VII. Half-hearted SEC regulation has hurt investors.
In 1980, the Securities and Exchange Commission caused considerable damage to mutual-fund shareholder interests by permitting mutual funds to pay for marketing and distribution expenses directly from fund assets.... Ironically, a December 2000 SEC study on mutual-fund fees and expenses concluded that 12b-1 fees essentially represented a net transfer from the fund shareholders to the fund management company.... In other words, mutual-fund advisers who charge 12b-1 fees take nearly the entire 12b-1 fee to the bank. The SEC continues to allow 12b-1 fees, even while explicitly recognizing the "inherent conflict of interest between the fund and its investment adviser."... Without the blessing of the SEC, fund directors could scarcely approve something as damaging to investors as 12b- 1 fees....
Shame on the SEC for allowing 12b-1 fees, shame on the directors for approving them, and shame on the mutual funds for assessing them. (257)
Recognizing that 12b-1 reflects a failed policy judgment is one thing, cleaning up the financial waste and legal mess it continues to generate is something else again. It turns out that turning off a spigot pumping nearly $12 billion annually into Wall Street's coffers is a task for which there is no constituency, even at the agency proud to bill itself as "[t]he investor's advocate."
A. The Failed "Clean Up" Effort--Rule 12b-1 Is "Untouchable"
In late 2002, the SEC Historical Society sponsored a roundtable discussion of notable Investment Company Act historical events, including 12b-1's birth and maturity. (258) In the course of those proceedings SEC Investment Management Division Director Kathryn McGrath referenced as "her biggest failure" her largely ineffectual efforts to "tackle and clean up 12b-1," in the 1980s. (259) The reason given for the failure is deeply disturbing, for it had nothing to do with legalities, public policy, or investor protection. It centered on political clout. McGrath lamented, "There was too much money flowing through 12b-1 fees to make it touchable." (260) This is a telling and deeply disturbing admission from someone who sought to reform a glaring problem while serving as a high SEC official. The money flowing to Wall Street through 12b-1 in the 1980s is a pittance compared to the nearly $12 billion generated annually by the rule today. (261) If 12b-1 was "untouchable" in the 1980s, one cannot be optimistic about reform today. All signs are that Rule 12b-1 has become politically sacrosanct. In Rule 12b-1 we have an "untouchable" rogue rule drafted and sponsored by the SEC, the so-called "investor's advocate," that annually is draining close to $12 billion from American investors, and there is no help in sight.
B. The SEC's Equivocation Over Directed Brokerages Payments for Distribution
When it adopted Rule 12b-1, the SEC took pains to make clear that both direct and indirect uses of funds assets to pay for distribution costs were covered by the rule. (262) This requirement has been honored in the breach. Over the years, the SEC turned a blind eye to various means used by the fund industry to evade the 12b-1 principle requirement: fund assets may be used to pay for distribution only if embodied in 12b-1 plans approved by fund board after a finding of likely benefit to the fund and its shareholders. (263)
In 2003, Congressman Richard H. Baker zeroed in on the fund sponsors' practice of padding funds' non-distribution expenses to generate cash to use to compensate brokerage firms for giving a preferred distribution sales push used to sell fund shares. Congressman Baker demanded information from the SEC relating to directed brokerage, soft dollar payments, and revenue sharing. (264) He sought information about "how these arrangements work, the impact of these expenses on investors, the legal issues raised by such arrangements with respect to Rule 12b-1, directors' obligations with respect to these arrangements, and the transparency of these arrangements and their associated costs." (265) Following the ensuing investigation, the SEC staff conceded that 12b-1 fee payments, though lush, still left the industry hungry for additional sources of funds to finance selling efforts:
[F]unds intensely compete to secure a prominent position in the distribution systems that selling broker-dealers maintain for distributing fund shares. Over the past decade, selling broker-dealers have increasingly demanded compensation for distributing fund shares that is in addition to the amounts that they receive from sales loads and rule 12b-1 fees. To meet this demand, fund investment advisers have increasingly made revenue-sharing payments to the selling broker-dealers, which may be a "major expense" for some investment advisers. Further, the allocation of fund brokerage to "supplement" the advisers' payments to broker-dealers for distribution generally is bundled into the commission rate and not separately identifiable or reported as 12b-1 fees. (266)
