Thursday, March 21, 2013

12b-1 Fees: RIAs and Registered Representatives Beware

Does the Receipt of 12b-1 Fees Subject Registered Representatives to IAA? Are 12b-1 Fees Anti-Competitive? Are Class C Mutual Funds the Next Scandal? Should Independent RIAs Avoid Funds with 12b-1 Fees?


Some funds charge an annual fee to compensate the distributor of fund shares for providing ongoing services to fund shareholders. This fee is called a 12b-1 fee, after the SEC rule authorizing it. The 12b-1 fee is paid by the fund and reduces net asset value.

It appears that 80% of 12b-1 fees received by a fund are used by mutual funds to compensate broker-dealer firms.

Class C shares, which usually charge the maximum 1% annually in 12b-1 fees, usually do not convert to another class. Class C shares are often called "level load" shares, although the "load" (i.e., "commission") appears to be of an ongoing nature - tied not to the transaction but to the continued holding of the fund.


In its January 2011 report, mandated by Section 913 of the Dodd-Frank Act, the SEC staff noted the ways that brokers receive compensation: “Generally, the compensation in a broker dealer relationship is transaction-based and is earned through commissions, mark-ups, mark-downs, sales loads or similar fees on specific transactions, where advice is provided that is solely incidental to the transaction. A brokerage relationship may involve incidental advice with transaction-based compensation, or no advice and, therefore no charge, for advice.” Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (hereafter “SEC Staff 2011 Study”), available at, at pp. 10-11.

Interestingly, the SEC Staff did not comment the fact that brokers also receive compensation which is in the form of asset-based compensation, similar to the “assets under management” fee structure of most investment advisers, such as 12b-1 fees and payment for shelf space. 12b-1 fees have been criticized by this author as possible “special compensation” and “investment advisory fees in drag.” See Ron Rhoades, “7 reasons why wirehouses shouldn’t milk the old business model,” RIABiz, Jan. 28, 2010 (available at

The U.S. Court of Appeals decision in Financial Planning Association vs. SEC, No. 04-1242  (D.C. Cir., March 30, 2007), possesses potentially far-reaching implications. Three times in that decision the Court emphasized that the term “investment adviser” was “broadly defined” by Congress.  Additionally, in discussing the exclusion for brokers (insofar as their advice is solely incidental to brokerage transactions for which they receive no special compensation), the U.S. Court of Appeals stated:

“The relevant language in the committee reports suggests that Congress deliberately drafted the exemption in subsection (C) to apply as written. Those reports stated that ‘investment adviser’ is so defined as specifically to exclude ... brokers (insofar as their advice is merely incidental to brokerage transactions for which they receive only brokerage commissions) ….” [Emphasis added.]

As a result of this language, all arrangements in which broker-dealer firms and their registered representatives receive compensation other than commission-based compensation should be reviewed to see if the definition of “investment adviser” found in 15 U.S.C. §80b-2.(a)(11) applies: “Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities ….”

The receipt of 12b-1 fees by broker-dealer firms and their registered representatives are, by the SEC’s own admissions, “asset-based fees” and “relationship compensation.” The written submissions to the SEC by many brokerage industry representatives, in connection with earlier hearings on this issue, expressly admitted that 12b-1 fees are utilized in large part to compensate registered representatives for the fostering of an ongoing relationship between the registered representative and the investor, including the provision of investment advice over time with respect to a customer’s personal circumstances, and including financial planning, estate planning, and investment advice (not specific to any transaction).

