Sunday, January 3, 2016

Part 6: Fiduciaries and Perplexing 12b-1 Fees ("Who Moved My Cheese" Series)

This is part of a series of blog posts, "The Future of Financial Advice - 'Who Moved My Cheese'?" Different scenarios are posed, for discussion of whether, and how, financial advisors might comply with the fiduciary standard of conduct, applying primarily either ERISA's strict guidelines, the proposed "Best Interests Contract Exemption" under ERISA, or state common law (as influenced by SEC rules and/or enforcement or lack thereof).

For an introduction to all of these scenarios, which involve the application of the fiduciary standard of conduct to variable compensation arrangements currently prevalent in the financial services industry, please first view Post 5.

[PLEASE NOTE: The mention of any particular mutual fund, fund underwriter, broker, or investment adviser does not constitute an endorsement by this author of such fund or firm, and is only utilized as a means of illustrating the concepts herein.]


A dual registrant desires to recommend a mutual fund to a client that will pay the dual registrant's firm either a commission and a low recurring 12b-1 fees, or an ongoing commission in the form of a 1% annual 12b-1 fee. Does either recommendation meet the fiduciary's duties to a client?

Introduction to Mutual Funds and their Marketing Channels.

By way of introduction, mutual funds provide investors with convenient ways to achieve broad portfolio diversification. Diversification has been called "the only free lunch in investing." By pooling capital with many other investors, each mutual fund shareholder owns a fraction of a larger, and usually well-diversified portfolio. Some mutual funds offer diversification across multiple asset classes, such as by holding both stocks and bonds (as a simple example). Many investors own several different mutual funds. While other pooled investment vehicles exist (including but not limited to closed-end funds, unit investment trusts, and variable annuity sub accounts), for ease of discussion this blog post refers to mutual funds in the context of "open-ended mutual funds."

Mutual funds are marketed through several types of distribution channels.
  • Direct marketing occurs by a fund underwriter to individual investors. For example, Vanguard primarily directly markets its funds to retail investors. This is often called the "direct" channel.
  • Other fund companies primarily market to consumers' representatives - i.e., investment adviser representatives, who, as fiduciaries, undertake due diligence (in adherence to their fiduciary duty of due care) prior to recommending any particular fund to their clients. Marketing in this manner is often called the "adviser channel."
  • Another marketing by the fund underwriter through a "full-service" broker-dealer firm and its registered representatives. Many fund complexes market their funds primarily in this manner. It is no surprise that this is called the "broker channel."
  • Other funds are marketed through discount brokers, who offer them in turn to individual investors through what might be termed the "fund supermarket channel."
  • Still other funds are offered directly by fund complexes to pension funds, larger defined contribution plan sponsors, endowment funds, and foundations. This is often termed the "institutional channel" or the "retirement channel." However, both brokers and investment advisers also market to these types of consumers.
Some mutual funds have different "share classes," with different types of fees assessed. For example, a fund may have a Class A (up-front sales load, or commission, often including an annual fee of up to 0.25%) for marketing through brokers, Class A "Load-Waived" funds for marketing through investment advisers, Class C (no sales load, and up to 1% annual 12b-1 fee), various "R" shares (with different levels of 12b-1 fees), and "institutional shares" (often with no 12b-1 fees or sales loads) for marketing directly to institutions or via investment advisers. Other share classes exist.

Introduction to Mutual Fund Fees, including Sales Loads, 12b-1 Fees, and More.

  • One-time sales charges, such as:
    • Sales load (up-front commission); and/or
    • Deferred contingent sales charges; and/or
    • Redemption Fees.
  • Annual expense ratio, including:
    • Management fees (paid to firm's investment adviser, which is often a firm affiliated with the mutual fund underwriter);
    • Other expenses, such as legal, accounting, registration fees and publication/mailing costs; and
    • 12b-1 fees
  • Transaction-related fees not included in a fund's annual expense ratio, including:
    • Securities brokerage commissions;
    • Principal mark-ups / mark-downs;
    • Bid-ask spreads;
    • Market impact costs;
    • Opportunity costs of delayed/canceled trades;
    • Sharing of securities lending revenue with affiliates or service providers;
    • Interest costs relating to maintenance of margins;
    • Costs of options or other derivatives; and
    • Opportunity costs due to the fund's cash holdings.
The above fees and costs do not include fees which may be imposed in connection with the maintenance of a 401(k) or brokerage account (such as an annual flat fee, typically imposed on small accounts). Nor do the above fees and costs include investment advisory fees that may be paid directly by the client to a registered investment adviser firm.

