The Deception Series, Part 9--What the Advisor Paid Fee Means to the SEC

Part 9--What the Advisor Paid Fee Means to the SEC

In the fall of 2009, SEC Chairwoman Mary Schapiro said the Commission is scheduled to hold hearings on the role of 12b-1 fees. As a revenue sharing agreement, the Advisor Paid Fee (APF) also should be considered a first cousin to 12b-1 fees, especially in how it was “disclosed” to shareholders and how it impacted an investment advisor’s professional and ethical responsibilities.

In an SEC press release, SEC Chairwoman Schapiro said: "I also have asked the staff to prepare a recommendation on rule 12b-1, which permits mutual funds to use fund assets to compensate broker-dealers and other intermediaries for distribution and servicing expenses. These fees, with their bureaucratic sounding name and sometimes unclear purpose, are not well understood by investors.

“Yet in 2008, rule 12b-1 was used to collect over $13 billion in investors' funds out of fund assets. It is essential, therefore, that the SEC engage in a comprehensive re-examination of rule 12b-1 and the fees collected pursuant to the rule. If issues relating to these fees undermine investor interests, then we at the SEC have an obligation to step in and adjust our regulations."


History of Complaints About Fees
Investor complaints about fees are not new to the SEC. While the SEC's efforts to date have not significantly reduced the size of fees and management expenses, it has addressed the need for greater disclosure and transparency in the relationship and fee arrangement between fund companies and their sales force.

Speaking at a conference in May 2004, SEC Chairman Donaldson said the SEC was working on 12 “major” new rules regarding conflicts of interest between a mutual fund and its managers, however these rules (expected to be released in late-July) does address fees and commissions.

“The SEC is not trying to massage fees,” he said. “Our rule is to let investors know what they are paying for,” through better transparency and disclosure. However, Donaldson acknowledged the SEC has “parted company” with former New York Attorney General Spitzer on this issue. “We got off the train on that juncture with the agreement of the whole Commission,” Donaldson said. As a result of this division, the call for legislation on fees and commissions has been muted by Congress,” Donaldson said.

While this situation is fluid, financial services companies offering the full range of financial products and have not disclosed fees affecting a large investor base could face more scrutiny than other firms which have followed greater disclosure practices.

The subjective nature of fees and commissions, especially in the wide array of financial services companies (credit card, insurance, currency exchanges, payday loans) and products (annuities, risk credit card, no doc loans) under the New York Attorney General’s regulatory purview make fully-disclosed advisor paid fee arrangement a low priority. This view gains more credence given the sharp split on this issue between the full SEC commission and the New York Attorney General. What’s also missing now is an aggrieved class of investors.

In the National Interest
As the SEC considers the future of 12b-1 fees, and the related issues of disclosure and the importance of reducing fund expenses, it should recognize that this once-esoteric issue plays an important role in re-shaping retirement policy.

This is because any change in fund operations which can enhance an investor’s total fund return can help recover fund losses.

Significant changes in these fees can also introduce more competition into the commoditized mutual fund business since it can remove the safety net of providing fee income for poor management, lackluster returns and rewarding a lack of innovation.Moving forward, any change which increases fund returns should be mandated as a means of enhancing retirement security.

Reforming 12b-1 fees will also force the mutual fund industry to become more competitive. Instead of relying on billions in shareholders fees, funds will be forced to introduce new investment and trading strategies by mixing ETFs, long-short, active and passive strategies and new fee arrangements based on performance.

Load funds especially will be forced to find lower cost, more efficient ways of selling their funds by employing hybrid internal wholesalers who are more knowledgeable and technologically savvy than the external wholesalers who make expensive, and often unproductive, office visits.

Any combination of these changes will reduce the industry’s commoditization, make it more innovative, and reduce shareholder expenses. In the process, a number of funds will consolidate or cease operations, but this should benefit shareholders by reducing expenses, which was the original intent of the 12b-1 fees.

Any changes should benefit shareholders as they explore opportunities to produce positive returns in an increasingly difficult investment environment.

Regulatory Reality Check in 2009
While shareholders should have a wish list about how their net fund returns can be improved by reducing fees, the reality is very different.

The financial services industry captured their regulators at least 30 years ago. That happened at the SEC, CFTC, and for banks and insurance company regulators, especially at the state level.

Since the mutual fund lobby is so powerful, changes in 12b-1 fees will not come from the top down since these huge fees provide the needed revenue to fuel customer acquisition, sales, marketing, salaries of top executives, and all the miscellaneous activities which provide the lubrication to keep the system going.

That leaves it up to shareholders to again bear the burden of knowing what to ask their investment advisers and mutual fund companies, including the key question: How do these fees benefit me? (If you are, or were, a SAM shareholder, see Part 10.)

If you ask this question to your investment adviser, you commonly will get a blank stare. Then, you may hear some rhetoric. There will then be an awkward silence. (All this explains why there is no Twitter, and electronic social networking among load-mutual funds.) If all of that happens, it's time to get a new adviser.