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SEC Official Offers Preview of Rule 12b-1 Overhaul

As the Securities and Exchange Commission prepares to issue its long-awaited proposal to revamp Rule 12b-1, Jennifer McHugh, senior adviser to the director of the agency’s division of investment management, has provided a preview of the forthcoming reform package.

McHugh, speaking at the Mutual Fund Directors Forum on April 17 in Washington, D.C., said that the proposal envisions a fiduciary role for mutual fund directors, aims to increase transparency, and will address problems with mutual fund C shares without moving to eliminating the share class.

In June, the SEC held a roundtable on the history, uses and potential changes to Rule 12b-1, which provides nearly $12 billion a year in fee income to the broker-dealers, banks, fund platforms and others that market and distribute mutual funds. In response, the commission received over 1,400 comments, 1,000 of them form letters from broker-dealers arguing against altering the rule.

One concern is that although 12b-1 fees pay for some services from which investors get clear value, certain retail mutual fund share classes--notably C shares, which impose a level, ongoing sales fee--levy charges that cumulatively could exceed the maximum fees and sales loads set by regulators.

Calling the rule in its current form “broken,” Andrew Donohue, director of the SEC’s division of investment management, in December said that revisions to the rule are his top priority this year. On Feb. 8, chairman Christopher Cox called the upcoming proposal a “complete overhaul.”

McHugh, who works closely with Donohue, told the fund directors that while 12b-1 fees “affect real people,” investors do not fully understand how they work. “Directors should look at 12b-1 fees as a substitute for a sales load,” she said, and make sure that the things they pay for are clearly spelled out--“Too often, it is ‘out of sight, out of mind’ for fund investors.”

While 12b-1 fees are an integral part of the distribution system, fund boards have little say on the basis point rate, said McHugh. The SEC’s proposal will recommend greater fiduciary responsibilities for directors.

The rule changes will also aim to reduce confusion. The 12b-1 fee is made up of a 25 basis point service fee and a 75 basis point, asset-based sales fee. “SEC rules do not disclose it as such,” she said. “From an investor’s perspective, they could be paying too much for C shares, far in excess of A shares.” And when investors purchase a mutual fund, they may not know how long the holding period will be. “It can be difficult to choose the best investment class. There is an alphabet soup of investor confusion. We will aim to simplify this by looking at the two pieces of 12b-1 separately.”

According to McHugh, the commission wants to permit competition in the load amounts set by funds. “We are not seeking to eliminate any particular share class, but to eliminate conflicts broker-dealers may face,” she said. The SEC hopes to issue the proposal this summer, she added.

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