Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, June 19, 2007

SIFMA Study in Support of Rule 12b-1 Fees

The Securities Industry and Financial Markets Association (SIFMA) has prepared a white paper on the history and purpose of Rule 12b-1 under the Investment Company Act of 1940.  Rule 12b-1 permits mutual funds to use fund assets to finance the distribution of their shares.  The white paper has been provided to the Securities Exchange Commission (SEC) as background material for panelists participating in a roundtable event on Rule 12b-1 being held today in Washington D.C. by the SEC.

“While we appreciate the SEC’s efforts to undertake a review of Rule 12b-1, we ultimately believe that the rule is important to both firms and investors,” points out Ira Hammerman, senior managing director and general counsel for SIFMA.  “For broker-dealers and other intermediaries, 12b-1 plans support important marketing, advertising, and administrative and shareholder servicing functions.”

The report is available at the SIFMA website.

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A possible fatal blow occurred to 12b-1 fees at the June 19, 2007 SEC Roundtable Discussion on 12b-1 Fees. With all five commissioners looking on, Consumer Federation of America’s long-time consumer advocate, Barbara Roper, raised the issue as to whether payment of 12b-1 fees to broker-dealer firms and their registered representatives violated the Investment Advisers Act of 1940 (IAA). After many speakers during the day discussed the ongoing advice provided by broker-dealers to customers, funded by 12b-1 fees, Ms. Roper noted that such advice appeared to not be "incidental advice" permitted under the broker-dealer exclusion from the definition of "investment adviser" found in the IAA. Moreover, payment of 12b-1 fees looked very much like payments to broker-dealers under fee-based accounts, and hence "special compensation," which payment arrangement was recently struck down by the District of Columbia U.S. Court of Appeals (as to fee-based accounts).

Written comments submitted to the Commission by Ron A. Rhoades on June 18, 2007, and available on the SEC's website, explain why payment of 12b-1 fees to broker-dealer firms often violate the IAA. Brokers and dealers are not subject to the "fiduciary status," comprehensive disclosure, and other requirements of the Investment Advisers Act ("IAA") where their investment advice is (1) "solely incidental to the conduct of [their] business as a broker or dealer," and (2) the broker or dealer "receives no special compensation therefor." 15 U.S.C. § 80b-2(a)(11)(C) (2000). However, as was made clear from many comments submitted from securities industry representatives and individual registered representatives, 12b-1 fees are often utilized to compensate broker-dealer firms for a wide range of ongoing advisory services which are not directly connected to a securities transaction. Even the NASD recently acknowledged that 12b-1 fees were not "transactional sales charges," but rather ongoing "assets under management" relationship compensation, in a comment letter dated April 19, 2007 to the SEC regarding Regulation R. While some 12b-1 fees may be utilized for legitimate purposes, to compensate broker-dealers for the actual costs of service (acting as custodians, providing prospectuses and annual reports to clients, etc.), it was clear from the many comments submitted that many broker-dealers utilized a substantial portion of both the (NASD-maximums) 0.25% annual "service fee" and the 0.75% annual "asset-based sales charge" to compensate registered representatives for ongoing "investment advisory" services – which are only permitted under the IAA.

Will powerful advocates such as the Financial Planning Association, Consumer Federation of America, Fund Democracy, the Public Investors Arbitration Bar Association, and state securities regulators (through the North American Securities Administrators Association), again band together to challenge certain 12b-1 fee payments as impermissible under the IAA? These organizations successfully challenged the SEC’s broker-dealer fee-based accounts rule (a.k.a. the "Merrill Lynch Rule") in court, and the SEC recently decided not to appeal the U.S. Court of Appeals decision which overturned that rule. Broker-dealer firms are struggling to adjust to the elimination of fee-based brokerage accounts (which now possesses an October 1, 2007 deadline under an extension granted by the U.S. Court of Appeals. Hence, given all of the current disruption in the broker-dealer industry, these associations are likely to wait for SEC action on 12b-1 issues. However, any rulemaking which either preserves, curtails or eliminates 12b-1 fees is likely to be very closely scrutinized.

Should the SEC repeal 12b-1 fees, or limit them substantially, I would hope that the SEC permits a very long transition period for broker-dealer firms to adjust. Noting that thousands and thousands of registered representatives depend upon 12b-1 fee income for a substantial portion of their personal income, a hoped-for transition period of at least a year, if not longer, would be desirable.

Posted by: Ron A. Rhoades, JD, CFP(r) | Jul 6, 2007 12:42:24 PM

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