An SEC investigation completed in 2004 confirmed that various fund sponsors were inflating brokerage expenses to generate cash to pay fund sellers in order to boost sales. (267) Specifically, the Commission's staff "found that the use of brokerage commissions to facilitate the sale of fund shares is widespread among funds that rely on broker-dealers to sell their shares." (268) The potential for abuse was so obvious and serious that three securities industry groups, the ICI, the Securities Industry Association, and the Mutual Fund Directors Forum, each supported eliminating arrangements whereby fund brokerage payments are diverted to reward brokers for selling fund shares. (269) Concern over the practice culminated in the SEC amending Rule 12b-1 to make clear that fund managers were prohibited from using fund brokerage to compensate broker-dealers for selling fund shares. (270) Interestingly, the SEC's 7800-word release outlawing directed brokerage conspicuously failed to attack sponsors participating in the banned practice for breaching their fiduciary obligations to fund shareholders. (271)
A very plausible reason why the SEC chose not to take fund sponsors to task for breaching their fiduciary duties by inflating fund brokerage costs to pay for distribution outside of Rule 12b-1 is that in 1981 the Commission had given the green light to the practice. (272) As with Rule 12b-1's adoption a year earlier, the seemingly modest, innocuous action taken by the SEC in 1981, with the belief fund managers would discharge their fiduciary duties, paved the way for excesses and abuses harmful to investors. The SEC's long-standing indifference to directed brokerage is particularly disturbing, for it allowed devious fund managers to hide selling costs amidst brokerage charges, costs that are invisible to investors at the point of sale and which never show up in funds' expense ratios. (273)
C. More SEC Laxity-Using "Advisory Profits" to Pay for Distribution
One source of money to pay indirectly for distribution is brokerage fees; as discussed above, the SEC allowed this evasion of the rule through directed brokerage payments until quite recently. A more serious loophole relates to fund advisers paying "brokers out of their own pockets for selling fund shares ("revenue sharing')." (274) Fund retailers are hungry for this revenue sharing money. Consider this commentary from PFS Investments Inc., a member of the Primerica group of companies and a subsidiary of Citigroup, which markets mutual funds:
PFS Investments Inc.... endeavors to collect a mutual fund support fee, or what has come to be called a revenue-sharing payment, from the fund families we offer to the public. These revenue-sharing payments are in addition to the sales charges, annual service fees (referred to as "12b-1 fees"), applicable redemption fees and deferred sales charges, and other fees and expenses disclosed in a fund's prospectus fee table. Revenue-sharing payments are paid out of the investment adviser's or other fund affiliate's assets and not from the fund's assets. (275)
Since pre-12b-1 times, with at least tacit SEC approval, advisers anxious to increase asset growth and advisory fee income have allocated a portion of advisory profits to pay distribution charges. (276) The SEC gave the go-ahead to this slippery slope practice in its Release adopting Rule 12b-1:
If a mutual fund makes payments, which are earmarked for distribution, that is obviously a direct use of fund assets for distribution. If a fund makes payments, which are ostensibly for some other purpose, and the recipient of those payments finances distribution, the question arises whether the fund's assets are being used indirectly. The Commission's position has been and continues to be that there can be no precise definition of what types of expenditures constitute indirect use of fund assets. That judgment will have to be made based on the facts and circumstances of each individual case.... It is the Commission's view that, an indirect use of fund assets results if any allowance is made in the adviser's fee to provide money to finance distribution. Therefore, when an adviser finances distribution, fund directors, in discharging their responsibilities in connection with approval of the advisory contract, must satisfy themselves either that the management fee is not a conduit for the indirect use of the fund's assets for distribution or that the rule has been complied with. However, under the rule there is no indirect use of fund assets if an adviser makes distribution related payments out of its own resources. In determining whether there is an indirect use of fund assets, it is appropriate to relate a fund's payments pursuant to the advisory contract to the adviser's expenditures for distribution and to view such expenditures as having been made from the adviser's profits, if any, from the advisory contract. To the extent that such profits are "legitimate" or "not excessive", the adviser's distribution expenses are not an indirect use of fund assets. Many commentators drew unwarranted inferences from the use of "legitimate" and "not excessive" in Release No. 10862. Profits which are legitimate or not excessive are simply those which are derived from an advisory contract which does not result in a breach of fiduciary duty under section 36 of the Act. The courts have not established definitive standards for determining what does or does not constitute a breach of fiduciary duty in the compensation area, and, although the Commission reserves the right to express its own views of what such standards should be, it has not done so. (277)
