Fishy fund fees need new SEC sniff test

Federal regulators are on the verge of opening a 20-year-old can of worms.

That’s what some mutual fund watchers say will happen if the Securities and Exchange Commission follows through with a recommendation to review Rule 12b-1 fees.

Controversy over the rule has grown because more funds than ever – as many as half, according to some estimates – impose the fees.

Critics contend that the fees’ widespread use is a departure from the original intent of the rule.

“It was originally done … to give funds with no loads, which had no money to spend on advertising or marketing, the right to spend it,” says John Bogle, founder and chairman emeritus of the Vanguard Group in Malvern, Pa.

“It was only a short matter of time thereafter that the funds that had sales charges wanted to make them look like no-load funds,” he says.

The impetus to review the rule comes from a newly released report on mutual fund fees by the SEC.

Such a review, however, would surely draw battle lines between the two camps, and it’s unclear which side would have the advantage.

Some mutual fund observers think it’s unfair to make shareholders pay a recurring fee for various distribution costs such as marketing expenses and sales commissions, especially since, they say, some funds have taken advantage of the rule’s vague and outdated guidelines to charge investors.

Supporters of the rule admit that its guidelines do need updating, but to eliminate it would be a mistake, they say.

For its part, the commission says it isn’t taking sides, but some believe it will stop short of acting.

“I’m skeptical they’ll ever do anything,” says Mercer Bullard, a former SEC official who is founder and chief executive officer of shareholder advocate Fund Democracy in Chevy Chase, Md.

“There’s no guarantee that this is going to happen. I was surprised they even stuck it in [the fee report].”

But who’s to say 12b-1 fees hurt the investor?

Long-term investors are hurt by an ongoing fee, but not the average investor, who may stay in a fund for only a couple of years, says Lou Stanasolovich, president of Legend Financial Advisors Inc. in Pittsburgh.

“I could justify paying an ongoing fee as opposed to an upfront fee in that situation,” Mr. Stanasolovich says.

Needless to say, Mr. Bogle finds 12b-1 fees to be unpleasant. While he says he doesn’t favor eliminating them for fear of depriving investors of a choice in fund options, he also doesn’t see the need for them.

“It’s just replacing a front-end cost with an ongoing cost,” Mr. Bogle says.

“I don’t think there is any evidence whatsoever … that these expenditures make more money come into the fund. Can you really spend yourself out of bad performance and bring in money? I think to suggest it defies imagination,” he says.

Clearing the air

Indeed, 12b-1 fees are supposed to be temporary and are not supposed to be used unless their justification is to bring more assets into the fund.

But the nine guidelines that accompany 12b-1 are vague, and their meanings can be stretched because of the way they have evolved.

Because of industry opposition when the rule was proposed in 1980, the SEC never made the guidelines mandatory, mutual fund observers say. Today, they are widely interpreted to be advisory.

Under the guidelines, fund directors are supposed to consider the problems and circumstances that make a 12b-1 plan necessary, the causes leading up to the fees and the merits of alternative plans.

Pamela Wilson, a lawyer at Hale & Dorr in Boston, says the vague rules allow mutual funds to pay for broker expenses and administrative activities, as well as advertising.

The SEC, however, has never really said stretching the rule to pay for such expenses is wrong.

Ms. Wilson says she suspects there are mixed feelings among those in the mutual fund industry about whether the rule should be revisited.

While they don’t want the SEC to question the manner in which they use 12b-1 fees, they would like some more direction to ensure that everyone plays by the same rules, she says.

“Sometimes making the rules more clear, even if it’s an uncomfortable process, turns out to be better for everybody,” Ms. Wilson says. “Clarity of the rules can be a good thing.”