Mutual Fund Distribution Fee Reform, Part IV

Before describing in a little more detail what the proposed rule would change, it's important to note what is left out.  Most critically, of course, are the other fees that go to paying for money management and operations.  Also not touched are the actual categories of expenses that are permissible.

Matthew Fink, former head of industry trade association, the Investment Company Institute, recommended more be done to look at the overall costs. As he explained to the New York Times, “Money is fungible, and in the end, all that anyone cares about is how much they’re paying, not what each little payment is called.”

Barry Barbash, former head of the investment management division at the SEC identified another problem, that the rule doesn't, in the words of Wall Street Journal reporter Sam Mamudi, "address revenue sharing between funds and brokerages, an area of the industry with very little disclosure."  As Barbash explained, "If you put a cap on how much can be paid out to distribute funds, and that cap doesn't satisfy the market, the market will figure out other ways to get paid."

Critics still have an opportunity to weigh in. Comments are due by November 5, 2010. Details can be found in the rule proposal.

The new rules would have the following impact:

Investor Choice on Upfront, Backend or Ongoing Sales Fees

Fund investors can choose whether to pay an up-front or back-end sales load or pay the sales fees over time. However, the amount paid over time must be no more than what the investor would have paid if she selected the up-front or back-end option. To accomplish this, fees can only be charged over a fixed number of years. And, this must be disclosed in writing.  Schapiro provided a useful example:

“That means if I was buying shares of a mutual fund that charged a 4 percent up-front sales charge, then that fund could not deduct more than 4 percent over time.”

If the fund does not have an out-of-pocket sales load, then the amount of ongoing sales fees would be limited to the current NASD cap of 6.25% of fund assets in the aggregate.

Broker-Dealer Competition over Up-front Sales Fees

Also, the rule permits a fund adviser to offer a class of funds for which it no longer sets sales loads or other ongoing sales fees. This rule allows broker-dealers to “sell funds at sales loads that they choose.”  As Schapiro explained,

“Rather than sales loads set by the fund in its prospectus, broker-dealers could compete with others—thereby likely leading to lower charges. I believe that mutual fund investors, like all consumers, want the ability to engage in comparative shopping based on price.”

Improved Disclosure of Ongoing “Hidden” Fees

The rule ends the use of the inside-baseball term “12b-1 fee.”  Understandably, this phrase was thought to confuse investors.  Instead, disclosures will have to use the term “ongoing sales charge” to describe the percentage of fund assets that go to broker-dealers.

Cap on Marketing and Service Fee

Also, funds will have to separately disclose “marketing and service fees.” These are fees deducted by the fund adviser from fund assets. The fund adviser then often pays third parties for services provided to fund investors including record keeping.  Under the new rule, “marketing and service fees” will “effectively be limited to 25 basis points per year.” This means ¼%. This is the same as the current NASD limit on service charges, but this could be used toward any distribution expense.

Any amount above the 25 basis points deducted from fund assets would be treated as an ongoing sales charge, and as noted above could not exceed what the investor would have paid if he or she selected an up-front or back-end sales load.

Disclosure of Up-front and Ongoing Charges on Trade Confirmations

The rule would also require broker-dealers to disclose on trade confirmations “the percentage of the up-front or ongoing sales charge.”  Chair Schapiro stated that:

“In addition, it also would have to disclose the amount of sales and marketing fees expected to be paid and would have to state that management and other fees will be deducted from the fund and thus indirectly paid by the investor.”