Revenue sharing has been billed as a "major expense" item that is "the dirty little secret of the mutual fund industry." (278) According to one source, "the sums are enormous," aggregating more than $2 billion annually. (279) The $2 billion spent yearly on revenue sharing was almost four times more than the fund industry spends on advertising. (280) It is far more than the total expenses of all kinds borne by all mutual funds during 1980, the year when 12b-1 was adopted. (281) Despite the enormity of revenue sharing payments, according to one source, the terms of revenue sharing dealings "are seldom codified in written contracts." (282) It is troubling to find a highly regulated industry known to crow about its embrace of transparency and accountability spending billions of dollars annually on agreements that are seldom committed to writing. Big money contracts that are oral and thus invisible are breeding grounds for deceptive practices and fiduciary duty breaches. Richard H. Baker, Chairman of the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, connected the dots leading to investor deception when he said: "Revenue sharing is generally not disclosed to investors, thus leaving investors unaware of the incentives a broker may have for recommending one fund over another." (283) Fund managers' cavalier and intentionally vague handling of billions of dollars of revenue sharing money can and has given rise to litigation asserting claims under federal antifraud laws and investment company fiduciary duty principles. (284)
In 1980, when it promulgated Rule 12b-1, the Commission had an opportunity to regulate, once and for all, all expenditures drawing directly or indirectly upon fund assets used to pay for sales efforts. In so many words, as the foregoing quote from Rule 12b-1's adopting release reflects, the Commission punted. In ruling that only payments out of advisory fees directly "earmarked for distribution" are covered by 12b-1, (285) whereas non-earmarked payments made outside of 12b-1 plans by advisers to generate selling activity would be tolerated, the SEC gave fund sponsors permission to raid fund assets to finance distribution costs without complying with Rule 12b-1. The notion that billions of dollars in "advisory profits" can be spent outside of 12b-1's disclosure requirements and fee caps to pay for distribution-related items is dubious at best. NASD Rule of Conduct 2830 broadly defines cash and non-cash compensation "paid in connection with the sale and distribution of investment company securities" and brings those payments within the 1% maximum payment limit of 12b-1.
As a result of the SEC's refusal to clamp down on the diversion of fund assets to pay distribution charges, advisory profits are used today to pay distribution costs, (286) just as was the case prior to Rule 12b-1's adoption. (287) In 1978 the Commission was told in no uncertain terms that "substantial fund assets are being used for distribution--and this is the case throughout the industry." (288) The same comment letter pleaded that "this fact should be fully disclosed in the fund's proxy and prospectus." (289) Today, the pre-12b-1 practice of distribution subsidization through bloated advisory fees continues with a vengeance, and still there is no SEC-mandated requirement of detailed disclosure in SEC documents. Instead, as discussed above, "revenue sharing," the new name for the old practice, has managed to grow in importance while earning a less neutral designation: the fund industry's "dirty little secret." (290)
By promulgating 12b-1 to allow advisers to dip into fund assets directly to generate cash for marketing costs over and above money derived from loads, the SEC really just temporarily lessened the need for advisers to subsidize distribution out of advisory revenues. In essence, the SEC gave fund sponsors a pay hike. As it is, the SEC's pay subsidy of nearly $12 billion per year to fund sponsors leaves the industry's marketing efforts still ravenous for more marketing money. (291) Revenue sharing has blossomed into a mechanism to evade caps on 12b-1 fees. (292) The lesson is clear: fund sellers have an insatiable demand for compensation, (293) and fund advisers' appetites for asset growth is likewise insatiable. The losers in this game are fund shareholders who get little to nothing out of added sales and yet are getting stuck with the tab.
