12(b)-1 reform needs some permanent grandfathering

Among the many provisions in the SEC’s plan to overhaul 12(b)-1 fees for mutual funds, perhaps the most contentious is the five-year grandfathering of existing share classes that charge in excess of 25 basis points. Any financial adviser affected by this temporary grandfathering of existing C shares should take a few minutes to go on the Securities and Exchange Commission’s website and submit a comment demanding that the SEC permanently grandfather the existing share class in its current structure.

This would also include funds that have other modified trail programs in excess of 25 basis points and various trailing programs in 401(k)s that charge more than 25 basis points in lieu of other, ultimately more expensive, options.

The SEC is trying to update terms and conditions of our client/broker relationships by modernizing terminology on the assumption that it will somehow protect investors or save them money.

But permanent grandfathering is needed to preserve business

models and client relationships that were regulated and legally disclosed by prospectus. It is in no way an assault on, or a challenge against, the fee-based planning community, as these small accounts are usually declined or abandoned due to an income stream inadequate to maintain and support them.

As an independent financial consultant, I have more than 800 accounts held directly at mutual funds without a clearinghouse account. These are mostly small accounts, with an average balance of $40,000.

I can serve these clients because of the ability to offer various share classes that compensate me well enough to make it worth the work.

The grandfathering limit will create the exact opposite effect. After five years, the average small investor will face fewer servicing options and increased costs.

Reducing C shares after the five-year grandfathering will result in the need to charge additional wrap fees of up to 2% to clients with fee-based accounts. The majority of these small-account holders will find that prohibitive.

As a result, investors who value their adviser relationships, but have less than $100,000, will be lost.

The SEC should consider permanently grandfathering such share classes for the following reasons:

• It is impossible to serve most small investors ($10,000 in investible assets) for a trail compensation of 25 basis points. After overrides and retentions, the gross pass-through to the adviser would be $6 to $20 a year before the adviser’s expenses. In most cases, these accounts will be abandoned and left to the fund companies, which will have to hire more (often not properly licensed) people to deal with all the nuances more appropriately left in the hands of registered representatives of record.

• Advisers already spend a lot of time complying with industry rules and standards. Along with the possibility that brokers will be held to a higher fiduciary duty, this will increase the time required to carry an investor’s account, regardless of its size.

• Investors often have to pay income taxes on wrap fees, but don’t pay taxes on the current 12(b)-1 C share class.

• There is enough competition from no-load funds for the grandfathering adoption to be made permanent. In fact, the SEC proposal states: “According to Investment Company Institute figures, in 2009, $323 billion flowed into no-load share classes of long-term mutual funds, while in comparison, load-share classes only received $39 billion in net new cash flow.”

• In order to maintain revenue, advisers and their firms will immediately begin looking for ways to replace 12(b)-1 fees, resulting in additional costs for the investor.

The C share, which typically pays a 1% trailer on the value of the investor’s account, allows the adviser the same profit opportunity available in asset-based managed accounts — without a middleman or third party that adds to expenses.

These accounts allow the smaller investor the ability to participate in an investment product that, over the years, compensates an adviser more as the account goes up in value and less as it comes down in value. This builds a long-term goal of investing and re-balancing by encouraging relationships that stay informed, educated and serviced.

Keeping existing share classes in their present form also inherently reduces the need for “switching” after expiration of a C class term.

After serving on cases as an NASD and New York Stock Exchange arbitrator since 1994, it was amazing how many cases involved some form of churning or switching.

The SEC proposal, however, creates the exact environment that would nurture those kinds of circumstances over the next five years.

There is a reasonable compromise to avoid these problems and preserve our businesses. New accounts opened after the effective date should be subject to the new trailing-compensation limits proposed by the SEC, while existing structures would be grandfathered permanently.

Oren Peretz, a registered financial consultant, is a branch manager consultant at First Allied Securities Inc.