According to the Investment Company Institute's 2015 Investment Company Fact Book, "Since 1980, when the U.S. Securities and Exchange Commission adopted Rule 12b-1 under the Investment Company Act of 1940, funds and their shareholders have had the flexibility to compensate financial professionals and other financial intermediaries through asset-based fees. These distribution fees, known as 12b-1 fees, enable investors to pay indirectly for some or all of the services they receive from financial professionals (such as their broker) and other financial intermediaries (such as retirement plan record-keepers and discount brokerage firms). Funds also use 12b-1 fees to a very limited extent to help defray advertising and marketing costs." Id. at p.102.

"Front-end load shares, which are predominantly Class A shares, were the traditional way investors compensated financial professionals for assistance. These shares generally charge a sales load—a percentage of the sales price or offering price—at the time of purchase. They also generally have [an annual] 12b-1 fee, often 0.25 percent (25 basis points). Front-end load shares are used in employer-sponsored retirement plans sometimes, but fund sponsors typically waive the sales load for purchases made through such retirement plans. Additionally, front-end load fees often decline as the size of an investor’s initial purchase rises (called breakpoint discounts), and many fund providers offer discounted load fees when an investor has total balances exceeding a given amount in that provider’s funds." Id.

An example of a broker-sold mutual fund Class A shares is The Investment Company of America mutual fund, one of the largest mutual funds in the United States. It's Class A shares (AISVX) possess an annual expense ratio of 0.59%, which includes "Annual Management Fees" of 0.24%, "Other Expenses" of 0.12%; and "Service" or "12b-1" annual fees of 0.23%.

The sales charge (sales load) of these Class A shares varies with the amount invested:
distributions are not subject to an initial sales charge.

                                                         Sales Charge as %
Amount Invested                             Net Offering Price
Less than $25,000                                     5.75%
$25,000 but less than $50,000               5.00%
$50,000 but less than $100,000             4.50%
$100,000 but less than $250,000           3.50%
$250,000 but less than $500,000           2.50%
$500,000 but less than $750,000           2.00%
$750,000 but less than $1 million           1.50%
$1 million or more                                     none
(Note that a 1% deferred contingent sales charge may be assessed for purchases over $1m, if the fund is sold within one year of its purchase.)

[Class B fund shares, which have largely disappeared, are not discussed herein.]

"Level-load shares, which include Class C shares, generally do not have front-end loads. Investors in this share class compensate financial advisers with an annual 12b-1 fee (typically 1 percent) and a [contingent deferred sales charge] (also typically 1 percent) that shareholders pay if they sell their shares within a year of purchase." ICI 2015 Investment Company Fact Book at p.103.

No-load share classes have no front-end load or contingent deferred sales charges. Some possess , a 12b-1 fee of 0.25 percent (25 basis points) or less; even though this "sales charge" is assessed the U.S. Securities and Exchange Commission and FINRA permit such funds to be marketed as "no-load funds." (At one time the SEC stated that the term "no-load fund" should NOT be used for shares of funds, when fund assets were used to pay distribution costs; the SEC subsequently reversed itself.)

The annual 12b-1 fee forms part of a mutual fund's "annual expense ratio," which also includes the "management fees" paid to the fund's investment adviser and "other expenses" (legal fees, accounting fees, registration fees, certain publication and mailing costs, etc.). The "sales load" (commission) paid on Class A share is not calculated into the annual expense ratio.

How are 12b-1 fees utilized by mutual funds? Professor Haslem reports that "Today, over 90% of 12b-1 fees compensate brokers and others for distribution of fund shares and servicing of fund investor accounts." Haslem, John A., Mutual Fund Revenue Sharing and Defensive 12b-1 Plans: 'Oz Revisited' (December 14, 2015). Available at SSRN.