Assuming the adviser elects to indirectly earmark a part of the advisory fee to pay for distribution, the only practical limitation on the amount of assets the adviser indirectly diverts out of "advisory profits" would arise under the fiduciary duty standard in section 36(b). (294) As is discussed below, the 36(b) standard has been interpreted to date as very forgiving toward fund sponsors and very problematic for fund shareholders.
D.A Complication: "Soft Dollar" Payments
A core disclosure and management integrity problem plaguing the fund industry is the chronic tendency of fund managers to hide what they are doing with fund shareholders' money. Another integrity problem relates to the ingenuity shown by managers in finding ways to divert fund assets to bolster sales outside of Rule 12b-1's strictures. This penchant for deception and diversion gave us the directed brokerage scam discussed above.
There is another way to achieve the same sales boost by using cash generated when funds overpay their portfolio brokerage expenses. This arises when, instead of paying the lowest possible commission for stock trades, a fund pays an inflated commission charge, creating an overcharge that gives rise to "soft dollars." The term "soft dollars" is not defined under the federal securities laws. Nevertheless, the SEC has interpreted the term to mean products and services, other than execution of securities transactions, that an investment manager receives from or through a broker-dealer in exchange for the adviser's direction of client brokerage transactions to the broker-dealer. (295) The overcharge is arranged with the "understanding that the brokerage house will use the excess to provide services that otherwise would be paid for directly by the fund, such as research." (296) When advisory profits are increased by offloading research expenses onto shareholders through soft dollar payments, the inflated advisory profits are then available to subsidize distribution. There is evidence that the excess commission money is huge. In 2002, "the mutual fund industry paid brokers about $6 billion in commissions." (297) A 1998 SEC study of 75 broker-dealers and 280 investment advisers and investment companies reflected that nearly 60% of brokerage commissions were returned to the adviser in the form of soft dollar products and services. (298)
Commission payments generating soft dollars currently are permissible within limits under section 28(e) of the Securities and Exchange Act of 1934. (299) That provision was added to the 1934 Act to make clear that, in the face of the abolition of fixed brokerage commission rates, money managers could consider the provision of research, as well as execution services, in evaluating the cost of brokerage services without violating their fiduciary responsibilities. (300) However, in the words of one SEC Commissioner, "Times have changed and the original limited goal of Congress in providing the safe harbor has long ago gone the way of the Dodo bird." (301) Meanwhile, soft dollar arrangements continue to flourish, together with the monitoring and accountability challenges they beget. (302)
If soft dollars are used to defray advisory expenses, this can free the fund's adviser from bearing those costs. This, in turn, can enhance the adviser's profitability, unless the soft dollar expenses paid out serve to reduce the advisory fee paid by the fund. If the advisory fee is not reduced, excess profits are created for the advisor. There is evidence this is occurring. According to one study, soft dollar payments do not reduce management expenses and hence do not benefit shareholders. (303) Instead of generating savings, it appears soft dollar payments simply set the table for revenue sharing payouts to brokers out of cash generated from fund assets by advisory fee overcharges. This is essentially the same payment scheme (inflate brokerage charges to free up cash to funnel to selling brokers) that was occurring with directed brokerage. Thus, the use of soft dollar payments to inflate fund brokerage bills allows evasion of the SEC's prohibition in 2004 of sales compensation-generating directed brokerage payoffs, (304) as well as an evasion of the premise that distribution payments made out of fund assets are supposed to travel through the 12b-1 corridor. The indirect linkage between brokerage payments and distribution charges is obvious, as is the adviser's conflict of interest and the opportunity for fiduciary duty breaches. (305)
Those challenges are so imposing that the Mutual Fund Directors Forum has recommended that "a fund's board should not permit a fund's adviser to participate in soft dollar arrangements in trades for the fund." (306) This is good policy. The cleanest way for a fund adviser to pay third parties for investment research is out of advisory fee proceeds, i.e., with "hard dollars," not out of excess brokerage commissions, (307) i.e., with "soft dollars." After all, spending cash visibly f or useful services is more consistent with the "transparency and accountability principles" that the industry embraces publicly rather than the hidden, convoluted, and conflicted compensation system that soft dollars payments epitomize and promote. At a minimum, anything purchased with fund brokerage dollars beyond the "best execution" of trades, needs to be identified by the fund's adviser, quantified in dollar terms, justified as a proper expense, and disclosed to the fund's board of directors in connection with the board's annual approval of the adviser's advisory contract. (308)
