Will the SEC Ban 12b-1 Fees?

As he explains, Class C shares charge 12b-1 fees, up to 1% a year. Class A shares charge a commission of up to 5.75%, with breakpoint discounts for larger investments. These shares may also charge 12b-1 fees, up to 0.25% annually.

“Nothing is wrong from a regulatory standpoint with the sale of such,” Rhoades said. However, “the difficulty comes when a broker is a dual registrant, as many are.”

Then, two questions arise:

First, Rhoades said, “are you choosing the arrangement that is in the ‘best interests’ of the customer or client?”

In other words, he said: Would the client be better off buying mutual funds in a brokerage account, or paying 12b-1 fees in an investment advisory account?

Second, “if the dual registrant is using an investment advisory account (as an RIA) for a client, and receiving a fee directly paid by the client, can a 12b-1 fee be justified?” he continued.

“Typically, no, as 12b-1 fees don’t add any value to a client,” Rhoades said. “The SEC has gone after dual registrants for having clients invest in funds with 12b-1 fees, on the basis of inadequate disclosure. Then, more recently, the SEC actions have applied the duty of best execution (which brokers possess), which is a quasi-fiduciary (limited fiduciary) duty.”

The only way dual registrants “who have clients in investment advisory accounts can recommend funds with 12b-1 fees, without getting in trouble (or at least ‘gray areas’) is when the 12b-1 fees are rebated back to the client (such as by lowering the investment advisory fee),” Rhoades explained. “This rebating makes the billing process prone to errors, however — which in turn could give rise to regulatory action.”

12b-1 Fee Repeal Ahead?

While the SEC examined 12b-1 fees just over a decade ago, “I would anticipate that the SEC move, at some point in the next few years, to again revisit 12b-1 fees. A progressive SEC would likely repeal 12b-1 fees,” Rhoades maintained.

Brokers, Rhoades continued, should “not be building a practice around 12b-1 fees, given the likelihood of their termination by the SEC at some point in the future.”

Rhoades stated that it’s “far better for brokers to move toward fee-based accounts, billing clients directly via one of several different types of methods (AUM, fixed annual fees paid quarterly or monthly, hourly, project-based flat fees, etc.). As brokers continue to migrate away from product-derived compensation, and toward fee-based accounts, the marketplace will become more competitive.”

James Lundy, partner at Faegre Drinker’s Chicago office, and a former SEC attorney, said he’d be very surprised to see the SEC tackle a 12b-1 fee rulemaking this year.

“The 12b-1 fee area may be one of the SEC’s greatest ‘regulation by enforcement’ successes, from the SEC’s perspective,” Lundy said. “So it is not at all a surprise that the majority of long-term mutual fund gross sales now go to no-load mutual funds without 12b-1 fees. This is due to the industry taking notice of the 12b-1 fee self-reporting initiative from 2018 and proactively revising practices accordingly.”

Alex Russell, managing director, White Collar, Regulatory & Internal Investigations at Bates Group, agreed that as a result of the share class initiative “and various carry over matters, firms are focused on reducing or eliminating the use of 12b-1 fee paying share classes despite the clear allowance of those fees by law.”

As a result, Russell said, “’regulation by enforcement’ is a reasonable description of the recent activity.”

Cipperman disagrees.

“It’s a false accusation in this area” to say the SEC is engaging in regulation by enforcement, he said. “The SEC has been very clear about how to approve and pay 12b-1 fees. There have been rules, FAQs, speeches, reports, etc. The law is pretty clear. I don’t have a particular issue with the SEC’s enforcement program in this area. We don’t need more rules.”

Ken Joseph, head of the Disputes practice at Kroll, noted that “regulation by enforcement in lieu of rulemaking, guidance, or precedent has been a familiar refrain by some that have landed in the regulatory crosshairs.”

Even before the formal share class initiative, “the Commission has been very clear about the fiduciary duty, conflict, suitability, and compensation disclosure obligations of registered advisers,” Joseph said. “The enforcement actions, buttressed by the risk alerts and announced priorities of the SEC, plus voluntary reforms that the industry have made have already had a significant impact on improving the practices that the Commission has found to be in violation.”