Various other fees and costs associated with investing in mutual funds are also not included in the mutual fund's annual expense ratio, primarily relating to transactions occurring in the fund, such as brokerage fees for executing securities transactions in the fund (which might include "soft dollar" compensation as well), principal mark-ups and mark-downs (primarily incurred in connection with trading of bonds within funds), bid-ask spreads and market impact costs and opportunity costs relating to delayed or canceled trades (usually in connection with the trading of stocks within the fund), opportunity costs arising from the mutual fund's cash holdings, and the sharing of securities lending revenue with a mutual fund's investment adviser or other service providers. A discussion of these additional costs of investing in mutual funds is beyond the scope of this blog post, although for many funds these costs can be substantial; in some cases these additional costs dwarf the annual expense ratio of a fund.

Are 12b-1 Fees "Sales Commissions" or Are They "Advisory Fees in Drag"?

Rule 12b-1 permits a mutual fund to use fund assets to pay broker-dealers and others for providing services that are primarily intended to result in the sale of the fund’s shares. The SEC adopted rule 12b-1 under its authority in section 12(b) of the Investment Company Act, which authorizes the Commission to regulate the distribution activities of funds that act as distributors of their own securities. Interestingly, the SEC stated at the time that Section 12(b) was designed to protect shareholders of funds from being charged excessive sales and promotional expenses.

Yet, 12b-1 fees - especially for Class C shares (where the 12b-1 fee is often 1% a year) appear to be often utilized to pay for financial planning and other advisory services of an ongoing nature by brokers. Many broker-dealer firm and asset management industry executives testified to that effect during hearings at the SEC in 2010 regarding proposals to reform 12b-1 fees.

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 require any brokers who recommend them to register with 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.

Despite the fact that 12b-1 fees are primarily intended to be used to promote the sale of a fund's shares, the SEC permits funds with 12b-1 fees to be referred to as "no-load" funds.

In 2010 the SEC conducted hearings on 12b-1 fees, at which many securities industry executives appeared. A proposal was floated at the time to reform 12b-1 fees. Since then, consumer groups have urged the SEC to abolish 12b-1 fees altogether. In April 2015 it was noted at a conference that the SEC is currently reviewing as part of its exam cycle the entire spectrum of 12b-1 fees (per Marc Wyatt, deputy director of the agency’s Office of Compliance Inspections and Examinations).

In conclusion, a judicial challenge to the validity of 12b-1 fees might occur in the future, on the basis that they constitute "special compensation" - thereby invalidating the broker exclusion from registration as an investment adviser. If this were to occur, mutual funds with 12b-1 funds could only be sold, or maintained, by dual registrants (both firms and their representatives).

However, for other reasons stated herein, 12b-1 fees continue to receive scrutiny, and could face either substantial modification (as was proposed in 2010 by the SEC) or even revocation at some future time.

12b-1 fees provide no benefit to existing fund shareholders, and they reduce investor net returns.

Even before the enactment of Rule 12b-1 fees, the SEC had generally opposed the use of fund assets
for the purpose of financing the distribution of mutual fund shares, noting that "existing shareholders of a fund “often derive little or no benefit from the sale of new shares." See Bearing of Distribution Expenses by Mutual Funds: Statutory Interpretation, Investment Company Act Release No. 9915 (Aug. 31, 1977) [42 FR 44810 (Sept. 7, 1977)] (quoting SEC, Future Structure of the Securities Markets (Feb. 2, 1972) [37 FR 5286 (Mar. 14, 1972)]).

Academic research has shown that 12b-1 fees impose a drag on performance. See Part 3 of this series.

Even the SEC, in a report written by Financial Economist Lori Walsh, titled "The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Returns," has noted the negative impact of 12b-1 fees on investor returns: "12b-1 fees appear to increase flow volatility and decrease gross returns ... [this fact] certainly discounts the original justifications made by 12b-1 plan proponents that 12b-1 plans stabilize fund flows and increase gross returns. Shareholders of 12b-1 funds do not obtain any benefits through higher gross returns, and may in fact be harmed. These results highlight the significance of the conflict of interest that 12b-1 plans create. Fund advisers use shareholder money to pay for asset growth from which the adviser is the primary beneficiary through the collection of higher fees. 12b-1 fees appear to increase flow volatility and decrease gross returns. Although these results are not overly strong, it certainly discounts the original justifications made by 12b-1 plan proponents that 12b-1 plans stabilize fund flows and increase gross returns. Shareholders of 12b-1 funds do not obtain any benefits through higher gross returns, and may in fact be harmed." Id. at pp.17-8.