The most telling reason why soft dollar payments for research should be banned, or at least included in the 12b-1 expense cap, is that key reasons given by the SEC for banning directed brokerage apply as well to soft dollar kickbacks coupled with distribution payments out of advisory profits. (309) Those key reasons were: (1) there is a potential for an adverse impact on the duty of the adviser to seek best execution of trades; (310) (2) extra compensation funneled to selling brokers can violate NASD sales compensation limits; (311) and (3) advisory profit or revenue sharing payments are off the books, which "diminishes the transparency of fund distribution costs and the ability of an investor or prospective investor to understand the amount of those costs." (312) In other words, when load increases in the form of brokerage allocations or soft dollar payments to fund advisers are hidden in inflated portfolio brokerage commissions, the costs never show up in fund expense ratios, causing investor confusion about pricing and management efficiency, and enabling the industry to report falling costs. (313)
E. Another Regulatory Failure--Spread Load Deception
By tolerating Rule 12b-1's use to facilitate spread load sales, the SEC has handed unscrupulous fund load sponsors a marketing ploy tailor-made for winning investors away from competitors offering a superior product, namely no-load fund shares. The proliferation of different load fund classes boils down to a cynical attempt to compete by engendering consumer confusion and exploiting consumer ignorance. (314) As fund industry pioneer John C. Bogle explained: "They don't just go by the alphabet anymore .... Franklin has class 1 and class 2 shares now. They leave investors in a perplexing miasma of imperfect knowledge, and the whole purpose is to make it look like they're selling a no-load fund." (315)
Mr. Bogle has a point. Before Rule 12b-1, the no-loads competed straight up with the load funds; loads typically were charged at the time of sale, with a smattering of funds featuring redemption fees. With a big assist from Rule 12b-1, load funds now have a marketing weapon able to counteract price competition pressure exerted by the no-loads. (316) Although marketing Class B shares as "no-load" is illegal, that does not mean brokers do not engage in the practice. In fact, the SEC has long been on notice that 12b-1 and CDSCs lend themselves to deceptive sales practices. (317) According to one report, distribution literature passed out by one fund sponsor lauds the deceptive nature of Class B shares: "Because there is no up-front sales charge, brokers who offer B (CDSC) shares may compete effectively with no-load funds." (318) Effective competition and fair competition are two different things. Class B share sellers who bill their product as "no load" are violating the NASD's sales charge rule which bars NASD members and their associated persons from describing a mutual fund as no load or having no sales charge if the fund imposes a front-end load, a back-end load, or a 12b-1 fee and/or service fee that exceeds 0.25% of average net assets per year. (319)
In 1998, the SEC proposed a rule aimed at creating detailed prospectus disclosure requirements for multiple class funds in order to help mutual fund investors understand the options presented by multi-class fund share offerings, particularly as to 12b-1 fees and CDSCs. (320) The notice sought public comment as to whether prospectus disclosure alone would be an effective way to ensure that fund investors would understand their investment options and whether the Commission should work with NASD to set standards for basic information that representatives must communicate with their customers, either orally or in writing. (321) Virtually all commentators assailed the SEC's detailed disclosure proposal, causing the agency to back off its proposed requirements. (322) In the Release adopting the proposed rule in modified form, the SEC noted:
The Commission recognizes that the complexity of distribution charge options can be confusing to some investors. Instead of relying on prospectus disclosure, however, the Commission is addressing these concerns through consumer education and the promotion of good sales practices.... The Commission staff has been working, and will continue to work, with the NASD on providing guidance about the duties of sales representatives when recommending the purchase of multiple class and master-feeder funds. Finally, the Commission expects to promote consumer education in this area through the development and publication of a brochure explaining the structures and expenses of multiple class and master-feeder funds. (323)