The fairly recent U.S. District Court case of Weiner v. Eaton Vance, 2011 U.S. Dist. LEXIS 38375 (U.S.D.C. Mass., 2011) may appear to provide some commentators with ammunition that 12b-1 fees are not “advisory fees in drag,” as I have suggested. In that case, the court found that 12b-1 fees, under the facts as alleged, did not compensate “special compensation.” However, the court discussed the linkage between the delivery of advice and the receipt of special compensation, and the judge specifically stated:

I decline to find that the asset-based 12b-1 fees paid by the Trust automatically disqualify broker-dealers from the use of the exemption. As described above, courts rely on fact-based inquiries into the compensation paid, the services rendered, and evaluation of the connection between the two in determining whether the exemption applies. Plaintiff fails to allege sufficient facts to claim that the broker-dealer exemption does not apply here. In particular, there is no allegation that any advisory services have been rendered with respect to the brokerage accounts or that the 12b-1 fees here are actually "special compensation" for the broker-dealers' advisory services to their customers.

Id. [Emphasis added.].  Hence, where personalized investment advice is being delivered, one might see a future case in which the courts find that 12b-1 fees do, in fact, amount to special compensation and the application of the Advisers Act.

While industry representatives have argued that the 12b-1 fee “compensation” received by the broker-dealer firm is not paid by the customer directly, there is no qualification in the definition of investment adviser which says that compensation must be directly paid by an investor. In fact, the SEC has in the past acknowledged that, to meet the “compensation” test under the Advisers Act: “It is not necessary that an adviser's compensation be paid directly by the person receiving investment advisory services, but only that the investment adviser receives compensation from some source for his services.” SEC Release IA-770 (1981). 

Moreover, there is a common law principle which attorneys were taught when they were in law school:  “You cannot do indirectly what you cannot do directly.”  In other words, “if it walks like a duck….”  

While admittedly Class C shares in particular, and fee-based compensation in general, might at times better align the interests of investors with those of financial intermediaries, such an alignment is not the basis of any exclusion from the application of the Advisers Act.

Given the significance of this issue, all ongoing payments to advice-providers deserve close scrutiny – including ongoing payments for shelf space, variable annuity product provider annual fees to broker-dealers, and – as stated above – 12b-1 fees. All of these might constitute “special compensation” under the Advisers Act.


12b-1 fees also may violate the Sherman Act and its anti-trust prohibitions, inasmuch as they negate the ability of a customer to effectively negotiate, in many instances, the compensation for advisory services. This issue involves the unlawful restraint of trade and the potential application of the Sherman Antitrust Act. In essence, do 12b-1 fees constitute a form of “price-fixing” which is per se illegal. Arguably they do not, as each seller of a mutual fund may establish its own fee, up to maximum limits. Yet many cases arising under the Sherman Act find "maximum fee" requirements to be anti-competitive.

Nevertheless, even if 12b-1 fees do not violate the Sherman Act, the anti-competitive nature of 12b-1 fees should not be overlooked. It makes no sense to charge the same 1% “marketing fee” to a client who invests $5,000,000 with a broker-dealer, as it does the client with $50,000. Some multiple classes (“R” shares, typically) of retirement funds exist for plan sponsors. But individual clients are seldom, if ever, provided the opportunity to negotiate 12b-1 fees (except for plan sponsors who can seek lower 12b-1 fees for funds where multiple retirement-share classes exist).


Another issue is whether Class C shares constitute unreasonable compensation. If Class C shares, with a 1% fee assessed, are continuous in nature, and continue to compensate the broker-dealer even after the transaction is complete, they would appear to constitute “unreasonable compensation.” As stated in a comment letter by the Consumer Federation of America, “12b1 fees can be collected in perpetuity, which means that they can result in investors’ paying much higher sales compensation than would have been permissible under other classes of shares.” Comment letter of Mercer Bullard, Fund Democracy, and Barb Roper, Consumer Federation of America, to U.S. Securities and Exchange Commission, dated November 5, 2010, at p.2., located at

About a decade ago, Class B shares were central to investor abuses — brokers sold large numbers of the shares to investors who would have done better with Class A shares. The scandals led so many to view Class B shares negatively that some financial services firms now limit the sales of the share class.