Are 12b-1 Fees "Anti-Competitive"?

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 could be an unlawful restraint of trade. 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 "minimum fee" requirements to be anti-competitive, and it might be relatively easy to show, through circumstantial evidence, the close relationship between major brokerage firms and the mutual fund complexes that provide mutual funds, and the close similarity in the amount of 12b-1 fees charged.

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).

In essence, again, 12b-1 fees could, in some instances, amount to unreasonable compensation.

12b-1 Fees are Confusing to Investors, and Frequently Overlooked.

Former SEC chairman Mary Schapiro once noted, as to 12b-1 fees, that: "Investors may have no idea these fees are being deducted from their mutual funds, what services they are paying for, or who they are ultimately compensating."

In hundreds of meetings with prospective clients over the past two decades, I discerned that not one of them understood 12b-1 fees. And not one of them understood that their brokerage firm was likely receiving a portion of the 12b-1 fee.

The investor confusion over 12b-1 fees continues, as does the outcry by consumer groups for their repeal, on the grounds of investor confusion (and more).

12b-1 Fees Are Too Large, and Inappropriate, to Pay for Just Account Maintenance Expenses.

Brokerage firms incur expenses each year to facilitate the custody of client assets. These include administration and technology costs, oversight (compliance) costs, mailing (or e-mailing or other access electronically) of client statements, mailing (or other e-delivery) of funds' annual reports, proxy statements, and other fund literature, annual tax reporting, cost basis upkeep, reinvestment of fund distributions, and the infrastructure needed for general client service.

While a 0.25% charge may have been appropriate before the modern era of computerized systems and electronic communications, which have significantly lowered the costs to custody mutual funds and provide "servicing" to them, such a 0.25% fee seems extraordinarily high in today's modern world. Moreover, a percentage-based fee for such shareholder servicing seems inappropriate - a client with $500,000 in a fund would pay ten times more than a client with $50,000 in the same fund, and 100 times more than a client who only has $5,000 invested in the same fund, for essentially the same "service." What is a fair charge for these services? I don't know. Often these costs are supported from other services, such as distribution (sales) of other products by the brokerage firm, the yield spread made on cash deposits at brokerage firms, etc., and revenue derived from these activities might be used to offset these costs (since a portion of the systems are used to support these activities).

One could speculate that the costs of delivering all of these services, for a discount brokerage firm who merely wanted the discount brokerage firm to "hold" the investments, might well amount to no more than a few hundred dollars a year (for discount brokerage firms that had economies of scale, and especially where e-delivery of reports and other documents was permitted by the client). Perhaps far less.

While 12b-1 fees can be used to offset these annual brokerage account maintenance costs, is that appropriate? What if the client holds $500,000 in mutual funds, and the mutual fund pays the broker 0.20% a year from the total 0.25% 12b-1 fee charged? This would amount to compensation to the broker of $1,000 a year. In essence, this could easily result in excessive compensation to the brokerage firm, at least for the accounts of larger clients.

I would further note that there are some registered investment adviser firms (including "roboadvisors" such as Wealthfront and Betterment, and also Vanguard Advisory Services) who provide not only custodial services (typically via relationship with a separate discount brokerage firm or an affiliated discount brokerage firm), but also providing ongoing investment advisory services, for fees of 0.30% a year or less. Some other independent, fee-only advisors provide investment advisory services for these fees, or less, depending upon the account size. Accordingly, the imposition of a 12b-1 fee for custodial services only, with no ongoing advice provided, appears inappropriate.

What Happens to 12b-1 Fees When the Client Leaves the Broker?

What if a client purchases a Class A share (maximum 12b-1 fee of 0.25% a year) or a Class C share (maximum 12b-1 fee of 1% a year), but then the client decides to "go it alone" and transfer the account to a "discount broker." Or the client may decide to work with an independent fee-only registered investment adviser, who recommends a discount broker (such as TD Ameritrade, Schwab, Fidelity, etc.) be used as custodian for the client's investments.

