Trailer commissions under siege (Part 1)

By Mark Noble | August 9, 2010 | Last updated on August 9, 2010
4 min read

New regulatory proposals by the SEC which drastically alter the way U.S.-based mutual fund companies disclose 12(b)-1 fees likely means it will become increasingly difficult for Canadian advisors to rely on non-transparent trailer commissions as their primary source of compensation.

In the U.S., 12(b)-1 fees were a relatively innocuous regulatory loophole introduced in the 1970s, which allowed the then struggling mutual fund industry to pass on sales and marketing expenses to the end investor.

But, in practice, 12(b)-1 fees ended up being used as a sales commission given to financial intermediaries that sold the funds, essentially the equivalent of the trailer-commission offered on advisor-class mutual funds in Canada.

What started as a trickle of few million dollars in the 1970s became an enormous source of revenue for the advisors who sold mutual funds. The SEC estimates that 12(b)-1 fees totaled more than $9 billion in 2010, and cost investors more than $13 billion in pre-crash 2007.

Bill Singer, member of the U.S.-based law firm of Gusrae, Kaplan, Bruno & Nusbaum PLLC, says it’s become difficult for U.S. brokers to defend the value of 12(b)-1 fees.

“While there was always much talk about earmarking the fees for ‘educating’ the public, in fact, the bulk of the bucks was essentially a pay-off to individual brokers for pushing product,” Singer says. “Under present regulations, funds can charge up to 1% a year in 12(b)-1 fees, but only 0.25% is permitted for marketing and service expenses. The remaining 0.75% is primarily used to pay ongoing sales commissions to brokers. If those numbers were reversed, perhaps those arguing that 12(b)-1 are a boon for investors would be on firmer ground.”

Unlike recent rules in Australia and the U.K. that will ban certain financial professionals from taking commissions tied to recommending certain investment products, the SEC is going to allow 12(b)-1 fees to continue, but the commission suggests capping them at 0.25%. Any “ongoing sales charges” will need to be clearly disclosed when the fund is sold to an investor.

would also forbid charging perpetual 12(b)-1 fees. If one class of the fund charges a 4% front-end sales charge, another class could not charge more than 4% in total to investors over time. The fund would be required to keep track of how long investors have been paying ongoing sales charges.

According to the SEC fact sheet, “The proposal would require the fund to identify and more clearly disclose distribution fees. In particular, the fund would have to disclose any ‘ongoing sales charges’ and any ‘marketing and service fees’ in the fund’s prospectus, shareholder reports and investor transaction confirmations. Transaction confirmations also would have to describe the total sales charge rate that an investor will have to pay.”

If investment fund fees become uniformly transparent, it creates a new avenue for competition. It’s not hard to imagine that advisors would compete on price, a particularly devastating development to the already struggling small-to-mid size U.S. broker dealer community, Singer points out.

“Certainly, the 4,000 plus members of the Financial Industry Regulatory Authority (FINRA) community — the overwhelming majority of which are independent, smaller players — has been slammed by the recent Great Recession and the loss of lucrative 12(b)-1 fees and full-priced mutual fund product would be an unwelcome if not potentially disastrous development,” Singer says. “Further, given the historic bias that propped up and furthered the business vision of the once favored financial superstores, there is a real concern that larger, national brokerage firms would use their superior pricing power and size to engage in predatory pricing practices designed to first drive smaller competitors out of business through unsustainable lowered fees, then try to scoop up the customers of those failed firms, and then, as history demonstrates, those lowered fees would like rise up to previously unheard of, astronomic levels since competitive forces would be removed.”

Canada keeping its trailers First Australia, then the U.K., and now the U.S.; Canada looks set to stand alone for now in allowing trailer commissions to be embedded in the management expense ratio of investment products and not separately disclosed to clients.

Investment advisors nevertheless need to assess what advantage there is to not disclosing what they earn for offering advice, especially since this practice is being all but condemned by the rest of the world’s major financial regulators. It would be fair to assume that investor advocates and members of the Canadian financial press will continue to criticize the practice.

In the U.S., Bill Singer, member of the U.S.-based law firm of Gusrae, Kaplan, Bruno & Nusbaum PLLC, anticipates the erosion of 12(b)-1 fees will further accelerate the growth of fee-based advising, such as what is offered in the rapidly growing Registered Independent Adviser (RIA) channel.

“My sense is that we will see an increase in investors using RIAs and paying flat percentage fees rather than remaining at Broker Dealers that have not produced results, but charge what are viewed as inflated commissions,” Singer says. “As investors demand more accountability for the bad times, they will demand lowered commissions or fees more related to profits rather than mere transactions.”

In fact, that transition already seems to be underway in Canada, where a growing number of advisors are moving to their client assets to fee-based platforms. This is already a standard practice for many established private client firms.

Read: Trailer commissions under siege (Part 2).

Mark Noble is a former financial services journalist who now works in communications for Horizons Exchange Traded Funds Inc, but from time to time still writes independent articles.

The article was written by Mr. Noble, independent of his role with Horizons Exchange Traded Funds Inc. Any views expressed are those of the author or those interviewed in the article. These views do not reflect or represent the views of Horizons Exchange Traded Funds Inc. or any of its related companies.


Mark Noble