nd Annual Conference on the Globalisation of Investment Funds, to be held in Boston on May 15-18. I’ll be talking with Glenn R. Carlson (Brandes), Nadine S. Chakar (BNY Mellon), Susan Coté (Ernst & Young), Keith Hartstein (John Hancock) and Mike Niedermeyer (Wells Fargo) in a wide-ranging conversation about industry trends. If you’d like to join us, information on the event — including registration information — is available here.

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