Thus, in the face of fierce industry opposition to detailed prospectus disclosure designed to protect investors, the SEC retreated in favor of a disclosure scheme premised on "the development and publication of [an explanatory] brochure" aimed at fostering "consumer education." The SEC's brochure commitment was made 12 years ago. The brochure has never been published. (324) This deficiency was pointed out in In re Flanagan, (325) an administrative proceeding brought against a broker-dealer, registered representatives, and an investment advisory firm for allegedly abusing clients by concealing from the clients that large investments in Class A shares entitled the investor to breakpoint discounts and that comparable discounts on sales charges were not available for large investments in Class B shares. (326) The administrative law judge held:
If a registered representative sells mutual fund shares, in amounts close to but less than a breakpoint at which a lower sales load becomes applicable, to a customer known to have available for investment total amounts which exceed the breakpoint, the representative must disclose to the customer prior to the transaction the savings in sales charges obtainable through increasing the amount of the purchase. A representative who fails to do so violates the antifraud provisions of the securities laws. The Division has shown that a reasonable "buy and hold" mutual fund investor would consider it material to know that, above breakpoints, Class A shares generally outperform Class B shares in the long run. It has also shown that the two investors in this case were not provided with such information. (327)
The administrative judge's ruling in In re Flanagan, that brokers commit a fraud on their Class B share customers when they fail to disclose savings available through investment in other classes, should concern fund retailers whose registered representatives overwhelmingly push B shares. The world of 12b-1 and CDSCs is never simple, however. The Commission subsequently reversed the administrative judge's ruling, (328) while nonetheless observing that "[c]ases involving breakpoints and the sale of Class B mutual fund shares involve important issues, and the Commission will continue to pursue cases on appropriate facts." (329) The SEC's loss in In re Flanagan illustrates the difficulty of proving fraud in cases attacking the suitability of Class B shares, a difficulty confirmed by results in other cases. Suits brought by injured customers must, as a rule, be filed as NASD arbitrations, and those tried to a conclusion usually result in defense verdicts. (330) Federal class action litigants have fared no better. (331) A relatively small number of regulatory proceedings, typically instituted by the NASD, have resulted in sanctions. (332)
Rule 12b-1 poses disclosure problems from multiple directions besides the no-load confusion/fraud angle. From the fund shareholder's standpoint, the rule has led to a single fund having different load fee configurations that make price comparisons extremely difficult, if not impossible. (333) At a minimum, choosing correctly between Class A, B, and C shares requires careful study of gross amounts available for investment, diversification needs, and foreseeable share holding periods. (334) According to former SEC Chairman Arthur Levitt, the differences between classes "leave investors' heads spinning" (335) and pave the way for misrepresentations by sales representatives. (336) The load funds, it seems, have chosen a marketing strategy built upon deception and obfuscation. (337) In the words of Chairman Levitt:
[T]he mutual fund industry ... does an exemplary job touting the benefits of mutual funds, but prefers to gloss over what it costs you each year. To the industry, one of the greatest design features of funds is the way they artfully camouflage fees as a percentage of assets. Most people would consider a 2 percent annual fee to be quite low, and don't realize that is really a punishing levy. (338)
Levitt offered these words of wisdom to investors about how they should react to fees charged under Rule 12b-1, a rule the SEC promulgated supposedly to serve investors' interests:
Naturally, investors don't like it when funds skim 5 percent of their savings right off the top. So fund companies have figured out ways to hide some of the load by assessing annual fees that you pay as a percent of your assets in the fund. This is called a distribution fee, or a 12b-1 fee, after the Investment Company Act rule that governs such fees.... You should avoid owning shares in a fund that charges these fees. (339)
Of course, though he was the longest-serving SEC Chairman in history, (340) Mr. Levitt never saw fit to take any action to fix SEC Rule 12b-1 while he was in a position to do so. The spectacle of a former-SEC Chairman warning investors to get out of the path of an SEC-created, administered, and sustained rule illustrates the extent to which Rule 12b-1 has run amuck. A simple, naive concept has evolved into something seriously flawed, if not grotesque.