At this time the client (and/or the advisor) may desire to retain the fund in the client's account, perhaps for a tax reason. For example, a stock fund may possess appreciation in value over time, and the sale of same could trigger negative income tax consequences (short-term and/or long-term capital gains, and possible imposition of alternative minimum tax).

In such circumstance, does the 0.25% 12b-1 fee in the Class A shares cease? Unfortunately, no. While nothing prohibits mutual funds from switching a mutual fund shareholders' funds to a different share class, such as an institutional share class, that has no 12b-1 fees, this author is not aware of any funds that actually undertake such a conversion. This should not be difficult to effect - at least upon request by the client (or the client's investment adviser). For example, Vanguard converts its higher-cost "Investor Shares" to "Admiral Shares" when they become eligible for such treatment, upon request of the client.

For example, in the situation in which a dual registrant / financial advisor recommended a Class C share, but the investment advisory relationship was subsequently terminated and the account was still maintained (as a brokerage account), and (such as for reasons as stated above) the mutual fund was not sold, then both the dual registrant firm (as a fiduciary) and the individual adviser [assuming the adviser continued to receive a portion of the 1% (or less) 12b-1 fee] would then be receiving compensation while no advisory services were provided. In such instance, unreasonable compensation could easily result. (Some fund complexes do appear to permit conversion of Class C shares to Class A shares, where a lower 12b-1 fee is charged; but not all appear to do so.)

Because 12b-1 fees do not appear to fully terminate, it would be difficult for a fiduciary advisor to recommend a fund with such fees, given the possibility that the client would be deterred from switching to an independent registered investment adviser (who does not receive 12b-1 fees). See, e.g., National Deferred Compensation, SEC Staff No-Action Letter (Aug. 31, 1987) ("an adviser
may not fulfill its fiduciary obligations if it imposes a fee structure penalizing a client for deciding to
terminate the adviser's service or if it imposes an additional fee on a client for choosing to change his
investment"). In addition, the receipt of 12b-1 fees in excess of the approximate costs of annual account maintenance would result in the receipt of unreasonable compensation by the dual registrant, in such instance.

In conclusion, as to this section, because of the very real possibility that ongoing imposition of 12b-1 fees would deter a client from switching from a dual registrant fiduciary-client relationship to an independent registered adviser-client relationship, and because of the possibility that unreasonable compensation to the selling dual registrant firm or to a new custodial firm could eventually result, it would appear to be difficult for a fiduciary adviser to recommend a mutual fund with any 12b-1 fee, unless the mutual fund complex possesses a mechanism to (upon request, at a minimum) transfer the Class A or Class C shares to a different share class in which no 12b-1 fees were imposed.

If a Dual Registrant Charges an AUM Fee in an Advisory Account, is a 12b-1 Fee Also Permitted, Where the Dual Registrant Receives Part of the 12b-1 Fee?

Can a dual registrant maintain an investment advisory account for a client, in which (for example) an annual fee is charged equal to 1% of "assets under management," then recommend to the client a load-waived Class A mutual fund share (so that no sales load or up-front commission is charged), which pays the dual registrant firm a portion of (for example) a 0.25% annual 12b-1 fee? This is "double-dipping."

In another fiduciary advisor context - that of trust departments of banks - the FDIC examination manual (2005) states in pertinent part: "The receipt of 12b-1 fees are required to be disclosed in the prospectus of all mutual funds. However, even if adequate disclosure is given and no regulations are violated in connection with these fees, trust departments must continually perform due diligence procedures to ensure that all investments are chosen with the interest of the beneficiaries in mind.  Furthermore, trust departments must be aware of state laws regulating securities."

Nearly all of the states have adopted statutes which permit the receipt by banks operating as fiduciaries to clients to receive 12b-1 fees, and to retain those fees. For example, the Illinois Common Trust Fund Act states in pertinent part: "A bank or trust company or its affiliate is not required to reduce or waive its compensation for services provided in connection with the administration, investment, and management of the common trust fund or a participant in the common trust fund because the bank or trust company invests, reinvests, or retains common trust fund assets in a mutual fund, if the total compensation paid by a participant to the bank or trust company and its affiliates, directly or indirectly, including any common trust fund fees, mutual fund fees, advisory fees, and management fees, is reasonable. However, a bank or trust company may receive fees equal to the amount of those fees that would be paid to any other party under Securities and Exchange Commission Rule 12b-1." [Emphasis added.]

