The SEC?s 12b-1 Proposal is Based on Misguided History, Flawed Economics

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In recent years, the SEC has been apologetic for its lax oversight in the wake of numerous high-profile regulatory shortcomings. Ironically, though, since 2003 the agency has been dogged in its pursuit of 12b-1 reform with SEC officials repeatedly referencing it as a “top priority.”

While the SEC’s stated aims of increasing transparency, reducing investor fees, and increasing competition among mutual funds are laudable, my review of its 278-page proposal found major flaws, including a misinformed historical pretext and naïve economic analysis.

I will review the SEC’s proposed changes and then explain why its plan is both misguided and would harm consumers.

On July 21, 2010, the agency released its proposal to entirely rescind Rule 12b-1 and replace it with a new “Rule 12b-2” to govern the use of fund revenue to pay for distribution expenses. The new rule effectively requires the conversion of class C shares to A shares at the time when the total cumulative 12b-1 fees paid equal the upfront sales charge the investor would have paid, including breakpoints, if he had originally purchased A shares. Rule 12b-2 also introduces an entirely new class of funds with no 12b-1 fees that would allow dealers to charge an ongoing “sales charge” as a separate externalized fee in a manner not dissimilar to the now vanquished fee-based brokerage accounts. The new set of rules also provides for clearer disclosure of fees and expenses in retail share classes – an improvement that is generally supported by both sides of the 12b-1 debate.

The basis for the SEC’s reform proposal is outlined in a video preamble by SEC Chairman Schapiro and in the introduction of the proposal. Specifically, the SEC posits that Rule 12b-1 was adopted in 1980 as short term measure to help the mutual fund industry stem net outflows. At that time, the proposal contends, the SEC believed that using a portion of revenue to pay for marketing and advertising would help fund companies attract assets and that investors would eventually benefit from economies of scale. The proposal also suggests that the SEC never envisioned the use of 12b-1 fees dealer compensation and that such applications evolved under the SEC’s radar. This historical perspective is surprisingly misinformed. The entire administrative history of Rule 12b-1 was delivered to the SEC in a 2004 public comment letter from the American Bar Association’s Section of Business Law and was echoed in the first panel discussion of the SEC 12b-1 Roundtable on June 19, 2007. The primary source documents referenced in the ABA letter reveal that state of the mutual fund industry had nothing to do with the adoption of Rule 12b-1 and that the SEC in 1980 had not been persuaded by the economies of scale arguments put forth by fund companies in the 1970’s. Instead, the record shows that the SEC adopted Rule 12b-1 to promote competition and innovation in the mutual fund industry and that its true aim was the reduction of the prevailing 8.5% up-front sales loads. Contrary to the 2010 revisionist retrospective, insofar as Rule 12b-1 gave rise to the no-load fund industry, led to competition that spelled the end of 8.5% sales loads, and dramatically increased fund choices, 12b-1 was remarkably forward-thinking and has unquestionably benefited individual investors.