F. A Consequence of Lax Regulation: Higher Risks Are Assumed and Hidden
Another documented way that Rule 12b-1 plays into deception is through the practice of some bond funds burdened by 12b-1 expenses to pump up their yields to investors by buying riskier portfolio holdings than their peer funds. (341) This is a phenomenon few investors know about, and which is largely ignored by the financial press. That expense-heavy funds resort to using high-risk portfolio holdings to raise investment returns has been considered insignificant by both the SEC, which has failed to require risk-adjusted return disclosures, and by a judge called on to rule in a case challenging the reasonableness of fund fees who thought it inappropriate to take into account the portfolio's volatility when evaluating the quality of the fund manager's investment performance. (342) Exactly why risk adjusted returns should not be disclosed is unclear, since pursuing high risk-adjusted returns is something business managers are expected to do. (343) Moreover, "[t]he method of analyzing risk-adjusted returns, known as the Sharpe ratio, is a fundamental of modern portfolio theory, an influential approach to investing." (344) Even more importantly, when buying fund shares, "most shareholders want to know about a fund's ... level of risk." (345)
Here, as with its failure to demand accurate, coherent spread load disclosure, the SEC's indifference to adequate cost disclosure plays into the hands of high cost sellers eager to compete by disguising a key fact--in this case, the investment risk of the portfolio that investors are buying into. Oddly, on its web site, the SEC implores mutual fund investors to consider a handful of key determinants of investment success other than past performance. (346) Prominent among the five factors listed is "the fund's risks and volatility." (347) The instructions to the SEC's mutual fund prospectus disclosure requirements likewise demand that the prospectus "help investors to evaluate the risks of an investment ... by providing a balanced disclosure of positive and negative factors." (348) The current disclosure regime is better than nothing. It uses a bar chart and table to reveal the fund's historical returns, comparing it with equivalent information for an index reflecting a "broad measure of market performance." (349) Funds are also required to disclose their highest and lowest returns for a quarter during the period covered by the bar chart. The SEC could help investors and eliminate fund performance deception by demanding (350) disclosure of risk-adjusted performance, but it has not. (351) This is a serious oversight. (352)
G. Another Rule 12b-1 Glitch: Extended Class B Payment Periods
Using 12b-1 fees in tandem with CDSCs is a way to assure that the fund will have available the money needed to pay the sales commission to the fund's salesperson, who typically receives payment at the time the shares are sold. In essence, the seller gets paid up front whether the shares sold are Class A or Class B. During the period that the CDSC withdrawal fee is assessed, there is not a big difference between the overall cost of either type of share, putting aside the availability of breakpoints with Class A shares.
If 12b-1 fees used to finance Class B share sales were solely a financing mechanism, the Class B shares would convert to Class A shares immediately after they had been held by the Class B shareholder long enough for the fund's underwriter to amortize the commission compensation paid at the time of sale. However, for many funds there is a delay, turning Class B shares into profit centers for fund distributors. Consider the following table, derived from Morningstar data, consisting of top Class B funds listed by assets, showing the maximum deferred load payable, and showing the number of years it takes to for Class B shares convert to Class A shares and escape 12b-1's load charge. This data raises the question why, once the commission paid at the time of purchase has been recouped, are the Class B shares not converted?