While Class C shares are not necessarily more expensive that Class A shares (nor were Class B shares necessarily more expenseive than Class A shares), this all depends upon the length of time the fund shares are held they can be much more expensive. This begs the question – in what circumstances are brokers recommending Class C shares, when Class A shares would have been better for the customer? If the client indicated that the fund was likely to be held for a long time (such as more than 7 years), why did the broker not recommend the Class A share, which would have likely been cheaper?

Moreover, more broadly, why do we permit this conflict of interest, in the sale of mutual fund shares, to continue? Conflicts of interest, especially where variable (or differential) compensation exists, are insidious and difficult to reconcile with fiduciary principles, much less monitor.

In addition, we must ask - why don’t all Class C shares convert to a cheaper share class, with no distribution fees, after a period of time? Why has the SEC not imposed such a requirement on mutual fund companies?


If you are not associated with a broker-dealer, I would urge you to avoid any mutual fund share class that includes any 12b-1 fees. Why? You have a duty of due care, which includes a duty of due diligence, to identify the best investments (such as mutual funds) for your clients. You act as a purchaser’s representative. Hence, any 12b-1 “marketing fees” charged by funds only constitute additional, unwarranted fees, from which your clients receive no benefit. As an investment adviser, you should be certain that any fees and costs incurred by your clients are reasonable, and result in a benefit to the client in some fashion.

A possible exception would exist for no-transaction-fee funds, where your client is making systematic purchases of the fund [such as within a 401(k) account). In this instance, as long as the value invested in the fund is small, avoiding transaction fees may be a positive. Of course, this assume that transaction fees cannot otherwise be avoided and achieve the same investment objectives; many custodians offer platforms for 401(k) plans which don’t impose transaction fees for periodic investments made by plan participants.


If you are associated with a broker-dealer, and if you receive 12b-1 fees which in part compensate you for advisory services, you should consider the relationship a fiduciary one. (See Wiener vs. Eaton Vance, discussed above.) This is so even if the account is denoted as a "brokerage account, not an advisory account" - since the name of the account is not controlling as to whether the Advisers Act is applicable, or whether common law fiduciary duties attach.

As such, you should meet all of the fiduciary obligations imposed by the Advisers Act, including due diligence with respect to the mutual fund recommended. You should fully and affirmatively and specifically disclose any and all compensation your firm receives (including sales loads, 12b-1 fees, payment for shelf space, soft dollar or other commissions paid by the fund, etc.). The fees you and your firm receive should in all respects be reasonable.

You should also affirmatively disclose to the client, in a manner which ensures client understanding, that funds exist without 12b-1 fees (and other payments to the broker-dealer firm, if such exists), and that should the client ever choose to terminate the relationship with you, that the 12b-1 fees could be avoided by selling the fund at a future time. You should also disclose any costs that may result from the sale of the fund (such as redemption fees, if they exist), and that if the fund is held in a taxable account that capital gains taxes could result which might deter the client from selling the fund.

Such disclosures should be undertaken as specifically as possible. Reliance upon the fund’s prospectus should not be undertaken, given that you know that clients rarely read such document. (The duty to read is abrogated, to a degree, in a fiduciary relationship). In addition, such disclosures should be undertaken prior to the time that the client purchases the fund shares.

Of course, your broker-dealer's compliance department, or your superviser, may not desire to have you undertake such disclosures. But there are many instances in which registered representatives have been the subject of arbitration proceedings, and a tarnished record, in "reliance" on what their firm has stated. Firms view possible liability as a "cost of doing business" ... for the individual registered representative, a tarnished record affects your personal reputation, and your livelihood, for years to come.

Lastly, since the provision of investment advisory services (especially those of an ongoing nature) in return for 12b-1 fees may trigger the application of the Adviser Act, make certain you possess Series 65/66 licensure.


Finally, any discussion of 12b-1 fees would be incomplete without noting that the receipt of 12b-1 fees by a fiduciary to a client may also result in a prohibited transaction under ERISA, in certain circumstances. In this regard, I defer to Fred Reish’s recent blog post, concerning a recent U.S. Department of Labor settlement, for a further discussion of this issue.

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