One wonders, however, given the compelling academic evidence that 12b-1 fees result in lower returns for investors, how bank trust departments can justify any investment in 12b-1 fees, applying the standard that the best interests of trust beneficiaries must be kept in mind.

While the enactment of state statutes as to bank trust departments muddies the fiduciary waters, no such statute exists which would apply to a dual registrant.

Under the U.S. Department of Labor's proposed Best Interests Contract exemption ("BIC exemption") (as proposed April 2015), many conditions exist for the fiduciary adviser's receipt of 12b-1 fees or other third-party compensation. Included are the requirements that the financial institution makes a “specific written finding” that the 12b-1 fees do not prevent the adviser from providing advice that is in the “best interest” of the retirement investor. Additionally, the receipt of 12b-1 fees implicates the "reasonableness" requirement for the fiduciary's fees.

In Conclusion.

The four major wirehouses have all, to a large degree, moved investors in investment advisory accounts out of both Class A and Class C share classes, and into lower-cost institutional shares. This was a wise move on their part. With the DOL's Conflict of Interest Rule likely to be finalized during 2016, other dual registrant firms should pursue the same course of action. Alternatively, those who will become fiduciaries should explore rebating 12b-1 fees back to clients in some fashion.

As discussed above, a host of inherent problems exists with 12b-1 fees: lack of client understanding (even with disclosure) in the face of a requirement of fiduciaries to ensure client understanding; the negative impact of 12b-1 fees on investor returns; the anti-competitive nature of 12b-1 fees; the possible receipt of unreasonable compensation should the advisory relationship be terminated but 12b-1 fees continue; the effect of the 12b-1 fee as possibly deterring the move to another fiduciary advisor and hence its possible impact as a prohibited "termination fee;" possible legal challenges to 12b-1 fees as "advisory fees in drag;" and continued pressure on the SEC by consumer and other public interest groups to re-visit 12b-1 fees and possibly do away with them altogether. Given all of these inherent problems, I would suggest to any and every securities firm and dual registrant or broker that they not seek to build their business, or any significant portion of their revenues, upon the continuation of 12b-1 fees in the future. We are a mere regulatory change away from their disappearance.

Additionally, even without a regulatory change, it would appear that a private client, whether applying state common law fiduciary standards, or the BIC exemption proposed by the DOL to apply to most defined contribution and IRA accounts, would possess many arguments that any "double dipping" for 12b-1 fees would be a breach of the adviser's fiduciary obligations. Just the mere fact, alone, that 12b-1 fees negatively impact investors' returns, leads to the inescapable conclusion that incurring such fees, absent a credit or rebate given to the client for same, does not serve the client's best interests.

However, if broker-dealers began to rebate most 12b-1 fees to clients, then the mutual fund's board of directors might, in the SEC's view, reasonably conclude that the continuation of the 12b-1 fee plan by the mutual fund was no longer reasonably likely to benefit the fund and its shareholders. See, e.g. Edward Mahaffy, SEC No-Section Letter, 2003 SEC No-Act. LEXIS 358 (pub. avail. Mar. 6, 2003) at p.4 (citing Southeastern Growth Fund, SEC No-Action Letter (pub. avail. May 22, 1986).

In the end, 12b-1 fees suffer from so many potential deficiencies that the ongoing use of funds with 12b-1 fees no longer makes sense, when funds are screened by a fiduciary advisor. This is especially true given the existence of low-cost, no-load, no 12b-1 fee "institutional class" funds that are increasingly made available to registered investment advisers and dual registrants.

NEXT POST: Part 7 of "Who Moved My Cheese": The Future of Financial Advice.

Ron A. Rhoades, JD, CFP® is the Program Director for the Financial Planning Program and an Asst. Professor of Finance at Western Kentucky University, at its beautiful main campus in Bowling Green, KY. He is a CFP certificant, a regional board member of NAPFA, a consultant to the Garrett Planning Network, and a member of the Steering Group for The Committee for the Fiduciary Standard.

This blog represents Ron's personal views and is not necessarily indicative of the views of any institution, organization or firm with whom he may be associated.

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