For example, note the Morgan Stanley fund on the chart. It converts only after 10 years, well after the fund sponsor has collected enough cash to pay off the commission earned by the seller at the time of sale. Fully a third of the 12b-1 fees collected by Morgan Stanley are not needed to compensate for selling costs, which, after all, is why the spread load is charged. What is the function of the extra 12b-1 fees assessed against Class B shareholders? Enrich the sponsor is one correct answer. This may help explain why we find that, "[w]ithin the Morgan Stanley Fund group, B shares comprise roughly 90% of the assets among share classes most commonly sold to individual investors, even though in many cases B shares are the costliest option when compared with the other shares." (353) This may also explain why Morgan Stanley came under attack for allegedly abusive sales practices. (354)
H. Another Failing: The SEC Allows the Industry to Issue Deceptive Data
In the fund industry we find a willingness by fund managers to use brokerage costs to pay for sales efforts (directed brokerage) and for advisory services (soft dollars). Data that should be readily accessible to the public is hard to find. Even very sophisticated financial analysts have severe problems getting basic information about what funds pay to buy and sell portfolio securities. (355) Analyzing the reasonableness of advisory fee payments is a task complicated by the SEC's failure to require standardized reporting of fund expenses. (356) In the distribution area, we find a mish-mash of terminology and varying ways of accounting for the same expense items. Thus, the SEC's web site counsels that "shareholder service fees" are accounted for as 12b-1 fees, (357) except when they are not. (358) As for accounting consistency, it is nonexistent. Consider this report in an SEC staff no-action letter:
The Commission's Office of Compliance Inspections and Examinations ... recently conducted a review of fund supermarkets and several brokerage firms that sponsor fund supermarket programs. The review revealed that different funds participating in the programs generally received the same services from program sponsors, although the funds characterized the services differently and paid for those services in different ways. Some funds, for example, characterized all of the services that they received as distribution-related in nature and paid for those services through plans of distribution adopted pursuant to Rule 12b-1 under the Investment Company Act of 1940. Other funds characterized a portion of the services that they received as administrative in nature and paid for those services outside of Rule 12b-1 plans. In some cases, advisers or their affiliates paid a portion of the fee. (359)
The same no-action letter mentioned that fund supermarkets charged fees to funds of "from .25% to .40% [25 to 40 basis points] annually of the average net asset value of the shares of the fund held by the sponsor's customers." (360) The fee ostensibly is used to pay "for permitting the fund to participate in the fund supermarket and for providing the services used by the fund." (361) The fee is bloated. We know the fee is bloated because the true all-in cost for all no-load equity mutual fund operations, other than investment advisory services but including profit to the sponsor and other service providers, is a maximum of .25% (25 basis points) on a weighted average basis. (362) Since the 25 basis point charge covers all mutual fund costs, excluding advisory services, the actual cost for services performed for shareholder out of the shareholder service component of the funds' annual payments to fund supermarkets obviously is miniscule. The large difference between the true cost of the service performed by the fund supermarket and the price charged is banked by the fund supermarket as profit. Most of the payments made by mutual funds to supermarket sponsors are not really for services performed; the payments largely are compensation for distribution efforts. Those expenses need to be accounted for as such.
I. Summary-A Regulatory Breakdown
When Rule 12b-1's supposed plusses are scrutinized closely, it becomes evident that the money management industry has outwitted and outmaneuvered the federal agency that supposedly regulates it, to investors' detriment. Fundamental flaws in the SEC's approach to fund marketing, principally through deficient disclosure requirements, have paved the way for industry marketing ploys calculated to exploit investor ignorance. The SEC's dealings with the mutual fund industry prove that regulatory capture can and does actually happen. The SEC regulators have been outsmarted and co-opted by the formerly weak but now robust industry they once tried to help and still ostensibly control.
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|Title Annotation:||The Mutual Fund Distribution Expense Mess|
|Author:||Freeman, John P.|
|Publication:||The Journal of Corporation Law|
|Date:||Jun 22, 2007|
|Previous Article:||VI. The acid test: does rule 12b-1 benefit mutual fund shareholders?|
|Next Article:||VIII. Wanted from the SEC: investor-oriented leadership.|