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Readers Select Top Fiduciary Stories of 2009: #7 The SEC’s Statement on 12b-1 fees

January 25
14:38 2010

Mary Shapiro, Chairman of the U.S. Securities and Exchange Commission, surprised the investing world when she declared, “We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate.”

1152028_52499693_old_cash_register_royalty_free_stock_xchng_300Her remarks, made during the Consumer Federation of America 21st Annual Financial Services Conference in Washington, D.C. on December 3, 2009 (see here for transcript) went on to state, “When it comes to these fees, there is a need for more fundamental change than mere disclosure reforms and a name change.” The Chairman then promised to ask her “staff for a recommendation on 12b-1 fees for Commission consideration in 2010.” Needless to say, this declaration set off an immediate firestorm in the industry, pitting (mostly) fee-based advisers versus their commission-based counterparts.

Will 2010 finally be the year this perennial issue meets its resolution? And why has it generated so much controversy? FiduciaryNews’ exploration of this hot potato reveals a surprising misconception.

As many vividly recall, 12b-1 fees came about when the mutual fund industry convinced Congress to allow it to establish a special fee for direct marketing purposes. Over time, 12b-1 fees evolved – for all practical purposes – into a payment stream to unaffiliated brokers who sold the funds. Many, with some justification, maintain this still falls under the “marketing” umbrella of the original intent. Others, also with some justification, assert 12b-1 fees amount to nothing more than a commission.

As a result, much of the focus on the apparent 12b-1 controversy centers on “transparency.” The concept of transparency surfaced as the prevalent theme in the various LinkedIn groups in which FiduciaryNews posed the question. We can best sum this up by the following comment by an independent 401k consultant, “In the end, it’s not how the costs are included or added up, but the disclosure and transparency of those costs. That’s the main issue! The message is getting clouded by stating that the original purpose is to blame.”  In the words of an insurance VP commenting on the potential elimination of 12b-1 fees: “Great! What would that accomplish?”

It seems the debate may have misinterpreted the SEC’s remarks. Mary Shapiro specifically cited the issue of 12b-1 fees went beyond mere disclosure. She bluntly stated “the issue of 12b-1 fees” was “directly related to” the issue of “security professionals’ compensation and conflicts.” She actually used the “F” word – “fiduciary.”

Aye, there’s the rub! From the SEC’s standpoint, the issue of 12b-1 fees transcends transparency – a topic it seems most financial professionals prefer to focus on. Instead, in the mind of the SEC, the matter hits precisely on the theme of fiduciary duties and responsibilities.

We now enter the arena of most confusion. But first, let’s set the table. Who is a fiduciary? The Department of Labor’s (DOL) Advisory Opinion AO 2005-11A (Hastings letter) states “according to section 3(21)(A) of ERISA, a person is a fiduciary with respect to a plan to the extent (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, (ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or (iii) he has any discretionary authority or discretionary responsibility in the administration of such plan.” The letter goes on to say a broker who only places trades is therefore not a fiduciary and can receive compensation for those trades. Presumably, this compensation would include 12b-1 fees.

This is not a minor point. One former banker who commented on the LinkedIn group claimed, “Collecting a 12b-1 fee… can confer fiduciary status (despite what many a broker believes).” Clearly, the Hastings letter suggests otherwise.

But, what if the vendor is providing investment advice and thus a fiduciary? Can this fiduciary claim 12b-1 fees? FiduciaryNews asked the DOL directly. The DOL suggested FiduciaryNews readers might want to review (AO) 97-15A regarding Frost National Bank.  In a nutshell, a fiduciary following the requirements of the letter may collect 12b-1 fees, but only as an offset of existing fees and if such fee offset is disclosed. This DOL Advisory Opinion went a step further than earlier Opinions (AO 93-12A re PNC Bank and AO 93-13A re Frank Russell Co.) which could not conclude there was an exemption “for plan purchases and sales of mutual fund shares if a 12b-1 fee is paid to the fiduciary.”

Clearly, Mary Shapiro’s statement seems to call into question the DOL’s 12b-1 exemption under the Frost National Bank letter. Ary Rosenbaum, ERISA attorney at Meyer Suozzi English & Klein, thinks, “The Frost letter will eventually be overturned. It was drafted in a time (1997) where plan sponsors weren’t concerned with plan expenses and litigation over plan fees didn’t materialize. 12b-1 fees are just another ingredient to a soup of unexplained 401(k) plan fees. The current model doesn’t work. It has outlived its purposes and it’s just another abuse of the 401(k) industry.”

Does this mean the SEC is declaring war on the DOL? Clearly, the regulators must reconcile any potential discrepancy. But, which agency will be the first to blink? The SEC has long talked about reforming 12b-1, but hasn’t. The DOL, on the other hand, does have on its 2010 agenda an item to look at the definition of fiduciary. Mr. Rosenbaum reminds us government agencies have had differing opinions in the past (e.g., the DOL and IRS once had dissimilar interpretations over plan fees) He concludes, “Since the DOL has been very vigilant on plan fees of late, I believe the DOL and SEC will maintain a consistent front when it comes to changing the current model.”

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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